Why these funds have recently underperformed.
2008 changed many investors' beliefs about commodities. Commodities were commonly thought of as diversification tools for traditional stock and bond portfolios, yet the two widely accepted commodity benchmarks, the S&P GSCI and the DJ UBS Commodity Indexes, fell as much or more than the stock market that year (negative 36% and 47%, respectively). A major reason for these losses, of course, was big declines in commodities such as energy. But the other culprit was one that no one had anticipated: negative roll yield (the negative return incurred by selling an expiring contract and buying a farther-out contract when the futures curve is in contango). Since 2008, a few long-short commodity products have emerged, designed to benefit from both declines in commodity prices and negative roll yield. More recently, however, these strategies haven't worked either (see table). So what's behind the recent blow-up of long-short commodity strategies, and what does it mean for the future?
The Misery of Momentum
Most long-short commodity futures strategies rely on some form of price momentum: When the price of a particular futures contract appears to be trending up, the strategies take long positions, and when the price appears to be declining, the strategies take short positions. Momentum is typically measured over a 6-12 month time frame. Some funds calculate momentum using a simple change in price; other funds use measures such as exponential moving average. Some funds calculate momentum over one single time frame; others use multiple time frames. Either way, momentum funds tend to do best when trends in several different futures contract markets last for several months.
The financial crisis was a prime example of a favorable environment for momentum strategies. Between mid-2007 and mid-2008, momentum strategies profited from long positions as the prices of many commodities (such as gold, corn, and crude oil) steadily climbed. Over the next nine months, the trend reversed and momentum strategies made money on short positions. The S&P Commodity Trends Indicator, which measures momentum in 16 different commodity futures contracts according to a seven-month exponential moving average, gained 21.5% between July 2007 and June 2008, and 10.0% between July 2008 and March 2009, for a total return of 33.6%. The S&P GSCI, a long-only commodity index, lost 43% over the same period.
Since 2008, however, longer-term, sustained price trends in commodities have been hard to come by, as have trends in other asset classes. Commodities have tended to move according to the same short-term "risk-on, risk-off" patterns of stocks and (non-U.S. Treasury) bonds. Sometimes, the switch between risk-on and risk-off can be very dramatic. June 2012 is a good example. After a couple months of negative returns, stocks, high-yield bonds, and many commodities suddenly rallied in early June, as investors reacted to positive news out of Europe. The average long/short commodity mutual fund lost 3.3% that month, and the S&P CTI dropped 9.3%, while the long-only S&P GSCI gained 1.2% (see table).
The Future of Long/Short Commodity Futures
The moral of the story is that there is more than one way to invest in commodities, and no one way is markedly better than another. Diversification is always the solution. Investors looking to minimize their exposure to negative roll yield can diversify some of their long-only commodity exposure with a long-short commodity product in order to benefit from downward price movements. But when momentum doesn't work, there are also long-flat commodity investments as well. United States Commodity Index USCI is one example, and several more are being developed. Stay tuned.