Home ListingJanuary 2, 2014

Applying Alternative Beta Strategies to Commodities

<em>Research has found that combining risk-based and factor-based alternative beta strategies in commodities allocation could improve returns and reduce risks.</em>

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(January 2, 2014) — Using alternative beta strategies in commodities allocation could deliver higher returns and lower risk than passive long-only strategies, according to research.

The authors of “Alternative Beta Strategies in Commodities”—Daniel Ung and Xiaoweig Kang of S&P Dow Jones Indices—found both risk-based and factor-based alternative beta indices in commodities have helped reduce risks and volatility.

“Both risk-based strategies have succeeded in lowering risk,” the research said. “It is also apparent from the results that the risk-weight strategy was far superior to the minimum-variance when seen through the prism of risk and return trade-off.”

Ung and Kang said that with the high correlation between commodity prices and volatility, “merely targeting the lowest level of volatility appears counter-intuitive, and a more satisfactory approach would be to target risk reduction by assigning a risk budget across different commodities and sectors.”

The paper concluded that in applying a factor-based approach on commodities to improve returns from potential risk premia associated with systematic factors, investors should look at value, curve, momentum, and liquidity.

Value strategies work to generate excess returns purchasing undervalued commodities with expectations of rising prices. S&P Dow Jones Indices’ research showed that value strategies performed well—achieving a higher Sharpe ratio than their benchmarks—but the authors said there would always be a possibility of periods of underperformance.

Curve strategies aim to alleviate the negative impact of the “contango” period of negative carry by pursuing contracts with longer maturity.

“These strategies aim to capture a risk premium for taking greater price uncertainty associated with futures contracts on the long end of the curve,” the study said.

The momentum strategies target the tenacity of commodity returns—“which are believed to drive from psychological biases exhibited by investors and behavior displayed by industrial market participants,” Ung and Kang found.

The research said momentum strategies could offer downside protection during sharp market corrections and still continue to provide upside participation during bull markets.

And lastly, liquidity strategies look to assess various lengths of the rolling period for higher returns. Though this approach would generate the smallest return—compared to value, curve, and momentum—“it is nonetheless unique to the commodity markets,” the paper found.

The most effective strategy, Ung and Kang said, was to combine all sources of risk premia to diversify risk.

“It should be borne in mind that alternative beta strategies often take substantial active risks, which are largely driven by factor exposures,” the authors said. “However, as these risk factors have a low correlation with each other, it may be sensible to combine them in order to improve return and reduce risk.”