Edhec-Risk
Features
Commodities - November 14, 2011

Long-Short Commodity Investing: Implications for Portfolio Risk and Market Regulation

The rise in commodity prices over the last ten years and their recent volatility has generated considerable interest on the part of investors, regulators and policy-makers.

Attracted by the prospect of robust returns, diversification benefits, and potential for hedging inflation and macroeconomic risks, investors have increased their allocations to commodities over the period, primarily via passive investment into long-only commodity futures indices. Recent market gyrations have contributed to reviving the debate on the role of commodities in strategic and tactical asset allocation and led to an increasing recognition of the relevance of long-short dynamic strategies to capture the commodities premium in the context of highly volatile markets.

The increased participation of financial investors on commodity markets has caused concerns about the latter’s possible increased integration with traditional financial markets, which could have weakened the diversification and hedging benefits from commodity investment.

The high volatility in commodity prices has also led to contentious political pronouncements on the role of financial investment in commodity markets and to calls for further regulation.

The attached publication addresses these issues head on. It examines commodity futures investment over the last ten years to shed new academic evidence on the performance of passive as well as active commodity investment and their conditional volatility and conditional correlations with traditional assets. It also investigates whether the increased participation of index and long-short investors on commodity futures markets has had an impact on the volatility of prices or the traditional benefits of commodities as an asset class. The publication’s in-depth consideration of long-short strategies is particularly notable as the extant academic literature has focused on long-only investments.

The research results confirm the relevance of commodity futures investment and document the benefits of adopting long-short strategies in terms of risk-adjusted performance, diversification and extreme-risk hedging. They find no support for the hypothesis that long-short investors have destabilised commodity markets by increasing volatility or co-movements between the prices of commodity futures investments and those of traditional assets. This holds true whether investors are defined broadly or approached as non-commercial traders or professional money managers. The results on the performance and risk characteristics of long-only and long-short commodity futures investing have important practical consequences for investors that are considering or have implemented commodity investment programmes.

This study was produced as part of a research programme on ”Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" in partnership with CME Group.


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http://www.edhec-risk.com/features/RISKArticle.2011-11-14.1708

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