Rolling down the curve

The benefits of trend-following in harvesting commodity yield carry

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Holding a long-only allocation to a diversified basket of commodity futures has delivered an impressive return of around 46%1 in the twelve months following the COVID-19 pandemic. In contrast, the long-term performance of such strategic long-only allocation over the past 26 years has been rather weak and amounted to +1.4%2 p.a. in excess of any risk-free return. In this note, we focus on analyzing the key return drivers of commodity futures and the challenges to generate attractive risk-adjusted returns with commodity investments. We show that the “roll-yield” (aka carry), an intrinsic and essential characteristic of commodity futures markets, has eroded the return on a diversified portfolio of commodity futures by a surprisingly high 5.5% per annum since 1994, offsetting almost any gains originating from rising spot commodity prices (+6.2% per year over the same period). We further show that this “cost of carry” may be reduced by up to 50% (before implementation costs) trading more back-dated contracts with longer times to expiry instead of the front-end of the curve. However, this yield enhancement is not a “free lunch” and comes at the cost of a significant reduction in the liquidity characteristics of the portfolio, which makes its net benefits questionable. This led us to investigate the return characteristics of a more dynamic and opportunistic systematic investment approach, that also takes advantage of short positions and preserves the attractive liquidity profile offered by the front-end of the futures market: systematic trend-following.

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Quantica Capital
September 8, 2021