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Unformatted text preview: How to Time the Commodity Market Devraj Basu, Roel C.A. Oomen and Alexander Stremme * June 2006 Abstract Over the past few years, commodity prices have experienced the biggest boom in half a century. In this paper we investigate whether it is possible by active asset management to take advantage of the unique risk-return characteristics of commodities, while avoiding their excessive volatility. We show that observing (and learning from) the actions of different groups of market participants enables an active asset manager to successfully time the commodities market. We focus on the information contained in the Commitment of Traders (COT) report, published by the CFTC. This report summarizes the size and direction of the positions taken by different types of traders in different markets. Our findings indicate that there is indeed significant informational content in this report, which can be exploited by an active portfolio manager. Our dynamically managed strategies exhibit superior out-of-sample performance, achieving Sharpe ratios in excess of 1.0 and annualized alphas relative to the S&P 500 of around 15%. * Basu is from the Faculty of Finance, Cass Business School, while Oomen and Stremme are from the Department of Finance, Warwick Business School, Coventry CV4 7AL, United Kingdom. Oomen is also a research affiliate of the Department of Quantitative Economics at the University of Amsterdam, The Netherlands. Contact e-mail: email@example.com 1 1 Introduction Over the past few years, commodity prices have experienced the biggest boom in half a century. Oil prices have almost tripled from around $25 in 2002 to more than $70 by the end of 2005. Over the same period, copper prices have more than quadrupled. Unsurprisingly therefore, investment in commodities has been gathering momentum with particularly the fund management industry becoming increasingly attracted to this asset class. However, the sharp decline in prices in May and June 2006 has lead some analysts to forecast the end of the commodities boom. The purpose of this study is to show that, by actively managing a portfolio that includes commodities, it is possible to take advantage of the unique risk-return characteristics of commodities, while avoiding their excessive volatility and hence reducing the risk of substantial losses. Much of the attraction of commodities appears to be the fact that they seem to produce equity-like returns while having low or even negative correlation with equities, thus poten- tially providing significant diversification benefits. A recent study by Gorton and Rouwen- horst (2006) supports this view, finding considerable evidence that the inclusion of com- modities in a portfolio can improve its risk-return characteristics. The results of this and other similar studies were widely publicized, and received attention well beyond the aca- demic community, which might be partly responsible for the renewed interest of the asset management industry in commodities. At the same time however, there have been calls formanagement industry in commodities....
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