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2/3/2005
Facts and Fantasies about Commodity Futures by Gorton and Rouwenhorst, reviewed by Charles Pennington

The claim of this paper is that a fully collateralized, equal-weighted portfolio of long, nearest-month futures positions in all the commodities in the Commodity Research Bureau (CRB) database has performed as well as stocks during the 7/1959-3/2004 period. Both stocks (the S&P) and commodity futures returned 11.02% compounded annually over the period (It is apparently a coincidence that these numbers are exactly the same). The standard deviation for stocks was 14.9%; the standard deviation for commodity futures was 12.1%.

The authors emphasize that their findings apply only to commodity futures, and not to spot prices. They find that futures outperform spot prices, returning 6.3% adjusted for CPI inflation vs returns of 3.8% for spot prices, also adjusted for CPI inflation. (Note: I actually extracted these numbers from a graph that the authors presented. I can t find these numbers given explicitly in the paper.)

It is not obvious that one should expect high returns from commodity futures, or even that one shouldn't expect high returns from short positions in commodity futures. The authors mention a prediction of Keynes, that companies that produce commodities would have a strong need to sell commodity futures short, in order to hedge. This results in a risk premium for speculators taking long futures positions. One could counter Keynes by arguing that many companies use commodities as raw materials. Such companies would hedge by taking long positions in futures markets, and that would result in a risk premium for speculators taking the short side. The question of whether there is a premium on the long or short side, or neither, is therefore an experimental one.

The authors find several more attractive features of commodity futures:

--The returns of commodity futures and stocks are negatively correlated, with correlation -6% for quarterly returns.

--While quarterly returns in stocks have a -20% correlation with the quarterly change in the CPI, the correlation between commodity futures and the CPI is +14%.

-- During the 5% of the months of worst performance of equity markets, when stocks fell by an average of 9.18%, commodity futures experienced a positive return of 1.43%.

--Both stocks and bonds do poorly in the early stages of recession (as defined by NBER), averaging -15.5% and -2.9% respectively, but commodity futures do well, returning +3.5%.

The authors find similar conclusions when they compare the returns of Japanese stocks and commodity futures denominated in yen.

Criticisms:
1) The authors have a survivorship bias problem of unknown magnitude. They use only the CRB database. They state that some commodities that were traded during at some point from 1959-present are no longer traded now, and are no longer in the CRB database.

2) During the period of the study, the authors report that CPI inflation adjusted spot prices returned 3.8%, while CPI adjusted futures returns were 6.3%. I do not see any reason why spot prices, over the long term, should appreciate faster than the CPI. Perhaps the high increases in spot prices during this 44 year interval are not indicative of what will happen going forward. If we subtract this 3.8%, then the CPI un-adjusted returns for commodity futures would be about 7.2%, less than the return of bonds, which was 7.7%.