The Use of Commodity Futures Momentum in Momentum Portfolio Diversification

Abstract

Commodity futures have gained popularity as an investment vehicle since the early 2000s. On their own, commodity futures are considered a volatile asset class. However, due to their low correlation with other assets, such as equities, they are often found to enhance the risk-return characteristics of equity portfolios.

This Master’s thesis examines whether the diversification benefits from including commodity futures in the regular long equity portfolios are applicable to momentum strategies implemented on the two asset classes. Furthermore, this thesis examines if the inclusion of commodity futures momentum in an equity momentum portfolio influences the severity momentum crashes experienced during market distress.

By using a 30-year (1990-2019) return series on two momentum strategies implemented on equities and commodity futures, an in-sample optimal portfolio is constructed. Furthermore, a beta hedging procedure is implemented on the two individual momentum strategies and an optimal portfolio out of the two hedged strategies is constructed.

To find whether the individual strategies or portfolios pose abnormal returns, multivariate regressions utilizing Fama-French Three and Six Factor Models are run. Additionally, to see whether the diversified portfolios are less exposed to momentum crashes, an optionality regression is run. Equity momentum returns are found to be influenced by the overall equity market risk and liquidity. To see whether the diversified portfolios are less affected by these factors, a regression applying proxies for risk and market liquidity is run.

The constructed optimal portfolios pose lower annualized volatilities and higher cumulative returns when compared to the individual momentum strategies. Additionally, when comparing to the pure equity momentum strategies, the diversified portfolios pose significantly fewer large drawdowns. However, due to high standard errors, there is no statistical difference between the Sharpe ratios of the diversified portfolios and their pure equity momentum counterparts. Furthermore, much like the individual momentum strategies, the diversified portfolios do not pose significant abnormal returns when corrected for the Fama-French six risk factors. Lastly, the diversified portfolios are not statistically less exposed to momentum crashes.