Commodity Futures in Asset Allocation

Commodity futures can supply fair investment return and unique diversification benefits to a portfolio manager. The relative performance between commodity futures and traditional financial assets is varied with business and market conditions. In general, commodity futures are negatively correlated with stocks and bonds. This negative correlation comes from the nature of the commodity market. Commodity futures can supply efficient diversification benefit to stocks and bonds investors when it is needed, i.e. when the stock or bond market displays poor performance or has a significant downside movement, commodity futures market usually shows strong performance and provides a good return.Both commodity futures and traditional financial assets display the structure break behavior and their risk/return characters change under different market and economic conditions. Markov regime-switching model can be applied to address this asset return dynamic and corresponding portfolio selection issue. The estimation results of a simple two-regime model support that for three risky asset classes there is a ¡°normal¡± regime characterized by relatively high return and low risk and a ¡°bad¡± regime characterized by relatively low return and high risk. An investment strategy ignoring the regime switching effect leads to inefficient asset allocation and poorer portfolio performance. When the market is in the ¡°bad¡± regime, commodity futures perform relatively stronger than stocks and can provide more significant diversification benefit. Meanwhile, the regime-switching model can predict the break change of financial market and send signal to investors to increase commodity futures investment when financial market switches to the ¡°bad¡± regime.A general regime-switching model extends the simple regime-switching model by using economic variables as instruments to predict asset returns. This model helps investigate asset return dynamics and optimal asset allocation under alternative economic environments. The first general regime switching model uses the short rate as the instrumental variable to predict expected asset returns and regime switching probability. This model shows that the short rate plays an important role in asset return regime switching and optimal asset allocation. The optimal asset weights on risky assets negatively relate to the T-bill rate. This is not surprising as the T-bill rate determines the risk-free asset. When the return of risk-free asset is increasing, investors expect a greater return from the risky assets and have a greater chance to switch investment to the risk-free asset if the expectation is not met. However, the fraction of commodity futures in the risky asset portfolio increases with the short rate level.The second general regime switching model is the IPI model which uses the monthly change of industrial production index (IPI) as the instrumental variable to model risky asset returns. The estimation results of this model support that the IPI growth rate plays an important role for efficient asset allocation since it determines both the regime transition probability and the expected returns of risky assets. Commodity futures return is always positively correlated with the IPI growth rate and the optimal weights on commodity futures increase with the IPI growth rate.To further investigate the diversification benefit of commodity futures, an alternative approach is provided. Commodity futures are included into the initial portfolio with various stocks and bonds components and a new risk measure, VaR, is adopted to measure the risk of these portfolios. Three different VaR estimations are proposed: parametric VaR with regime-switching model, historical simulation VaR, and the EVT VaR. These estimation results again strongly support that commodity futures can reduce portfolio risk and improve portfolio performance. However, for different initial traditional portfolios, the optimal weight on commodity futures is not identical. Allocating 5-10% capital on commodity futures investment, as most intuitional investors have done, is not the optimal investment strategy, especially for equity investors. Meanwhile, extreme negative market movement for the traditional asset does not occur synchronously with that for commodity futures; hence, commodity futures do provide good downside protection.