Commodities: To Short, or Not to Short?

Commodities: To Short, or Not to Short? [Chart]

Comparing “Dogs of the Dow” inspired strategies over the last decade

The Chart of the Week is a weekly Visual Capitalist feature on Fridays.

Over the last week, we have received a wide variety of reactions from our audience regarding the Periodic Table of Commodity Returns that we published last Thursday from our friends at U.S. Global Investors.

The most interesting email came from Brad Farquhar, the Executive Vice President and CFO of Input Capital, a Canadian-based agricultural streaming company. In his email, Brad attached a chart summarizing the cumulative returns using a long/short commodity strategy where he imagined going long on the worst performing commodity of the previous year, while shorting the best performing commodity.

For example, the long-only portfolio would have invested in natural gas in 2007, because gas was the worst performing commodity in 2006 with a -43.9% return. The short-only strategy would have shorted nickel in 2007 (betting that nickel would drop in price) because it was the best performer of 2007 with 145.5% returns.

On a cumulative basis (re-investing money from each year), the long-only strategy returned -0.9% compound annualized growth between 2007 and 2015, while the short-only strategy brought in 12.4% annualized returns.

A 50/50 hybrid (50% long, and 50% short) gave us the equivalent of 9.6% returns each year.

Our Variation

Inspired by Brad’s analysis, we did our own variation of this “Dogs of the Dow” type of exercise to look at these long and short commodity portfolios in a slightly different light.

We analyzed five portfolios (100% long, 75% long, 50% long/short, 75% short, and 100% short) for the average annual return, volatility, and number of years with positive returns.

Here’s the results:

The best performing portfolio was 100% short, with an average annual return of 14.5%. The 75% short portfolio had nearly as good of returns at 13.1%, with the lowest volatility (using standard deviation) at +/- 17%.

Both the 100% short and 75% short portfolios provided positive returns in 7 of the last 9 years. Meanwhile, going long was much more risky. A 100% long portfolio had gains in only 4 of 9 years, with a huge standard deviation of +/- 55%.

Over the time period in question, energy commodities killed portfolios with “long” exposure. In 2011 and in 2015, the worst performer of the previous year (natural gas and oil respectively) was also the worst performer the following year, creating terrible returns for the long-heavy portfolios.

Oil, for example, was down -45.6% in 2014 and then was also down -30.5% in 2015. Not a very effective strategy.

What will be a better trade in 2016: shorting the best performing commodity of last year (lead), or going long on nickel, the worst performer of 2015?