Applying momentum factor to commodity rotation strategies
Dorsey, Wright & Associates’ John Lewis explains the virtues of using a relative strength methodology for a commodity rotation strategy and how it can give investors dynamic exposure to the commodities complex to generate excess returns.
Dorsey Wright & Associates (‘DWA’), a Nasdaq company and a provider of technical research analysis for more than 25 years, is applying its well-established proprietary relative strength methodology to the commodity markets.
In much the same way that DWA runs bespoke indexes that use a momentum factor to create sector rotation strategies within equities, it also has a proprietary model that applies the same sector rotation concept to a universe of 21 commodities.
DWA has been running commodity-based models for years but late last month its relative strength methodology was used by Elkhorn Investments, LLC, to launch the first true commodity rotation ETF: the Elkhorn Commodity Rotation Strategy ETF (‘DWAC’). This is really the first active ETF in the US that commodity rotation. Most ETFs have broad-based commodity exposure that behave more like an index.
“Like an equity rotation strategy that takes a benchmark index like the S&P 500 to generate excess performance, we take a broad commodity benchmark and do sector rotation across 21 commodities,” explains John Lewis (pictured), Senior Portfolio Manager at Dorsey, Wright & Associates.
One of the biggest issues with ETFs that offer broad-based commodities exposure is the way they weight commodity indexes. Oftentimes, they are weighted based on production or liquidity and if you look at something like the S&P GSCI, it is extremely heavily weighted towards energy. It is in the region of 60 per cent and before the energy crisis a couple of years ago it was even higher.
“If you buy the S&P GSCI in an ETF or replicate it, you are basically getting a huge amount of energy exposure. But energy markets have not been great in the last couple of years. In 2014 and 2015, they were terrible performers. If you had exposure to a broad-based index, you would have been heavily weighted towards energy whether you liked it or not.
“This is comparable to the S&P 500 Index, which is cap-weighted. If you buy the S&P, you get more exposure to high-cap stocks, whether you want them or not,” explains Lewis.
As well as investing in an ETF like DWAC, investors and advisors also have an opportunity to leverage the virtues of DWA’s relative strength methodology on their own by using the Dorsey Global Tactical Research Platform. The platform provides research, modelling and indexes which apply DWA's expertise in relative strength for use in various financial products, including exchange traded funds, mutual funds, UITs, structured products, and separately managed accounts.
“If someone wants to do a commodity rotation strategy on their own they can subscribe to the platform for a monthly fee and get access to research analysis, asset allocation tools, different models etc. We look at 21 commodity markets in the strategy but if somebody wants to use more commodities (or fewer), or if they want to do something similar by building a sector rotation strategy with spot prices or with ETFs, the platform gives them the flexibility to do so,” confirms Lewis.
The DWA methodology uses point and figure as the main driver for momentum rankings. Time is taken out of the equation. All that the model looks at is the volatility of individual commodities. Each month, Lewis and his colleagues run relative strength charts. Every commodity competes against every other commodity and is given an objective score. All 21 commodities are then ranked from best to worst.
The model identifies the five strongest performers each month and equal-weights them in the strategy. It is entirely driven by momentum, and given how volatile commodities are, the strategy has the ability to look at performance dispersion and hone in on the best performing commodities, from a relative strength perspective, creating a highly tactical, dynamic allocation framework.
“Even though energy is a huge market, production wise, in 2014 and 2015 we didn’t have to own any of it. We could exclude it totally from our index. In both of those years we had more exposure to precious metals and agriculturals which, on a relative strength basis, did better than energy.
“It is a very dynamic strategy that we can rotate aggressively and rapidly depending on where the greatest strength is in the commodity market,” confirms Lewis.
To illustrate just how dynamic commodities are, in 2009 industrial metals were up 78 per cent whereas agriculturals were flat. The following year, industrials returned 15 per cent and agriculturals bounced back to return 26 per cent .
“That’s a huge amount of dispersion for a strategy like ours (to capitalise on). We can focus on the best commodities and strip out the non-performers,” says Lewis, who adds:
“We use the volatility of all 21 commodities to our advantage in this rotation strategy. If you look at something like industrial metals, in 2006 it was the top performer. Then in 2007 and 2008 it was the worst performer before it once again became a top performer in 2009; that’s the kind of commodity we can own, not own, and then own again and use it to our advantage.”
This is why momentum works so well in a commodity rotation strategy. There is such a large dispersion of performance, not just across commodities but also within the same commodity sector on a year-to-year basis.
“We can identify the best and worst performers within a particular sector. Within softs, for example, coffee and sugar have been great performers in 2016 but feeder cattle and wheat have done terribly. Another strong performer this year has been silver.
“We’ve therefore been gravitating more towards precious metals and soft commodities as opposed to energy in 2016,” says Lewis.
Over the long term, Lewis explains that since this is a trend following strategy, “we do tend to reduce some of the volatility and large drawdowns that one gets in commodities, but we are concentrating our positions so that does add a little to the day-to-day volatility. We’ve shown that we can reduce some of the large drawdowns by going into some of the less volatile areas of commodities.”
Aside from the momentum rotation strategy a second driver of returns in the strategy comes from using a futures roll strategy.
A large number of commodity strategies get their exposure by buying the front-month futures contract. That is not necessarily the most efficient way to build exposure. Instead of only looking at front-month futures, DWA uses an intelligent futures-roll algorithm (Deutsche Bank does something similar with its Optimum Yield strategy).
“Instead of buying front-month futures all the time, the strategy looks at contract prices at all different points on the futures curve, for a particular commodity, and determines which one is going to be the most optimal to hold. It could be that the front-month contract is the most optimal, but equally it could be one that is three or six months out,” says Lewis.
It is important to stress that the DWA commodity rotation strategy is a long-only strategy. There are plenty of CTAs running similar strategies, building exposure tactically both long and short, but obviously these are more expensive, and less transparent products, to invest in.
Lewis thinks that the DWA commodity rotation strategy is beneficial for investors who are looking for core commodity-type exposure.
“We think we can offer a smarter way of gaining commodities exposure by focusing on areas of the commodity complex that are strongest. We do this in a very disciplined way. It doesn’t work every single year because of reversals but over the long term there are differently ways to generate alpha using such a commodity rotation strategy,” opines Lewis.
Investors could mix the strategy with a broad index such as S&P GSCI – for example 50 per cent to S&P GSCI, 50 per cent to DWA’s commodity rotation strategy – as a way to generate excess returns.
“What we are essentially trying to do is identify the best sectors in the commodities market – just as we do with sectors in the equity market – and overweight them. Dorsey Wright has been known for sector rotation for years. We have numerous models that financial advisors have allocated to and have widely accepted the benefits of such an approach.
“We are simply applying the same concept to the commodity markets,” concludes Lewis.
For tactical investors, now is a good time to be thinking about getting commodity exposure in their investment portfolio.
Editor’s Note: To learn more about Relative Strength and the Dorsey Wright Relative Strength strategies, download the whitepaper Point & Figure Relative Strength Signals.