The extreme outperformance of commodities over the last several weeks has sparked interest in this asset class. New research finds that commodities are subject to lottery-like returns, providing information on future performance.
Academic research has found that there are investors who have a “taste,” or preference, for lottery-like investments – those that exhibit positive skewness and excess kurtosis. This leads them to irrationally (from a traditional finance perspective) invest in high-volatility stocks (which have lottery-like distributions), driving their prices higher, resulting in poor future returns – they pay a premium to gamble.
If the markets were perfectly efficient, arbitrageurs would drive prices to their right levels. However, in the real world, limits to arbitrage, and the costs and fear of shorting, can prevent rational investors from correcting mispricings. The low-beta/low-volatility anomaly (low-beta/low-volatility stocks have higher risk-adjusted returns than high-beta/high-volatility stocks) is an example of the lottery effect, with mispricings persisting.
Academic research, such as the 2020 study “Lottery Preference and Anomalies,” has found lottery-like distributions in IPOs, penny stocks, extreme high-beta stocks, small-growth stocks with low profitability and high investment, financially distressed stocks that are either in or near bankruptcy, and even in horse racing, where long shots are systematically overvalued. The research has also found that the anomaly returns are mainly driven by the short leg of lottery-like stocks – relating the anomaly to short-sale constraints. Those constraints prevent arbitrageurs from correcting mispricings (stocks with high lottery features have lower short-sale volumes on average, and investors are reluctant to short sell them, which exacerbates their mispricing).
Asymmetry of returns in commodities
Ladislav Ďurian and Matus Padysak contribute to the literature with their September 2021 study, “Return Asymmetry in Commodity Futures,” in which they examined the return asymmetry in the commodity futures. Their measure of asymmetry (𝐼𝐸) was the difference between upside and downside return probabilities – the greater the measure, the greater the upside potential of the asset return. 𝐼𝐸 was measured by taking the number of days with returns above two standard deviations and subtracting the number of days below two standard deviations based on the past year. They began by noting: “Typical risk-averse investors prefer extreme gains and avoid extreme losses. Consequently, they bid up the prices of assets with a high chance of extreme gains and pay a lower price for assets with a high likelihood of extreme losses. As a result, the high (low) 𝐼𝐸 assets become overvalued (undervalued), and their subsequent returns are lower (higher).”
To construct their measure, at the beginning of each month they calculated asymmetry for each commodity using the latest 260 daily returns. Then they ranked commodities according to their 𝐼𝐸. Their portfolios went long on the bottom 𝑚 commodities with the lowest 𝐼𝐸 in the previous month and short on the top 𝑚 commodities with the highest 𝐼𝐸 in the previous month. They studied 11 different portfolios with up to 11 commodities in the long and short legs. Their data sample covered 22 commodities and the period April 1991-July 2021. Following is a summary of their findings:
- The asymmetry effect is distinct from the skewness effect.
- Portfolios 3-11 all produced statistically significant (at the 5% level) monthly alphas of 0.18% to 0.41% and Sharpe ratios of 0.34 to 0.58.
- The portfolio that went long on the bottom seven commodities with the lowest 𝐼𝐸 in the previous month and shorted the top seven commodities with the highest 𝐼𝐸 in the previous month performed the best, achieving a statistically 0.38% mean monthly return (t-statistic = 3.33) and a Sharpe ratio of 0.58.
- When the monthly S&P 500 return was negative, the average monthly S&P 500 return was -3.50%, while the average monthly return of portfolio 7 was 0.50% – the strategy provides a hedge for equity risk.
Summary
Consistent with previous literature, Ďurian and Padysak demonstrated that commodities with the largest probabilities of extremely high returns underperform, while those with high probabilities of extremely low returns outperform. Their findings offer further evidence on the pervasiveness of the impact of skewness of returns on asset prices, providing investors with greater confidence that the strategies will outperform in the future. In addition, their findings demonstrated that the 𝐼𝐸 strategy provided a diversification benefit, acting as a hedge against equity bear markets. However, there was some decay in the benefits provided, which is generally the case when research on factor premiums becomes public.
In their funds that employ commodities strategies, AQR implements skew factors in intra-sector, inter-sector and directional strategies, and those skew factors have added to returns.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
The article above is for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party information which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Buckingham Strategic Wealth recommends AQR funds in client portfolios. The above mention of AQR is for information purposes only does not imply a specific AQR fund is suitable for all clients. Buckingham Strategic Wealth is not affiliated with AQR. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-163
Read more articles by Larry Swedroe
The extreme outperformance of commodities over the last several weeks has sparked interest in this asset class. New research finds that commodities are subject to lottery-like returns, providing information on future performance.
