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The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the constituents of the long–short portfolios reveals that the momentum strategies buy backwardated contracts and sell contangoed contracts. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commodity-based relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios.

Commodity futures are excellent portfolio diversifiers and, for some, an effective hedge against inflation (Bodie and Rosansky, 1980 and Bodie, 1983). They also offer leverage and are not subject to short-selling restrictions. Besides, the nearby contracts are typically very liquid and cheap to trade. For all these reasons, commodity futures are good candidates for strategic asset allocation and have been proved to be useful tools for alpha generation (Jensen et al., 2002, Vrugt et al., 2004, Wang and Yu, 2004 and Erb and Harvey, 2006). This article examines the profitability of 56 momentum and contrarian strategies in commodity futures markets. The momentum strategies buy the commodity futures that outperformed in the recent past, sell the commodity futures that underperformed and hold the relative-strength portfolios for up to 12 months. The contrarian strategies do the opposite. They buy the commodity futures that underperformed in the distant past, sell the commodity futures that outperformed and hold the long–short portfolios for periods ranging from 2 to 5 years. To put this differently, the article investigates whether the short-term price continuation and the long-term mean reversion identified in equity markets by Jegadeesh and Titman, 1993, Jegadeesh and Titman, 2001 and De Bondt and Thaler, 1985 are present in commodity futures markets. The paper also builds on the research of Erb and Harvey (2006) who show that a momentum strategy with a 12-month ranking period and a 1-month holding period is profitable in commodity futures markets. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies in commodity futures markets. Tactically allocating wealth towards the best performing commodities and away from the worst performing ones generates an average return1 of 9.38% a year. Over the same period, a long-only equally-weighted portfolio of commodity futures lost 2.64%. In line with the analysis of Erb and Harvey (2006), this result suggests that active investment strategies have historically been profitable in commodity futures markets. While they are not merely a compensation for risk, the momentum returns are found to be related to the propensity of commodity futures markets to be in backwardation or in contango. The results indeed suggest that the momentum strategies buy backwardated contracts and sell contangoed contracts. Therefore our analysis indicates that one can link the momentum profits in commodity futures markets to an economic rationale related to Keynes, 1930 and Hicks, 1939 theory of normal backwardation. Interestingly, the momentum returns are also found to have low correlations with the returns of traditional asset classes, making the commodity-based relative-strength strategies good candidates for inclusion in well-diversified portfolios. There are strong rationales for implementing momentum strategies in commodity futures markets rather than in equity markets: Our commodity-based long–short strategies minimize transaction costs,2 trade liquid contracts with nearby maturities, are not subject to the short-selling restrictions that are often imposed in equity markets and focus on 31 commodity futures only (as opposed to hundreds or thousands of stocks). It is therefore unlikely that the abnormal returns we identify will be eroded by the costs of implementing the momentum strategy or will be a compensation for a lack of liquidity (as in Lesmond et al., 2004). On a less positive note, institutional investors who implement momentum strategies in commodity futures markets have to post initial margins, monitor margin accounts on a daily basis, roll-over contracts before maturity and pay margin calls. As they are not born by equity asset managers, such costs have to be weighed against the benefits of implementing momentum strategies in commodity futures markets. The margin calls and roll-over risk, however, should not be overstated: As the momentum strategies buy backwardated contracts and sell contangoed contracts, little to no cash will be required for margin calls and the roll-over trades will be more often than not profitable. The article proceeds as follows. Section 2 introduces the dataset. Section 3 outlines the methodology used to construct momentum and contrarian portfolios. It also presents the risk models that are employed to measure the abnormal returns of the strategies. Section 4 discusses the results from the momentum strategies. In particular, it highlights the relationship between momentum profits, backwardation and contango and the diversification properties of the momentum portfolios. Section 5 focuses on the contrarian strategies. Finally, Section 6 concludes.

The article looks at the performance of 56 momentum and contrarian strategies in commodity futures markets. We build on the research of Erb and Harvey (2006) who focus on one momentum strategy. While contrarian strategies do not work, 13 momentum strategies are found to be profitable in commodity futures markets over horizons that range from 1 to 12 months. Our tactical allocation in commodity futures markets generates an average return of 9.38% a year. Interestingly, a portfolio that equally weights the 31 commodity futures considered in the study lost 2.64% a year over the same period. The momentum returns are also found to have low correlations with the returns of traditional asset classes, making therefore our relative-strength portfolios good candidates for inclusion in well-diversified portfolios. While the momentum profits are not a compensation for risk (whether it is constant or time-dependent), they are related to the backwardation and contango theories. The results indeed indicate that the momentum strategies buy backwardated contracts and sell contangoed contracts. This result implicitly suggests that a momentum strategy that consistently trades the most backwardated and contangoed contracts is likely to be profitable. We see this subject as an interesting avenue for further research. The possibility remains that the momentum profits may be eroded by transaction costs or may be a compensation for thin trading and market frictions (as in Lesmond et al., 2004). These explanations seem unlikely for four reasons. First, transaction costs in futures markets range from 0.0004% to 0.033% (Locke and Venkatesh, 1997) and are therefore much less than the conservative 0.5% estimate of Jegadeesh and Titman (1993) or the more realistic 2.3% estimate of Lesmond et al. (2004) for equity markets. Second, while short-selling restrictions are often imposed in equity markets, taking short posi- tions in commodity futures is as easy as taking long positions. Third, the nearest or next nearest contracts, typically the most liquid ones, were used to form the long–short portfolios. Fourth, the strategies were implemented on only 31 commodity futures and are therefore much less trading intensive than the ones typically implemented in equity markets. These points notwithstanding, trading costs are not considered in this study and, as a result, we cannot draw final inferences on the magnitude of the net momentum profits. We leave this as a possible route for future research.