20 Jun 2018 3 min read

Looking for independent sources of return

By Willem Klijnstra

True diversification requires looking for independent return streams. You normally cannot rely on the weather, but in investments that lack of reliability is an interesting feature.     


Typical investment portfolios are dominated by equities and bonds. Both asset classes are driven by macro fundamentals, micro fundamentals and investor sentiment. They provide a certain level of diversification, but this can disappear quickly when you need it the most. Commodities are driven by similar factors as equities and bonds, but at times can really react to the weather. 

You normally cannot rely on the weather, but in investments that lack of reliability is an interesting feature

Within our most unconstrained multi-asset portfolio we implement a long/short commodity strategy using total return swaps. The strategy uses commodity indices that are comprised of 22 commodities across the energy, agriculture, industrial metal and precious metal sectors. The intention is to benefit from the positive convexity present on average at the short end of commodity forward curves (i.e. upward sloping, but levelling off) without taking any net commodity exposure (i.e. long and short the same commodity, but with different futures' expiry dates).

The strategy provides a form of insurance against supply shocks and is implicitly short volatility. The short positions of this strategy are always in the near commodity contracts, which are most vulnerable to a supply shock and are the most volatile. The long positions are further out on the commodity forward curves.

We believe there are three reasons (not mutually independent) why this strategy should earn you a positive excess return over time, with the below chart being an effort to visualise it: 

  1. On average individual commodity curves are in contango (i.e. upward sloping) and exhibit positive convexity. The strategy will earn a positive carry if and when the shape of the commodity forward curves remain unchanged (i.e. earning a positive carry).
  2. The main commodity indices take exposure in the near commodity contracts. When these indices roll into the next commodity contract, our strategy sells this next contract, thereby providing liquidity to the market.
  3. The strategy provides insurance against supply shocks and demand surges, which typically affects the front of the commodity curve the most (i.e. near-term contract prices rise more than contracts further out).

It's the third argument where the weather comes into play. Historically the weather has played a key role in many of the supply disruptions and demand surges in commodities across the energy and agriculture sectors. Extreme temperatures impact the demand for heating and cooling, in turn affecting the demand for energy. Extreme precipitation (too much or too little as in a drought) can result in supply disruptions in agricultural commodities, which in turn could affect livestock prices through increased animal feed costs. 

When looking at the performance attribution of our long/short commodity strategy for the last couple of years (see the table below) it is indeed the weather-sensitive sectors that have contributed the most to the positive performance, with the energy sector leading the pack and natural gas easily being the winning single commodity.

However, as we all know, the weather is pretty unpredictable and cannot be relied upon. Moreover, it's not clear how the weather should affect stock prices and bond yields.

After all the weather is a local phenomenon and changes all the time. As such it is not obvious why a drawdown in the long/short commodity strategy should coincide with a drawdown in other financial markets. This is an interesting observation, as the commodity strategy may provide a return stream that is independent from the equities and bonds in your portfolio.

So, perhaps the weather is proving to be reliable after all, at least in a financial context. 

Willem Klijnstra

Currency Strategist

Willem is a stubborn Frisian, allegedly a descendant of an obscure hero resistance fighter called Grutte Pier (ca. 1480-1520). While in the office his focus is on currency movements; at home he does most of the moving as he chauffeurs his three young kids around. Mister currency is a sporty character with a balanced lifestyle – he enjoys burning lots of calories as much as he enjoys family sized bags of M&Ms.

Willem Klijnstra