Commodity Returns: Lost in Financialization

Abstract

The financialization of commodity markets, characterized by a dramatic increase in institutional investors and index capital flows into the commodity futures market around 2004, has significantly impacted the asset class. This paper investigates the effect of this growth in investment capital on the average returns of popular commodity futures trading strategies over time. Our findings reveal that approximately 80\% of commodity futures strategies that generated statistically significant average returns before financialization are no longer profitable. Our results suggest that this decline in strategy returns is primarily driven by an adverse change in the average returns of a few systematically priced factors in the cross-section of commodity futures. Furthermore, we find that commodity strategies with relatively higher exposure to the Dow Jones Commodity Index experience a significant reduction in average returns, providing a possible channel for this observed effect. Robustness tests indicate that the publication of commodity strategies in the academic literature accounts for only about 25\% of the observed decrease in commodity futures strategy returns.

Keywords: Commodity futures markets, Commodity risk premium, Index investing, Financialization of commodities, Latent factor models, Commodity investment strategies JEL Classification: G11

JEL Classification: G11, G12, G13, G14, G29