PastPaperHero | Asset classes and characteristics - Commodities and managed futures

Learning Outcomes

This article explains the characteristics, return drivers, risks, and portfolio uses of commodities and managed futures, including:

Defining commodities and managed futures as alternative asset classes and distinguishing them from traditional equity and bond investments.
Identifying how investors typically obtain exposure to commodities through futures contracts and understanding the roles of spot returns, collateral return, and roll yield.
Describing contango, backwardation, and how the futures curve shape affects roll yield and total futures-based commodity returns.
Evaluating key risk factors for commodities—such as volatility, event risk, storage and perishability issues, and variations in market liquidity across different contracts.
Explaining how managed futures programs are structured, the role of Commodity Trading Advisors (CTAs), and the common use of systematic, trend-following strategies.
Assessing the main sources of return and risk for managed futures, including the effects of leverage, short positions, and model-driven trading.
Analyzing how commodities and managed futures can contribute to diversification, inflation protection, and drawdown management in multi-asset portfolios, and recognizing circumstances when diversification benefits may weaken, which is important for CFA Level 1 exam questions.
Distinguishing between physical commodities, commodity futures, commodity indices, and commodity-related equities, and explaining how each behaves within a portfolio context.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the characteristics of major asset classes, including alternative investments, with a focus on the following syllabus points:

The fundamental characteristics and rationale for investing in commodities and managed futures.
The principal sources of return and risk for both asset classes.
Structure, liquidity, and unique risks of commodity and futures markets.
The diversification and risk management benefits of commodities and managed futures in traditional portfolios.
The impact of correlation and diversification when adding commodities and managed futures to equity–bond portfolios.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

For a fully collateralized long position in a commodity futures contract, which set correctly lists the three main components of total return?
1. Spot price return, dividend yield, management fee
2. Spot price return, roll yield, collateral return
3. Collateral return, credit spread, default premium
4. Roll yield, convenience yield, earnings yield
Managed futures strategies most commonly seek to provide diversification benefits by:
1. Buying and holding commodity-producing equities over the long term
2. Holding cash and short-term government bills at all times
3. Taking long and short positions in futures based on systematic trend-following models
4. Concentrating positions in a single commodity with strong supply–demand imbalances
Compared with investments in financial assets such as equities or bonds, investments in physical commodities are most likely to involve which additional risks?
1. Higher interest rate risk and currency risk
2. Storage and insurance costs plus perishability or quality deterioration
3. Increased credit risk and default risk
4. Lower price volatility and reduced event risk
Roll yield for a long commodity futures position is most accurately described as:
1. The interest income earned on collateral posted to support the futures position
2. The change in the spot price of the commodity over the life of the futures contract
3. The gain or loss from closing a near-maturity contract and opening a longer-dated contract, typically negative in contango and positive in backwardation
4. The difference between the futures price and the strike price of an option on the commodity

Introduction

Commodities and managed futures represent alternative investments differing fundamentally from stocks or bonds. Their payoffs and risks are driven by unique pricing mechanisms, market structures, and supply–demand factors, with important portfolio roles due to distinct return sources. This article summarizes their key characteristics, return drivers, risks, and use in modern portfolio management.

Key Term: Alternative Investment
An investment in assets or strategies other than traditional long-only public equities, bonds, and cash, such as real estate, private equity, hedge funds, commodities, and managed futures.

From an asset-allocation standpoint, both commodities and managed futures are often considered alongside equities, bonds, and cash when constructing diversified portfolios. Traditional asset classes are typically evaluated in terms of expected return and volatility, but also in terms of how their returns move together (correlation). Combining assets whose returns are not perfectly positively correlated can reduce overall portfolio risk for a given expected return, which is a core principle of modern portfolio theory.

Mathematically, for a two-asset portfolio with weights $w_1$ and $w_2$ , standard deviations $\sigma_1$ and $\sigma_2$ , and correlation $\rho_{12}$ , the variance of the portfolio return is:

\sigma_p^2 = w_1^2\sigma_1^2 + w_2^2\sigma_2^2 + 2w_1w_2\rho_{12}\sigma_1\sigma_2

If $\rho_{12} < 1$ , then $\sigma_p$ is less than the weighted average of the individual standard deviations, illustrating the diversification benefit. Commodities and managed futures are interesting because their correlations with equities and bonds are often low or even negative, especially in certain environments.

Commodities are real assets—tangible goods used as inputs in production—whereas managed futures are strategies that trade financial instruments (futures and options) across many markets. While they often entail higher complexity and volatility than traditional assets, they can contribute valuable diversification and, in some cases, inflation protection.

Key Term: Commodity
A tangible real asset—typically a raw material—that is interchangeable with others of its type and traded on an exchange using standardized contracts.

Key Term: Spot Price
The quoted price for immediate delivery of a physical commodity in the cash market.

Key Term: Futures Contract
A standardized agreement to buy or sell a specific commodity (or financial instrument) in a set quantity and quality for delivery at a fixed price on a specified future date, traded on an exchange and marked to market daily.

Commodities are mostly accessed through derivatives, particularly futures contracts, rather than through direct physical ownership. Managed futures strategies are typically offered by specialized managers who trade futures and related derivatives on behalf of investors.

Inflation protection is a recurring theme when discussing commodities:

Key Term: Inflation Hedge
An asset whose returns tend to increase when inflation rises, helping to preserve real purchasing power.

Because many commodity prices (especially energy and food) are part of consumer price indices, commodity exposures can sometimes help hedge against unexpected inflation, though this relationship is imperfect and time-varying.

The rest of this article first examines commodities, then managed futures, and finally their combined role in multi-asset portfolios.

Commodities: Features, Returns, and Risks

Characteristics of Commodities

Commodities are physical, fungible goods such as oil, natural gas, precious and industrial metals, and agricultural products. Common sectors include:

Energy: crude oil, natural gas, gasoline, heating oil
Metals: gold, silver, copper, aluminum
Agriculture (“grains”): wheat, corn, soybeans
Soft commodities: coffee, cocoa, sugar, cotton
Livestock: live cattle, lean hogs

These broad groups differ in important ways:

Energy commodities often depend on geopolitical developments, OPEC decisions, and technological changes in extraction.
Industrial metals are closely tied to construction and manufacturing activity.
Precious metals such as gold are sometimes used as “safe-haven” assets during financial stress.
Agricultural commodities and livestock are subject to pronounced seasonality and weather risk, with planting and harvest cycles and risks such as droughts and floods.
Some commodities (e.g., gold) are highly storable, while others (e.g., live cattle) are costly or difficult to store.

Their prices are determined primarily by immediate economic supply and demand and can experience rapid swings due to unexpected weather events, geopolitical disruptions, regulatory changes, and technological advances. Because many commodities are basic inputs to production or consumption, relatively small changes in supply (for example, a drought) or demand (for example, a global slowdown) can lead to large price changes.

A useful conceptual distinction is between:

Investment commodities: such as gold, which are often held for store-of-value or portfolio reasons, and
Consumable commodities: such as oil or wheat, which are ultimately consumed in production or consumption.

Consumable commodities are more affected by short-term inventory levels, storage constraints, and convenience yield (discussed later), whereas investment commodities may be more sensitive to real interest rates and investor sentiment.

Commodities are real assets, not claims on future cash flows like equities or bonds. As a result:

There is no built-in “growth of the business” component in the price—long-term real prices for many commodities have tended to fluctuate around relatively flat trends, influenced by productivity improvements and substitution.
Valuation is driven more by current and expected supply–demand balances than by discounted cash-flow models.

In the long run, technological progress often reduces production costs or leads to substitutes (for example, aluminum instead of copper, or renewable energy instead of oil). This can put downward pressure on real commodity prices over multi-decade horizons, even though short- and medium-term fluctuations can be very large.

Most investors access commodities not by holding physical goods, but through derivatives such as futures contracts or through commodity-linked funds and indices that use those derivatives.

Key Term: Futures Curve
A graph showing futures prices for the same reference commodity across different contract maturities; also called the term structure of futures prices.

Commodities are often traded on major centralized exchanges, resulting in generally high market liquidity for leading contracts (e.g., crude oil, gold), but much lower liquidity for niche contracts (e.g., certain minor metals, softs, or livestock). Liquidity is typically highest in near-term (“front-month”) contracts and lower in far-dated contracts.

In the real economy, producers (e.g., mining companies, farmers) and users (e.g., airlines, food manufacturers) frequently use futures to hedge price risk, while financial investors use them primarily to gain or reduce exposure.

Access Vehicles for Commodity Exposure

For exam purposes, you should be able to distinguish among the main ways investors gain commodity exposure:

Physical holdings: Direct ownership of the commodity (e.g., bars of gold, barrels of oil).
- Advantages: Direct exposure to spot price; no dependence on futures curve shape; straightforward conceptually.
- Disadvantages: Storage, insurance, transportation, security, and, for many commodities, perishability or quality deterioration. These costs can be significant and are one reason institutional investors avoid large physical positions, except in highly storable commodities like gold.
Futures contracts: The most common method for institutional investors.
- Advantages: Low transaction costs; ability to use leverage; standardized contracts; central clearing that reduces counterparty credit risk; easy to go long or short.
- Disadvantages: Contracts have fixed maturities, so investors must “roll” positions as they approach expiry; returns depend on futures curve shape (roll yield), not just spot price changes; margining introduces cash-flow and liquidity considerations.
Commodity index products: Exchange-traded funds (ETFs), mutual funds, or index-linked notes that hold futures according to a rules-based methodology.
- Investors get diversified exposure across many commodities without managing futures directly.
- Index methodologies differ in weights (e.g., energy-heavy vs more balanced) and roll rules (e.g., front-month vs longer-dated contracts).

Key Term: Commodity Index
A rules-based basket of commodity futures contracts designed to represent a broad commodity market or a specific sector, with specified contract selection, weighting, and roll rules.

Some indices are:

Broad-based: covering energy, metals, and agriculture.
Sector indices: focusing only on energy, metals, or agriculture.

Returns for commodity indices are typically reported in two forms:

Key Term: Excess Return Commodity Index
A commodity index that reflects only the change in futures prices plus roll yield (the “futures excess return”), assuming no interest earned on collateral.

Key Term: Total Return Commodity Index
A commodity index that combines the futures excess return with a collateral return earned on cash invested in short-term, high-quality instruments such as Treasury bills.

Understanding this distinction helps when decomposing commodity returns.

Commodity-related equities: Shares of commodity producers (e.g., oil companies, mining firms).
- These are equities, not pure commodity exposures. Returns reflect both commodity prices and company-specific factors (cost control, management quality, capital structure, hedging, political risk).
- Their correlation with broad equity markets is usually higher than that of commodity futures with equities.

On the exam, be careful not to equate commodity-producing equities with direct commodity exposure. The return behavior can be quite different, especially during periods of sharp commodity price moves or company-specific events.

Sources of Return (Commodities)

Direct commodity investments via spot holdings earn returns only from changes in spot prices (net of storage and other costs). However, most investors use futures contracts, which introduce additional return components.

For a fully collateralized long futures position, total return can be decomposed into three main parts:

Spot return
Collateral return
Roll yield

Key Term: Fully Collateralized Futures Position
A futures position where the full notional value is backed by cash or liquid securities, so the investor is not borrowing to finance the exposure.

Spot return: Change in the commodity’s spot price over the holding period.
Collateral return: Return on the cash or high-quality securities (such as Treasury bills) posted or held as collateral to support futures positions.
Roll yield: Gain or loss realized when selling expiring contracts and buying new ones to maintain exposure.

Key Term: Spot Return
The percentage change in the commodity’s spot price (or, practically, the nearest futures price converging to spot) over the investor’s holding period.

Key Term: Collateral Return
The interest or investment income earned on cash or securities set aside to meet margin requirements or to fully collateralize a futures position.

Key Term: Roll Yield
The return from rolling a maturing futures contract into a new one, arising from the price difference between the expiring and replacement contracts; depends on the shape of the futures curve.

In a simplified form, the total return on a fully collateralized long futures position over a period can be expressed as:

R_{\text{total}} \approx R_{\text{spot}} + R_{\text{collateral}} + R_{\text{roll}}

where:

$R_{\text{spot}}$ is the spot return.
$R_{\text{collateral}}$ is the collateral return.
$R_{\text{roll}}$ is the roll yield.

Strictly speaking, a futures contract’s price change reflects both spot movements and changes in expectations or term structure. For CFA Level 1, however, you should focus on the three-part decomposition above.

Contango, Backwardation, and Convenience Yield

Because a futures contract specifies a price for future delivery, its price does not necessarily equal today’s spot price. The pattern of futures prices across maturities forms the futures curve. Two important shapes are:

Key Term: Contango
A market condition where longer-dated futures prices are higher than the current (or expected future) spot price; all else equal, a long position rolling forward along a contango curve typically experiences negative roll yield.

Key Term: Backwardation
A market condition where longer-dated futures prices are lower than the current (or expected) spot price; all else equal, a long position rolling forward along a backwardated curve typically experiences positive roll yield.

Suppose an investor is long a near-month contract and, as expiry approaches, closes it and opens the next-month contract to maintain exposure:

In contango, the next-month contract is more expensive than the expiring one. The investor “sells low and buys high,” generating negative roll yield.
In backwardation, the next-month contract is cheaper than the expiring one. The investor “sells high and buys low,” generating positive roll yield.

Spot prices and roll yield may be affected differently by supply disruptions, economic growth cycles, or inflation shocks. For example:

Backwardation often arises during anticipated or actual shortages, when users value having physical inventory, leading to high “convenience yield”.
Contango tends to occur when inventories are abundant and storage plus financing costs push longer-dated futures prices above spot prices.

Key Term: Convenience Yield
The non-cash benefit of holding physical inventory, such as securing production, avoiding stockouts, or responding to unexpected demand quickly.

A simplified cost-of-carry framework helps explain the relationship between spot and futures prices:

F_0 \approx S_0(1 + r + u - y)

where:

$F_0$ is the current futures price.
$S_0$ is the current spot price.
$r$ is the risk-free interest rate (financing cost).
$u$ represents storage and other carrying costs (as a rate).
$y$ is the convenience yield.

If $r + u > y$ , futures prices tend to be above spot prices (contango). If $y$ is sufficiently high, futures prices can be below spot prices (backwardation).

Basis and Convergence

The relationship between spot and futures prices is often summarized by the basis:

Key Term: Basis
The difference between the spot price of a commodity and the price of a futures contract on that commodity for a given maturity; commonly defined as spot price minus futures price.

Over the life of a futures contract:

The basis can change (basis risk), affecting the performance of hedges.
As the contract approaches expiration, futures price and spot price converge, so the basis tends to move toward zero (ignoring delivery frictions).

This convergence is what allows rolling a futures position to maintain economic exposure to the reference commodity over time.

Curve Shape and Index Design

Commodity indices differ in how they roll futures contracts:

Some always roll into the nearest contract, maximizing liquidity but making returns highly sensitive to front-end contango/backwardation.
Others use longer-dated contracts or dynamic roll rules to reduce negative roll yield when markets are in strong contango (for example, in certain energy markets).

For exam questions, you should understand that:

In persistent contango, a long-only front-month index can suffer from significantly negative roll yield, especially if spot prices are flat or falling.
In persistent backwardation, positive roll yield can be a major source of long-only commodity index returns, even if spot prices are relatively stable.

Historically, some commodity sectors (such as certain agricultural markets) have tended to exhibit backwardation more often, while others (such as oil during periods of high inventories) have often been in contango. These tendencies are not guaranteed and can change over time.

Worked Example 1.1

A multi-asset manager allocates 5% to a diversified commodity futures index. In a year of unexpected global crop failure, equity and bond returns are negative, but the commodities index—dominated by agricultural futures—delivers a strong positive return, reducing total portfolio loss.

Answer:
Commodities, through their real asset nature and exposure to supply/demand shocks, can provide important crisis-period diversification, though their long-run return is highly volatile and not necessarily higher than equities. The benefit arises mainly from low or negative correlation with traditional assets in specific scenarios, rather than from superior standalone performance.

Worked Example 1.2

An investor holds a fully collateralized long position in a crude oil futures contract for one year. Over the year:

The spot price of oil rises by 12%.
The collateral is invested in Treasury bills earning 3%.
Because the futures market is in contango, rolling the contract each month produces a cumulative roll yield of −5%.

What is the approximate total return on the position?

Answer:
Approximate total return is the sum of the three components:
$R_{\text{total}} \approx R_{\text{spot}} + R_{\text{collateral}} + R_{\text{roll}}$
With $R_{\text{spot}} = +12\%$ , $R_{\text{collateral}} = +3\%$ , and $R_{\text{roll}} = -5\%$ :
$R_{\text{total}} \approx 12\% + 3\% - 5\% = 10\%$
Even though the futures curve is in contango and roll yield is negative, the positive spot return and collateral return more than offset the drag from roll yield.

Worked Example 1.3

A commodity index rolls every month from the expiring futures contract into the next maturity. Assume the current month’s expiring contract trades at 100, and the next-month contract trades at:

102 in Market A
98 in Market B

If the investor is long the expiring contract and rolls into the next-month contract in each market (ignoring transaction costs and any spot price changes), what is the one-step roll yield for the roll in each market?

Answer:
In Market A, the investor sells the expiring contract at 100 and buys the next one at 102, effectively “selling low and buying high.” The roll yield is negative:
$R_{\text{roll, A}} \approx \frac{100 - 102}{100} = -2\%$
In Market B, the investor sells at 100 and buys the next contract at 98, “selling high and buying low.” The roll yield is positive:
$R_{\text{roll, B}} \approx \frac{100 - 98}{100} = +2\%$
Market A is in contango (higher price for the next-month contract), while Market B is in backwardation (lower price for the next-month contract).

Risks, Margining, and Liquidity in Commodity Futures

Commodities exhibit high absolute price volatility—often comparable to or greater than equity volatility—with unique risk drivers:

Weather and natural events: Droughts, floods, and other extreme weather events can dramatically affect agricultural yields.
Geopolitical conflict and supply disruptions: Wars, sanctions, strikes, and OPEC decisions can sharply move energy prices.
Regulatory or technological shifts: Environmental regulations, new extraction technologies (such as fracking), or substitution toward alternative materials can change long-term demand and supply.

Other important risks include:

Leverage risk: Futures allow large notional exposures for relatively small margin outlay. Adverse price moves can trigger margin calls and forced liquidation if the investor cannot post additional collateral.

Key Term: Notional Exposure
The total face value of the reference asset or assets controlled by a derivatives position, often much larger than the capital initially invested.

Key Term: Leverage
The use of borrowed funds or derivatives to increase exposure to an asset relative to the amount of capital invested.

Basis risk: Investors hedging or seeking exposure to a specific physical commodity may use a related but not identical futures contract (for example, jet fuel exposure hedged with crude oil futures), creating risk that futures and spot prices do not move in lockstep.

Key Term: Basis Risk
The risk that the price of a hedging instrument, such as a futures contract, does not move in perfect alignment with the price of the exposure being hedged.

Storage and perishability: Direct holdings of many commodities incur storage costs, potential spoilage (for example, grains), or quality deterioration (for example, some agricultural products), as well as security and insurance costs.
Liquidity risk: Liquidity varies widely across commodities and contract maturities. While front-month crude oil or gold futures can be extremely liquid, some agricultural or minor metals contracts can be thinly traded, with wide bid–ask spreads and price gaps.

Futures trading involves posting margin rather than paying the full notional value upfront:

Key Term: Margin
The amount of capital that must be deposited with a broker or clearinghouse to open and maintain a futures position.

Key Term: Initial Margin
The minimum margin that must be deposited when a futures position is first opened.

Key Term: Maintenance Margin
The minimum margin balance that must be maintained; if the margin account falls below this level, the investor receives a margin call.

Key Term: Variation Margin
Additional funds that must be deposited into a margin account when daily marking-to-market causes the balance to fall below the maintenance margin.

Key implications:

Futures are marked to market daily, meaning gains and losses are realized every day and credited or debited to the margin account.
Large adverse moves can result in margin calls; if the investor cannot meet them, positions may be closed at unfavorable prices.
This creates liquidity risk: even if an investor is correct about the long-run direction, they can be forced out by short-term volatility.

Physical holding introduces additional operational and logistical risks—notably, securing storage facilities, meeting transportation requirements, and obtaining adequate insurance. These practical difficulties explain why most financial investors prefer futures-based or fund-based exposure rather than direct ownership.

Commodities do not provide cash flows or dividends, and many individual commodities have exhibited low or negative real long-term returns over extended horizons. Their appeal is therefore not primarily high expected return, but rather diversification and potential hedging benefits.

From a liquidity and market-structure standpoint:

Exchange-traded commodity futures are standardized and centrally cleared. This reduces counterparty credit risk compared with bilateral over-the-counter contracts.
Some commodities are subject to daily price limits on exchanges. When limits are hit, trading may halt or occur only at the limit price, complicating hedging and position adjustments.

For exam questions, it is important to recognize that:

Price volatility, event risk, and leverage are key differentiators of commodity investments compared with traditional assets.
Storage, insurance, and perishability risks are relevant for physical holdings but not for purely futures-based exposure.

Portfolio Role of Commodities

The main rationale for adding commodities to a portfolio is diversification and, in some cases, inflation protection.

From a mean–variance standpoint, the total risk (variance) of a two-asset portfolio depends not only on the individual volatilities of the assets but also on the correlation of their returns. If the correlation between two assets is less than +1, the portfolio’s volatility will be less than the weighted average of the individual volatilities. The lower (or more negative) the correlation, the larger the risk reduction for a given expected return.

As discussed earlier, if we combine Asset 1 and Asset 2 in a portfolio, portfolio volatility is:

\sigma_p = \sqrt{w_1^2\sigma_1^2 + w_2^2\sigma_2^2 + 2w_1w_2\rho_{12}\sigma_1\sigma_2}

When $\rho_{12}$ falls, the last term becomes smaller, reducing total risk. Commodities are potentially attractive because their return drivers (weather shocks, OPEC decisions, inventory cycles) differ from those of corporate profits and interest rates.

Commodity prices may be weakly or even negatively correlated with equities and bonds, especially during:

Periods of unexpected inflation, when commodity prices (especially energy and food) rise and fixed-coupon bonds perform poorly.
Commodity-specific supply shocks, such as crop failures or oil supply disruptions, which may hurt corporate profits and equity markets but benefit certain commodity exposures.

Thus, a modest allocation to a diversified commodity futures index can sometimes reduce overall portfolio volatility and improve risk-adjusted returns, even if the expected return of the commodity allocation alone is not very high.

However, diversification benefits are not guaranteed:

Correlations can change over time as market structure evolves. For example, as commodities became more “financialized” (through index products and increased participation by financial investors), correlations with equities rose in some periods.
A highly concentrated commodity exposure (for example, only crude oil) may be more closely tied to global growth and equity markets than a broad, diversified basket.
In severe global recessions, both equities and economically sensitive commodities (such as industrial metals and energy) may decline together, reducing diversification benefits.

Inflation protection is another potential role. Many commodities are direct components of consumer price indices, so their prices tend to respond positively to inflation surprises. Over long horizons, however, commodity returns may not track inflation perfectly, and the relationship may vary across commodity sectors:

Energy and food prices are typically very sensitive to inflation, particularly cost-push inflation driven by higher input costs.
Precious metals such as gold are sometimes used as a store of value in periods of high or uncertain inflation, although their performance can also be influenced by real interest rates and investor sentiment.
Some agricultural commodities are more affected by weather and crop yields than by general inflation trends.

Because of these features, practitioners often distinguish between:

Strategic allocations to commodities: long-term, small allocations aimed at diversification and inflation hedging.
Tactical positions: shorter-term positions based on views about economic growth, inflation trends, or specific supply–demand imbalances.

Worked Example 1.4

An investor holds a 60% equity / 40% bond portfolio with an annualized volatility of 12%. She considers adding a 10% allocation to a diversified commodity index, reducing equities to 55% and bonds to 35%. Assume:

Equity volatility = 18%
Bond volatility = 7%
Commodity index volatility = 20%
Correlations: equity–bond = 0.2, equity–commodities = 0.1, bond–commodities = 0

Ignoring expected returns, is it plausible that adding commodities could reduce portfolio volatility?

Answer:
We compare the diversified portfolio’s volatility with and without commodities.

Original 60/40 portfolio volatility (given) = 12%.
New weights: equities 55%, bonds 35%, commodities 10%.

Approximate new variance (using the formula for three assets and given correlations) adds:

Each asset’s variance term: $w_i^2\sigma_i^2$ .

Cross terms: $2w_iw_j\sigma_i\sigma_j\rho_{ij}$ .

Because the correlations of commodities with both equities (0.1) and bonds (0) are low, the additional variance contributed by the commodity allocation is significantly offset by diversification. A rough calculation shows that the new volatility can be slightly below 12%, illustrating how an asset with relatively high standalone volatility (20%) can still reduce overall risk if its correlations with existing holdings are low.

Commodity allocations in practice are often small (e.g., 2–10% of total portfolio value) but can have a noticeable impact on the distribution of returns, especially during inflationary shocks or commodity supply disruptions.

Worked Example 1.5

A pension fund is worried about rising inflation over the next five years. It currently has a 60% equity / 40% bond portfolio. Trustees are considering adding a 5% allocation to a broad commodity index and funding it by reducing bonds from 40% to 35%. Which potential benefit is most relevant for this decision?

Answer:
The main benefit in this context is potential inflation hedging. Commodities, especially energy and food components, tend to perform relatively well when inflation surprises to the upside, whereas fixed-rate bonds are hurt by higher inflation. A small allocation to a diversified commodity index funded from bonds can therefore help protect the real value of the portfolio during inflationary periods, although the relationship is imperfect and returns remain volatile.

Managed Futures: Strategies and Characteristics

What Are Managed Futures

Managed futures involves professional managers—commonly Commodity Trading Advisors (CTAs)—who use futures (and to a lesser degree, options) contracts to trade a diverse set of reference assets: commodities, currencies, stock and bond index futures, and interest-rate futures.

Key Term: Managed Futures
An investment approach where professional managers trade futures (and often options) across asset classes, frequently using systematic, trend-following programs to profit from price movements in either direction.

Key Term: Commodity Trading Advisor (CTA)
A regulated investment manager specializing in futures trading based on documented trading strategies or models, typically offering managed accounts or pooled funds to investors.

Managed futures programs are typically offered in several structures:

Pooled funds or commodity pools: Similar to mutual funds or hedge funds, where investors subscribe for shares.
Separately managed accounts: The CTA trades a futures account in the investor’s name, according to a mandate.
Regulated fund formats: In some jurisdictions, managed futures strategies are packaged in retail-oriented vehicles (for example, certain UCITS funds in Europe).

Many managed futures funds employ systematic, rules-based models that react to price data rather than making discretionary judgments. The most common systematic style is trend-following.

Key Term: Trend Following
A systematic trading approach that takes long positions in markets with upward price trends and short positions in markets with downward trends, seeking to profit from the continuation of those trends.

Trend-following models often use technical indicators—such as moving average crossovers or breakout rules—to identify whether prices are trending up or down over horizons ranging from weeks to months. Other managed futures programs may use:

Fundamental macroeconomic inputs (for example, interest-rate differentials, growth data).
Relative-value strategies (for example, trading spreads between related futures contracts).
Short-term mean-reversion or pattern-recognition strategies.

But for the CFA Level 1 exam, the key point is that systematic, trend-following strategies dominate the managed futures universe.

Trend-following performance is often linked to a more general concept:

Key Term: Time-Series Momentum
A pattern in which an asset’s own past returns positively predict its future returns over intermediate horizons; this empirical regularity underpins many trend-following strategies.

In other words, if an asset has performed well over the recent past (e.g., last 6–12 months), it tends to continue performing relatively well in the near future, and vice versa. Managed futures strategies seek to harvest this pattern across many markets.

Because futures require only margin rather than full notional funding, managed futures funds typically hold most of their capital in cash or high-quality short-term securities. This structure is important for understanding their sources of return and risk.

Sources of Return (Managed Futures)

Managed futures programs can go long (profit from rising prices) or short (profit from falling prices), earning returns from directional price trends across any liquid futures contract that meets their trading criteria.

Their performance is generally uncorrelated with broad market indexes and may even deliver positive returns during market crises. Returns derive from:

Capturing sustained price trends (up or down) in equities, bonds, currencies, and commodities.
Exploiting short-term inefficiencies or patterns in futures prices (for non-trend strategies).
Earning or paying roll yield, depending on how positions are held along the futures curve.
Earning interest on collateral held in cash or short-term government securities.

Because capital is mostly held as collateral, the return on that collateral contributes to overall performance, similar to the collateral return in commodity investing.

Managed futures returns are often described as alternative risk premia, particularly the “time-series momentum” or “trend” premium. Historical evidence suggests that simple trend-following strategies have generated positive long-run returns with low correlation to equities and bonds, although real-world performance depends heavily on implementation, costs, and risk management.

An important operational concept is that many managed futures strategies target a specific volatility level:

Key Term: Volatility Target
A specified level of return volatility that a manager aims to maintain, often by scaling the size of positions up or down as market volatility changes.

If markets become more volatile, position sizes may be reduced to keep portfolio volatility near the target; if markets are quieter, position sizes may be increased.

Managed futures strategies typically exhibit:

Convexity to trends: They tend to perform best when trends are strong and persistent, whether markets are rising or falling.
Path dependence: They may suffer during choppy, range-bound markets in which trends repeatedly start and then reverse (“whipsaw” losses).

From an exam standpoint, remember that managed futures can generate returns in both bull and bear markets, because they do not rely on markets moving in one direction; they rely on the presence of trends.

Worked Example 1.6

A pension fund’s multi-asset portfolio suffers during an equity bear market. However, its 7% allocation to a systematic managed futures fund, which captured the evolving equity downtrend by shorting stock index futures and holding long positions in rallying government bond futures, delivers large positive returns, cushioning overall losses.

Answer:
Managed futures, able to go long or short across asset classes, can act as portfolio insurance when market trends are pronounced and negative. Their performance is driven more by the presence and direction of trends (e.g., downtrends in equities, uptrends in safe-haven bonds) than by the overall level of equity or bond markets. As a result, they can generate positive returns precisely when traditional assets are under stress.

Risks and Liquidity (Managed Futures)

Most futures markets accessed by managed futures strategies are highly regulated and liquid, especially for major contracts. However, the risk profile of a managed futures program depends on several factors:

Notional exposure and leverage: Funds usually target a specific volatility level and adjust position sizes accordingly. Higher target volatility implies larger swings in performance and greater effective leverage relative to capital.
Model risk: Systematic strategies are based on historical relationships that may break down. A model calibrated to past data may perform poorly if market conditions change (“regime change”) or if it is overfitted to historical noise.
Short positions: While shorting is essential for benefiting from downtrends, it introduces the potential for rapid losses if markets reverse sharply. For some futures (such as equity index futures), large rallies can hurt short positions significantly.
Whipsaw risk: In sideways or range-bound markets, trend-following models may repeatedly enter and exit positions as apparent trends start and then reverse, leading to a pattern of small losses.
Crowding and liquidity risk: If many managers follow similar models, they may attempt to exit positions simultaneously during stress, exacerbating price moves and slippage.
Operational risk: Managed futures rely heavily on technology, execution systems, and risk controls. Failures in these areas can lead to unexpected losses.

Despite these risks, managed futures typically trade exchange-traded futures, which:

Are subject to central clearing, reducing counterparty credit risk.
Have transparent pricing and standardized contract terms.
Allow relatively rapid adjustment of positions in response to new information.

Still, during extreme market events, even liquid futures can experience widened bid–ask spreads or price gaps, and positions may be marked to market daily, requiring margin calls. Poorly managed leverage can increase these stresses.

Managed futures funds also involve fee risk for investors: many charge management and performance fees. For exam purposes, you do not need to memorize specific fee levels, but you should recognize that higher fees reduce net returns relative to the trading strategy’s gross performance.

An important risk concept here is:

Key Term: Drawdown
The peak-to-trough decline in the value of an investment or portfolio over a specific period, usually expressed as a percentage of the peak value.

Trend-following strategies can experience meaningful drawdowns during low-trend or rapidly reversing environments; investors must be prepared for such periods.

Portfolio Benefits of Managed Futures

Managed futures provide diversification primarily through:

Access to alternative risk premia (for example, the trend-following premium) that are different from equity and bond risk factors.
Historically low, and sometimes negative, correlation with equities and bonds.
Ability to profit during market drawdowns by taking short positions in falling markets.

Because trend-following does not rely on markets going up, managed futures have historically delivered some of their strongest returns during periods of elevated volatility and large market declines—offering defensive characteristics in traditional portfolios. This property is sometimes referred to as providing “crisis alpha.”

Key Term: Crisis Alpha
The tendency of some strategies, particularly managed futures trend-followers, to generate positive performance during periods when traditional assets experience large, sustained drawdowns.

At the same time, there are clear trade-offs:

In extended sideways or range-bound markets, trend-following strategies can experience repeated small losses (“whipsaws”) as trends fail to develop.
Managed futures may underperform equities in long bull markets, reducing overall portfolio returns if their allocation is large.
Because strategies rely on historical relationships, prolonged changes in market behavior can lead to multi-year periods of underperformance.

From a portfolio-construction point of view, a modest allocation to managed futures can reduce overall volatility and drawdowns, even if their long-run average return is similar to or slightly below that of equities, provided correlations remain low.

Worked Example 1.7

An investor holds a 70% equity / 30% bond portfolio. She considers adding a 10% allocation to a managed futures fund that targets a volatility similar to equities but has zero correlation with both equities and bonds. She reduces equities to 60% and bonds to 30%. Qualitatively, how might this affect portfolio risk and behavior?

Answer:
Because the managed futures fund has similar volatility to equities but zero correlation with both equities and bonds (by assumption), adding a 10% allocation can reduce overall portfolio volatility through diversification. The fund may also provide positive returns during equity bear markets (e.g., by taking short equity futures positions) or during bond sell-offs (by shorting bond futures), reducing portfolio drawdowns. However, during a strong equity bull market with modest trends in other asset classes, managed futures may lag, slightly lowering peak returns. The main benefit is improved downside protection and smoother return patterns over time.

Worked Example 1.8

A simple trend-following rule on an equity index futures contract goes long if the price is above its 200-day moving average and short if the price is below. Over one year:

The index starts at 1,000 and ends at 800 (−20%).
For most of the year, the index trends down, and the rule stays short after an early signal.
The managed futures program earns +18% from this short position, plus 2% from collateral, for a total of +20%.

What is the key lesson for portfolio construction?

Answer:
While the equity market lost about 20%, the trend-following rule earned a positive return of roughly 20% by being short during the downtrend. Adding such a strategy to an equity-heavy portfolio can materially reduce the portfolio’s overall loss in a bear market, illustrating the potential “crisis alpha” benefit of managed futures. Importantly, this benefit arises because the strategy can profit from downtrends, not just uptrends, and because it is structurally able to take short positions.

Exam Warning on Diversification

A common error is to assume commodities or managed futures always deliver diversification. Correlations can increase in market crises or during periods where trend strategies underperform. For example:

If commodities become tightly linked to global growth (for example, due to synchronized global expansion), their correlation with equities may rise.
If most managed futures funds follow similar models, they may experience simultaneous losses during sudden reversals, producing unexpected correlation with equities.

On the exam, when evaluating diversification benefits, always think about why an asset class should be diversifying and recognize that relationships can change over time.

Revision Tip

Know the difference between direct commodity investing (spot/physical) and futures-based exposure:

Direct spot/physical holdings: Return comes only from changes in spot prices (minus storage and other carrying costs).
Futures-based exposure: Total return includes spot return, collateral return, and roll yield, and is the predominant method for institutional investors.

Be prepared to explain these three components and how contango and backwardation affect roll yield.

Summary

Commodities and managed futures, as alternative investments, provide exposure to real assets and trend-driven strategies distinct from stocks and bonds. Their key value lies in:

Diversification benefits stemming from low or variable correlations with traditional asset classes.
Potential inflation protection, especially for commodity exposures tied directly to consumer prices.
The ability of managed futures to profit from both rising and falling markets through long and short futures positions.

However, both asset classes can exhibit high volatility and periods of underperformance:

Commodities face unique event risk, storage and liquidity issues, and may not deliver high long-term real returns. Returns from futures-based positions depend crucially on collateral returns and roll yield in addition to spot price movements.
Managed futures rely on model-driven trading and can suffer in non-trending markets or when trends reverse abruptly; they also employ leverage and face model and operational risks.

Within a multi-asset portfolio, small allocations to commodities and managed futures can improve risk-adjusted performance by:

Reducing overall volatility through imperfect correlation with equities and bonds.
Providing potential protection in inflationary environments (commodities) and in severe market drawdowns (managed futures).
Expanding the set of risk premia beyond the traditional equity and duration exposures.

For CFA Level 1, you should be able to:

Describe how investors gain commodity exposure primarily via futures and identify the roles of spot return, collateral return, and roll yield.
Explain contango, backwardation, basis, and how the futures curve shape affects roll yield and total return.
Distinguish between excess return and total return commodity indices.
Describe how managed futures funds are structured, the role of CTAs, and the basic idea of systematic trend-following and time-series momentum.
Assess the diversification and risk-management roles of commodities and managed futures within multi-asset portfolios, recognizing when these benefits may weaken.
Recognize the main sources of risk for both asset classes, including leverage, liquidity, model risk, margining, and event risk.

Key Point Checklist

This article has covered the following key knowledge points:

Commodities are physical real assets traded globally; their prices are driven by short-term supply–demand conditions and can be highly volatile.
Most investors obtain commodity exposure via futures contracts rather than by holding physical inventory, due to storage, perishability, and logistical costs.
Futures-based commodity returns for a fully collateralized position can be decomposed into spot return, collateral return, and roll yield.
Roll yield is determined by the shape of the futures curve: typically negative in contango and positive in backwardation.
Convenience yield and cost-of-carry considerations help explain why futures prices can be above or below spot prices.
Basis (spot minus futures) changes over time and converges toward zero at expiry, creating basis risk for hedgers.
Excess return commodity indices reflect only futures price changes and roll yield; total return indices add the collateral return.
Main commodity risks include high price volatility, event and regulatory risk, storage and perishability issues, basis risk, and large variations in liquidity across contracts and maturities.
Futures use margin and leverage, leading to daily mark-to-market cash flows and potential margin calls.
Managed futures invest across global futures markets using professional CTAs, frequently implementing systematic, trend-following strategies.
Managed futures strategies can take both long and short positions and often target specific risk levels using leverage, leading to return patterns that are typically lowly correlated with traditional investments.
Trend-following seeks to harvest time-series momentum by going long in uptrending markets and short in downtrending markets.
Managed futures can provide “crisis alpha” by potentially performing well in periods when equities suffer large drawdowns, though this benefit is not guaranteed.
Both commodities and managed futures can provide diversification and risk management benefits in portfolios, especially during periods of equity or bond market stress, but diversification benefits are time-varying and can weaken.
For exam questions, it is essential to distinguish between physical commodities, commodity futures, commodity indices, and commodity-related equities, and to understand how each behaves within a portfolio.

Key Terms and Concepts

Alternative Investment
Commodity
Spot Price
Futures Contract
Inflation Hedge
Futures Curve
Commodity Index
Excess Return Commodity Index
Total Return Commodity Index
Fully Collateralized Futures Position
Spot Return
Collateral Return
Roll Yield
Contango
Backwardation
Convenience Yield
Basis
Notional Exposure
Leverage
Basis Risk
Margin
Initial Margin
Maintenance Margin
Variation Margin
Managed Futures
Commodity Trading Advisor (CTA)
Trend Following
Time-Series Momentum
Volatility Target
Drawdown
Crisis Alpha

Asset classes and characteristics - Commodities and managed ...