Finding a better way to trade commodities

20 November 2023

This article has been written by Winton.

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• Winton’s approach to trading commodities has developed considerably in recent years with their expansion into new markets and strategies designed by sector specialists.
• For most of the firm’s history, Winton has pursued a ‘top-down’ approach to commodities trading, focusing on identifying signals that are ‘narrow’ in the data inputs required, but widely applicable across a range of markets.
• A ‘bottom-up’ approach, by contrast, relies on greater ‘depth’ of data market-specific expertise. Both approaches are highly complementary.
• Winton has been hiring specialists with backgrounds in commodity trading to further expand its ‘bottom-up’ capabilities - this has proven to be effective to date.
• This article recaps the evolution of Winton’s commodities trading over time and describes where they are identifying opportunities to further enhance their capabilities in the asset class.

Focused on innovation

A constant throughout Winton’s history is our commitment to research and development. We have continually sought to increase the opportunity set of our strategies by developing new signals and applying these signals to a wider range of markets and instruments.

From the pure trend-following strategy we pursued back in 1997, our trading of commodities has evolved over time with the regular addition of new signals. We now apply more than a dozen distinct systematic macro signals across the commodity sectors, which aim to profit from effects ranging from carry and seasonality to cross-sector relationships and mean reversion.

We have also expanded our universe of commodity markets over time. We added new futures contracts as and when they reached sufficient levels of liquidity, introduced alternative OTC-traded markets from 2017, and participated in the opening of China’s highly diversifying commodity markets to offshore investors from 2019.

The benefits of this continual development of our commodities trading have been evident in recent years. Trend following on commodities, particularly the European energy complex, were an important performance driver during 2021 through to the first quarter of 2022. Our diversifying systematic macro signals then anticipated the reversals in major commodity markets around the middle of 2022 and have continued to generate profits this year.

Winton’s 26 years of commodities trading: a timeline of key milestones

Source: Winton

Top-down versus bottom-up

For most of our history, we have pursued a ‘top-down’ approach to commodities trading. As a quantitative investment firm, with a research department comprising almost entirely statisticians and mathematicians, we discovered signals that were ‘narrow’ in the data they used, but ‘wide’ in the number of markets to which they were applied. Trend following is the perfect example of this, yet the same is true of many of our other systematic macro signals.

Developing these types of signals requires expertise in statistical analysis and avoiding issues such as selection bias and overfitting. A great deal of time is spent on research and hypothesis testing, and we arrive at statistical confidence by backtesting the signal across many years of data and multiple markets. The resulting trading signals tend to: 1) be relatively slow; 2) have a modest Sharpe ratio, at least in each market; and 3) maintain a continuous position, which is adjusted each day. Overall, we have enjoyed success with this approach and many of our signals are now backed by more than a decade of out-of-sample performance.

There is, however, another ‘bottom-up’ approach to commodities investing practised by hedge fund managers and commodity trading houses. This approach tends to be ‘wide’ in the data used, but ‘narrow’ in the markets to which it is applied; that is, it requires data-rich models tailored to each market or subsector. These strategies generally have a higher Sharpe ratio in each market and take discrete positions when the data collectively suggests a forecasting edge.

This bottom-up approach is highly complementary for our longstanding top-down approach, as it incorporates market-specific information that builds on more generalised market properties we are already trading, such as price trends or carry. However, developing this type of specialist strategy is not trivial, as it requires hiring experts in each market or subsector.

Take grains for example. Global supply and demand is driven by everything from trade policy and harvest yields to substitution and government subsidies. Knowing exactly what does and does not matter for each crop and how these factors can be modelled requires extensive domain knowledge outside of the purview of a typical quantitative researcher. For instance, forecasting harvest yields accurately requires detailed knowledge of the biology of each crop, as precipitation and temperature is critical at different times in the growing cycle.

Drivers of crop prices

Source: Winton

The development of specialist commodity strategies is – along with alpha capture and mid-frequency trading – broadening the breadth of our signal development. To support this initiative, we have been hiring specialists with backgrounds in commodity trading. A team focused on agricultural commodities joined us in 2021; a natural gas trader joined us in 2022; and, this quarter, we have hired another sector specialist who will be joining us in early 2024. Combining deep market-specific knowledge with our expertise in systematic investment management is proving to be effective and, while it is still early days, initial results are promising.

The Target Market Determination (TMD), available at macquarie.com/mam/tmd, includes a description of the class of consumers for whom the Fund is likely to be consistent with their objectives, financial situation and needs.