Long-term mean reversion returns in commodity futures markets

Abstract

Desire for alternative long-term investment vehicles has increased considerably, and are well known to the public by such terms as "value investments" and "contrarian investments." These trading strategies buy under-priced assets and sell over-priced assets, with the expectation that price will moderate towards its true value in the long-term as suggested by mean reversion theory. If long-term mean reversion exists in commodity futures markets, then it may be useful for developing long-term trading and hedging strategies. This study tests for long-term mean reversion in commodity futures markets using two long-term mean reversion commodity futures trading systems. The first system uses a fundamental model to calculate equilibrium futures prices, while the second system uses a technical model to calculate equilibrium futures prices. Long positions are entered when futures prices fall below equilibrium, and short positions are entered when futures prices rise above equilibrium. Positions are exited when futures prices moderate and revert back towards equilibrium. Trading performance is tested for corn, wheat, oats, and canola over the 1980-1997 period. The two trading systems both appear to support the hypothesis that long-term mean reversion exists in commodity futures markets. Trading results show that both trading systems earn positive long-term returns, and also show that trading performance improves as reversion parameters are increased. The fundamental system earns average monthly returns of 3.0 percent and the technical system earns average monthly returns of 2.6 percent.