Cocoa Investment: An Active Strategy via Futures
by Patrick Oberhaensli, on Oct 26, 2020 2:45:00 PM
As of August 2020, the year-to-date returns of an active Long/Short cocoa investment resulted in a performance that was more than 60% better than that of US equities including the rallying growth stocks indices. When looking at 2017, the highest annual performance for cocoa in over 8 years, the result was closer to the around +79%.
Commodities, in particular agricultural commodities, can be difficult to manage since an attentive strategy is required. But with such an efficient performance, it is certainly worth looking into a cocoa investment. In this article, we will detail the investment profile for cocoa and discuss several key construction elements of an alternative approach.
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Cocoa Profile: Low beta risk-based approach
Based on a cross-assets dynamic risk-based alternative investment strategy, the following low beta profile could be established.
For the period starting end of January 2009 up to the 3rd of August 2020, including specific costs, we see the following results for a Cocoa Long/Short investment (implying being in the market – there is no out “position”).
This non-leveraged alternative strategy has an attractive profile considering its Sharpe Ratio of 0.97. Another advantage, is that the volatility isn’t higher than a passive long-only strategy despite being always in the market. The beta of 0.42 can be considered as a low beta, indicating the diversification potential as well as within the cocoa (asset class) allocation. Moreover, the maximum drawdown is reduced by 20% (percentage points!) in the Long/Short format versus the long-only one, while the percentage months with a positive return has increased by 3% (percentage points).
Integrating a Long/Short Strategy
Focusing on the price action of 2020, traders can see that an alternative cocoa strategy needs to identify certain key rapid movements which occur in both directions. This was the case in January and July for up-moves and March and June for down-moves. In the latter, the fully developed strategy went short more often since the risk in cocoa itself was increasing in both March and June.
February 2020 was in a sense cut into two, up and then down with an acceleration that was “nicely indicated” during the days before the sharp fall. In April and May, both positive months, it was the quicker series of short positions that made the difference. Essentially, one day we saw an immediate substantial drop followed by a “full” recovery which led to a risk-on positioning. This is exactly what a risk-based strategy should be able to deliver! With the right conditions, it can go well beyond expectations. Investors should consider the risk situation not only cross-markets, but also from markets in other segments such as equities and fixed-income.
Now, what if we were to focus on common approaches with technical analysis? When using simple moving averages (SMA), investors must understand that an SMA which is too fast (looking back at a fewer number of days) isn’t adapted for cocoa since it is simply too volatile. But, applying a 50 day and a 200 day moving average combination would prove to be worthwhile. In that context, an example of a very profitable cocoa trade would have been achieved with a short positioning during 2016 and the beginning of 2017 which resulted in +50% cumulated performance.
Protect Your Investment and Avoid Unwanted Risk
Indeed, a Long/Short investment strategy for cocoa can avoid the weaknesses caused by repeated strong falls in the price while still benefitting from the up-moves. The consequent up-moves offer an investment profile that puts risk and return in a much better relation. One of the main appeals of a Long/Short strategy, is that the maximum drawdown seen with a passive long-only exposure, which is bigger than that of US large cap equities (for the same period), gets sharply reduced thanks to the use of short positions. Essentially, reducing the maximum drawdown is a key resulting characteristic of a successful investment strategy. Investors should also note, that because the Long/Short cocoa strategy is based on futures, it could be implemented as an overlay investment as well, meaning even more potential application!