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The strategy had double digit return and high Sharpe for about eight years from 2000-2008, with a kicker that let you continue running it until ~2014 if you were crafty
First you need to know about the GSCI -- the Goldman Sachs Commodity Index. It was created by GS in 1997 to track passive long exposure to commodity markets. Crucially it is an *investable index* which means that you can replicate its returns by trading in liquid instruments,
in this case commodity futures. GS fully laid out the methodology for calculating the index and how to replicate it by trading in futures, which meant that dealers were able to sell swaps on the index and pull in a nice fee, which they started doing in size.
The index is now administered by S&P and you can find the full methodology here. Apart from some tweaks to the exact commodities included and their weights, it is exactly the same as it was in 1997 https://www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-gsci.pdf …
The key that makes the trade possible is to replicate the index dealers need to hold near-term futures and roll them to a later expiry before they become due. The index methodology lays out the exact schedule of rolls for every commodity, including which contract months will
be held, and which days they will be rolled on -- in basically every case the roll takes place over five days, with 20% of each position being rolled before the close on the 5th, 6th, 7th, 8th and 9th and ninth business days of the month.
Because the aum tracking the index got so large, this created a predictable and sizable flow in commodity futures spread contracts which you could get ahead of. The strategy was to put on the same spread that the dealers would need to do, five days before they
needed to do it, and then sell the spread position to them as they begin the roll. Doing this equal-weighted across all futures in the index gave you a strategy with ~25% returns and a Sharpe of 2.5 from 2000-2008 --pic.twitter.com/ai36VimwAZ
After 2008 too many people knew about it and the trade became unprofitable after costs (and newer commodity indices were developed which weren't as vulnerable to front running) but a cute twist was to try to front-run the front-runners, i.e. do everything another 5 days early
This wasn't quite as profitable but it meant you could continue doing the trade for another six years or so, until it finally died out around the end of 2013.pic.twitter.com/FcjzTVM4ae
Trying to repeat the same trick didn't work -- by trying to push it earlier and earlier, you end up "running into" the previous month's roll and it's no longer profitable (plus by this point, anyone who was anyone knew the idea and was probably trying it)
No big lessons from this but a cute example of how fixed, systematic trading strategies can create price distortions when they get large. I haven't looked but I'd be willing to get you can find similar effects created by some of the big "smart beta" funds today. FIN.
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