“The Poverty of Academic Finance Research”:Trading Brent/WTI spread

 the poverty 4

This paper analyzes spread trading in the crude oil futures market between the WTI and the Brent.

It is a strategy commonly used by Commodity focused Hedge Funds.

Those who intend to read this article to trade commodity futures spreads will be disappointed, but at least will learn something.

The author reports for his very simple strategy a long-term Sharpe-ratio ­> 3.0

He defines a Brent/WTI long/short portfolio p.

From this he defines a signal z as


pt is the performance of the Portfolio at t.

MAt is a moving average of p over the last k days.

σt is the volatility of p.

Although this value is very critical for the performance of the trading strategy the author
gives no details how σt is calculated.

This is a general rule in the paper: there are a lot of general explanations, references to the literature and all the other redundant stuff of academic papers, but the essential details are missing.

Zt defines a Bollinger-Band around the Brent/WTI portfolio.

One goes the portfolio short if zt > 2.0 and long if zt < -2.0.

One exploits the swings around the mean-level.

The impressive results of Th. Lubnau can be explained by the embarrassing fact that the author has ignored the contango of oil-futures.

Additionally he has tweaked the calculation to get impressive Sharpe-Ratios.

The results are too good to be true and everyone with a minimum understanding of the trading profession gets suspicious when he reads about a constant Sharpe ratio of 3+ over 23 years.


The author concludes with an observation that most published empirical discoveries about Spread Trading Strategies are redundant and likely false.


To close this loop, long/short quantitative strategies used by Hedge funds trading commodities are in reality less gleaming than they appear.

Commodity Hedge Funds (CHFs)

Missing on the top line and beaten on the bottom line; the money flows to commodity that saw over the last couple of years was essentially based on two assumptions;

1. Hedge Funds are super natural vehicles, (they can do things that normal trader or people can’t do) but it’s not because they are tied to their own economics and cannot escape gravity anymore than any other speculators can.

2. Commodities returns are uncorrelated with other assets and that Hedge Funds can provide positive sharp ratios. [2]

Even before considering the strategies used that appeared less easy than they truly are, and more risky than how they are representedCHFs have by-design flaws :

The two and twenty structure is skewed to the CHF sponsors, (20% on PnL earned and 2% flat management fee on asset under management).

CHFs have also their own economics; they are leveraged units.

An interesting corollary for the market resides in the redemption process:

Because CHFs are leveraged units, investors redeeming force funds to liquidate more positions into the open-market purging the market. (systemic risk). [3]

Animal spirits is the term used by Keynes to describe the instincts, proclivities and emotions that ostensibly influence and guide human behavior.[4]

An essential part of this animal spirit resides in a constant flow of new people bringing new ideas in the markets. 

This process also implies that some have to go; it is a necessary condition so the forest renews itself…

A Valid Economic Function

Money will continue to flow into CHFs also under good reasons.

Financiers have an economic function to match the money with people, making a spread between the best performers ( the 9th decile) and the capital savers (usually high net worth individuals, pension funds, insurance companies endowments, etc).

The market carries a two-fold message for Financiers: will reward success but has no-tolerance for variance (in absolute terms).

Ask Carlyle Group’s Vermillion who was until recently, one of the largest CHF in the world…


[1] The Poverty of Academic Finance Research”: Spread Trading Strategies in the Crude Oil Futures Market, Chrilly Donninger, Sibyl-Working-Paper, June 2015

[2]The poverty of Academic research in finance research is no stranger to this phenomenon, see Facts and Fantasies about Commodity Futures

[3] see Long-Term Capital Portfolio L.P specialized in relative-value arbitrage

[4] http://www.investopedia.com/terms/a/animal-spirits.asp

© 2015 Navigating the commodity markets with Freight and Spreads


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