As New Players Jump on the Seasonality Bandwagon, Trends Could Disappear

by: Hard Assets Investor

More than, say, bonds, there is true seasonality in commodities. There's no magic or animal spirits involved. Commodities are simple (hah!) supply- and demand-driven assets:
• Gasoline prices tend to go up in the summer months (gotta get to the beach somehow, right?)
• Heating oil prices rise in the winter—those of us in the Northern states have the heating bills to prove it.
• Agricultural commodity prices rise and fall with the growing cycle.
• Even precious metals have some seasonality, with Indian gold buyers seeing increased activity during festival months and jewelry makers everywhere cashing in on June brides and Christmas gift givers.

Source: MRCI

Knowing that historically there is a high demand for, say, heating oil in December, purchasing that December contract in June (on the theory that far contracts have the most noise) would let you buy low and sell high, all else being equal. You'd also minimize the effects of contango, should the contracts be impacted by that nefarious feature (which they were until recently), as the contango penalty is generally strongest in the near months.

Given that this seasonality is known, it would seem that it would be a phenomenon that is exploited in the markets, and therefore would no longer have much benefit. Traders love to spot trends and inefficiencies and take advantage of them, and the concept of seasonality is not new. A Google search on the seasonality of commodities yields a wealth of people looking to sell you their book or seminar on how to use this knowledge for profit.

We have one approach which is to chart each week of the year on a bear to bull scale for each commodity, the theory being that this information gives you a forward-looking indicator to use in conjunction with other indicators and/or news.

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There are also a number of financial advisors that give insights on how they use seasonality in trading to benefit their clients, and, supporting them, companies that make their money off of supplying data on seasonality.

Of course, all of these types of long-term-trend strategies share significant short-term risks. That's because they always live in the caveat of "all things being equal," which of course they never are.

Now, however, Merrill Lynch seems to be upping the ante. On September 13, they quietly (very, very quietly) announced their official entry into the seasonal race in the pages of their Commodity Strategist client newsletter.

Merrill has created a series of indexes designed by construction to take advantage of these seasonal inefficiencies. The first, the ML Unseasonal Natural Gas Index, was launched in October of last year. Despite the fact that no public funds openly track it, it must have been well enough received by private investors, because Merrill has followed up by launching three new narrow “unseasonal” indexes, and one big composite index.

The three new strategies are Unseasonal takes on Unleaded Gasoline; Heating Oil; and Lean Hogs. Each has a unique process for determining which contracts to hold when. For example, the Heating Oil index rolls twice a year, rolling into December and June contracts in April and October, respectively. Theoretically, this lets them constantly be buying low and selling high, allowing the index to offset recent contango (and perhaps still capture the benefits of backwardation).

It's no surprise that it's Merrill doing the work here. Merrill Lynch has already tried to separate themselves from the pack by running their existing futures indexes a little differently compared with the GSCI. They trade second- to third-month contracts instead of front month to second. They also use a 15-day rolling period as opposed to GSCI's five-day period when making their trades. Both strategies are intended to increase yield, and according to their research, it seems to justify the change.


But Merrill Lynch isn’t the only one jumping on the seasonality bandwagon. Goldman Sachs recently launched an exchange-traded note tied to a tweaked version of the GSCI that attempts to capitalize on seasonality in the natural gas market.

All and all, these folks seem like they are the smart guys in the room, capitalizing on simple and indisputable trends in the marketplace. But then again, everyone's backtests always look good. The big question will be how these strategies perform in the real world. If they do well (and if the media and investors catch on), we might see a whole raft of ETFs and ETNs jumping on the bandwagon.

Of course, the problem with all inefficiency-exploitation strategies is that as soon as "everyone knows," the magic of a free market almost guarantees that the alpha dries up. There’s a battle for seasonality in the commodities space between users who really do drive up demand during certain seasonal periods, and investors looking to exploit those trends. With so many new investors piling into the marketplace, these seasonality trends could disappear very quickly indeed.