Questions:

• Standard commodities indices, which are based on fixed allocations to a basket of commodities, are popular and easily tradeable.
• Can we produce an overlay strategy for the standard indices?

Approach:

• The AiLA strategies are typically based on allocation decisions associated with individual assets, such as the March Corn or December WTI contracts.
• The individual asset allocations are aggregated to form a commodity level allocation.
• The commodity allocations are combined according to the standard index weights to obtain the overlay strategy allocations for the standard index as a whole.

• All the individual assets like March Corn, May Corn etc. are considered for all the commodities that form the standard commodity index.
• The AiLA models generate the allocation decisions for all the individual assets.
• Based on a recent study on the structures of the individual asset allocations^[1], a balanced set of individual assets are used as they provide hedging benefits and therefore better risk adjusted performance.
• The allocation decisions of these individual balanced assets are combined at the commodity level based on the majority vote.
• The individual commodity weights used by the standard index are further used to calculate the overlay strategy allocations.
• Figure 4 shows that the top 5 commodities in terms of their daily weights, which belong to the Oil and Gas sector, are given an average weight of 60% in the standard index calculation.

^[1] Hedging Benefits from Individual Assets - https://aila-x.com/perspectives/hedging-benefits-from-individual-assets

• The overlay strategy allocations is obtained by taking the weighted average of the daily commodities allocations based on the weights of these commodities in the standard index.
• The obtained overlay strategy allocations are winsorized at ±2SD, where SD is the running standard deviation of the allocations, and then normalized to ±100% (shown in Figure 2).
• Based on the risk-adjusted performances compared in Figure 5, the overlay strategy on the standard index performs significantly better than the standard index alone with the Sharpe Ratios
  

  𝑆𝑅 (𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐼𝑛𝑑𝑒𝑥) = 0.36

  𝑆𝑅 (𝑂𝑣𝑒𝑟𝑙𝑎𝑦 𝑆𝑡𝑟𝑎𝑡𝑒𝑔𝑦) = 1.94

• As Oil and Gas sectors are allocated 60% in the standard commodity index, the performance of the overlay strategy is also shown when based only on the Oil and Gas commodities allocations, as well as when excluding them.
• The ability to take long and short positions in the standard index helps the overlay strategy with obtaining the better performance than the long-only position in the standard index.

• The above PL chart of the overlay strategy for Non Oil and Gas Sectors indicates that during the dips, the allocations turn negative suggesting a short position in the standard index which helps the overlay strategy performance.
• Whereas, the overlay strategy on the Oil and Gas Sectors has been consistently performing and contributes to the stable performance of the entire overlay strategy.

• The individual asset allocation decisions for a balanced set of assets are aggregated based on majority vote to obtain the commodity level allocation decisions.
• The commodity level allocation decisions are weighted according to the standard index weights to obtain the overlay strategy allocation.
• The risk adjusted overlay strategy performance appears significantly better than the long-only standard index performance and the historical performance can be attributed to the following factors.
  • The individual AiLA allocation models that run at the ground level extracting the optimal performance out of any asset.
  • The balanced asset selection process which results in the low correlation between the individual asset allocation and thus provides hedging benefit and better risk adjusted performance.
  • The ability to identify the market regimes and to appropriately take both long and short positions on the standard index.