Integration of the Regime-Switching Framework for Portfolio Construction with Commodity Futures

Abstract

Commodity futures have long been considered excellent portfolio diversifiers due to their low correlation with other traditional financial assets. However, given the susceptibility of commodity futures markets to upheavals from both external (e.g., geopolitical events) and internal factors (e.g., shifts in supply and demand) — with volatility accentuated by global crises such as the Covid-19 pandemic and the Russian invasion of Ukraine — it is pivotal that investors capture these market dynamics accurately. In this study, we explore the application of the regime-switching framework to construct portfolios including commodity futures. Our research employs advanced methodologies to precisely identify and predict periods of price contagion within the commodity futures markets. Using the regime-switching framework, we optimize strategies of mean reversion, trend-following, and risk parity. We then assess these strategies against traditional portfolios, evaluating them through various performance metrics and varying degrees of diversification. Our findings reveal that the regime-switching framework significantly enhances strategy performance, offering higher risk-adjusted returns and superior drawdown management, although the efficacy of our approach appears to be influenced by the portfolio's composition, the selected commodity index, and the investor's risk tolerance. This paper thus demonstrates the regime-switching framework's potential to provide investors with a novel methodology for leveraging the unique benefits of commodity futures in volatile market conditions.