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December 2009 Mutual Fund Red Flags

Contango takes a bite out of commodity funds.

Greg Brown, 12/28/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

After a painful 2008 for commodity mutual funds, investors have recently returned to this asset class with a vengeance. The three largest broad-basket commodity mutual funds have raked in an estimated $7.5 billion in net inflows, with PIMCO Commodity RealReturn Strategy PCRDX leading the way with $6 billion in new money. (Harbor Commodity Real Return HACMX is a near clone of the fund.) The PIMCO fund is one of the top 10 recipients of cash in Morningstar's entire database for the year to date.

Diversification has long been one of the main selling points for commodity funds as performance tends to be driven by supply and demand for raw goods (or an unforeseen surprise event such as a freeze in Brazil) rather than corporate earnings and interest rates.

Yet, commodities lost about the same amount as stocks did in 2008. The S&P 500 Index slid 37% in 2008. Meanwhile, the Dow Jones UBS Commodity Index--a common proxy for many commodity mutual funds--slid 36%.

With the global economy on firmer footing, things are looking up for commodities funds, but there's a more subtle threat to commodity fund investors: contango. Contango refers to an implicit yield (that can be positive or negative) that is driven by the shape of the futures curve. Futures investors must continuously roll their contracts forward as time passes, and when futures prices are higher than today's spot price, investors experience a negative drag called contango along the way.

Essentially, you are forced to sell low and buy high when the futures curve is in contango. PIMCO told us that the amount of annualized contango in the Dow Jones UBS Commodity Index was negative 12.4% at this time last year. More recently, that number has come down to negative 8.4%, but it's still a sizable hurdle for management to overcome--many times larger than funds' expense ratios. It means that commodities have to rise about 8% plus another 1% for expenses just for the fund to break even.PAGEBREAK

PIMCO Commodity RealReturn Strategy is the biggest commodity fund in our database. Lead manager Mihir Worah hews closely to the Dow Jones UBS Commodity Index but layers active bond management on top to try and beat the benchmark. He uses derivatives to gain full exposure to the index with only part of the fund's assets and invests the collateral in inflationfocused PIMCO Real Return PRTNX.

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