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The Long and Short of Commodity Investing

Three new funds that reinvent the wheel of commodity investing.

Mallory Horejs, 06/07/2012

Over the past decade, more and more investors have turned to commodities to enhance portfolio diversification. Investments in commodity mutual funds, for example, have grown from $9.2 billion at the end of 2002 to more than $137.6 billion by the end of 2011. The growth story for commodity-tracking exchange-traded funds is even more impressive--assets have skyrocketed to $150.4 billion from $770 million over the same period.

Furthermore, the strategies  used to gain commodity exposure continue to evolve. While the industry's earliest products invested in commodity-related stocks, futures-based strategies continue to make up a larger piece of the commodities pie. Although the first physical commodity exchange-traded fund wasn't launched until 2004, today nearly 70% of all commodity ETF assets are held in futures-tracking and physical-commodity funds.  

The most recent innovation in the commodity space, however, is the availability of long/short strategies in mutual fund form. Rydex launched the first long/short commodity offering in June 2009, now called Guggenheim Long/Short Commodities Strategy RYLBX. This fund's management team uses a systematic, rules-based strategy to identify price trends, both positive and negative, in a subset of commodities included in the S&P GSCI Excess Return Index. More recently, several similar products have come to market, two within the past six months. These shops all argue that taking a momentum-based long/short approach to commodity investing serves investors better than long-only strategies. And this technique couldn't be more timely--due to increasing fears of a global economic slowdown, the S&P GSCI Index is down 8.3% for the year to date, while Guggenheim Long/Short Commodities Strategy is up 4.5% (using monthly data through May 2012).

Forward Commodity Long/Short Strategy FCMLX
This index-tracking fund seeks exposure to the commodity markets and returns that correspond to the Credit Suisse Momentum and Volatility Enhanced Return Strategy Index, or Credit Suisse MOVERS Index. The index uses a systematic allocation model, which generates long/short signals for a broad universe of 24 commodities on the basis of market performance and realized volatility. 

From this group, the 10 commodities with the strongest absolute signals, filtered by volatility, are grouped together in an equally weighted basket. The basket can be composed of all long, all short, or a combination of long and short positions. Each month the basket’s composition is reweighted using the quantitative strategy and will consist of a new selection of 10 commodity long and/or short positions exhibiting the strongest (bullish or bearish) momentum signals. As of March 31, 2012, the fund held 10% long positions in WTI crude oil, unleaded gasoline, aluminum, silver, and live cattle. The portfolio also had -10% positions in natural gas, lead, wheat, Kansas wheat, and coffee. 

The primary advantage of this fund's index-based long/short commodity approach is its cost effectiveness. While the Institutional share class's 1.52% net expense ratio may seem high for an index-based product, it's still small potatoes relative to what other managed-futures funds are charging. The average managed-futures fund costs 2.73%, but that doesn't always account for the fees paid to the underlying commodity trading advisors. When fees reign supreme, Forward Commodity Long/Short Strategy is worth considering. 

LoCorr Long/Short Commodity Strategy LCSAX
In contrast to Forward's index-based structure, LoCorr Long/Short Commodity Strategy takes an active approach. This fund can invest up to 25% of its assets into a portfolio of diversified commodities futures positions, which is run by Millburn Ridgefield Corporation. (Futures contracts are leveraged and therefore do not require large, upfront investments to get 100% exposure.) Galliard Capital Management subadvises the funds' remaining 75% of assets according to a fixed-income strategy of short- to intermediate-term investment-grade corporate and government-agency bonds.

As of March 31, 2012, Millburn held roughly 50 long and short commodity futures positions allocated across the following sectors: energy (31%), grains (23%), metals (22%), softs and lumber (18%), and livestock (6%). To construct the portfolio, Millburn utilizes both trend-following and nontrend models (such as pattern recognition, event, intraday, fundamental, and relative value).

Active futures trading strategies don't come cheap, though, and this fund is no exception--it's 3.92% net expense ratio makes it one of the most expensive offerings in the managed-futures category. However, a simple fee rank would be misleading--while LoCorr includes the management and incentives paid to Millburn in its expense ratio, most funds of this nature do not yet account for the fees paid to each of the portfolio's underlying commodity trading advisors (which can exceed 2% and 20%, respectively). With this in mind, it's no surprise the fund's fees appear well above-average, but it's difficult to say how they actually stack up next to fees paid in less-transparent multimanager funds.

William Blair Commodity Strategy Long/Short WCSIX
Unlike the previous two offerings, William Blair Commodity Strategy Long/Short takes a multimanager approach. This fund allocates its capital across commodity trading advisors, or CTAs, who invest both long and short in global commodity futures contracts. There are several advantages but also some major disadvantages to this multimanager structure. The key benefit here is that investors gain better diversification as well as access to (hopefully) more-sophisticated hedge fund managers, who are actively managing exposures and can tactically respond to market changes. However, investors pay a high fee and sacrifice a great deal of transparency for access to these skilled managers.

This fund's portfolio-management team allocates to three broad categories of CTAs: systematic (which use quantitative models to exploit trending behavior of futures markets over various time frames), fundamental (which research fundamental supply-and-demand drivers that drive commodity futures markets), and sector specialists (which employ specialized knowledge, research, and analysis systems to seek value from niche markets). As of April 25, 2012, the fund was invested in six CTAs and the broad strategy allocation was as follows: systematic (45%), sector specialists (35%), and fundamental (20%). Currently, William Blair does not disclose its underlying manager allocations or the aggregate management and incentive fees paid to these CTAs.

Launched on April 25, 2012, this is the youngest of the long/short commodity bunch. Time will tell if management can generate the returns necessary to overcome the fund's high fees. (Its 1.70% net expense ratio does not include the management and incentive fees paid to the underlying CTAs.) For those who prefer an actively managed, highly diversified approach, though, William Blair Commodity Strategy Long/Short is the best option.

The Appeal of a Long/Short Approach
The primary advantage of a long/short strategy is that it has more opportunities to generate profits. First, long-only indexes can't capture the returns available when commodity prices are falling. Second, long/short strategies are better able to manage "roll yield". (A futures strategy has three sources of return: changes in the commodity's spot price, collateral yield, and roll yield. Roll yield refers to the gains or losses that result from replacing an expiring contract with a farther out contract in order to avoid physical delivery yet maintain a position.) When commodity markets are in contango, meaning that the futures price curve is positively sloped, long-only indexes must lock in roll yield losses to maintain their positions. This means that long-only strategies may lose money even when commodity prices are rising.

To benchmark momentum-based long/short commodity strategies, Morningstar created a family of commodity indexes that includes combinations of long commodity futures, short commodity futures, and cash. The primary index, called the Morningstar® Long/Short Commodity IndexSM, holds commodity futures both long and short based on momentum signals.

Each month, if the linked price on an individual commodity exceeds its 12-month daily moving average, the index takes a long position in the subsequent month. Conversely, if the linked price is below its 12-month moving average, the index takes the short side. (An exception is made for commodities in the energy sector--because energy prices are extremely sensitive to geopolitical events and not necessarily driven purely by supply-demand imbalances, the index will move to cash when necessary rather than take a short position.)

The results are indisputable: The Morningstar Long/Short Index has demonstrated better performance, lower volatility, and better downside protection than the three major traditional long-only indexes: the Dow Jones UBS Commodity Index, Reuters/Jefferies CRB Index, and S&P GSCI Index. Furthermore, the long/short index has generated returns that are virtually uncorrelated to equity markets--its 10-year correlation with the S&P 500 Index is negative 0.07. For investors seeking true diversification in their stock and bond portfolios, one of these long/short commodity strategies may be worth considering.


Mallory Horejs is an alternative investments analyst with Morningstar.

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