A Hedge Fund for Cheap

Markets like the present, in which equities, bonds, other currencies, and even commodities seem to fall further each day, show us the value of true diversifiers--assets or strategies that somehow elude the investing truism that "in a crisis, only the correlations go up." Hedge funds originally arose to perform precisely this role by investing in new asset classes and new financial strategies that would remain unscathed by a market fall, but their hefty fees and lack of disclosure made it difficult to tell what they were actually investing in and a very expensive gamble to see if their strategy would pan out. Fortunately, some clever ETF managers and index companies were also reading the academic papers that uncovered potential sources of uncorrelated returns, and the fruits of their labor are now available to adventurous individual investors willing to find a place for bargain-priced alternative investments in their portfolios.

One of the most exciting newer funds we have seen in this area is  ELEMENTS S&P CTI ETN , a new exchange-traded fund that follows Standard & Poor's little-known long-short Commodity Trends Indicator Index. This long-short index makes monthly momentum trades on each of six commodity sectors (energy, precious metals, industrial metals, grains, livestock, and more exotic agricultural goods) based upon whether the sector index's current price is above or below a weighted average of the previous seven months' prices. The weighted average skews  heavily toward the trailing three months, making this fund sensitive to medium-term movements in commodity prices. Testing this strategy over the past 20 years, it has shown slightly higher returns than traditional long-only commodity indexes with substantially lower volatility. Best of all, it has even held up extremely well over the past few months! As commodity prices began to fall in July and August, the fund slowly switched out of its long positions. By October, it was almost entirely short and able to return 20% in the month as oil, gas, gold, and agricultural commodities collapsed.

But our endorsement does not just hinge on back-tested data and a couple of good months. We feel this strategy has a solid theoretical base because commodity prices tend to be rooted in two main factors: macroeconomic trends and global supply. A booming economy creates the demand that can drive commodity prices up, while stagnation without monetary inflation can pull the prices back down. Economic conditions certainly persist over multimonth and even multiyear periods, leading to steady trends in commodity prices. Similarly, supply constraints in a specific sector can cause prices to slowly increase as inventories dwindle. These supply constraints also take long periods to clear, as the additional grains grow or new mining equipment is ordered, or new oil exploration is performed. By taking advantage of medium-term price momentum in commodity sectors, as well as being able to capture both positive and negative roll yield (the price difference between a futures contract and the spot price of the commodity it is based upon), this fund seems well positioned to potentially profit in any market environment.

But lest I sound too Panglossian, this fund has risks like any other. It will not continue to inexorably rise in any and all markets; it will have down months and down years just like any other investment. Its benefit lies in diversification, so it would be best used as a 5%-10% stake in a balanced portfolio of equities and bonds, similar to a long-only commodities fund. Potential investors should also be aware of the pros and cons surrounding this issue's structure as an ETN instead of an exchange-traded fund. ETN owners don't have a claim on a portfolio of cash and commodity-related securities. Rather, they hold a 15-year note backed by HSBC bank that promises the return on the underlying index minus the 0.75% annual fee. Although this eliminates the risk of tracking error and provides some tax benefit due to the lack of distributions, it also exposes investors to credit risk from HSBC. The bank has so far weathered the credit storm well, and currently it has the highest market capitalization of any bank in the world; however, it would not be unreasonable for investors to consider HSBC's credit risk as part of their required returns from this fund. Finally, our biggest single concern lies with this fund's small asset base and tiny trading volume, which frequently leads to large bid-ask spreads. Although we expect this fund to become more liquid as it garners notice, potential investors should keep a close eye on net asset values and use limit orders to make sure they are buying near fair value.

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