Investing In Hard Assets

Author: Eric Uhlfelder

20 August 2008, Private Wealth

Commodities have been very hot, and that’s when an asset class is most risky, observes Eric Uhlfelder.

There’s nary an industry expert who would argue against the long-term merits of having commodities in a balanced portfolio. A diversified basket of metals, energy and agricultural products has shown to improve returns and reduce volatility, while acting as an effective hedge against inflation. And there’s various means in which advisors can get their clients such exposure: hedge funds, partnerships, stocks, mutual funds, ETFs and ETNs.

Despite their recent sell off that sliced more than 22 percent off a key benchmark, commodities have been performing extraordinarily well for quite some time.According to the Standard & Poors’ Goldman Sachs Commodity Index [S&P/GSCI], commodities are up more than 40 percent over the last year thru August 18. Five-year annualized returns were nearly 24 percent. And 10-year annualized returns were 17.28 percent.

These returns trounced the S&P 500, which is down 9.73 percent over the past year, up 7.02 percent per annum over the last five years, and in the black by a paltry 2.91 annualized over the past decade.

For the record, the S&P/GSCI benchmark is comprised of energy, industrial and precious metals, and agricultural-related commodities. It’s weighted by global production. This means a heavy tilt toward energy, which currently comprises more than three-quarters of the index.

The basic question for advisors looking to jump in for the first time: should they consider doing so during the current slide or wait until prices stabilize? At the same time, for those whose exposure has grown fat on the proceeding run up, should they consider taking some profits off the table or let their positions ride?

The Case for Commodities

Before the current rally began, a recent report by the City of London Investment Management Group [IMG] recalled commodities were in a 20-year-long funk. This was most evident in the collapse of market capitalization. Between 1980 and 2000, the broad-market industry weighting of natural resources declined from 35 to just 5 percent, according to S&P.

Then came a perfect storm of events, started in the mid-1990s, that’s been driving the current rally. The end of the Cold War opened up tremendous growth across eastern Europe. Chinese and Indian demand for raw goods began increasing exponentially, joined by a number of Latin American economies. And developed market demand surged following the recession of the early 1990s and again post 9/11.

A five-year sampling of spot prices by S&P through the end of 2007 shows that Copper rose nearly 34 percent a year. Crude Oil jumped by more than 25 percent annually. Wheat was up more than 22 percent a year. More volatile Natural Gas prices, which collapsed nearly 44 percent in 2006, saw more limited annualized gains of just 9.3 percent.

The second argument for commodity exposure comes from a 2006 study by asset allocation specialist Ibbotson Associates. It revealed exposure to this asset class reduced overall portfolio risk while boosting total returns by more than a full percentage point.

Thomas M. Idzorek, CFA, director of research at Ibbotson and the study’s author, tracked commodity performance from 1970 through 2004. Despite their sluggish state during the 1980s and 1990s, commodities generated the highest returns of all investments while being negatively correlated to all major asset classes. He also found commodities were positively correlated to inflation, thus making them a good hedge against rising prices.

Moreover, Idzorek thinks there is little risk that commodities will dramatically underperform other asset classes on a risk-adjusted basis over any reasonably long time period and suggests an optimal allocation range between 9% to nearly 14%.

Near the Top?

While Idrorek makes his case statistically, a problem may come in applying his conclusions in the real world. Commodity prices are notoriously trend animals. If an advisor moves his clients into this arena late into a rally and then suffers a significant drawdown, he may be tempted to get out before the sell-off bottoms and prices rally into the next uptrend.

Indeed moving capital into commodities at this time could be investing into a bubble where some prices have gotten well beyond their underlying fundamentals. Within a matter of a few days in the second half of July, the S&P/GSCI index sold off 10 percent.

Before commodities began selling off in July, JP Morgan’s Chief Market Strategist, David Kelly, thought there was inordinate risk in energy exposure [which we remind readers currently represents more than three-quarters of the S&P/GSCI Index]. He said at that point “buying oil and many other popular commodities is more speculation than investing and not consistent with basic long-term principals of fundamental wealth management.”

Kelly agrees prices have been driven by strong demand and insufficient supplies, exacerbated by geo-political concerns. But he also sees the increasing use of oil as a hedge against a weak U.S. dollar, the huge flows into commodity funds, and a surge in speculative trading of oil futures by disinterested players.

AIG Financial Products projected that $200 billion alone has been directed into commodity index funds worldwide over the last year through the end of June.However, Eric Kolts, commodity indexes product manager at S&P, thinks the market is large enough to handle that influx of capital without seriously moving prices.

Still, with the doubling of oil prices over the last year, Kelly sees a bubble forming.But because the oil markets are an amalgam of unpredictable forces, he thinks shorting is also a dangerous prospect.

Lehman Brothers’ chief energy economist Edward L. Morse is downright bearish about oil and regards the current market as Dot-com II. Before crude started sliding, he said oil inventories will start building up this fall. Production at deepwater wells will increase with the arrival of new extraction equipment.Refinery capacity will expand over the next five years, capable of processing dirtier crudes. Just as important, he suspects that Chinese growth will slow after the Olympics. By year’s end, Morse thinks oil will have collapsed below $100.

But then there are folks like Goldman Sachs who are predicting oil will hit $200.

Gaining [and Understanding] Exposure

High net-worth investors can access two commodity-focused investment vehicles: hedge funds and partnerships. The most transparent type of hedge funds are commodity trading advisors [CTAs]. Their investment positions and performance are reported monthly, collected by firms that follow the industry.

According to Sol Waksman, head of the data-tracking firm BarclayHedge, six commodity-focused CTAs, with 3-year track records [the longest meaningful period available] gained an average 28.59 percent a year through the end of May. They outpaced the S&P and DJ indices by more than 10 percent annually with volatility that’s in between the two indices.

The most compelling feature of five of the six CTAs is that they can go short as well as long, giving investors potential protection if markets change direction. And in this kind of environment, that could be the most attractive skill set of all.

Viennese-based FTC Capital’s Commodity Fund Alpha relies on systematic [as opposed to discretionary] trading of liquid commodity futures contracts, currently targeting energy [45 percent], base and precious metals [25 percent], and grains and soft crops [25 percent]. Having started up in April 2005, FTC’s trailing three-year annualized returns through May was 23.4 percent.

According to Roy Ratliff, an independent registered rep based in Kentucky who focuses on private placements, qualified investors can gain direct ownership rights to oil, natural gas, and metals through general and limited partnerships. Ranging in size from $500,000 to $300 million, available to investors during a limited offering period, partnerships also typically offer attractive tax benefits, wherein an investment can be entirely deducted after just a few years.

However, Ratliff urges investors to consider partnerships only via an experienced broker or private banking service who is thoroughly familiar with the opportunities and the risks of partnerships.

He recommends visiting, a website maintained on behalf of private placement issuers as way to promote greater information about partnerships. But unlike funds, Ratliff says there is no industry clearinghouse or data tracking service that compares partnerships and their sponsors. Therefore, due diligence is extremely important.

Key issues Ratliff urges investors to initially focus on include: 1) level of sponsor participation, 2) independent verification of geological findings, 3) copy of drilling and mining permit, 4) management’s track record in all previous ventures, 5) transparency and quality of investor relations, 6) existence of 3rd-party due diligence report, and 7) audited financials.

More traditional and instant commodity exposure can be gained through industry-leading equities such as BHP-Billiton, the world’s largest mining company based in Australia, whose shares have almost tripled in US dollar terms over the past five years through July 23. Suncor Energy, a leading Canadian extractor of oil from tar sands, has seen its shares rise more than five fold. And shares in US-based Archer Daniels Midland, a leading global agricultural commodity producer, has more than doubled.

However, since mid-April, ADM has plummeted more than 38 percent. And from the third week in May, when Suncor, Freeport-McMoran, and BHP peaked, all are now down more than 20 percent.

A more passive, diversified approach advisors can take is through ETFs and ETNs. Leading providers include Invesco’s PowerShares, Barclays Global Investors iShares, and UBS’ E-TRACS, and Merrill Lynch’s ELEMENTS. Some of these products track specific commodities, such as timber and forestry, biofuels and platinum. Others offer access to broad-based commodity indices, for which most advisors would likely opt.

But there is a big difference among the various diversified indices. As mentioned earlier, the S&P/GSCI index is production-weighted, with energy contracts representing nearly 78 percent of the fund. Industrial and precious metals represents 8.11 percent. Agricultural-related exposure is 14.16 percent.

Reflecting the “economic significance” of each sector, the DJ/AIG Commodity Index strives for diversity with a 33 percent limit on sector weightings. Energy, accordingly, tops out at one-third of the fund, while agricultural and metals weighting is 2.5 and 4 times their respective positions in the S&P/GSCI. This balance constrains volatility, with annual deviation running less than 15 versus nearly 22 for the S&P Index.

Such content difference produces distinct performances. Because of oil’s strong showing, one-year returns of the S&P/GSCI through June is up a whopping 76 percent. Three- and five-year annualized returns were 19.74 and 21.30 percent, respectively, while 10-year gains were 15.50 percent. The Dow Jones AIG Index gains were more modest. One-year returns were 41.56 percent. Three- and five-year gains were 18.84 and 18.60 percent, respectively. And 10-year returns were 13 percent.

Commodity funds can vary by more than just their underlying indices. Mihir Worah, portfolio manager of the PIMCO Commodity Real Return Strategy Fund, which tracks the DJ/AIG Index, has consistently outperformed his benchmark. Over the past year, he did so by 15.53 percent for reasons that go to the heart of how a commodity fund works.

Most commodity funds don’t buy stocks; they invest in futures contracts of the actual commodities. This requires little upfront payment. But it does require managers to hold the bulk of their assets in collateral, typically short-term Treasuries, to meet margin calls in case contracts fall in value.

In seeking above-market returns, Worah maintains the same sector exposure [e.g., Energy] as the index, but he will alter his subsector bets [e.g., heavier Heating Oil; underweight Gasoline] based on where he thinks there’s most upside. But he also manages his collateral to exploit interest rate trends. Currently, he’s invested in inflation-linked Treasuries with an average maturity of seven years via the Lehman Brothers TIPS Index. This meant that when the Fed cut rates last year, his collateral soared 15 percent.

Through active management, Worah believes his fund offers a more complete inflation hedge than most other indices. “Commodity exposure provides protection at the wholesale price level,” he says, “while TIPS provide it on the retail CPI level.”

E-TRACS UBS Bloomberg CMCI Index ETN reveals further strategic variation. Not only does UBS believe it has conceived a more balanced commodity index than S&P’s and Dow Jones’, but the bank claims its investment in more diverse commodity contracts, ranging from 3 months to 3 years, produces better results. Pro forma analysis between December 1997 through April 2008 indeed showed this, along with less volatility of 12.2.

Looking for even more octane or reverse drive? Leveraged exposure can be found in exchange-traded securities such as the Direxion’s Commodity 2X Bull Fund. Inverse exposure can be gained from DB’s Commodity Short and Double Short ETNs. Advisors can also short long ETFs to bet against the market.

Whichever way to decide to gain commodity exposure, make sure you understand what’s under the hood. Even the most comparably sounding investments can be quite different. And given the sharp U-turns commodity markets can make, constant monitoring of investments is essential.


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