A Commodities ETF with a Hedge-Fund Strategy

04/28/2010 1:00 pm EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, associate director of ETF research at Morningstar, says a long-short commodities ETF is very attractive, even though it underperformed in the bull market

ELEMENTS S&P CTI ETN (NYSEArca: LSC) is our strategic choice for commodity investing, and it uses a long/short strategy rather than the long-only exposure provided by more-popular funds such as iPath DJ-UBS Commodity Index TR ETN (NYSEArca: DJP) or iShares S&P GSCI Commodity-Indexed Trust (NYSE: GSG).

LSC has lost 16% over the last year, while DJP and GSG have each gained just a tad more than 20%. LSC’s poor performance over the last year compared with long-only funds’ is mostly due to the nature of the underlying market.

Commodity prices rose substantially over the course of the year, and most of the upward movements were sharp and sudden. This did not cause the momentum indicator to shift the fund’s exposure in time to capture the gains.

When commodity-price volatility is high but trending in one direction, we should expect LSC’s returns to be abnormal. We simply think volatility will likely decrease over the long haul.

So, what about the performance since the fund’s June 2008 inception? During that period, LSC lost only 15% while DJP and GSG lost 42% and 56%. None of these funds offered the diversification benefits strategic commodity investors seek when the market crashed, but LSC did a heck of a lot better than the alternatives. Furthermore, LSC did so with much less volatility than the long-only funds.

We expect lower volatility and higher risk-adjusted returns when deploying a long-short commodity fund than its long-only counterparts over long periods of time, but we know some years will be exceptions (2009 was one of them).

If you were prescient or lucky enough to own a long-only commodity fund over the past year, good for you. But pardon if I ask why you own commodities in the first place? If it is for a noncorrelated asset class to increase the risk-adjusted returns of a stock/bond portfolio, do you always expect your commodity position to rise when stocks and bonds are both performing well?

It would be unrealistic to expect every asset class to increase in value simultaneously over any given time period. If this were the case, we wouldn’t own commodities at all. In fact, we wouldn’t own bonds, either. We would simply select the highest-returning asset class (given a long-enough time horizon) and tolerate the volatility. Correlation, or the lack thereof, is why we diversify across asset classes in the first place.

Commodity funds of all sorts have all been plagued by futures-markets inefficiencies over the past few years. I do believe, however, that if you do decide to own commodities in a passive portfolio, you should consider keeping a long-short strategy like LSC in your portfolio regardless of last year’s returns.

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