A Hedged Commodity Play for the Masses

12/24/2008 12:01 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns of Morningstar ETFInvestor and analyst Bradley Kay find an ETF that uses sophisticated hedging strategies to invest in commodity markets. 

Based on a long-short commodities index, ELEMENTS S&P CTI ETN (NYSEArca: LSC) is one of the few "hedge-fund-light" strategies available to individual investors at a small fraction of hedge funds' fees.

It tracks Standard & Poor's Commodity Trends Indicator Index, which is a long-short index meant to capture the "roll yields" and momentum of a wide variety of exchange traded commodity futures to produce a more stable return with little correlation to traditional asset classes.

Commodities have historically provided a hedge against inflation and nearly 0% correlation with equities, which makes them a worthwhile diversifier despite very low long-term returns. (In the recent market meltdown, however, commodities have declined in tandem with stocks-Editor.) 

The S&P Commodity Trends Indicator Index separately invests either long or short in six different commodity sectors: energy, industrial metals, precious metals, livestock, grains, and softs (exotic agricultural commodities). The allocation to each individual commodity within the sector is reset annually to reflect relative changes in production value.

This index will not short energy, but instead will proportionately redistribute energy's share of index exposure to the other five commodity sectors when the price is falling.

This index moves into long positions in commodity sectors when the underlying commodity prices are rising and shorts a sector when prices are falling in order to capture multimonth momentum in the futures contract prices.

This strategy has held up well during the incredible test of 2008, rising in the first few months of the year along with the majority of commodity prices, then experiencing a couple of months of smaller losses, and finally providing substantial positive returns through September and October as it switched into short positions while prices [fell].

This particular fund is structured as an ETN. Unlike commodity mutual funds or exchange traded funds, ETN owners don't have a claim on a portfolio of cash and commodity-related securities. Rather, they hold a 30-year note backed by HSBC (NYSE: HBC).

Given the natural persistence of global macroeconomic conditions and supply constraints, this strategy seems likely to continue reaping excess returns relative to long-only commodity exposure for some time.

And given its higher returns and lower volatility than long-only commodity indexes over the past six years while maintaining near 0% correlations with major equity indexes, we believe this promising ETN deserves careful thought from any investor seeking a portfolio diversifier beyond bonds and stocks.

This ETN charges 0.75% a year, which is the same as long-only commodity ETFs from iShares and PowerShares.

Our single-biggest 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, potential investors should [watch] net asset values and use limit orders to make sure they are buying near fair value.

(It traded above $11 on Tuesday—Editor.)

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