October 10, 2010

Finding a Place to Hide in the Next Broad-Market Plunge

 

A solidly middle-class acquaintance once recounted how a century ago his family were large landowners in a then “undervalued” city. In the midst of an economic crisis, the family was forced to sell all their land for a pittance and emigrate. Naturally, that land, now located in the heart of an expensive, fashionable city, would be worth gazillions. This is precisely why the wise King Solomon counseled investors to “distribute portions to seven, or even to eight — for you never know what calamity will strike the land.”

Investment advisors do not usually hold much sway over clients’ employment or property ownership, but it is in the realm of liquid investments where you have the greatest influence and are most able to help clients both increase and protect wealth. In theory, you should effectively diversify to avoid the need to sell client investments at a loss; in practice, however, a crash like we saw in 2008 posed the rare challenge of having no place to hide, forcing many investors in need of liquidity to sell at a loss.

In search of Solomonic investing wisdom in today’s world, I turned to Southern California investment advisor Less Antman. Among the top echelon of talented advisors and brilliant researchers, Antman is unique in bridging both worlds, managing assets in the real world while consuming academic research and performing his own studies. True to form, Antman has a solution that should be of profound interest to all financial advisors.

A True Diversifier

“I always tell clients volatility is the price which must be paid for long-term growth: Buffett’s Berkshire Hathaway has lost 50% of its value three separate times. But I still try to diversify portfolios as much as possible without sacrificing returns, and a relatively unknown alternative investment is one of my favorites.”

Specifically, Antman recommends a commodity trends fund. Note that I am not talking about the commodities futures funds which became very popular in the past decade as other asset categories became ever more closely correlated. Alas, they offered no protection in the latest bear market; while a portfolio divided equally between U.S. and international stocks lost nearly 60%, adding a third equal commodity leg only cut that loss to around 55%.

A commodity trends fund is different, though. “It is designed to capture major moves in commodity prices, and performs well during both severe inflation and severe deflation,” Antman says. When does it lose money? “It suffers when commodities are trendless, getting whipsawed just as other moving average systems do. But stable prices help provide a business climate that is favorable for stocks.”

What a commodity trends fund gets you, in other words, is a “much stronger negative correlation to stocks than long-only commodity funds… making it a better diversifier,” Antman says. “In the 2000-2002 bear market, when global stocks declined 45%, adding either type of commodity hedge would have reduced the loss to around 30%. In 2008, however, because of the severe commodity deflation, long-only funds suffered along with stocks while trend-based indicators rose substantially.”

Two Funds Following the CTI

Currently, only two funds follow the Commodity Trends Indicator (CTI) on which he based his analysis. Antman favors Direxion Commodity Trends Strategy Fund (DXCTX) in spite of its high 1.93% net annual expense ratio, which should decline as assets increase. He is less comfortable using Elements’ S&P Commodity Trends Indicator exchange-traded note (LSC) because of the company risk inherent in the ETN’s structure (it essentially involves an unsecured loan to HSBC).

So how would it have performed in the 2007-2009 debacle? According to Antman’s research, “once the trend in commodity prices was down, most of the commodities flipped to short or neutral, while gold stayed long, and the overall effect was for a three-way split between U.S. stocks, international stocks, and a CTI fund to decline just over 30% overall, instead of nearly 60%.”

Still a bear market, but not nearly as devastating. That just might have kept my friend’s ancestors in their property.

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