From the November 2011 issue of Investment Advisor • Subscribe!

Not Your Father’s Commodity Investments

Today’s commodity mutual funds are built to increase the diversification in long-term, buy-and-hold portfolios

As a rule, I don’t write about the companies that I work with as consulting clients (or their products) due to the obvious conflicts of interest. But, I have made exceptions from time to time, when, in the course of my work, I come across information that would be valuable to independent advisors. For me, the bottom line is helping advisors better serve their clients, and if I have to bend a rule to do that (even one of my own), I will, and let the advisors be the judge.

In this case, while I recently was working on a white paper about the emergence of alternative strategy funds for Direxion Funds (scheduled to be published this fall), I came across some tangential information about alternative investment mutual funds that I didn’t know—and I suspect that many traditional asset allocating advisors don’t know, either: To use alternative investments in investment portfolios, you don’t have to actively trade them yourself or meet the qualifications for a privately traded hedge fund to manage them for you. This is particularly important these days, as more traditional advisors than ever are considering the potential for low-correlating alternative investments to protect client portfolios from another across-the-board market drop like we saw in 2008 and 2009.

Specifically, I’m talking about commodities and currencies, which many traditional advisors have, well, traditionally shied away from. And for good reason: Holding gold went out of vogue in fashionably allocated portfolios when inflation fell to low single digits, and commodity investments included the risk of having to find a place to store a truckload of pork bellies if things went against your position. In fact, I remember many years ago, IAFP (the forerunner of the FPA) board member Bill Kovasic, who lived in Chicago, the home of the commodities trading pits, argued that effective asset allocation required the diversification and inflation hedge of commodities. His reception by advisors couldn’t have been cooler if he had been pushing ostrich farms.

The other reason why most advisors have historically avoided commodities and currencies—despite their low correlation to equities and bonds—is because they are volatile, market-trend investments that aren’t particularly well-suited to a buy-and-hold strategy. Most independent advisors simply weren’t, and still aren’t, philosophically or operationally oriented to actively trade investments.

I suppose one might argue that over time, commodity prices tend to trend upward. But even so, with inflation rates low during the past 25 years, they would still underperform even bonds as a long-term investment. What’s more, with the exception of precious metals, commodities such as livestock, grain or oil tend to have short shelf lives, which means commodity-based investment vehicles tended to be relatively short-term as well. Consequently, advisors looking for longer term hard assets have tended to turn toward gold or real estate.

The introduction of long/short commodity and currency mutual funds has changed that equation. Bought and sold just like any other mutual fund (with a short-term redemption fee), commodity funds provide access to the correlation and total return profiles of commodities, without the need for daily management or specific market expertise on the part of financial advisors. What’s more, the use of short-selling techniques in addition to long positions allows fund managers to generate positive returns regardless of which direction commodities markets are trending.

“Today’s financial world is steeped in uncertainty about interest rates, taxes, sovereign debt in Europe and a slowdown in China,” says Andy O’Rourke, chief marketing officer for Direxion Funds in Newton, Mass. “And uncertainty tends to be a self-fulfilling prophecy; it creates more volatility. This market—with its multi-decade lows and unusually high volatility—is making people think about putting more diversity into their portfolios. Downside protection is a term we hear a lot more these days. What they are looking for are nontraditional asset classes that will provide additional stability to portfolios.”

Commodities and currency are two nontraditional asset classes designed to provide more of the portfolio diversification that Andy is talking about. But as it turns out, the ability to go either long or short is only half the sophistication required to provide the quantifiable diversification that many advisors are looking to add to their allocated portfolios. The other half is a rules-based investing system that use indexes designed to perform in predictable ways.

For instance, Direxion uses its experience and expertise in replicating indexes that employ a consistent rules-based methodology such as the Commodity Trends Indicator, a single proprietary index that tracks exposure to 16 commodity markets in six sectors—energy, industrial metals, precious metals, grains, livestock and soft commodities, which include cocoa, coffee, cotton and sugar.

Then, in its Commodity Trends Strategy Fund, Direxion management holds each of those sectors long or short, based on the price trends indicated by the CTI. The long/short decisions involve monitoring the price of the sectors compared to their seven-month moving average prices. The only exception is the energy sector, which, due to its long-term upward trend mixed with short periods of intense volatility, is held either long or neutral, but never short.

Using its CTI, Direxion generates investment returns that have a 0.38 correlation to the S&P 500, 0.34 to the Russell 2000, 0.37 to the MSCI EAFE and even a 0.40 correlation to the MSCI Commodity Related Index (which itself has a 0.92 correlation to the S&P). So much for diversification, but what about actual returns? For the seven-year period from the beginning of 2004 until the end of 2010, the Direxion CTI posted a compound annual return of 10.29% compared with 1.35% and 4.98% for the long-only S&P Goldman Sachs Commodity Index and the Dow Jones UBS Commodity Index, respectively.

We see a similar noncorrelating picture on the currency side of the equation. Direxion’s FX Trends Indicator follows 11 global currencies (also with relatively low correlations to each other), that independently profit from a rise or fall in the U.S. dollar: the euro, Japanese yen, Swiss franc, Brazilian real, British pound, Mexican peso, South African rand, Norwegian krone and the Canadian, Australian and New Zealand dollars. The correlation of the FXTI to the S&P 500 is -0.14 and -0.08 to the BarCap U.S. Bond Index. Since Dec. 31, 2003 through June 30, 2011, the FXTI has generated annual returns of 7.72% versus 2.72% for the S&P and 5.74% for the BarCap Bond Index.

“Retail portfolios today need to be concerned both about rising interest rates and the falling dollar,” says O’Rourke. “Ten years ago, you had to be a full-time player using sophisticated investment vehicles to hedge your position. Today, in a well-structured commodity fund, investors can benefit from either a rising or falling dollar, or rising or falling interest rates. Index funds have changed over the years. Now, we are able to use completely transparent models to generate alpha with indexes, in addition to simple diversification.”

Despite their portfolio advantages, alternative investment funds obviously are not for every portfolio. Still, now that commodity and currency investments have been packaged into index mutual funds, they are essentially the same as investing in an S&P 500 fund, with different MPT characteristics. With many advisors and clients reassessing their investment strategies after the turbulent past few years, it’s a very good time to explore additional portfolio diversification and adding noncorrelating income streams.

It’s also not a bad time to talk to clients about adapting to the new financial and economic environment by adding more sophisticated investments. During the 25-year bull market that has spanned the careers of many advisors, there hasn’t been much of a need for alternative investments in client portfolios. Now that the ride up seems to have come to an end, it’s probably time to reconsider which asset classes should comprise an adequately diversified portfolio.

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