July 25, 2012

Is There a Way to Play Commodities’ Wild Ride?

Do investors short the asset class, which is going down, or factor in segments that are heading up?

The CORN ETF is up 25% this month as drought plagues the Midwest. The CORN ETF is up 25% this month as drought plagues the Midwest.

Commodities prices are famously unpredictable, but many on Wall Street are nevertheless predicting these tangible investments can only continue to lag as a result of the global economic slowdown.

The Dow Jones-UBS Commodity Index, a broad index comprising 19 physical commodities including energy, agriculture and industrial and precious metals, has fallen nearly 15% for the year, one of the worst performances of any investment class. But in characteristic style, the same index has shot up nearly 10% over the past month, largely as a result of agricultural commodities within the index that have surged as a result of drought conditions limiting supply.

In fact, the corn crop has been so battered that pork producer Smithfield Foods has taken the unusual and counterintuitive step of importing corn from Brazil, where even the addition of expensive shipping costs results in a lower price than corn offered in the U.S. market, long the world’s No. 1 corn producer.

Pureplay commodities traders who owned the Teucrium Corn Fund (CORN), an exchange-traded fund, saw their investments surge 25% in the past month. The weather in St. Louis on Wednesday was expected to reach 106 degrees and dry, with some rainfall relief expected on Thursday.

The persistence of hot weather and low precipitation can only result in low U.S. crop yields, which is why even commodities bears like Morgan Stanley Smith Barney favor some commodities within the agricultural sector. But the thrust of the Wall Street firm’s recent Global Investment Committee monthly commentary is that slowing global economic activity will lessen demand for commodities, for which reason the firm is officially underweight the asset class.

Says Morgan Stanley in its report: “Hussein Allidina, head of commodity strategy at Morgan Stanley and a member of the Global Investment Committee, lists certain base metals—namely zinc, lead, aluminum and nickel—among his least favored commodities from a short-term, tactical perspective, primarily because of their ties to industrial activity.”

The Wall Street firm is also negative on oil for the same reason, but is bullish on gold, seeing it as a hedge favored by investors to guard against low interest rates and eurozone troubles.

Investors who understand that economic weakness reduces consumption of commodities as a group but that individual commodities are also as unpredictable as the weather in the Midwest’s agricultural heartland have a choice between buying or shorting a broad basket like the Dow Jones-UBS Index or taking a chance on single-commodity ETFs like CORN or SOYB (the Teucrium Soybean Fund), which may have—who knows?—fully priced in the effects of the drought and could be ready for a fall.

An actively managed commodities fund that picks winners and losers offers the possibility of benefiting from both the broader trend and micro-trends, which may at times be at odds with one another. The success of such a strategy of course depends on the skill and foresight, or lack thereof, of the manager.

The PIMCO Commodity Real Return Strategy Fund (PCRIX), which is designed to invest in commodity-linked investments, is currently invested mostly in Treasury notes, suggesting it too is bearish on the economy and its industrial inputs. That strategy has served the fund well over the past month, when it rose nearly 12%, but the fund’s long-term performance has been negative over 1-year, 5-year and 10-year periods. The Oppenheimer Commodity Strategy Total Return Fund (QRAAX) has had nearly identical performance over the same time periods.

In contrast, the Van Eck Global Hard Assets Fund (GHAAX), which actually invests in commodities companies, is up just 3% over the past month but has returned 213% to its investors over the past 10 years.

In related news, earlier this month, AQR Capital Management, which manages portfolios for large institutional investors and which in 2009 began managing mutual funds sold through financial advisors, announced the launch of the AQR Risk-Balanced Commodities Strategy Fund (ARCIX).

A release announcing the new fund says “the commodities fund seeks to achieve higher returns than its benchmark (DJ-UBS Index) while maintaining a more consistent risk level and smaller drawdowns using an actively managed, risk-balanced approach.”

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