August 22, 2012

How to Hold On for Commodities’ Wild Ride

Longview index sports 10-year returns more than double the two most popular benchmarks

The daily price of corn is up 25% year to date. (Photo: AP) The daily price of corn is up 25% year to date. (Photo: AP)

The brutal summer has continued to bring devastation to corn, soybeans and other staples, causing food prices to rise and roiling global commodities markets.

The pureplay Teucrium Corn Fund, (CORN) for example, has risen a further 5% in the past month, following a 25% spike which AdvisorOne reported the previous month, thus upending traders who assumed prices would not rise above corn's $8-per-bushel peak in July. As of Tuesday, the daily price of corn reached $8.58, representing a 25% increase year to date.

Experience teaches that the vagaries of drought, flood, disease and pests are entirely unpredictable, which is why individual commodity investing is considered high risk and really more akin to a bet.

And the demand side is similarly unpredictable, since supply shortages and their consequent price increases induce greater consumption of commodity substitutes that have decreased in price. (Lamb and beef prices have fallen this year, for example, and some industrial producers likewise have the ability to shift production inputs.)

So, to avoid commodities’ wild ride, while gaining their investment benefits, which include their noncorrelation with equities and stock-like returns, many investors favor ownership of broad-based commodities futures indexes.

The best known index in the space is probably the Dow Jones-UBS Commodities Index, and retail funds based on this index include the popular PIMCO Commodity Real Return Strategy Fund (PCRIX). The other primary index in the space is the Goldman Sachs Commodity Index, and a popular ETF that tracks that index is the iShares S&P GSCI Commodity-Indexed Trust (GSG).

But an article in the July/August issue of the Journal of Indexes, called Better Beta in Commodities Indexing, discusses a little-known index with long-term performance more than double that of either the Dow Jones-UBS or Goldman Sachs indexes. That index is the Longview Extended Commodities Index, which is available to retail investors through the Arrow Commodity Strategy Fund (CSFFX).

Jon GuyerThe author of the Journal of Indexes article, Jonathan Guyer, is an interested party. Guyer (left) is the principal and chief investment officer and portfolio manager of the Longview index. But the results he reports do not appear to be the usual ballyhooed superiority claims that are typical for the investment industry since Longview’s long-term results stand out rather dramatically from its competition, precisely as the index (whose name, “Longview,” is intended to convey its long-term focus) is designed to do.

In the 10 years ending June 30, the Longview Extended Commodity Index generated returns of 12.44%, compared with 4.95% for the Dow Jones–UBS index and 3.43% for the Goldman Sachs index.

In a phone interview with AdvisorOne, Guyer, a commodities wonk who has analyzed the various indexes since 1994, said his index was unique because it was “attuned to replication costs associated with high-frequency index strategies” as well as the “rolling issues of contango.”

Contango and backwardation refer to the shape of the curve of commodity prices when taking positions in commodities futures contracts. Guyer says “you want to mitigate the contango issue; you can’t eliminate it.”

While other indexes attempt to minimize contango and maximize backwardation in their efforts to achieve price momentum, Guyer’s focus is on efficiency.

Through its use of far-dated futures contracts 12 to 15 months from expiration, Longview has lowered frictional costs and reduced volatility. Other benchmarks, which take positions in futures contracts just one to three months out, have standard deviations of 18% (DJ-UBS) or 25% (GSCI) compared with 17% for Longview.

Guyer says another key difference for Longview is that it is the only market-cap-weighted commodity index in the world. He approvingly cites Vanguard Group founder John Bogle as saying that any non-market-cap weighting is essentially “a directional bet”—in other words, speculation.

Rather than letting a committee or computer program project the direction of commodities prices, Longview’s long-term approach, like Vanguard’s, is to let market prices sort all that out as commodities prices constantly change and adjust to market conditions.

“What matters is supply and demand,” he says.

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Read Is There a Way to Play Commodities’ Wild Ride? on AdvisorOne.

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