Not Your Father’s Commodity Investments

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.”