Low correlations between asset classes can help investors.

Investing in a poorly performing asset class can be a tough sell with clients, especially those who have a tendency to chase winners. Broad-based commodity funds with a long bias—those that invest (but don’t short sell) in multiple, unrelated commodities—certainly have fallen into that category recently.

Consider the recent annual percentage returns of the Broad Commodity funds as categorized and tracked by Morningstar. (“Flat” funds can move to cash as a defensive maneuver.)

Those results aren’t surprising in light of the underlying performance of commodities lately.

Fund Category/

Year

Year-to-date (%)

2014 (%)

2013 (%)

2012 (%)

2011 (%)

2010 (%)

Global Long/Flat

-0.6

-5.9

-2.9

-5.5

 0.6

 12.6

Long/Short

 0.9

-5.4

 5.2

-11.4

 1.6

 11.4

Long-Only

-3.5

-24.4

-3.8

 3.7

-5.3

 23.6

Long/Flat

-0.1

-5.9

-2.1

-4.6

-1.6

 17.4

Short/Flat

 1.0

 0.4

 7.5

-7.5

 3.4

-5.3

Short-Only

 0.4

 28.8

 3.2

-9.4

 2.4

-19.2

(Source: Morningstar Index Data. 2015 returns through 7/13/2015.)

In 2014, all 12 of the major categories were lower, ranging from gold (-1.5%) to gasoline (-47.2%). In contrast, in 2010 11 of the 12 commodities moved higher, led by cotton’s 91.6% increase.

Otherwise, though, since 2010 it’s been a tough slog for the broad-based funds with long positions. But does the recent underperformance mean advisors and investors should avoid this asset class?

Relying on Correlation?

The low correlations between commodities and stocks and bonds are a cornerstone of the diversification argument for including commodities in the portfolio.

Ed Egilinsky, managing director, head of alternatives with Direxion Investments in New York, managers of the long/flat Direxion Indexed Commodity Strategy Fund, believes it’s still a valid reason. Over longer periods, he notes, commodities do not have a significant correlation with equities and consequently can add diversification within a portfolio.

Despite the asset class’s poor recent performance, he says, advisors and investors need to consider past market cycles, as well as the current low interest rate, bullish stock market scenario.

“There’s going to be different market cycles and periods of time where asset classes perform better than others and commodities has had a number of headwinds to it over the last couple of years,” the portfolio expert explained.

Historic correlations can change, however, particularly during aggressive bear markets. Chicago-based Morningstar analyst Kevin McDevitt points to some funds’ performance in 2008 as an example. The long-only category funds dropped an average of about 34%, and several funds lost 40% or more of their value.

“So, I wouldn’t want to go all-in on kind of that diversification argument or at least looking at them as a way to prevent losses,” he cautioned. “It’s possible that diversification benefit will be there in the future but I just think it’s very hard to predict.”

Among the broad-based categories, the long-only category was by far the weakest performing long category in 2008. However, the long/flat funds’ average loss was only -1.3%, and global long/flats were up 1.1% that year. Those results compare very favorably with the equity markets’ 30%-plus drop.

Waiting for Economic Growth

The key drivers for long positions typically are the U.S. dollar’s value and global economic growth, which increases demand for commodities and can lead to higher prices.

The Direxion Indexed Commodity Strategy Fund’s recent portfolio changes may be a sign that commodities’ prices are finally stabilizing and about to move higher. The fund tracks the performance of the Auspice Broad Commodity ER Index (ABCERI) with a quantitative long/flat decision model for the 12 major commodities in the energy, metal, and agricultural sectors.

The model is generating more buy signals: On March 31, 2015, the fund held long positions in only cotton and gold but it held seven long positions as of mid-July, says Egilinsky.

Risk-averse investors seeking commodity exposure based on the potential for continued economic growth might want to consider a long/flat fund because those funds usually exhibit lower volatility than long-only funds.

For example, during the period from Oct. 1, 2010 to March 31, 2015, the ABCERI’s annualized standard deviation of 10.1%  was significantly less than the major long-only indexes’ standard deviations.

Similarly, the ABECRI’s maximum drawdown percentage (i.e., peak to trough decline) of 26.7%  for the same period was much lower than the long-only indexes.

While it may still be too early for a large commitment to commodities, establishing a position in a long/flat fund could make the waiting period easier for clients to manage.

— Check out Top 10 Mutual Fund Firms Most Trusted by Advisors: Cogent on ThinkAdvisor.