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While the basic materials equity index is up nearly 24% over the past month, iPath Dow Jones AIG Total Return Commodity Index ETN (DJP) is up only 8%. If you blinked and missed this historical run up in equities, you can still gain some exposure to a possible recovery in the global economy. Commodity prices reflect relationships between short-term supply and demand for goods. Commodity price increases will occur in greater effect once economic activity begins to pick up. Unlike commodities, investing in individual commodity producers requires an investor to be exposed to a great deal of unsystematic risk. Commodity producers have recently priced in much of the future prospects of economic growth, whereas commodities have not reflected these prospects to the same extent.

The Dow Jones AIG Total Return Index is composed of several components of returns. Through DJP you are exposed to price changes in the basket of commodities held by the index, the roll yield of managing the futures within the index, and the collateral yield of the index. The roll yield is the gain from methodically rolling futures in a backwardated market. Rolling occurs when a future contract is near expiration and the long must enter into a new future contract of the same commodity. The gain occurring from the roll happens during a backwardated market, because the future price is less than the current spot price when the long enters the contract. Assuming the spot price does not change drastically from the purchase of the future, the long can sell the future at the current spot price and roll into another long contract with a future price less than the current spot price. The roll yield is that gain from the difference between the future price and spot price.

The other aspect of return to this index is the collateral yield. A collateral yield in the interest earned on the money used as collateral for the futures contracts. A collateralized futures position is one in which an investor invests the collateral of the futures position into T-Bills in order to maximize returns.

Another reason to favor the DJP index is the re-balancing of the index adds value to the total return of the portfolio. Unlike the Goldman Sachs S&P Commodity index, DJP caps the amount that a single commodity group can comprise to 33% of the overall index. Therefore, energy cannot comprise more than 33% of the portfolio, whereas the S&P Goldman Sachs Commodity index is a production weighted index, so energy comprises 65.90% of the index. DJP also requires that an individual commodity comprise at least 2% of the portfolio but no more than 15%. Because DJP index is re-weighted and re-balanced on a price-percentage basis annually, DJP will take money out of well performing commodities and invest it back into poorer performing commodities. Since commodities price increases over the long run do not actually outperform the risk-free rate, re-balancing is an important aspect of a commodity fund. This allows the fund to capture and save increases in out-performing commodities each year.

Commodities are also a good addition to a portfolio in order to reduce the variance of the portfolio. Correlation with the S&P 500 is only .37 and only .09 with the Barclays Capital U.S. Aggregate Index.

The five-year annualized return of the index was a positive .23% at the end of 2008 compared to –2.19% for the S&P 500.

By replacing a portfolio consisting of 100% of S&P 500 index with a 5% exposure to DJP and 95% exposure to the S&P 500 index, an investor can reduce their standard deviation to 12.62 from 12.86 (S&P 500 standard deviation). A 10% exposure to DJP and 90% exposure to the S&P 500 can reduce the portfolio standard deviation to 12.45. Given the positive long-term annual returns shown in Figure 3, this can provide an investor with significant returns not correlated to equity or bond price movements.

With the Federal Reserve’s extensive quantitative easing causing future potential dollar weakness and the risk of high inflation, now is the time to buy commodities. Commodities will provide a hedge against future inflation and buffer your portfolio against current instability in the financial markets. Over the past three months, DJP has traded in a much smaller range than the overall market.

If you want exposure to potential future economic growth without the volatility of equity, DJP is currently an attractive buy. Remember that DJP is more than an exposure to commodity prices. DJP is an alternative investment to a pure commodity price index because of the roll yield, re-balancing of the index, and collateral yield.

Disclosure: Currently holds no position in DJP.

Source: DJP: An Alternative Investment in Commodities