Commodity ETF Strategies: Now and Later

Managed futures has been long recognized to be an excellent portfolio diversifier.

However, long only commodity investment is not good enough. For example, in this 2008-2009 period, commodity ETFs such as DBC, GSG based on broad based commodity indexes and most of ETFs based on narrow commodity industry indexes such as DBA, DBE, DBB did not do well.

Thus, even a diversified portfolio such as Roger Gibson's portfolio or Individual Investor Portfolio proposed by David Swensen suffered big loss. The long short momentum based commodity trading strategies such as S&P Diversified Trends Indicator (S&P DTI) and turtle based strategies achieved outstanding performance, thus, they truly performed as a good hedge in a portfolio.

Momentum strategies are the most often used strategies in commodity trading. They usually take long or short positions based on the underlying commodity(ies) established trends. The reason why such a momentum driven investing is a good diversifier is when market is in a downturn, the commodity markets (as well as currency markets) exhibit great volatility and apparent trends.

With such trends established during these periods, these momentum driven strategies captured the performance of the rising and falling trends why other parts of the markets such as stock markets are falling.

Furthermore, because of supply and demand constraint, commodity prices often go on a period of rising and falling trends in such a market condition.

If you are an investor who prefer taking less action on your own, you might want to hire good managed futures managers to do the trading for you. Recently, there have been several mutual funds which employ such momentum long short strategies. They usually invest commodity futures while putting majority of money in the safe treasury or short term bonds to get some extra return.

These include Rydex managed futures fund (RYMFX) or Direxion's commodity trends strategy fund (DXCTX) or their financial trends strategy fund (DXFTX, which, strictly speaking, is not considered to be a commodity strategy since it is investing in financial futures such as interest rates and in currency futures such as Euro, Pound, Japanese Yen etc.).

The major drawback for these funds is the high fees they charge: RYMFX: 1.75%, DXCTX: 2%. For active or do it yourself investors, you could use the underlying ETFs to implement the same strategy.

For example, ValidFi's S&P Diversified Trend Indicators strategy invests in the ETFs in the following table.

Commodities 50%	Energy 18.75%	Powershares DB Energy (DBE)
	Industrial metal 5.00%	Powershares DB Base Metal (DBB)
	Precious metal 5.25%	Powershares DB Precious Metal (DBP)
	Agriculture 21%	Powershares DB Agriculture (DBA)
Financial 50%	Euro 13.00%	CurrencyShares Euro Trust FXE
	Japanese Yen 12.00%	CurrencyShares Japanese Yen Trust FXY
	British Pound 5.00%	CurrencyShares British Pound Ster. Trst FXB
	Swiss Franc 2.00%	CurrencyShares Swiss Franc Trust FXF
	Australian Dollar 2.00%	CurrencyShares Australian Dollar Trust FXA
	Canadian Dollar 1.00%	CurrencyShares Canadian Dollar Trust FXC
	U.S treasury Bond 7.5%	iShares Lehman 7-10 Year Treasury IEF
	U.S treasury Note 7.5%	iShares Lehman 1-3 Y SHY

Its model portfolio achieves the following performance, compared with RYMFX (bold is ValidFi's S&P Diversified Trend Indicator)

	2008	2009
Annual Return(%)	8.521	-2.536
ValdFi S&P DTI	14.869	0.556
Sharpe Ratio(%)	52.239	-49.24
ValdFi S&P DTI	117.588	4.612
Maximum Draw Down(%)	11.775	9.435
ValdFi S&P DTI	9.077	6.091

ValidFi also maintains the famous Turtle Trading strategy using commodity ETFs. Since the underlying ETFs are unleveraged, the strategy achieves much lower return with lower volatility. Its Sharpe ratio, however, is still very impressive. More detailed could be found in its model portfolios.

Year to date, the momentum strategies in commodities have not done very well. This is due to the trend change and then whipsaw of several commodities such as agriculture and the Japanese Yen (DBA and FXY). This is well expected. As stock market has risen so much, a possible correction or double dip recession possibilities loom large. One should expect that such strategies will again perform as intended when such downturn happens.

Furthermore, if the economy indeed recovers rapidly, the demand of the commodities will increase again. With the severe under investment in the supply side during this recession, one could expect the demand will outpace the supply again, thus making commodity prices rise rapidly. Moreover, such commodity investing strategies could be excellent hedging against the rising inflation threat.

Commodity ETFs have drawn more attention (thus assets) in the past several years. This will affect the limited commodity markets and increase the speculation bubble. Although it is unclear how such a bubble will affect the strategies mentioned above, one still should exercise caution while employing these strategies.

Disclosure: No positions.

Comments

[oldman:]

how do you expect DBA to be affected, if at all?

Aug 26 11:12 AM