Sign of the Times: Long, Short and Flat in One Index

By Brad Zigler

Index investors used to be easy to spot. They once wore "long-only" signs around their necks. Recently, though, indexes of all sorts have been created that aren't limited to simple buy-and-hold methodologies. We now have "strategy indexes" that allow for short, long and/or flat positions in a portfolio.

Among these is the S&P/Commodity Trend Indicator [CTI] Index, a composite of 16 commodity futures grouped into six sectors. The index algorithm positions each sector as long, short or flat, based upon its recent price behavior, and uses market momentum vs. a seven-month moving average as the trigger for repositioning.

In particular, the CTI methodology treats two sectors specially—softs and energy. For softs—that is, cotton, sugar, coffee and cocoa—positions are set on an individual commodity basis. For energy, the only exposure options are long or flat; CTI countenances no shorts in petroleum group futures.

Since June 2008, the S&P/CTI has been tracked by the ELEMENTS S&P CTI Exchange-Traded Note (NYSE Arca: LSC), an obligation of AA-/Aa3-rated HSBC.

When we last looked at LSC, it had handily outperformed long-only commodity trackers, such as the iPath Dow Jones-UBS Commodity Index Exchange-Traded Note (NYSE Arca: DJP) over the second half of 2008. By year's end, LSC had gained 6.3%, while DJP had lost 50.1%.

Much of LSC's 2008 outperformance was due to its avoidance of the crude oil market. DJP, on the other hand, had outsized exposure—on the long side—to the historic midyear plunge in energy prices.

LSC Performance: 23 June 08 - 31 Dec 08

This year, however, LSC's been dragging its tail. Since the top of the year, the momentum-following ETN has given up 11%, while DJP's gained 6.5%. Apparently, buy-and-roll has been the better approach to commodities in 2009.

Contango's Effect On Commodities ETNs

Because of contango, DJP's return actually understates the returns that can be earned from buying commodities. (Contango describes a carrying charge market, where commodities destined for later delivery are priced higher than commodities delivered earlier; the price spread mostly reflects storage, insurance and financing costs.) Rolling a long futures position forward in a contango means selling the expiring, near-term delivery at a lower price than it costs to acquire the deferred contract. The cost of rolling eats into the returns garnered by the appreciation in the price of the commodity.

Keep in mind that the roll effect is reflected at the index level. DJP and LSC are exchange-traded notes, not funds, so there's no portfolio directly backing these notes.

LSC isn't immune to contango's effect. The note's underlying index methodology often calls for positions to be held over expirations, thus subjecting them to the roll yield. The CTI index, for example, has held a nominal long position in the energy sector for four straight months this year.

Because short positions can be maintained, LSC can also turn contango into an asset multiplier. Why? Because rolling a short position forward in a carrying charge market dictates buying (to cover) the lower-priced nearby contract while simultaneously selling the higher-priced distant futures. For shorts, the roll produces a positive yield in a contango.

Breaking Down LSC's Composition

This year, LSC's index has been whipsawed by a number of markets, particularly in the softs sector. Coffee, which vacillated throughout 2009, has been a particularly troublesome commodity. And while the index is long sugar now, early-year fluctuations flipped the allocation between short and long for losses.

LSC Performance: 31 Dec 08 - 02 Oct 09

Also, the CTI index has called for a short position in the livestock sector for the entirety of 2009. Although short was definitely the place to be in the hog market, a worthy short really didn't develop in live cattle until July, which cut into the sector's return.

Plus, after the precipitous drop in energy prices in 2008, the momentum signal didn't flash "long" until June, just at the time prices began to plateau. The CTI energy sector also includes natural gas, which nose-dived through Labor Day, further trimming the gains from other petroleum futures. So what was a distinct advantage last year has turned out to be a bit of a liability this year.

What does the LSC mix look like now?

The index algorithm most recently called for the reversal of its short position in precious metals, while at the same time flipping to the short side of cocoa.

LSC Sector Positions - September 2009

Sector	August Position	September Position	Nominal Weight
Energy	Long	Long	37.50%
Grains	Short	Short	23.00%
Industrial Metals	Long	Long	10.00%
Precious Metals	Short	Long	10.50%
Livestock	Short	Short	10.00%
Softs (by Commodity)
Cocoa	Long	Short	2.00%
Coffee	Long	Long	3.00%
Cotton	Long	Long	2.00%
Sugar	Long	Long	2.00%

It remains to be seen if the momentum-following style of LSC will win out over the long-only approach over the course of the entire year. One thing is certain, though: Despite being under water on a "since inception" basis, LSC is still ahead of DJP by a wide margin. Since June 2008, LSC's off 5.4%; DJP has lost 46.9%.

Now, is that enough of a difference to make you want to tear up your "long-only" sign?

Since-Inception LSC Performance

Comments

[BullnBear:]

This current market moves with no fundamental basis so the only way to play anything seems to be with a hedge in both directions.

Oct 06 01:18 PM

[searcher:]

Thinking about anything to do with commodities trading makes me want to go and lie down until the feeling passes.

Oct 07 01:01 PM