Commodity Investing: Long/Short (S&P Commodity Trend Indicators) vs. Long-Only

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 |  Includes: DBA, DBB, DBE, DBP, GLD, SLV, UNG, USO
by: MyPlanIQ

Last week's market volatility is a good reminder on how precarious it is in commodity investing. For the week, the broadbased commodity index ETF (NYSEARCA:DBC) dropped 3.09% while Gold (NYSEARCA:GLD) fared better, dropping only 0.81%. Agriculture commodities (NYSEARCA:DBA) dropped even more: 3.71%.

It is now generally recognized that adding commodity exposure to a long term portfolio that adopts a strategic asset allocation strategy can increase the diversification effect and thus possibly improving risk adjusted returns. However, given the high volatility (and risk) of commodities, it is important for an investor to understand the difference between a long-only approach and long/short approach in this asset investing.

A long-only approach is simply buying a commodity index such as Powershares DB Commodity Index ETF (DBC) or GSCI commodity index (NYSEARCA:GSG) (or sub index such as agriculture (DBA), precious metal (NYSEARCA:DBP)). A long/short approach, on the other hand, can simultaneously take long and/or short positions in multiple commodity components. The long/short approach is mostly based on technical indicators such as moving averages, momentum and reversals. This approach has been adopted by professional CTAs (Commodity Trading Advisors). A simple and popular strategy is the S&P Diversified Commodity Trend Indicators. In the following, we describe a simplified variation of this strategy that uses Powershares DB commodity ETFs.

1.The original asset allocation

Energy 37.5%

Powershares DB Energy (NYSEARCA:DBE)

Industrial metal 10%

Powershares DB Base Metal (NYSEARCA:DBB)

Precious metal 10.5%

Powershares DB Precious Metal (DBP)

Agriculture 42%

Powershares DB Agriculture (DBA)

Click to enlarge

2. Position determination

At the end of each month, the monthly percentage change of an ETF's price is compared to its past monthly price change that is exponentially weighted by giving greatest weight to the most recent return and least weight to the return seven months prior.

The weights are as follows:

NUMBER OF MONTHS

WEIGHT

7

2.32%

6

3.71%

5

5.94%

4

9.51%

3

15.22%

2

24.34%

1

38.95%

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Simply put, it compares its monthly price change (return) with its exponentially weighted average of monthly returns in the last seven months. If the most recent month return is bigger than its seven month exponentially weighted average, the strategy takes the long position otherwise, it takes a short position. A position's weight is determined by the table # 1.

3. Monthly rebalancing

The portfolio is rebalanced monthly by setting every ETF to its original percentage.

For more information, please refer to Standard and Poor's Commodity Trend Indicator document.

The following table compares the performance between S&P Commodity Trend Indicators Portfolio (S&PCTI) and the general broadbase commodity ETF (DBC):

Portfolio

Last 3 Years

Last 1 Years

2007

2008

2009

2010

2011

AR(%)

S&PCTI

5.049

14.884

15.939

23.768

2.282

3.186

5.148

AR(%)

DBC

-8.826

25.383

31.579

-31.799

16.187

10.154

7.695

Sharpe Ratio(%)

S&PCTI

29.127

113.142

91.832

107.569

14.048

23.723

39.12

Sharpe Ratio(%)

DBC

-20.516

150.174

160.984

-97.51

58.736

52.501

415.108

Standard Deviation(%)

S&PCTI

16.389

13.074

16.719

21.232

15.572

13.045

13.119

Standard Deviation(%)

DBC

27.914

18.435

17.728

34.962

27.397

19.578

15.275

Click to enlarge

Though compared with DBC, S&PCTI under performed in 2009, 2010 and 2011, it out performed DBC in the last 3 years. This is because it had 23.8% return in 2008, compared with DBC's 31.6% loss in the same year. Furthermore, S&PCTI has a standard deviation 16%, compared with DBC's 28%. In fact, S&PCTI's standard deviation is consistent with that of an overall stock market index such as S&P 500 (NYSEARCA:SPY).

It is perhaps even more important to pay attention to maximum drawdowns for S&PCTI: since its inception 10/1/2007 (this is due to the short history of commodity ETFs used in this portfolio), its maximum drawdown is about 19% vs. DBC's whopping 60% (during the 2008-2009 detacle).

The takeaway is that for active investors, one might want to consider adopting a long short approach in commodity investing. Investors can find Element's ETN (NYSEARCA:LSC) or Direxion's Commodity Trend Strategy Inv (DXCTX) that implement the S&P Commodity Trend Indicators strategy or just implement this by using the ETFs mentioned above. Before you invest, however, you are encouraged to compare the portfolio S&PCTI with LSC and DXCTX.

In the follow up articles, we wil further compare how the long only and long short strategies can be used in strategic and tactical asset allocation portfolios.

Disclosure: MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical

Disclosure: Author is long DBA, DBC, GLD, SLV.