Despite Recent Correction, DBC Remains a Solid Long-Term Holding

Mar.27.08 | About: PowerShares DB (DBC)

The last week or so showed that the seemingly unending run-up of commodity prices isn’t immune to the wild volatility of world financial markets. Crude oil prices dropped almost 10% from a record high, gold dropped 11% in three days, and the Reuters/Jeffries CRB Index of 19 commodities futures lost 8%, representing its worst week since its 1956 inception, according to Reuters on Tuesday.

The PowerShares DB Commodity Index Tracking Fund (NYSEARCA:DBC) took a beating, too, with a five-day loss of 7.9%, compared to a 4.5% gain by the S&P 500. The move probably shocked investors who’ve piled into the fund in recent months—DBC’s asset base grew by 167% over the last 12 months, including a $238.6 million gain in February—and left many wondering if the five-year commodity bull market had gone bearish.

Not likely, at least over the longer term, because the sector has too much going for it, fundamentally speaking. “We had a bit of a correction, but it’s to be expected,” Bill O'Neill, former commodities research head for Merrill Lynch, told Reuters, “given the magnitude of the advance and the volatility of the markets. The long-term growth patterns set up extremely well for commodities—looking a year, two or three years forward. These are long-term, demand-based rallies.”

We added DBC to our PowerShares Momentum Tracker Portfolio on Nov. 1, 2007. From then until March 13, the ETF’s NAV grew 29.4%. Despite last week’s dip, DBC’s NAV return stood at 14.6% year to date (through March 24) and was up 56% since its February 2007 inception, with the bulk of the gains coming in the last nine months.

Nonetheless, the dip provided evidence that relying too heavily on commodities to combat today’s inflation, economic slowdown, and nerve-rattling market volatility might not be a good strategy. Commodities are best employed as portfolio diversifiers, because above and beyond being inflation hedges, the value of commodities as an investment class comes in their negative correlation to the broader markets. They zig, as the old saying goes, when the market zags, just as they did last week, when stocks rallied.

DBC tracks the Deutsche Bank Liquid Commodity Index by investing in futures contracts and other derivatives to track the price of crude oil, heating oil, aluminum, corn, gold, and wheat. The ETF is rebalanced annually to match the index’s ratio of 35% crude, 20% heating oil, and 10% to 12.5% of the other four.

While that certainly doesn’t cover all commodity markets—as Morningstar’s Karen Dolan pointed out, she’d like to see natural gas, livestock, and copper represented in a broad commodity fund—the six that are represented are seen by some as the “most liquid and well correlated with the other commodities in their respective sectors,” Dolan says.

Virtually all of those sectors have appreciated significantly, driven by a perfect storm of global and emerging-market growth, high demand (especially from China and India), a weak dollar, inflation and recession fears, and U.S. interest-rate cuts. All have the tendency to lift commodity prices. Despite the recent dip, oil trades at approximately 80% higher than it did a year ago. Wheat dropped below $10 a bushel last week, after reaching nearly $13.50 in February, but remained historically high—a phrase that applies well to gold, corn, and aluminum.

Aside from its unusual bogey, DBC differs from most commodity funds in its approach to the price differences among futures contracts with different maturity dates. Essentially, when the price of a longer-term contract is higher than the spot price of a commodity, the futures price will drop closer to the current price as it nears maturity. That condition is known as “contango,” or negative roll yield. Likewise, when a contract’s price is lower, the futures price rises to match the spot prices near maturity—known as backwardation or negative roll yield.

Because DBC allows managers flexibility in maturity dates, the fund can minimize or avoid the effects of negative roll yields and maximize positive roll yields, often by investing further along the curve, as it does with corn and aluminum, with contracts that expire toward the end of 2008.

All that said, investors here should remember that with commodities investing comes risk. The asset class is notoriously volatile—something investors might not need a refresher course in after last week—and should be approached with caution, especially after a long run-up. Some commodity bears are convinced that a violent shift is either under way or coming soon, and such a turn would be especially painful now.

The bottom line: While DBC might offer some protection in today’s stormy seas as a hedge against inflation and other market troubles, the fund is probably best used as a long-term niche holding designed to diversify a portfolio.