Where are the Short Funds?

By Brad Zigler

Judging from recent headlines, the business page editor of my local newspaper must have told reporters to go out and find the silver lining for the dismally gray clouds now descending upon our economy.

Yesterday, the business section was topped with the query: "What downturn?" The subhead offered this teaser: "For healthy companies, now's the time to expand."

The accompanying story featured an auto body repair business that's using the downturn in real estate values and interest rates to double the size of one facility and to build a new operation in a neighboring town.

That got me thinking about the markets we track here at Hard Assets Investor. Commodities, of course, have been running in the opposite direction of the economy at large. While stocks and real estate have zigged, oil, gold and soybeans have zagged.

So why do commodity market product manufacturers seem stuck, for the most part, on putting out just bullish exposures? Put another way, why aren't the gray clouds being sought instead of more silver - or gold, oil or soybean - linings?

After all, one day the commodity party will be over. A lot of the assets acquired in the current bull run will then be looking for new homes. The neophyte outfits with limited offerings - GreenHaven Commodity Services, with its single exchange-traded fund (AMEX: GCC) immediately comes to mind - seem especially vulnerable. With no other in-house places for assets to roll, investor money will lurch out the exits when the decks start to pitch. An outfit like Barclays will have an easier time of it. If folks bail out of the iShares S&P/GSCI Commodity Indexed Trust (NYSE Arca: GSG), for example, there are dozens of slots within the iShares or iPath platforms into which investor coinage can roll.

The only outfit that seems to have fully appreciated the utility of short commodity exposures so far is Deutsche Bank. Back in February, DB floated three gold-based exchange-traded notes, two of which (NYSE Arca: DGZ and NYSE Arca: DZZ, respectively) take the short and double-short tack on the yellow metal.

DB was first-to-market with short products, largely because the firm went the easier-to-navigate ETN route rather than trying to break new ground with an ETF. Whether realized through an ETF or an ETN, though, short exposures give investors the flexibility to not only switch gears strategically when market fortunes reverse, but also to maneuver tactically in the current market.

Let's put this into a real-world perspective.

Victoria Bay Asset Management made quite a splash last week by launching the United States Heating Oil Fund (AMEX: UHN). With the new product, long exposures in crude oil, gasoline, heating oil and natural gas can now be obtained by investors without venturing directly into the futures market. And the especially savvy can now trade the crack spread, exploiting seasonal changes in refiners' profit margins by pitting crude oil shares (AMEX: USO) against the gasoline (AMEX: UGA) and heating oil products, something futures traders have been doing for years. (You can see how oil refiners' profits have gyrated this year in the recent HAI article, "Volatility Cuts Into Profits").

To pull off a crack spread presently, though, you'd have to sell one or more of the funds short, which would put you outside the pale if you're trading inside a tax-deferred account such as an IRA or a 401(k) with a brokerage window.

If short exposures to crude oil and the distillate products were available, though, tax-deferred investors could share in oil refiners' widening margins by buying the long oil exposure together with short funds tracking gasoline and heating oil. Likewise, when margins are expected to narrow, a reverse spread can be created by purchasing a short crude oil fund together with the long exposures in heating oil and gasoline.

The inevitable question that comes up whenever these spreads are illustrated is this: "Why bother? Why not just buy an oil stock if you think profit margins are going to go up?"

The answer is simple: There's no systematic equity risk absorbed in the spread trade. You're trading the refining margin and the refining margin only, without regard to a particular company's competitive position or future earnings prospects. That's, more often than not, a simpler forecasting proposition.

The availability of short positions, too, gives investors a means to exploit or to hedge declines in commodity-related stocks that are already owned in a portfolio. If you own ExxonMobil (NYSE: XOM), for example, a short crude oil fund or reverse crack spread can soften the effect of commodity market downside volatility while you await a bottom or tax-wise exit point.

Bearish equity ETFs were introduced a couple of years ago, after spending a long time in registration purgatory at the SEC. Fund assets ballooned when the equity market started to wobble in the summer of 2007, benefiting investors and fund sponsors alike.

You'd think commodity index fund manufacturers would be able to take the hint.