Agile Investing Reduces Commodities, Gold Exposure (GLD)

We are making two changes in our model portfolios this week:

1. We are exiting in full our position in the Pimco Commodity Real Return Fund [PCRDX], which we held at a 5% weighting in all three of our model portfolios.

2. We are reducing our allocation to the streetTracks Gold Shares (GLD) from 5% to 3% across all three model portfolios.

Our rationale for exiting PCRDX at this point is several-fold:

1. Commodities are only fours year into a secular bull market that will probably last for at least a decade, but have likely completed, or nearly completed, their first major upward leg. The Dow Jones – AIG commodity index, which is the index that PCRDX is designed to track, has produced an annualized return of 16% since the beginning of 2002, when the current commodities bull market began. Speculation is running rampant in the commodities markets, due to perceptions that the global economy will continue to thrive. In addition, demand for cyclical commodities will continue at their current high levels, particularly from emerging economies. Many of the commodities contained in the DJ-AIG index are highly cyclical and will be quite sensitive to marginal increases in both production and demand. One or both of these appears likely if, as 2006 progresses, the global economy cools and production increases, which are the natural economic consequences of higher prices.

2. It is certainly true that over the long-run, commodities are an attractive component of a diversified portfolio, due to their history of positive returns, their historic negative correlation with stocks and bonds, and the hedge against inflation they provide. These were the key reasons we originally added PCRDX to our portfolios. However, our belief is that in the current environment, commodities are moving more in tune with global stock prices because both asset classes are benefiting from the glut of liquidity that has been created by excessively loose monetary policies from the world’s central banks.

In recent weeks, this liquidity trade has received an additional (unneeded) boost from the U.S. Federal Reserve, thus signaling that it wants to wrap up its tightening campaign. Even though the Fed would like to discount the role of commodity prices as barometers of inflation, we can’t recall a tightening cycle that ended with commodity prices soaring to new records, so we suspect that either commodities will soon top or the Fed will be in the game longer than it would like to be. Moreover, central banks around the world are either currently tightening policy or moving in that direction, which should have the effect of draining some of the liquidity that has inflated global asset prices.

3. Despite the recent surge in many commodity prices, PCRDX has only produced marginally positive returns year-to-date. The reason for this is two-fold. The Dow Jones – AIG index is the most diversified of the major commodity indexes. Whereas other commodity indexes, such as the Goldman Sachs Commodity Index and the CRB index, are more concentrated in crude oil, the Dow Jones-AIG index is composed of 19 commodities and has only a 13% weighting in crude oil. Oil, unleaded gasoline, industrial metals, and precious metals have been the strongest commodity sectors year to date. Other commodities, including grains, livestock and “soft” commodities such as cotton and coffee, have been flat or down year-to-date.

The second reason for PCRDX’s lackluster performance this year involves the fund’s strategy of investing its cash “collateral” (i.e. the excess cash beyond what is required to gain unleveraged commodities exposure in the futures markets) in TIPs bonds. Although TIPs bonds do provide greater inflation protection than nominal bonds, they are not immune to the effects of rising interest rates. The medium to long-term TIPs bonds held by PCRDX have produced about a 3% drag on the fund’s returns year-to-date.

4. We have used PCRDX, a mutual fund, in our portfolios only because there has not been an ETF on the market that provides comparable diversified commodities exposure. That will soon change when the pending ETF from iShares is launched in May or June that will track the same commodity index underlying PCRDX. The iShares fund will be superior to PCRDX in at least two respects. First, it will carry a 0.75% expense ratio, which is much more attractive than PCRDX’s 1.24% expense ratio. Second, it will invest the fund’s collateral not in TIPs bonds but rather in T-bills. This will provide more pure exposure to commodities as an asset class and not introduce the risk of rising rates impairing the value of TIPs bonds. When we elect to reintroduce diversified commodities into our portfolios, we will in all likelihood use this pending ETF from iShares.

Our decision to trim our position in (GLD) is driven primarily by the fact that even the strongest bull markets do not make uninterrupted ascents. Gold prices are up 40% in the past six months, and are currently the most overbought since the gold bull market commenced in 2001. We think we will see $1,000 gold prices in the next two to three years, precipitated by the next round of inflation that will get underway when the Fed has to reverse course and begin cutting short-term interest rates to stimulate/inflate the economy. However, in the short term, we think gold is vulnerable to a correction. We will look to increase our position in (GLD) back to 5%, if not higher, if gold prices fall back to between $550 and $600. Investors not interested in this tactical maneuver can elect to just ride out any possible short term downside volatility, especially if they want to avoid the nonsensical 28% “collectible” tax levied on gains from precious metals investments, regardless of the length of the holding period.