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Inverse Commodities - An Imperfect Solution

I cannot count the number of you that I have spoken to or exchanged emails with about the choice of inverse commodity ETF/ETN options. Our primarily long option (betting commodity price moves up) works great. You can see its profile here on the PowerShares site.

However, our inverse or short options, they don't work near as well.

Why is this?

Really two reasons:

First, none of these options trade with significant daily volume. Most have rather large spreads between what you must Bid to buy the ETF or what you must accept as an Ask to sell the ETF. This forces you to buy higher and then on the sale give back more to get out.

Second, most of the short or inverse ETF options do not mimic the underlying DB Commodity index (more specifically the DBIQ Optimum Yield Diversified Commodity Index).

Both items lead to performance drift vs. the hypothetical performance we post monthly. More importantly they lead to lower profits.

So what is the solution?

Quite frankly this isn't one as you will see below:

1. ProShares UltraShort DJ-UBS Commodity ETF (NYSEARCA:CMD)

This ETF has 3.57 million in assets and average volume of 683,000 per day. It is two times leveraged. The kicker with the index is it tracks the DJ UBS Commodity Index, not the above index, and it carries a rather wide Bid/Ask spread. Morningstar claims the average is $2.61, but as a I write this today the spread is a whopping $5.60. That is ridiculous!

Here is CMD relative to DB Commodities Tracking Index (NYSEARCA:DBC). You can see they are a good match other than the Bid/Ask issue.

2. PowerShares DB Commodity Short ETN (NYSEARCA:DDP) and PowerShares DB Commodity Double Short ETN (NYSEARCA:DEE)

These ETNS track the DB Commodity Index, which is slightly different from the DBIQ Optimum Yield Diversified Commodity Index. DEE is the two times leveraged version of DDP, otherwise they are identical solutions. Click here for a fact sheet on these ETNs.

Both PowerShares funds are ETNs which means that the investor is dependent on underlying institution to make good on the derivative note. I honestly don't like ETNs as much because one day maybe we have another crisis and Deutsche Bank becomes the next Lehman Brothers and fails to make good on these notes.

Neither ETN has an average Bid/Ask spread available, but as of today that spread for DDP is just $.80 and $.55 for DEE. Not too bad!

Each averages 2.5 to 1.6 million shares in volume per day. Not too bad either!

The problem? Neither really does a good job of matching the underlying index, especially since 2013.

In fact, as you can see from the chart above. Their correlations are not an exact opposite. This must be due to the lower heating oil and crude allocations in DDP and DEE or maybe the addition of smaller allocations to silver or other softs, but this is obviously not an ideal solution!

3. PIMCO Commodities Plus Short Strategy D

This is a mutual fund that is short or inverse commodities. This particular one is a D share which means there is no load, but it does have a higher fund expense of $1.29% to make up for it. Each of the solutions above has a lower annual fee to investors averaging around .75%.

It matches up with the DB Commodity Index pretty well. The problems, besides higher fees, are (1) It's a mutual fund….enough said. (2) Many custodians charge transaction fees on the trading of mutual funds and if they don't require a certain holding period or they charge a redemption fee. This holding period is usually 60 days or more at most brokers.

So bottom line, if the commission charges don't hit you hard (they are usually much higher than similar trading fees for ETFs and ETNs), the redemption charges will. So this really isn't a good solution for what we do since I cannot promise you we will not have a trade within the next 60-90 days. In fact, I can pretty much guarantee we will have one.

So what is the ultimate solution?

There just isn't one. My recommendation is to stick with our old friend CMD with the large Bid/Ask spreads. What I have done to counter this is use a limit order between the bid and the ask. I wait until my limit order gets hit to get in (or out). This is usually at the end of the day's trading. Patience is key, but it does seem to work.

I also finding attempting to trade CMD in the first 30 minutes of trading or last hour works best.

How about you? Do you have a better solution or idea?

Disclosure: I am long CMD.