Last week’s market volatility is a good reminder on how precarious it is in commodity investing. For the week, broadbase commodity index ETF (NYSE:DBC) dropped 3.09% while Gold (NYSE:GLD) fared better, dropping only 0.81%. Agriculture commodity (NYSE:DBA) dropped even more: 3.71%. For more detailed information, please refer to here.
It is now generally recognized that adding commodity exposure in a long term portfolio that adopts a strategic asset allocation strategy can increase diversification effect and thus possibly improving risk adjusted returns. However, given the high volatitily (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 investment.
A long only approach is simply just buying a commodity index such as Powershares DB Commodity Index ETF (NYSE:DBC) or GSCI commodity index (NYSE:GSG) (or sub index such as agriculture (NYSE:DBA), precious metal (NYSE:DBP)). A long short approach, on the other hand, can take long and/or short positions on mutliple commodity components simultaneously. It is mostly based on technical indicators such as moving averages, momentums 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. The following is a short description of the strategy:
The strategy is a simplified variation of S&P commodity trends indicator (CTI). It is a subset of the S&P DTI by simply eliminating half of the financial assets.
1.The original asset allocation
|Energy 37.5%||Powershares DB Energy (DBE)|
|Industrial metal 10%||Powershares DB Base Metal (DBB)|
|Precious metal 10.5%||Powershares DB Precious Metal (DBP)|
|Agriculture 42%||Powershares DB Agriculture (DBA)|
2. Position determination
The monthly percentage change of a sector’s price is compared to past monthly price changes exponentially weighted to give 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|
3. Monthly rebalancing
The portfolio is rebalanced monthly by setting every sector to their original percentage and do the position determination again.
For more information, please refer to “Standard and Poor’s Commodity Trend Indicator” document.
The following table compares the performance between such S&P Commodity Trend Indicators Portfolio (S&PCTI) and a general broadbase commodity ETF (NYSE:DBC):
|Portfolio||Last 3 Years||Last 1 Years||2007||2008||2009||2010||2011|
Though 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 (NYSE: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 histories of commodity ETFs used in this portfolio), the maximum drawdown is about 19% vs. DBC’s whopping 60% (during the 2008-2009 detacle).
The takeaway from this article is that for active investors, one might want to consider adopting a more conservative approach in commodity exposures. Investors can find Element’s ETN (NYSE:LSC) or Direxion’s Commodity Trend Strategy Inv (DXCTX) that implement the S&P Commodity Trend Indicators strategy. Before you invest, however, you are encouraged to compare the portfolio S&PCTI, LSC and DXCTX.
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.
LTI Systems, Inc. is the operator of MyPlanIQ.com and ValidFi.com. The founders of LTI Systems have extensive technology and business background in computer and semiconductor industries. They have been using the strategies provided by MyPlanIQ for their own personal retirement and taxable investments. The mission of LTI Systems is to make wealth management investment strategies that are used to be only accessible to institutions and high net worth individuals available to private investors with a fraction of flat cost and ease of use. The founders of LTI Systems, investors themselves, take pride in creating such a system and service for investors by taking the perspective from the investor side. They are using the system and the strategies for their own investment and align their interests with their customers.
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