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Commodity Funds or Commodity Exchange-traded Products?

Commodity Funds or Commodity Exchange-traded Products?

There’s very little real difference between the performance of mutual funds and ETPs in the commodity space, but there’s a whole lot of difference in the products’ risk characteristics.

The tumult in the equities markets has forced a lot of investors and advisors to consider diversifying their portfolios with alternative asset classes. Commodity exposure, in particular, has been sought out as the yang to equities’ yin.
At last count, retail investors had committed more than $30 billion to broad-based commodity products—$21 3 billion tucked into mutual funds and another $8.9 billion sprinkled among 15 exchange-traded notes and funds. (These numbers reflect products holding actual futures or futures-like derivatives and not so-called commodity stocks.)

The disparity between mutual funds and exchange-traded products (ETPs) isn’t limited to asset size. There’s also a considerable gulf between the securities’ annual holding costs. On an asset-weighted basis, the average expense ratio for mutual funds is 1.34 percent; the average cost for ETPs is just 0.81 percent.

Over the past decade, as more ETPs launched, investors began to question the higher costs of mutual funds. They’re wondering if they’re buying better performance or better servicing. Well, there’s no time like the present to address that question. And the best place to start looking for answers is to check the products’ performance.

We’ll have to make sure we compare apples to apples, though. The commodity product market isn’t monolithic. The first distinction to consider is management style. Some products are passively managed, or index-tracking, while others employ active, or discretionary, investment selection.

Let’s first breakdown the mutual fund choices.

With $16.5 billion under management, The PIMCO Commodity RealReturn Strategy Fund (PCRAX) is the 800-lb. gorilla of commodity funds. The portfolio’s commodity exposure is derived by replicating, to one degree or another, the returns of the Dow Jones-UBS Commodity Index. That’s the passive part.

Because of the leverage employed in commodity transactions, however, only a small portion of the fund’s cash is committed to trades. The bulk of the fund’s cash actually buys money market instruments which collateralize the commodity investment. The fund’s managers try to outdo the benchmark by actively trading the collateral -- PIMCO’s natural marketplace. You wouldn’t be far off the mark in saying only a part of the fund is passively managed. Hence the quotation marks around the word “passive” above.

Still, with all that management, the fund lost 8.19 percent for the year through July 23. The fund also has one of the lowest volatility stats in the commodity fund universe. Unfortunately, the low volatility actually punishes the fund when the portfolio’s Sharpe ratio is calculated. According to the Capital Asset Pricing Model, a lower standard deviation should produce more positive returns.

Let’s turn our attention to actively managed funds now.

Portfolio managers of four broad-based commodity funds are given free rein, within each product’s mandate, to pursue index-beating strategies. Still, the larger funds produced returns fairly close to that earned by the PCRAX portfolio this year

The Rydex/SGI Managed Futures Strategy Fund (RYMFX) tries to match the daily performance of the S&P Diversified Trends Indicator, a momentum-based trading algorithm. Technically, you could classify this as an index fund, but because the underlying strategy mandates position reversals (short to long and long to short), it behaves like an actively managed portfolio. Call it an “active” (with quotes) fund, then. Like PCRAX, the RYTFX portfolio was penalized with a low Sharpe ratio for its low volatility. CAPM is an unforgiving task master.

The Oppenheimer Commodity Strategy Total Return Fund (QRAAX) allocates its commodity-linked investments along the lines of the components in the fund's benchmark, the S&P/GSCI (formerly the Goldman Sachs Commodity Index). From there, active management takes hold, leaving the fund managers to pursue their strategies within the allocations.

The Russell Commodity Strategies Fund (RCCSX) was launched in July, so its figures actually represent less than one month of operation. The multi-strategy funds’ impressive asset build is a testament to the notion that brokered mutual funds are sold rather than bought.

The Rydex Long/Short Commodity Fund (RYBLX) pursues a singular approach, attempting to exploit pricing disparities between related futures and other commodity derivatives. While its returns this year are negative, RYBLX takes Best of Class honors for actively managed commodity mutual funds.

Now that we know what mutual funds have offered investors this year, we can compare their results with those of exchange-traded products. First, however, we’ll need to do a lot more slicing and dicing of these apples to make direct comparisons possible. First up: passive long-only portfolios.

Among index-tracking exchange-traded portfolios, the GreenHaven
Continuous Commodity Index Fund (GCC) has produced the best year-to-date performance. Its equal-weighted benchmark (the current iteration of the Commodity Research Bureau Index) gets the credit for its relative underweight in petroleum products and its comparative heaviness in agricultural commodities.

The other two funds, particularly because of their relatively large exposures to the energy sector, hit performance numbers in the same circle as the bulk of mutual funds assets examined earlier.

Exchange-traded funds (ETFs) such as these are actually very much like their mutual fund cousins: They’re portfolios of actual securities or derivatives.
ETFs are one thing, but exchange-traded notes (ETNs) are something quite different. ETNs are zero-coupon debt instruments issued by financial institutions that promise to deliver a commodity index return. That promise, of course, is contingent upon the issuer remaining solvent. When using ETNs, an investor trades away index tracking error and frictional transaction costs—phenomena that beset ETFs—for credit risk.

For the most part, that trade-off paid off this year in slightly better returns, most especially from the ELEMENTS Rogers International Commodity ETN (RJI). That, in large part, was due to the global reach of its underlying index.

All the ETPs examined so far are long-biased. Now, the beauty of the futures market is the ease with which one can take a short position. It costs no more to margin a short position in futures than a long position. That opens the door to wider trading opportunities. And this year, short commodity ETNs (to date, there are no short-only ETFs in the U.S. market) were successful in exploiting that opportunity.

There’s but one broad-based unleveraged ETN extant in the domestic market. It’s smallish. Well, truth be told, it’s tiny. The PowerShares DB Commodity Short ETN (DPP) has a market cap of only $3 million presently, a quarter the size of its leveraged sibling.

The PowerShares double-short note (DEE), is still small, but is of far more utility to its user base -- as a hedge against short-term market volatility. Hedges are much more efficient if they’re leveraged. There’s little sense in tying up a substantial amount of capital (as a note purchase would require) to obtain protection if leverage can provide the needed insurance at a lower capital threshold. A leveraged note works more like and options- or futures-based hedge.

Unlevered ETPs track indexes constructed as fully collateralized portfolios. That’s the equivalent of a customer depositing the full contract value, rather than just the margin requirement, to take a futures position. That’s why commodity ETFs don’t get margin calls.

Leverage is incorporated on the long side as well as the short side of in commodity ETPs. There’s both an ETF and ETN version, of approximately equal size and near-equal performance. Not surprisingly, double-long products produced losses this year at twice the pace of their single-dose confreres.

The final reckoning

If you tally up the asset-weighted returns for the long-only unlevered ETPs, you’ll see that there’s hardly any daylight between them and that of the “passive” commodity mutual fund. PCRAX, remember, lost 8.19% this year. The ETPs collectively lost 8.18 percent.

And what about those actively traded portfolios? To what can we properly compare them? Well, there aren’t yet any truly active ETPs, but there are a couple of products that mechanically follow index-mandated strategies incorporating long and short position turnover.

The ETF version is the iShares Diversified Alternatives Trust (ALT) and employs long and short futures and forward positions that historically exhibit low correlation to traditional asset classes. The trust’s methodology produced breakeven results this year.

The ELEMENTS S&P CTI ETN (LSC) tracks Standard & Poor's Commodity Trends Indicator which is a long/short strategy designed to capture yields from rolling futures contracts forward over time. The deeply negative return earned by the note reflects the persistent contangos in most commodities this year.

The asset-weighted return for the “active” ETPs is -8.98%. Active commodity mutual funds extant since the beginning of the year earned a -8.42% return. There’s more daylight here, but not much -- just over 50 basis points.

Judged only on share price appreciation, or diminution, only the actively managed mutual funds outperformed their ETP analogs. The returns earned by passive ETPs and mutual funds were nearly identical.

Does that mean active commodity mutual funds earned their high fees? Not necessarily. The performance difference wasn’t that great. And we haven’t examined the other factors an investor or advisor must consider when making a choice between a mutual fund and an ETP. Will there be sales charges imposed on the mutual fund transaction? What about commissions and spreads on the ETP trade? Is there an opportunity cost for an end-of-day mutual fund purchase or redemption? What about the counterparty risk inherent in an ETN transaction?

The bottom line is this: There’s actually very little real difference between the performance of mutual funds and ETPs in the commodity space, but there’s a whole lot of difference in the products’ risk characteristics. If investors and advisors can concentrate on tallying up the comparative costs and benefits of those, they’ll be better able to judge the products’ utility.

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