Low-Risk Commodities Investing

As investors spy a growing number of hints that the economy may be nearing a bottom, they are regaining their appetite for commodities. Prices for gold and oil have shot up recently, and the broad-based Dow Jones-UBS Commodity Index, which plunged 54% from July 2008 through February, has since rebounded about 20%.

As the numbers show, commodities are notoriously volatile and fickle, making it hard for the average investor to make money off of them. After years of sharp ups and downs, many investors find that they've earned nary a nickel from their commodity holdings. But a strategy that a couple of fairly new investment vehicles are using milks the ups and the downs to deliver enviably stable and solid returns.

Before we tell you about this strategy and the funds that play off it, here's a quick reminder of why you should consider holding commodities in your portfolio. Aside from the potential for high returns, there are two reasons: Commodities provide a hedge against inflation, and commodity prices don't move in tandem with stock or bond prices. So adding commodities to your portfolio should reduce its volatility while at the same time giving you an opportunity to boost returns.

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The method

The new investments play off of Standard & Poor's Commodity Trends Indicator, or CTI, which bets on some commodity prices to rise and others to fall, depending on where the indicator's caretakers think a commodity is in its price cycle. So at some point, the indicator might call for holding futures contracts that will profit from corn prices rising (a "long" position), while at the same time it might call for selling short silver futures to bet on a drop in the metal's price.

The long/short indicator is well diversified. It tracks 16 commodities in six sectors: energy, industrial metals, precious metals, livestock, grains and "softs," which includes cocoa, coffee, cotton and sugar. It can go long or short in all sectors except energy -- the possibility of a catastrophe that could cause energy prices to skyrocket, such as a war in the Middle East, makes shorting energy too risky, according to the indicator's developers.

The results are tantalizing. From the CTI's creation at the start of 2004 through May 29, it more than doubled, while Standard & Poor's 500-stock index dropped 8%. Over the same period, the two most widely used commodity indicators -- the Dow Jones-UBS index and the S&P GSCI Commodity Index -- rose nearly 8% and fell 6%, respectively (both the DJ-UBS and S&P indexes measure performance of a basket of commodities; neither engages in short selling).

The CTI had its worst month in July 2008, when it fell 13%, but for all of 2008 it rose 18% (while the S&P 500 dropped 37% and the DJ-UBS and S&P commodity indexes lost 36% and 46%, respectively). And back-testing -- seeing how a strategy would have worked if applied in the past -- shows that the CTI would have returned an annualized 12% over the past ten years through 2008. Over that period, the S&P 500 sank 1.4% annualized.

So if past is prologue, the CTI may be on to something. But that's a big "if." The problem with such static strategies is that often the future takes a different course from the past. One way to foul up a strategy is to invest too much money in it. And sometimes investors exploit a strategy in a way that undermines its effectiveness.

The developers of the CTI say those problems won't occur. The indicator is based on the work of Victor Sperandeo (also known as Trader Vic), chief executive of Alpha Financial Technologies, an investment firm in Southlake, Tex. Bryan O'Leary, head of U.S. index marketing for Alpha Financial, says that based on the long history of how commodity prices behave, the cycles upon which the CTI are based are unlikely to change much.

O'Leary acknowledges that there are times when the strategy won't work. When commodity prices are flat, of course, you can't make money on either the long side or the short side. And because the strategy is based on cycles that last months, O'Leary says, it will lose money when prices move dramatically in either direction. "We can be whipsawed at times." But neither of those developments lasts for long, he says.

Alpha Financial plans to tinker with the formula so that the strategy isn't ruined by its own success. About $3 billion is invested in the strategy so far. But, says O'Leary, should that total approach $10 billion, Alpha plans to include more commodities to lessen the chance that the strategy affects prices so much that it stops working.

Investment choices

Two publicly available investments mirror the CTI. One is the Direxion Commodity Trends Strategy Fund (symbol DXCTX), a traditional mutual fund. The other is an exchange-traded note, Elements S&P CTI ETN (LSC).

Annual expenses for the Direxion fund are stiff, at nearly 2%. The ETN's expenses are fairer, at 0.75% per year. But ETNs come with a major drawback: They are essentially debt instruments of the sponsor, meaning that you could lose some or all of your money if the issuer fails.

A better option is on the way. Claymore Securities has filed papers to start an exchange-traded fund based on the CTI strategy. A Claymore spokesman says that the ETF will be available this summer and that its annual expenses will be less than 1%.