A Bumpy Year for Harbor Commodity Real Return Strategy Fund

Harbor Commodity Real Return Strategy (symbol HACMX) has had a bit of a bumpy year. A springtime slump in the commodity market -- brought on by concerns about the health of the global economy -- dragged down the fund's returns in early 2012. But manager Mihir Worah, who invests in futures linked to a commodity index and backs them up with Treasury inflation-protected securities and other bonds, says the Federal Reserve's latest economic stimulus plan, announced in September, has been a boon for the fund. The plan's effect on the economy remains to be seen, but its impact on hard assets, such as gold, was "clear and immediate," he says. His fund's one-year return of 7.3% beats other broad-based commodity funds by a whopping 6.0 percentage points (all returns are through October 17).

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Like most of its peers, Harbor Commodity is really two funds in one. On the commodity side, the fund seeks to track an index -- in its case, the Dow Jones UBS Commodity Index -- using a basket of derivatives (mostly futures). The derivatives call for only a small portion of collateral, though, so Worah invests the remaining cash in inflation-protected bonds issued by the U.S. and other countries, as well as in investment-grade corporate debt (bonds rated better than double-B).

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The combination is designed to give investors two levels of inflation protection. So far, albeit in a benign inflation environment, it has delivered. Over the past three years, the fund's 9.7% annualized return far outpaces the average annual inflation rate over that period of just over 2%. And the figure beats the typical broad-basket commodity fund by an average of 6.1 percentage points per year.

If the fund were passively managed, Worah says, he'd split the fund's assets down the middle and own half in fixed-income and half in commodity derivatives. But he adjusts his holdings to account for his outlook for both commodities and inflation-protected bonds. Depending on his view, that means the portfolio may tilt more toward commodities or more toward bonds.

The fund went lighter on TIPS in mid 2012, for instance. After the Fed's September announcement that it would hold down long-term interest rates indefinitely, Worah became a buyer of TIPS again, focusing on securities with maturities of less than ten years. Harbor Commodity now has 95% of its fixed-income collateral in TIPS as well as inflation-linked bonds from other countries, including Australia and Mexico. The rest is in short-term, high-quality debt.

On the commodity side, Worah has beefed up his holdings in precious metals, by buying futures in gold and platinum: "I think they should perform well over the next year." The fund's current allocation to precious metals -- 12% of assets -- is the highest it's been this year, he adds.

With inflation at bay, why the big bet on TIPS? Because price increases for goods and services are coming, Worah says. He expects the inflation rate to hold at 2% in 2013, but he sees it climbing to 3% "and maybe even higher" after that. Among the many tools the Fed has, says Worah, is the ability to raise inflation expectations by lowering interest rates. This in turn will weaken the U.S. dollar, he says. "Lower rates, a weaker dollar -- all of these factors are positive for the fund." (See Kiplinger's inflation outlook.)

In principle, Harbor Commodity is a clone of Pimco Commodity Real Return Fund, which Worah also runs (Worah is a managing director at Pimco). The two funds are managed in the same way, he says, with the same objectives -- to offer investors broad exposure to commodities.

Yet, although the two funds' holdings are similar, they are not identical. The reason boils down to the ebb and flow of investors' money. "As money comes and goes in each fund, I buy some bonds and sell some," says Worah.

But the allocations within the funds are similar: Both, for example, were loading up on precious-metals futures contracts in the early fall of 2012. Says Worah: "I have one pot, and when I do a trade, the same trade in the Pimco fund happens in the Harbor fund, too. But when there are significant cash flows, there are differences." Big moves in assets typically hit the $21.8 billion Pimco fund, which can have $10 million to $15 million coming in or going out on a given day, says Worah. Flows in and out of the $359 million Harbor fund are steadier, he adds.

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