Commodity Investing: Long Short (S&P Commodity Trend Indicators) vs. Long Only

Last week's market volatility is a good reminder on how precarious it is in commodity investing. For the week, broadbase commodity index ETF (DBC) dropped 3.09% while Gold (GLD) fared better, dropping only 0.81%. Agriculture commodity (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 (DBC) or GSCI commodity index (GSG)  (or sub index such as agriculture (DBA), precious metal (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.

The following table compares the performance between such S&P Commodity Trend Indicators Portfolio (S&PCTI)  and a general broadbase commodity ETF (DBC):

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 (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 (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.