New commodity ETF launch: actively managed, but long-only

I won’t complain about having more possible commodity investment vehicles, and I like the concept behind this new ETF, but I’m not a huge fan of the idea because it’s long-only, and I prefer a long/short approach. The new fund will track the SummerHaven Dynamic Commodity Index, which we be rebalanced monthly. The “based on observable price signals” line sounds to me like a trend following model, just like the LSC ETF I prefer, but this new fund will be long-only. Full disclosure: they don’t have a ticker for the fund yet, so I’ll update this post when they have one.

The announcement press release:

SummerHaven Index Management Announces Launch of the SummerHaven Dynamic Commodity Index

STAMFORD, Conn., Dec. 18 /PRNewswire/ — SummerHaven Index Management, LLC announces the launch of the SummerHaven Dynamic Commodity Index (“SDCI”) – an innovative approach to commodity investing that uses fundamental signals about underlying physical markets to create an active benchmark for commodity futures investors. The index builds on academic research by professors from Yale University and the University of Tokyo. The SDCI tracks the performance of a fully collateralized portfolio of 14 commodity futures, selected each month from a universe of 27 eligible commodities based on observable price signals, subject to a diversification requirement across major commodity sectors.

The SDCI is composed of commodity futures contracts for which active and liquid contracts are traded on futures exchanges in major industrialized countries. The commodities are denominated in U.S. dollars. The commodity sectors for the Index include precious metals, industrial metals, energy and agricultural products including livestock, softs, and grains.

The First Long-Only Active Benchmark for Commodity Investors

The SDCI was designed as an active commodity benchmark index with the investor in mind. The index construction embeds active re-balancing instead of passive weights because not all commodities are expected to contribute equally to the overall performance of a commodities portfolio. The SDCI focuses on a subset of the commodity universe based on a periodic evaluation of fundamental signals, while at the same time maintaining a diversified exposure to the global commodity complex. Professor K. Geert Rouwenhorst of the Yale School of Management commented “Over the past decade commodities have gained acceptance by investors as an important element of the investment universe. As the asset class has matured, investor interest has naturally shifted towards active management. The SDCI design incorporates research ideas from two academic studies, Facts and Fantasies about Commodity Futures and the Fundamentals of Commodities Futures Returns, into a practical and implementable investment benchmark for investors.”

The SDCI is the first commodity index designed by SummerHaven Index Management. SummerHaven Index Management, LLC is the owner of the Index.

About SummerHaven Index Management

Headquartered in Stamford, CT, SummerHaven Index Management is focused on creating innovative commodity indices. The firm is led by a seasoned management team with over 50 years of collective financial markets experience with commodity futures, capital markets, investment management, and exchange traded products.

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The link to the announcement press release: http://www.prnewswire.com/news-releases/summerhaven-index-management-announces-launch-of-the-summerhaven-dynamic-commodity-index-79605862.html

The link to the fund’s latest prospectus filed with the SEC: http://www.sec.gov/Archives/edgar/data/1479247/000114420409066339/v169761_s1.htm#tPS

Bespoke Investment Group’s 2010 roundtable discussing asset class expectations

The 2010 Bespoke Roundtable is out, and as always, they’ve done some interesting work. I think it’s extremely insightful. the link to their full post is here: http://bespokepremium.com/roundtable/

They present the aggregated “up or down” predictions very clearly in this table:

I have a few quick comments:

-The up/down prediction for the S&P 500 is mostly “up” with only a couple “experts” disagreeing. Who knows? No one has EVER been able to successfully profit from trying to time the market over a reasonable time period. There are a zillion studies that reach that conclusion, and my summary of the Morningstar book has their conclusions based on their data that confirms the same thing. SO what do you do? Well, I think  you try to capture potential upside from equities by having some long-equity exposure, but you keep long-equity allocations to a minority of your portfolio, and instead spread your assets across multiple asset classes, with a preference for long/short strategies, and you try to generate current income (all the while trying to focus on uncorrelated investment returns).

-Long bonds: everyone polled agreed that they should have a negative return in 2010. There could be multiple reasons: rising interest rates, higher default rates, less attractive yields/valuations…the list goes on and on. This is why I prefer munis that are insured and through closed end funds that are trading at a discount: you reduce your tax liability and you reduce your default risk. The rising interest rate or rising inflation scenario is why I like floating / variable rate debt. You get income from being long debt, but the interest payments increase in size as overall interest rate levels rise.

-Junk bonds: not for me. I don’t know of any consistent and low-risk funds that have demonstrated success in the junk bond / high-yield debt space that I would consider for my portfolio at this present time. I say “at this present time” because entire asset classes can occasionally get cheap enough that you don’t really need to worry about the skill of a fund’s active asset management, but given the recent run-up in junk bonds and the uncertain default risk trend I just can’t stomach purchasing high-yield debt now when I can get similar income generation from other asset classes and can lower the tax impact by going with municipal bonds. Sure, junk bond prices can rise much more when they do rise versus munis or other higher-credit quality debt, but the reason junk bonds rally is usually because of optimism about near-to-medium term economic prospects, and I think that the best case scenario is already reflected in the massive recent appreciation of both junk bonds and equities.

-Gold & Oil: The roundtable has mixed expectations for the next year. I think that’s why I prefer a long/short commodity strategy and a long-term investment horizon. Commodities are an important asset class to have in your portfolio, so you don’t want to forget to have some exposure, even if it’s only a little. If inflation does become an issue, regardless of what macroeconomic demand is, then commodities will benefit.

-The US Dollar: The roundtable is uncertain and so am I about what the Dollar will do in the next year. Over the medium-to-long-term, however, I have very high conviction that the US Dollar will continue to lose its purchasing power and will continue to decline against other currencies, just like it has done over the last 50+ years. This is why I like an absolute-return strategy currency allocation. Currencies are a very, very tricky asset to trade profitably, and I would advise non-expert investors to let the experts handle it and go with a good mutual fund.

-China: Who knows what happens. I will probably always keep a portion of my assets in Chinese equities (I hold HAO), although I have recently trimmed my allocation after the very large run up in Chinese equity prices. Regardless, China has much more attractive prospects for equity investment returns over the long-term than the US does, so I will always hold some China and will look to buy more over time when the overall indexes decline.

Hedge fund replication ETFs

A natural extension of the ongoing ETF creation boom, we’re starting to see full-blown “hedge fund” ETFs. After examining the funds (strategy, holdings and expenses) I come away unimpressed. I’m referring to IndexIQ’s two “hedge fund” ETFs: QAI and MCRO. They are not expensive, with total expense ratios around 1.0%, but the logic as to what they hold and why is less than obvious, nor do they appear to be in any way positioned to outperform for any smart/unusual/unique/non-consensus reason.

Here’s IndexIQ’s website: http://www.indexiq.com/etfs/etfsiqh.html

Their HF ETFs at the moment:

1) IQ Hedge Multi-Strategy Tracker ETF (Ticker QAI)

2) Q Hedge Macro Tracker ETF (Ticker MCRO)

The “multi-strat” ETF prospectus says that the ETF will try to match the underlying returns of the IQ Hedge Multi-
Strategy Index. They elaborate a bit more:

“The Index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.”

So basically what you get is a hodge-podge of various hedge fund strategies, although the allocations and composition of the exact holdings is essentially unknown. I’m not a big fan of low-transparency (not that they’re trying to hide anything, you just don’t really know what they hold and what they’re changing and why). The majority of those pieces can be replicated by just separately buying funds that focus on each specific piece. For example, you can buy the emerging market ETF EEM, any number of “event driven” or “special situations” or “merger arbitrage” funds like the other ones I’ve discussed in previous posts, and you can take your pick of long/short equity funds based on YOUR evaluation of the manager and their track record (QAI doesn’t really have a track record at this point b/c it’s young and simulated returns are dangerous to rely on in the vast majority of situations as the past rarely repeats itself). Furthermore, as of their last holdings disclosure, the fund held 42% of assets in long positions in short-term treasuries (like you need them to earn a treasury yield) and 24% of assets were long the EEM ETF exactly with about 10% of assets in the Powershares G10 currency ETF. So…they’re not doing anything you can’t do for yourself (and if you do it yourself you can control things, which may or may not be what you’re looking for).

The macro fund tracks the performance of the IQ Hedge Macro Index. Looking at their top 10 holdings, the macro fund’s portfolio is slightly-more complicated than the QAI portfolio, but pretty straight forward anyway.  28% of the fund’s holdings are just EEM. There’s a tiny short treasuries position, but it’s dwarfed by the long treasuries positions. The “ultra short” real estate position is one of the few distinguishing positions (tho it’s only 3.7% of fund assets) b/c it’s both short and levered, so presumably they have reasonable conviction that there is further downside in real estate. I don’t see anything here that impresses me or suggests to me that this fund does anything beyond simplify the construction and purchase of a portfolio of emerging market stocks, various treasury and corporate bonds (both US and international), currency ETF holdings, and a small position betting against the real estate sector. All in, MCRO doesn’t do it for me, but I’m not you, and maybe you like the idea of one purchase that requires no follow-up maintenance.

TickerName Weight
EEMiShares MSCI Emerging Markets Index Fund 28.43%
SHYiShares Barclays 1-3 Year Treasury Bond Fund 15.90%
LQDiBoxx $ Investment Grade Corporate Bond Fund 13.29%
BWXSPDR Barclays Capital International Treasury Bond ETF5.63%
BSVVanguard Short-Term Bond ETF 5.23%
SHViShares Barclays Short Treasury Bond Fund 3.97%
SRSProShares UltraShort Real Estate 3.69%
DBVPowerShares DB G10 Currency Harvest Fund 3.35%
TWMProShares UltraShort Russell2000 3.29%
BILSPDR Barclays Capital 1-3 Month T-Bill ETF 1.99%

Strategies For Uncertain Times: Short / Bear Funds

Short/Bear funds

Overview: Provides upside should equities decline, however, will be a drag on returns over long-term b/c long-term trend for equities is consistently positive. Only makes sense if you have large long-equity holdings and you want to reduce your overall portfolio volatility or are very cautious about equities in general. There are a TON of ETFs that are “short” various indexes with leverage, and try to generate 2x or 3x the decline in their underlying securities. However, for several reasons that are probably a bit too complex for the vast majority of investors, these ETFs do not accurately reflect changes in the underlying securities the way that they are assumed to on a short-to-medium term basis. Hold in a taxable account so that if the market declines your short/bear position gains will be covered by bigger losses in long-equities positions.

• Open-end mutual funds:
  • BEARX: Federated Prudent Bear
    • Not always net short
    • Underperf GRZZX in 2008, better performance all other years, even up mkts
    • 5% load, 1.8% annual fee
  • GRZZX: Grizzly Short Fund
    • Quant based
    • US only
    • Better 2008 than BEARX, much more volatile LT returns
    • No load but 3% annual fee
• ETFs: (you can clearly short the index ETFs as opposed to being long these inverse-index ETFs)
  • SH: S&P short
  • PSQ: Nasdaq short
  • RWM: Russell 2000 short
  • SBB: S&P Small-Cap 600 Short
  • EUM: Emerging market equities (MSCI) short
  • EFZ: Emerging market equities (MSCI) short

Strategies For Uncertain Times: Long/Short Equity

L/S Equity or Market Neutral Equity

Overview: Funds are either long/short with some long exposure (not entirely hedged against market movements) or are market neutral (which TRY to be entirely hedged against market movements). This strategy has roughly a 0.60 beta vs. S&P over the last 10 years. Long/short funds either pick their positions based on fundamental analysis or employ quantitative screens for identifying investments. Additionally, not all funds short single stocks against their long positions, and might short various equity indexes or short futures to hedge against market declines. If you’re gonna be long equities at an uncertain time in the macro cycle or at uncertain overall market valuations it makes sense to be long/short as opposed to long-only. Hold in either a taxable or tax advantaged account.

• Open-end mutual funds:
  • HSGFX: Hussman Strategic Growth
    • Long single stocks, short index and buy puts
    • Almost entirely hedged exposure
    • Down 9.6% in 2008, good
    • 1% expense fee
    • No load
    • Low turnover
    • Down 10% in 2008
    • 8% std dev
  • DRCVX: Comstock Capital Value
    • Up to 50% short, solid returns
    • Global
    • UP 50% IN 2008
    • Lose money frequently, negative 5 year annualized return, down 2009 YTD
    • 22% std deviation
    • 5.75% load and 1.7% annual fee
  • COAGX: Caldwell + Orkin Market Opportunity
    • Totally unrestricted hedge fund, great manager, Michael Orkin
    • $25k minimum
  • CVSIX: Calamos Market Neutral A
    • Convert arbitrage and covered call strategies only (roughly 50/50)
    • 1.1% annual expense with 4.75% load
    • 7.7% std dev on 3 year basis
    • 5 year annualized return of 2.2%
    • 110 positions with high turnover
    • MOSTLY covered calls
    • Down 13% in 2008
  • OLA: Old Mutual Claymore Long-Short
    • Long/short equity with covered calls for ~85% of portfolio
    • 130/30, so roughly 20% short with no more than 100% long
    • Specific stock longs and shorts based on quant model
    • Stocks are mostly large cap
    • Beta of 1.07 w/ S&P
    • Down 40% in 2008, very poor performance for a “hedged” strategy
    • 18% std dev
    • 2.7% annual fee
  • BPLEX: Robeco Boston Partners Long/Short
    • No load, 2.75% annual fee
    • Fundamental analysis
    • Down 21% 2008, too much for a “hedged” strategy
    • 13% 5 year annualized return
    • 22% std dev
    • 5 star Morningstar
    • Very diversified, individual stock shorts (20% short)
  • Other poor L/S equity fund choices
    • (HSKSX: Highbridge Statisical Market Neutral: not fundamental, $1m min investment), (ALPHX: Fee too high), (MADEX: Not consistent in returns), (DIAMX: Too volatile), (MLSAX: Closed), (TFSMX: Closed), (AARFX: Too young), (FMLSX: Too volatile), (JAMNX: Weak returns), (TMNVX: The Market Neutral Fund: Just switched advisors), (NARFX: Too new/young, not enough track record)
• CEFs:
  • DHG: Dreman Value:
    • Volatile returns, does have specific stock shorts
    • Has beta of roughly 1.25 w/ S&P (very high)
• ETFs:
  • ALT: iShares Diversified Alternatives ETF. Full range HF multi-strat ETF
    • Objective:Yield/futures arb, technical trades, fundamental relative value
    • Current holdings are mostly currency, IR, and index futures
    • Just started
  • QAI: IQ Hedge Multi-Strategy Tracker ETF
    • Just started

Strategies For Uncertain Times: Merger Arbitrage (and Special Situations)

Overview: Merger arbitrage involves long/short equity positions in an attempt to exploit M&A takeover mispricings. In some ways the merger arbitrate strategy can’t be divorced from general “special situations” strategies like spin-offs and corporate reorganizations.

Merger Arbitrage/Special Situations

Overview: Low correlation with S&P. Current historically high levels of corporate balance sheet cash balances combined with unfreezing of credit markets should lead to more M&A activity and benefit merger arb strategies. Merger arb strategies throw off lots of cap gains b/c of high turnover on deals so it’s best to hold it in a tax advantaged account.

• Open-end mutual funds:
  • ARBFX: Arbitrage Fund
    • ¼ the size of MERFX, might mean they can get out of blown deals easier
    • Mgmt focuses on strategic deals, not LBOs, and is focused on vol-adjusted returns
    • 1.9% annual expense
    • 5.28% std dev on 3 year basis, has roughly 0.40 beta w/ S&P
    • 5 year annualized return of 4.7%
    • 65 positions with high turnover
    • Down 1% in 2008
  • MERFX: The Merger Fund
    • 1.5% annual expense
    • 4.96% std dev on 3 year basis
    • 5 year annualized return of 4.4%
    • 42 positions with high turnover
    • Down 2% in 2008
  • GABCX: Gabelli ABC Fund
    • 0.64% annual fee, no load
    • 4.6% std dev on 3 year basis, beta of 0.20 vs. S&P
    • 5 year annualized return of 5.3%
    • 140 positions with high turnover, very diversified, currently 100% long
    • Merger arb, special sits, value oriented common stocks, convertible bonds
    • Down 2.6% in 2008
    • Morningstar 5 star fund
    • Almost entirely US although is global in focus
• CEFs:
  • GDL: Gabelli Global Deal Fund    
    • VERY diversified
    • All special situations: merger arbitrage, spins, reorgs
    • Global, but almost all US at the moment
    • Existing holders are buying at the moment
    • 90 positions with high turnover
    • Low annual fees of only 0.66%
    • Only 3 year history, but has a 0.65 beta w/ S&P
    • Down 8% in 2008
• ETFs:
  • MNA: IQ ARB Merger Arbitrage ETF
    • Does NOT actually short shares of the acquirer, only indexes, so it’s not real arbitrage
    • Just started
    • 0.75% annual fee

Strategies for Uncertain Times: Commodities

Overview: I’m talking about the actual commodity futures, not equities of companies involved with commodities, and also preferably on a long/short basis. Commodities have a negative 0.04% correlation with equities over the last 10 years. Commodities CAN be an uncorrelated play on basic raw materials & energy, which may move independently of equities although they are macro cycle dependent. Commodities are positively correlated with inflation, which will increase. I prefer long/short commodity strategies to long-only b/c the risk of draw-down is less when commodities are not in a strong uptrend. Low distributions from actual-commodity funds (as opposed to equity-focused funds) means it’s probably best to hold in a taxable account if you plan on holding for longer than one year. Remember, equities of natural resources companies have a VERY high beta versus the S&P over the last 10 years, so you don’t get the diversification benefit as well as if you hold actual commodity futures.

• Open-end mutual funds:
  • PCRDX/PCRAX: Pimco commodity real return fund
    • Invests partially in another Pimco actual commodity fund
    • 29% std dev and a 0.80 beta vs. S&P
  • HACMX: SAME as PCRDX but with lower fees, same mgmt team
  • CRSAX: Credit Suisse Commodity Return Strategy (long-only)
    • 0.90% annual fee
    • 23% std dev and 0.58 beta vs. S&P
  • RYLBX/RYLFX: Rydex Long/Short Commodities Strategy
    • Based on 12 month price trend following model
    • 4.75% load, 2% annual fee (estimated fees, it’s brand new, but still too high)
    • Can be long or short any commodity, can be net short depending on model outcomes
• ETFs:
  • GRES: Global resources, hedged. All commodity sectors but only through equity positions. Short the index against long equity positions. Does not hold actual commodities.
  • LSC: ELEMENTS S&P Commodity ETN
    • Long/short actual commodity futures ETN based on price trend following.
    • Direction of long/short based on 7 month exponential moving avg
    • 6 sectors, 16 actual commodities. Fixed weight to sectors, always long energy
    • Rebalanced monthly
    • Only 0.75% annual fee
  • RJI: Broadest long-only actual commodity ETF, followed by DJP and then GSG
  • IGE: North American Natural Resources
    • Only holds equities of natural resources companies
  • HAP: Hard Asset Producers
    • Only holds equities of hard asset companies, 60% international

Other Notes:

• Equity-based natural resource funds have VERY high beta vs. S&P, so DON’T buy them
• L/S commodity funds have a NEGATIVE beta vs. S&P
• Agribusiness is popular subset of this (like Potash fertilizer, etc).
  • MOO is the active agribusiness ETF
  • PAGG: PowerShares Global Agriculture ETF

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.