Can Levered Commodity ETFs Work In A Long-Term Strategy?

NEW YORK (TheStreet) — Commodities are one of the hottest investment categories, with a popular notion being that we’re in the middle of an 18-year so-called super-cycle of returns.

Some investors are speculating on higher prices, while others are trying to hedge equity portfolios with commodities, which tend to have a low correlation to stocks.

One of the first exchange traded products offering broad commodity exposure was the iPath Dow Jones UBS Commodity Index Total Return ETN(DJP). The fund allocates 34% to energy, 29% to agriculture, 16% to industrial metals, 14% to precious metals and 6% to livestock.

Despite expectations of a low correlation to equities, there has been mixed outcomes. According to ETFreplay.com, the correlation between the iPath Dow Jones UBS Commodity Index and the benchmark S&P 500 Index of the biggest U.S. stocks was about 0.20, which is a low correlation, during much of 2007 and into 2008. Early in 2008, the correlation actually went as low as minus 0.50 before skyrocketing to 0.75 during the worst of the financial crisis. It’s recently been near 0.20 again.

As the iPath Dow Jones UBS Commodity Index and the strategy of hedging (and speculating) became more popular, Bethesda, Md.-based ProShares came out with the Ultra DJ UBS Commodity ETF(UCD), which targets twice the move of the iPath Dow Jones UBS Commodity Index on a daily basis. It turns out, Ultra DJ UBS Commodity won TheStreet’s 2010 Best Funds award in the commodities category for exchange traded funds. The ETF climbed 28% in 2010 and has extended its gains this year. The runner-up is PowerShares Global Agriculture Portfolio(PAGG).

As much negative attention levered funds attracted in 2008, and rightfully so, a funny thing happened as markets normalized: They have been working out as longer-term proxies. This year, the iPath Dow Jones UBS Commodity Index is up 5.1% and Ultra DJ UBS Commodity is up 9.4%. For one year, the iPath Dow Jones UBS Commodity Index has risen 26% and Ultra DJ UBS Commodity has jumped 53%. One thing that got lost in 2008 is that these funds can “work” for longer periods of time than just daily, but this all depends on the combination of up-and-down days.

The question, then, is can a levered long fund like Ultra DJ UBS Commodity “work” over a longer period? There’s no concrete answer. It appears as though this type of fund has a better chance of functioning longer term during normal market volatility. Were a repeat of 2008 to ensue, I would have no confidence in a long-term holding period for these funds in terms of closely tracking twice the underlying index.

Ultra DJ UBS Commodity has been a top performer. It just so happens that it was able to double the return of the broad commodity index it tracks. It could have just as easily done poorly, on a relative basis. Anyone using double-long funds, whether for trading or hedging, needs to understand that there can be no certainty of returns relative to the benchmark index for any period beyond one day.

Levered funds made a lot of noise during late 2008 for “not working,” which was a function of the daily reset required to meet the stated objective of twice the result on a daily basis. Fund managers buy or sell futures contracts to bring the levered fund in line with twice the original fund — in this case the iPath Dow Jones UBS Commodity Index. It’s that dynamic that has left investors disappointed and explains why the industry advises short-term trading in levered funds, not long-term strategies.

This post originally appeared at TheStreet.

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