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Commodity Funds Can Dilute Your Risk

Wheat field
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Wheat field

Some people believe that you can treat diseases by giving sick people more of what made them sick in the first place. Using that logic, you'd use an electric chair to cure people struck by lightning.

For people sick of volatility, there's evidence that adding another volatile investment — managed commodities — can calm a portfolio. This isn't a strategy for everyone, particularly those prone to nervous tics, but it may work for you.

A futures contract is the obligation to make or take delivery of a certain amount of a commodity by a set date. A corn futures contract, for example, might be for 5,000 bushels of corn for delivery in September. Futures aren't just for agriculture: You can trade futures on metals, energy and financial indexes, too.

The futures markets arose to reduce risk, not increase it. A farmer may decide that he wants to use futures to lock into the current price of corn, for example, rather than gamble on what he'll get at harvest. By using futures, he'll give up the potential for higher prices in return for not getting a lower one.

Who takes the risk from the farmer? In many cases, speculators. The overwhelming majority of the time, speculators have no interest in owning a freight car of coal or a stack of gold bars. While commodity price moves can be dramatic, that's not what gives the futures market the reputation as a place for speculation. It's the fact that most commodity contracts are leveraged — that is, your principal is a fraction of the contract's value.

Traders typically put down about 5 percent to 15 percent of the contract invested, which raises the stakes considerably. If you invest on 10 percent margin, a 10 percent move in the underlying commodity will either double your money or wipe you out. (Commodity margin is not the same as a margin account at a brokerage. In commodities, the margin is more of a good-faith deposit.)

Most professional commodity investors use relatively little of their assets — about 15 percent — for actual commodity trading, leaving the rest in Treasury securities as a reserve. They tend to be more concerned with avoiding losses than hitting home runs. "You want to live to trade another day," says Dave Kavanagh, manager of the Grant Park Fund.

Most commodity traders are trend-followers rather than forecasters. They can make money on rising or falling prices. For that reason, managed commodity pools do well when there's a clear trend, and poorly in flat markets.

So why invest in commodities? For one reason, they're not particularly correlated with stocks and often do well when stocks decline. In part, that's because stocks decline when there are big dislocations in the financial markets, and commodities traders love a trend.

The other reason: Commodity funds have many different markets from which to choose. For example, Cole Wilcox, manager of Longboard Managed Futures Strategy fund , is betting on rising prices for bonds, grains, U.S. stocks and the U.S. dollar. He's betting that the euro, European stocks and precious metals will fall.

Managed futures funds are considerably different from the exchange traded futures funds that have been launched in the past five years. Many of these ETFs concentrate on a single commodity, such as gold.

And most diversified commodity index funds are long-only — meaning they can't take advantage of a price decline.

Morningstar has created a new fund classification for managed futures funds and lists more than a dozen of them. Drawbacks? Of course.

High fees. The high-end commodity funds for wealthy investors charge outrageous fees: 2 percent for the general manager and 20 percent of profits. In the mutual fund world, fees are lower than hedge funds but generally higher than average. Guggenheim Managed Strategy A (RYMTX), one of the oldest managed commodity funds, charges 1.97 percent of assets for expenses and sports a maximum 4.75 percent sales charge.

Variability. The average managed futures fund is down 8.6 percent the past 12 months, according to Morningstar. The top performer, MutualHedge Frontier Legends , gained 3.6 percent. The worst, Direxion Indexed Commodity Strategy, plunged 26.1 percent.

Managed futures funds are best used sparingly to even out some of a portfolio's highs and lows. If you're prone to night sweats and terrors, you're better off with aspirin and a bank CD.

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