Hedge this wild market with commodities

By Tim Middleton

Last week's violence in the stock and bond markets is a reminder that you benefit from hedging your portfolio with assets that perform differently. In market jargon, the term is uncorrelated.

It used to be easy: Stocks performed differently than bonds, and foreign stocks differently than domestic ones. But there has been a trend toward ever-higher correlation among financial assets as the economy becomes truly global. Last week's turbulence hit equities and fixed-income with equal force, and hit overseas as hard as home.

One group with very low correlation to financial assets is commodities. Actually, even this sector has been less-than-ideal for mutual-fund investors, because funds invest in public companies, which means you get stock risk even from the oil patch.

But Wall Street has delivered up some new alternatives for fund investors. The most recent is the DB Commodity Index Tracking fund (DBC). This is an exchange-traded fund that has attracted more than half a billion dollars in assets since its launch in February -- one of the most successful ETF launches ever.

It will soon be joined by iShares GSCI Commodity-Indexed Trust, an ETF currently in registration at the Securities & Exchange Commission. With the DB fund and two other portfolios already on the market, investors can gain much-improved exposure to commodities while tilting that exposure toward or away from the riskiest parts of the market.

Varying volatility

The case for commodities has been made by any number of gurus, including Jim Rogers, co-founder with George Soros of the fabled Quantum hedge fund and author of "Hot Commodities." Rapid global growth, especially in China and India, adds vast demand for products whose production capacity is already strained.

Rogers is particularly keen on agricultural products, and they comprise 35% of his Rogers International Commodity Index ($RCT). The Dow Jones-AIG Commodity Index ($DJAIG) puts even more into agriculture, some 41% of its weight.

At the other end of the spectrum are the Goldman Sachs Commodities Index and the DB Liquid Commodities Index. They put much less stress on agriculture and correspondingly more on energy.

Top commodity indices with sector weighting

Index/fund	Energy	Agriculture	Metals
GSCI Commod	73%	16%	11%
DB Liquid Commod	55%	22.50%	22.50%
Rogers Intl Commod	44%	35%	21%
DJ AIG Commod	33%	41%	26%

Source: MSN Money, IndexInvestor.com

The two indices that put more stress on energy currently are performing better than the others, but research by Tom Coyne, editor of IndexInvestor.com, finds that over long periods all four are very similar. He says investors should ignore their recent returns because, "depending on the period, it is easy to show any of the four indices outperforming the others."

Instead, he said investors should focus on volatility, the extreme price swings that tend to unsettle investors and lead them to buy or sell based on fleeting market enthusiasm. The indices with lower volatility are those with lower energy holdings, and he favors them.

Coyne prefers the Dow Jones index, which is available to investors in the form of a mutual fund, Pimco Commodity Real Return Strategy (PCRDX). This fund gains exposure to the index through what are called structured notes

The notes are basically contracts with third parties to deliver the return of the index in exchange for fees. The fees are a fraction of the value of their collateral, and Pimco's strategy is to more than compensate for them by investing most of its assets in Treasury Inflation Protected Securities.

The Rogers index is available to investors through a futures contract called Merrill Lynch TRAKRS. These are not conventional futures; they can be owned in an ordinary brokerage account rather than a separate options account. But they have high annual expenses, of nearly 2%, which is twice the fee charged by Pimco.

Investors who can handle more volatility will be drawn to the high-energy indices. The highest of all, the GSCI, isn't immediately available. A mutual fund that invests in it, Oppenheimer Real Asset A (QRAAX), is closed to new investors.

The new iShares ETF hasn't been approved by the SEC yet, although that's expected to happen this summer.

The DB index is available through the Commodity Index Tracking Fund. Since it came out in February, it has been down when the S&P 500 was up, and up when the market was down.

This contrary behavior is exactly what to look for in a hedge. Actually, the fund's behavior isn't strictly contrary -- for a time, both it and the S&P were higher. The behavior is simply uncorrelated, moving to its own rhythm.

Down, together

To get an idea how independent the behavior of this fund is, construct your own chart, comparing it since it began trading Feb. 6 both with the S&P 500 and with T. Rowe Price New Era (PRNEX), an excellent natural-resources fund.

You'll see that New Era almost exactly matches the stock index for most of this period. Correlation to stocks is, therefore, very high. The fund's hedging value is correspondingly diminished.

I'm not picking on the T. Rowe fund -- I own it, and so does my wife. And over longer periods, the sector indeed performs differently (i.e., better) than the overall market, which is why we own it.

But despite investing in commodities, the fund has given us no defense against the market's recent rout, and we could use some. One of the funds I've discussed here, either the DB or the Pimco fund, is likely to end up in my portfolio. The DB fund is also a candidate for my model portfolio of exchange-traded funds, which I'll be rebalancing later this month.

Investing in commodities is almost certainly a good long-term bet, but that's not the only reason why it's a good idea. Diversification helps moderate market tempests, and moderation is a good thing.

At the time of publication, Timothy Middleton owned the following securities mentioned in this article: T. Rowe Price New Era. Middleton writes about investing for a variety of publications, and is a radio commentator for WCBS in New York. A former reporter for the Dow Jones News Service and editor at Crain's New York Business, he works from home in Short Hills, N.J.