The biggest growth in the investment markets in the past decade has been the rise of the long only commodity allocation, as now held by everyone from large pension funds like Harvard Management or CalPERS to small investors through funds like Dow Jones-AIG Commodity Index Total Return ETN (DJP) and PowerShares DB Commodity Index Tracking Fund (DBC). Over $100 billion went into such strategies in 2009, a level expected to be eclipsed in 2010.
But Howard Simons, a longtime futures expert, author and strategist for Bianco Research, cuts against conventional wisdom in dismissing this still-popular approach. “When people ask me where commodities are going, I always tell them there is no such thing as 'commodities'," he remarks. "They are a collection of unrelated markets we lump together only when they are both tangible and exchange-traded. “
To prove his point, Simons points to a chart of one-year rolling correlations of returns between various commodity sub-indexes stretching back nearly 20 years. Examining the correlation between precious metals and energy, or livestock and energy, or precious metals and agriculture, he fails to see the stable, consistent and positive correlations over time necessary to establish real economic linkages and not just spurious coincidence.
Source: Howard Simons
“Either two things have a fundamental relationship or they do not” says Simons. If individual commodity markets were intrinsically related, “We would not see these random relationships over time.”
The positive correlations shown between industrial metals and precious metals and a few other pairs only came during the heyday of the mid-2000s commodities boom as a massive bull market brought billions into the strategy.
The relationship quickly evaporated once fund flows ebbed. “These markets get forced together for periods by the weight of money flowing into commodities, but they have no intrinsic correlation” he explains. “I could take a couple of random number series and probably get similar correlations over short periods.”
Those investing in long-only commodity funds like iShares GSCI Commodity-Indexed Trust (GSG) have been “sold a bill of goods,” Simons says While he admits there have been periods of time that long-only commodity funds have done well, “you are taking a collection of unrelated markets where you have high transaction costs, a known strategy that can get front-run and sources of return are not intrinsic. You’re gambling that everything is going to go your way.”
Instead of investing in baskets of commodity, Simons recommends “trading like the old CTAs (commodity-trading advisors)” instead of simply adding a broad-based fund. “There’s nothing to be gained in taking a long-only position in a basket of commodities. Go both long and short in individual markets with promising trends.”
As to my current bet on livestock?
“I’m bullish” he quips.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.
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