The DJ/AIG Commodity Index tries to reflect the "economic significance" of each sector, and so it strives for diversity with a 33% limit on sector weightings. Energy, accordingly, tops out at one-third of the fund, while the agricultural and metals weighting is 2.5 and 4 times their respective positions in the S&P/GSCI. This balance constrains volatility, with annual deviation running less than 15 versus nearly 22 for the S&P index.
Such different content results in different kinds of performance. Because of oil's strong showing, one-year returns of the S&P/GSCI through June are up a whopping 76%. Three- and five-year annualized returns were 19.74% and 21.30%, respectively, while ten-year gains were 15.50%. The Dow Jones AIG Index gains were more modest. One-year returns were 41.56%. Three- and five-year gains were 18.84% and 18.60%, respectively. And ten-year returns were 13%.
Commodity funds can vary by more than just their underlying indices. Mihir Worah, portfolio manager of the PIMCO Commodity Real Return Strategy Fund, which tracks the DJ/AIG Index, has consistently outperformed his benchmark, doing so by 15.53% over the past year for reasons that go to the heart of how a commodity fund works.
Most of these funds don't buy stocks; they invest instead in the futures contracts of the actual commodities. This requires little up-front payment. But it does require managers to hold the bulk of their assets in collateral, typically short-term Treasurys, to meet margin calls in case contracts fall in value.
In seeking above-market returns, Worah maintains the same sector exposure in something like energy as the index, but then he alters his subsector bets (for example, he will invest more heavily in heating oil and go underweight in gasoline) where he thinks there's the most upside. At the same time, he manages his collateral holdings to exploit interest rate trends. Currently, he's invested in inflation-linked Treasurys with an average maturity of seven years via the Lehman Brothers TIPS Index. This meant that when the Fed cut rates last year, his collateral soared 15%.
Because it is actively managed, Worah believes his fund offers a more complete inflation hedge than most other indices. "Commodity exposure provides protection at the wholesale price level," he says, "while TIPS provide it on the retail CPI level."
The E-TRACS UBS Bloomberg CMCI Index ETN reveals further strategic variation. Not only does UBS believe it has conceived a more balanced commodity index than S&P's and Dow Jones', but the bank claims its investment in more diverse commodity contract lengths, ranging from three months to three years, produces better results. Pro forma analysis between December 1997 and April 2008 indeed showed this, along with less volatility of 12.2.
Looking for even more octane or reverse drive? Leveraged exposure can be found in exchange-traded securities such as Direxion's Commodity Bull 2x Fund. Inverse exposure can be gained from Deutsche Bank's DB Commodity Short and Double Short ETNs. Advisors can also short long ETFs to bet against the market.
However you decide to gain commodity exposure for your clients, make sure you understand what's under the hood. Even the most similar-looking investments can be quite different. And given the sharp U-turns commodity markets can make it essential to constantly monitor them.