“We don’t short oil because of geopolitical risk,” O’Leary says. All it takes is one catastrophe. “[Oil] can go infinitely higher, and this would cause a far-greater loss than acceptable for its goal of robust returns.”
For that reason, when the recommendation to short oil comes in, the indicator instead goes flat.
The indicator determines when to be long or short in an individual commodity by using a 7-month moving average, taking only the information from the end of the month. As illustrated in the chart above, when a commodity is above the average, it’s held long. When it’s below, it’s held short.
O’Leary points out that commodities tend to hit a point that they become so expensive that people will stop buying them, as we saw with oil and gas this summer. People simply began to stay home. The indicator didn’t sense that oil was nearing that price point, though, because “the indicator never looks forward, only backward,” he says. “It has to have that price input and has to end a month below the seven-month weighted moving average.”
There are several scenarios in which the indicator loses such as flat commodity prices, during disinflationary/low interest rate/low GDP periods (but not necessarily recession or depression), and when there are dramatic trend reversals, as seen in July, causing money to be lost due to whipsaws. O’Leary says that at the beginning of that month, trends as reflected in the moving averages had all sectors long just before everything changed.
However, generally, the indicator accumulates positive performance over time picking up intermediate- to long-term trends.
“Other indices assume a high correlation between all the commodities in their basket – sugar, to oil, to cattle,” O’Leary says. “This indicator allows the investor in the index the potential to profit from the independent movements of the sectors.”
For example, livestock could be rising while precious metals are falling. Investors potentially could profit from both trades.
“Even under intense pressure, the indicator held up. It’s a clever way of investing in commodities that does so by means of a very simple algorithm,” O’Leary says.
Michael Forstl, managing director at Nuveen, says they developed the ETN in part with Merrill Lynch.
“We really focus, unlike our competitors, on notes that appeal to tactical traders and more on the fee-based advisory marketplace,” Forstl says. They target advisors who are working with high-net worth individuals and practice in a fee-based environment.
The S&P CTI is more of an allocation strategy than a tactical one. “The indicator itself has the ability to adjust to market conditions.”
Forstl says the strategy works for investors who don’t want to worry every few months about what oil is going to do, or how corn is going to look in a few weeks.
“We’re trying to bring to the market strategies that have a high level of intellectual content,” Forstl says.
