Commodities are still in a major correction period, so it is especially interesting when there’s any fund, index or indicator that’s not only outperforming, but is up year-to-date by double digits.
The S&P Commodity Trends Indicator is the underlying indicator for the ELEMENTS S&P CTI ETN (LSC). Although it launched in June, just in time for a big commodities correction, it’s up 13.2% year to date through Nov. 14 (while the S&P CTI Total Return is up 24.29% year-to-date from Jan. 1 through November 14.)
While the ETN is new, the indicator itself is not. Bryan O’Leary, head of U.S. Index Marketing for Alpha Financial Technologies, the creator of the S&P CTI, notes that it’s coming up on its five-year anniversary as calculated by Standard & Poor’s.
This significant milestone means that its one, three and five-year performance will now be real, as opposed to theoretical. The five-year annualized returns for the S&P CTI Total Return as of the end of October are 18.46%, outpacing its long-only competitors by a large margin. The indicator has also benefited from having been seen in a variety of commodity conditions.
“Most of the last five years, commodities have been bullish,” O’Leary notes. But that this indicator has managed to continue to perform in a challenging environment such as the current commodities bear market is especially noteworthy.
That the indicator is providing returns is a simple matter of its construction, which reflects trends. This allows commodities to be either long or short (except the energy sector which is long or flat but never short). Rather than going down with a sinking ship, the indicator can adjust its positions on a monthly basis, depending on how the individual commodities are trending at month’s end.
This chart tells the story:
The white line represents CTI; the red indicates the DJ AIG and green represents the S&P GSCI.
For a time, the major commodity indexes were more or less trading in line with one another. But in late summer, they diverged and the S&P CTI begins to steal the show.
The indicator goes both long and short in six areas: energy (long or flat only), softs, grain, livestock, industrial metals and precious metals. Using a seven month weighted moving average, the indicator then determines in what areas it will be long and where it will be short.
Earlier this year, as everything was trending up, the indicator was long in every area. In July, the indicator suffered along with everything else when the commodities decline began. But in August, the indicator began to change direction after the signal came to be short in everything – but oil.
“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.