1

XVIII. Publicly Traded Commodity Funds

2

Publicly Traded Commodity Funds

Private partnerships offered by prospective:

1. Most funds have the ability to trade (and do trade) in many futures and forward contracts on financial instruments, foreign currencies and commodities. In addition, they frequently hold financial instruments directly (using them for margin against their futures transactions). Most fund prospectuses stress diversification and the ability to take long as well as short positions in commodities (i.e., to buy or sell futures contracts).

2. Most funds can only be purchased for a short time after the initial prospectus, but allow investors to liquidate their position at net asset value at monthly (sometimes quarterly) intervals. A monthly rate of return can, however, be computed.

3. Most funds use technical and trend following systems to decide whether to take a long or short position with respect to any commodity (futures contract).

3

4. Most funds incur high management fees and transaction costs relative to other types of asset management such as mutual funds. Management fees usually exceed 5 per cent of capital a year, while the sum of management fees and transaction costs exceeds 19 per cent of capital per year.

5. Most fund prospectuses contain a clause that calls for the fund to dissolve if either the net asset value per share falls below a predetermined level (most often 25 to 30 per cent of the initial capital an investor pays in) or the total size of the fund (assets under management) falls below a specific level.

4

Typical quote from prospectus

“Trading decisions of the Advisor will be based primarily on technical analysis and trend-following trading strategies which seek to identify price changes and trends. The buy and sell decisions based on these strategies are not based on analysis of fundamental supply and demand factors, general economic factors or anticipated would events.”

5

6

Data – monthly returns July 1979 – June 1985 latter updated through 1988 (second study)

Problems in date – managed account reports

Ending returns

Surviving bias – assumed reinvested in surviving funds

Latter assumed reinvested in T-bills

7

Value Return

June 601

July 881 46.6

August 954 8.3

September 1617 69.5

October 1834 13.4

November 1902 3.7

MHR 28.3%

December 254 -86.7

MHR 9.1%

GHR -13.43%

8

THE PERFORMANCE OF PUBLICLY-TRADED

COMMODITY FUND

A. AS A STAND-ALONE INVESTMENT

B. AS PART OF A PORTFOLIO OF STOCKS AND BONDS

IDENTIFYING (PERDICTING) SUPERIOR

PREFORMING FUNDS.

CONCLUSION

9

Year # of Funds

Return Stan. Dev.

1 12 .0027 .1577

2 16 .0090 .1211

3 34 .0112 .0824

4 49 -.0267 .1167

5 70 -.0054 .0793

6 85 .0048 .0943

Average -.0007 .1130

Average Monthly Returns Based on Annual Holding Period

June–July

10

Avg. Monthly returns (based

on 1yr HP)

S.D. Monthly Returns

Commodity Funds

-.0007 .1130

Small Stocks .0123 .0639

Common Stocks .0074 .0414

LTC bonds .0045 .0271

LTG bonds .0041 .0279

Treasury Bill .0051 .0026

266 fund years

49% negative

61% below T-bills

11

12

Approaches

1. Average each years standard deviation – ignores more funds (observations later years).

2. Average each funds standard deviation – ignore over counting common variance later years.

3. Estimate the systematic and non-systematic component of standard deviation separately.

ityytiyiyity IR

2222iyiyiyiy

222 I

5

1

22 5y

IyI

5

1

22

iyiy

13

Recall from lecture on International Stocks to put any money in commodity funds

CPP

FP

C

FC RRRR

P = portfolios of stocks and bonds

14

15

16

This date suggests that commodity funds must earn about 9% a year to be considered a good candidate for inclusion in a portfolio of stocks and bonds.

Recall that investments in futures is a zero sum gain – return from buyer + return to seller = 0 (less transactions costs)

Funds fees average 19% per year

Management must have information worth 28% per year to produce this return. Evidence from other capital markets make this unlikely.

17

Funds bad on average but can we use information to pick good funds

Weak predictability in Sharpe Ratio.

Virtually no information in past returns

Fair amount of information in past standard deviations

%R 42

18

If performance is bad why do investors purchase. Two explanations.

1. Markets are irrational

2. Investor receive biased information. Sucker born every minute. Can’t evaluate inaccuracy.

Important consideration – no way an informed investor can trade against to make an arbitrage profit.

If an informed investor can not benefit from an overpriced asset all we need for it to exist is enough uninformed investors.

19

Sources of Information

a) Prospectuses

b) Press Coverage

Prospectuses – acquired 79 of the 91 funds in original sample –

Prospectuses Return minus Public Fund returns same month = 2.81 Value of 5.15

20

What went wrong?

1. Transaction costs and management fees

2. Self Selection bias

3. Control over reported #’s

1. Transaction Costs and Management Fees

Public funds often have higher management fees and transaction costs than private accounts. 23 prospectuses estimated change in fee. From these number average returns in prospectuses would be lowered by .13% from 5.59 to 5.46. Doesn’t account for much.

21

2. Self SelectionThere were 2080 registered commodity trading advisors. Only about 10-15 went public each year. If the mean was zero given the standard deviation more than 40 a year should have return above the 5.59% reported. Select good past record bring public – This has implications for all private partnerships.

3. Control over reporting numbers Must report 36 months if such data exists – can report morea) return in 36 month = 4.14% per month b) in extra months 8.85% per monthc) in starting month 14.6%

22

Other source of information – the popular press

Looked at 34 business magazinesLooked at Wall Street Journal and New York Times (8 articles)

Almost all were favorable many discussing the spectacular results of some particular manager.

Even the article that is not favorable often contains details on one successful fund. Typical is April 26, 1982 article in Business Week. After explaining that half the funds in the industry suffered losses in 1981, it explains the industry is continuing to grow probably because of the outstanding performance of some funds and then discusses in some detail the performance of Heinhold which earned a 75% rate of return in the previous year.

23

Why do the funds exist and continue to exist?

1. Biased information

2. Limited experience of any investor

3. No way that an informed investor can trade against them – all an informed investor can do is not buy.