Investing In Commodities Without Leverage

June 12, 2013


The worst-performing commodities index of the three, the Dow Jones-UBS Commodity Index, fell 2.24 percent in May. Meanwhile, PCRAX finished the month down more than 5 percent. To understand why this may be, look no further than the U.S. and Global aggregate bond indexes from Barclays Capital.

BarCap US Agg vs Barcap Global Agg

As you can clearly see, yields rose across the board in May, punishing bondholders. While there were certainly pockets of the market that performed better than others, the weakness in the bond market was systematic.

When commodities prices and bond prices are rising in lock step, this flexibility—if you would like to call it that—can be a boon to investors. When the opposite is true, it can punish investors.

All of this is to say that PCRAX, like many strategies that provide this type of collateral optimization, are leveraged products that aren’t labeled as such. After all, if ETF managers wanted to invest cash collateral in Mexican government bonds or Fannie Mae agency debt, the Securities and Exchange Commission would force the ETF issuers to amend their prospectuses.

None of this is to say that Pimco is necessarily misleading its clients. It lays out all of the risks of this strategy in the requisite legal documents and clearly displays its holdings for all to see. For their purposes, they have provided full disclosure.

It’s therefore a matter of perception and how one defines leverage. When you hold a commodity ETF, the requirement is that all cash collateral be invested in cash or cash equivalents.

Any departure from this, by definition, represents the introduction of leverage. Meanwhile, PCRAX invests 100 percent of its portfolio’s collateral in a wide range of debt instruments, none of which expires less than a year from now.

Why then doesn’t anyone call PCRAX a leveraged fund when it’s clear the collateral in the portfolio is exposed to everything from default risk to geopolitical risk? Considering that most people use commodities and the products that aggregate them as a means to diversify away from credit and equity exposure, why would they want to invite these risks into the commodity portion of their portfolios?

We all know Pimco is the most respected bond manager in the world. I’m not questioning its ability to manage the collateral effectively and navigate the various risks of investing in the various debt instruments they currently hold in PCRAX.

What I am questioning is why more people don’t view PCRAX as a leveraged commodities play given the laundry list of risks the portfolio takes on above and beyond those provided by the basket of commodities futures contracts it holds.

I guess it’s just another example of why I love ETFs.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at [email protected].


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