Investing In Commodities Without Leverage

June 12, 2013

Who knew the world’s biggest commodities mutual fund was a leveraged play, and who knew the world’s biggest commodities ETF isn’t?

Last month, the largest commodities fund in the world, the Pimco Commodity Real Return Strategy Fund, fell more than 5 percent, while the worst-performing broad commodities ETF fell slightly more than 2 percent. What gives?

May was a rough month for commodities and bonds. Thankfully, ETF investors only had to worry about the former. The bad news for investors in Pimco’s Commodity Real Return Strategy Fund (PCRAX) is the latter was perhaps even more important.

PCRAX—again, the world’s largest commodities fund—currently has more than $16 billion in assets under management, which is roughly $5 billion more than is invested in all broad market commodities ETPs combined.

Like the $6.44 billion PowerShares DB Commodity Tracking Fund (NYSEArca: DBC)—the world’s biggest commodities ETF—and the iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca: DJP), PCRAX tracks a diverse basket of commodities ranging from corn to Brent crude.

As with the broad-market commodities ETPs, PCRAX aims to provide investors with balanced exposure to the commodities complex and the diversification benefits they provide.

Unlike these exchange-traded products, however, PCRAX is able to invest cash collateral in all manner of credit instruments.

A quick look at the holdings list of PCRAX confirms this. As of March 31, PCRAX held everything from Bear Sterns Adjustable Rate Mortgage Trusts to Petrobras corporate debt to Mexican sovereign bonds. In fact, the bulk of the fund’s $16 billion asset tally is invested in TIPS, and the portfolio has an effective maturity and duration of six and 4.6 years, respectively.

To be fair, this isn’t news. The fund’s home page plainly states: “The fund seeks to capture the performance potential of a commodities index backed with a portfolio of Treasury Inflation-Protected Securities (TIPS), offering broad participation in the return of commodities while harnessing Pimco's innovative Double Real approach.”

That “Double Real” approach effectively means investing collateral in securities other than three-month Treasurys. Said another way, whereas ETFs like DJP and the United States Commodity Fund (NYSEArca: USCI) invest collateral in ultra-short-term Treasurys, PCRAX takes everything from credit to currency to duration risk with its collateral.

What is news, however, is how this approach impacted returns during a period where commodities and bonds fell in price. The chart below shows the performance of PCRAX along with those of widely followed commodities benchmarks.

Indexes Performance



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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