By Eric Uhlfelder, Investing Across Borders

March, 2001

The rapid and pervasive descent of the stock market has left investors scratching their heads, wondering where in the world they can turn. For those whose feet aren’t caught in the quicksand of Wall Street, an alternative investment is commodity trading funds.

By their very nature, commodity funds excel during bouts of volatility, precisely the conditions we’re experiencing now. Using futures contracts to make leveraged bets on various pieces of the global economy -- currencies, energy, bonds and interest rates, stock indices and agricultural and consumer goods -- commodity trading advisers [CTAs] are able to profit from price swings regardless of which direction they are heading.

Because futures are leveraged plays, an adviser need be right only once out of every two to three bets to make money. And downside is managed through two basic techniques: systematic trading programs [used by a majority of advisers] to automatically limit losses and maintenance of approximately two thirds of assets in Treasury bills as margin protection on futures positions.

An example of the specific kinds of investments traders make comes from Michael Clarke, principle of Clarke Capital Management, Inc., a CTA based just outside of Chicago with more than $200 million under management. In the middle of March, Clarke had nearly half of his positions in fixed-income-related contracts, betting interest rates would continue to fall and bonds would continue to rise. He held currency contracts that shorted the euro and the Swiss franc against the U.S. dollar. And he was also shorting grains and precious metals, expecting their prices to further decline as the economy enters a deflationary period.

Clarke’s read of commodity markets has been exceptional. Over the past three years through the end of 2000, his five systematic trading programs have averaged annualized gains of 29.11 percent. His new Atlas Futures Fund [800-331-1532], soared 32 percent in 2000. However, Clarke is quick to emphasize that individual investors should not be deluded by these returns. "Like all financial markets, commodities can be quite mercurial," warns Clarke and recommends that asset allocation in such funds should not exceed five to ten percent of an investor’s portfolio.

According to Richard Pfister, director of La Jolla, California-based International Traders Research [managedfutures.com], a firm that tracks historical performance data, CTAs as a whole have significantly outperformed major U.S. market indices over the past three years. Through the end of February 2001, three-year annualized returns of the Dow, Nasdaq, and S&P 500 had collapsed from their remarkable heights, registering gains of just 6.60, 5.47, and 5.74 percent, respectively. Average annualized returns of CTAs with assets over $10 million were 12.46 percent.

Just as important, CTAs have been able to double the performance of the market with substantially less risk. ITR reports that the standard deviation [the amount returns fluctuate above and below their monthly averages] has been far lower for CTAs [2.70 percent] than for the Dow [4.94 percent], Nasdaq [11.21 percent], and the S&P 500 [5.17 percent].

"Draw down," the pace and size of descent from a price peak to valley, is another way to view risk. Over the past three years, commodity funds’ worst draw down over a six-month period resulted in a loss of 3.2 percent versus –11.8 percent for the Dow, –48.8 percent for the Nasdaq and –18.3 percent for the S&P 500.

"Most investors don’t realize," observes Pfister, "that commodity trading accounts offers an effective means to diversify a portfolio with a near-zero correlation with stocks and funds and a proven record of long-term profitability."

To buy into a fund starting with a small minimum investment of $5,000 [$2,000 for IRA accounts], investors can go through a number of full-service brokers, including Salomon Smith Barney, Morgan Stanley, and Merrill Lynch. There are also a limited number of funds that deal directly with the small-time investor.

There are usually no sales charges to get into a fund. Liquidating a position is permitted only at the end of the month, and some funds will hit you with an exit charge if you want out within two years. While this may not ensure an optimal exit, such control on the flow of cash helps advisors sustain a stable asset base and keeps costs down.

Management fees are around 2 percent, and the CTA earns on average 20 percent of the profits, similar to most hedge funds. However, such incentive profits are only paid out when a fund’s net asset value exceeds its previous high. So if a fund has been off, a CTA will not earn an additional bonus until the fund surpasses this so-called previous "highwater mark."

While profits are not distributed to investors like in mutual stock funds, investors do accrue tax liabilities, most of which are short-term in nature, consistent with the term of most futures contracts.

So the bottom line, according to Brian Kline, an Indiana-based CPA/financial adviser and principal of Kline’s CPA group, is that "commodity funds are an effective way of enhancing portfolio returns." But the potential for greater performance comes often with greater risk, and investors must not only be able to tolerate this, they also must do their homework in selecting a fund. Some funds, Kline has occasionally observed, are less than scrupulous.

Toward that end, investors can turn to two oversight agencies, the Commodity Futures Trading Commission [cftc.gov] and the National Futures Association [nfa.futures.org], to ensure the integrity of a fund and find extensive information about the ins and outs of commodity trading.

Eric Uhlfelder is the author of "Investing in the New Europe," recently published by Bloomberg Press, and is European Editor at Investing Across Borders. For more information, please go to InvestingInEurope.com.