COM - COM: A Long/Flat Strategy That Delivers

2023-04-10 05:16:56 ET

Summary

• COM is an excellent choice for investors looking for low-volatility exposure to commodities.
• The fund's risk-adjusted returns and low correlation to the market make it a superior hedge within the context of a diversified portfolio.
• COM charges a seemingly high expense ratio, but in this post, I will explain why this is justified.

Thesis

Direxion Auspice Broad Commodity Strategy ETF ( COM ) is an interesting commodity ETF that I think investors looking for a low-volatility exposure to commodities should consider.

Its correlation to the market is significantly lower than that of other famous commodity ETFs. And although it uses a full-replication approach, it managed to outperform its index over a long time, with a trend that also hints at even greater outperformance to come.

There may be some outperforming commodity ETFs out there that charge lower fees, but COM's risk-adjusted returns justify the cost. If you are looking to diversify using commodities like me, your best bet is this one.

What Does COM Do?

COM was issued by Direxion Investments on March 30, 2017, and is managed by Rafferty Asset Management LLC. It invests in commodity futures contracts, as well as fixed-income securities. For the commodity allocation, it uses a full-replication technique to track the performance of the Auspice Broad Commodity Index.

The ETF invests in the futures through a wholly-owned Cayman Islands subsidiary to be taxed like an equity ETF. For this reason, it also won't have to distribute a K-1 form to shareholders. It's allowed to allocate up to 25% of its assets to commodity futures contracts and it will use the rest of the assets to invest in fixed-income securities.

The portfolio will include 12 commodities for which the index will be either long or flat based on trend signals for each commodity; it will go long when a commodity's price is increasing and flat when it identifies a downward trend. The idea is to provide better risk-adjusted returns than other long-only strategies can.

The commodities it's exposed to are gold, silver, gasoline, natural gas, heating oil, copper, soybeans, wheat, corn, sugar, crude oil, and cotton. As for its fixed-income portion, it will invest in short-term and money-market fixed-income securities.

Last, COM allocates its assets based on a risk-parity approach. The index will rebalance on a monthly basis when a component's volatility exceeds a specific threshold level.

Performance

Since COM tracks an index that is significantly older than the fund, I am naturally interested in how the index performed over a longer time frame. So, let's examine the performance of the index compared to other trackable commodity indices:

A cumulative return of 14.91% over nearly a decade puts it into the "decent" category for a commodity index. One performed worse and two performed better (let me note that the SummerHaven Dynamic Commodity Index TR performed slightly better with greater volatility and that the Barclays Commodity Index Pure Beta TR is only trackable through an ETN issued by Barclays).

So far, the performance of the index is interesting. But it's only relevant to the extent COM was successful in replicating it.

As you can see it "failed" to replicate it because it outperformed it. Since it was launched, it returned 53.52%, while the index returned 45.19%. You can also notice a trend for this difference in performance to widen. I think this is surprisingly good considering the large tracking errors you often encounter in commodity ETFs, even for such short time frames.

Speaking of which, let us now examine the ETF's performance against some commodity ETFs that also track indices:

COM's much less erratic performance totaling 53.52% since its inception looks very attractive. It sits right in the middle, underperforming two ETFs and outperforming two others.

The selection of the above ETFs was conducted based on the sole criterion of sharing the characteristic of an index commodity ETF like COM. Though the most relevant here, I was curious to see how it fared against some actively managed commodity ETFs:

Right in the middle again, with the more volatile Invesco DB Optimum Yield Diversified Commodity Strategy No K-1 ETF ( PDBC ) outperforming it.

Speaking of volatility, since COM was launched it had a maximum drawdown of -15.95%, with a standard deviation of 9.3%. This is impressive considering that the actively managed PDBC had a maximum drawdown of -40.74% and a standard deviation of 17.81%. And for a more fair comparison, consider that all of the index ETFs that we compared COM to above were more volatile as well:

What's more, COM is the least correlated to the market, which makes it a much better potential diversifier.

However, I understand that many investors may not care for either low volatility or uncorrelation. For this reason, I suggest you take a look at an analysis I wrote for iPath Pure Beta Broad Commodity ETN ( BCM ) recently. Just keep in mind that it's most suitable for long-term ownership.

Fees

When it comes to fees, COM charges an expense ratio of 0.81%. This is high, but because of the sophistication of the index it tracks, I believe it's worth it. The size of its AUM justifies this as well.

From the standpoint of the best historical performance possible, PDBC and COMT have much more attractive fees. However, when it comes to those who are looking for the best risk-adjusted returns, I wouldn't say they'd overpay for COM.

How Does COM Fit Into a Portfolio?

For a traditional 60/40 portfolio, even allocating a quarter of your bond portion to COM can have decent results. I did a backtest and a 60/30/10 structure since COM's inception yielded 64.82%, while the 60/40 portfolio returned 56.62%; SPY and BND were used for the stock and bond allocation, respectively. Additionally, the Sharpe ratio for the 60/30/10 portfolio was 0.65 while the 60/40 had a Sharpe of 0.59.

These results assumed annual rebalancing. I tested a monthly and semi-annual rebalance frequency too, but there wasn't any significant difference in performance.

Risks

• Counterparty Risk: COM is subject to this risk because of the possibility that the other party in a futures transaction won't be able to fulfill its obligation.
• Commodity Risk: As the usual commodity ETF, COM will trade futures contracts to get exposure to commodities and is, therefore, exposed to the risks that concern the underlying assets (war, market events, regulatory changes, etc.)
• Credit Risk: COM uses a large part of its assets to invest in fixed-income securities and may encounter defaults.

Verdict

COM is an excellent choice for alpha-seeking investors who are looking to diversify their portfolios. An expense ratio of 0.81% is reasonable for an ETF that uses a dynamic long/flat strategy for commodities; especially since this bore fruit in the form of a much less volatile fund with highly competitive returns.

I intend to allocate to it the first chance I get (this relates to my personal situation and not market conditions). What do you think? I'd love to know, so let me know in the comments below. Also, make sure to follow to not miss more posts like this. Thank you for reading.

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