My Commodity Portfolio Is Underperforming… Help!

You’ve been told that commodity futures can at times have a negative correlation to equities. When one goes up the other goes down, so they say. A portfolio of futures, then, makes for a good portfolio hedge–one that allows you to capture upside during market downturns, and one whose negative returns are offset by stocks during a broader market uptrend.

But what if the commodity side of your portfolio has been underperforming for a long, long time?

On one hand, you know that commodity prices can’t go to zero. There’s always going to be some base level demand for them. But on the other hand, seeing month after month of underperformance can be grating on your patience and risk tolerance.

Ultimately, you reach a juncture where you ask (referencing a 1980s pop song), “should I stay or should I go?”. The answer might be neither. Or it can be to start over, as you might have gotten it all wrong. In other words, you may need to remix your entire portfolio to optimize your chances of better returns while further reducing your risks.

Let’s put this all into perspective. We’ll give you a few tips to help you weather commodity slumps and volatility so that you may benefit from their potential upside when market conditions are ripe for a commodities boom.

Overconcentration–the Quintessential Portfolio Killer

Yes, we’ve heard it many times before: diversify, diversify, diversify! But isn’t that why your trading commodities in the first place? You may be thinking: “Am I not already diversified enough by holding commodities?”

The problem of overconcentration often resides where you aren’t looking.

  • Is more than 5% of your total invested assets in futures? Depending on your unique financial situation, you may (or may not) have an over-concentration problem.
  • Is your portfolio being managed by one commodities program or commodity trading advisor (CTA)? You may be over-concentrated.
  • Are you diversifying into more than one broad market trend following system? How do you know you’re not over-exposed to any one commodity class?

Allocating Too Much Capital Into Commodity Futures

Every financial advisor has a percentage limit as to how much you should allocate to a given asset class. Some say as low as 3%, some go even higher. It all depends on your total asset portfolio weightings. For example, if you are investing in an energy commodities portfolio while also investing in energy-related stocks, then you may hold a slight imbalance in your sector risk exposures.

Another thing to think about is whether your futures allocation truly represents your total market risk. Futures are leveraged instruments, meaning they are traded on margin. If your initial investment into a futures trading program represents the minimal amount to begin trading, then you may be required to inject more funds into your account should your trading program experience serious drawdown (to avoid a margin call).

The main point is to know exactly how much you are allocating to your futures investment and to assess whether that amount fits within both your risk tolerance and financial goals.

All Your Eggs in One Program or CTA Basket

Let’s suppose you have $150,000 to put toward a trend following program. You find five programs that may be favorable, but you choose only one. If the program you choose performs well, you may be lucky. But what if it doesn’t?

What if three out of the five you’ve identified performed well, and yours belonged to the underperforming two? What if your program undergoes a management change or encounters a technical error (say, a miscalculation of data) that significantly affected the program’s performance? You could be in a lot of trouble.

Instead of investing your entire allotted capital to one program, why not divide it into two or three programs (assuming you can meet the initial required investment)? You may not end up with the best performing program, but you may also reduce the risk of ending up with the worst performer. There is a caveat to this, however, and this is what we’ll discuss next…

Hidden Market Over-Concentrations

Here’s a rather simplistic scenario. Let’s suppose that  you decided to invest in four out of the five trend following programs. Each program includes exposures to equity indexes, energies, agriculture, softs, and precious metals.

But let’s assume that two of the five hold 35% allocation to equity indexes while the other three are equally weighted across all five commodity classes (20% for each class).

If you are participating in one of the programs that has 35% index allocation, let alone both of them, you may be overexposed to equity indexes. Should the market shift into bear mode, or should the economy fall into a recession, your portfolio may be more impacted than if you had invested in the other programs that had only a 20% allocation across the board.

This scenario illustrates hidden over-concentrations, and it happens more often than most investors think, especially when they try to construct or rebalance their own portfolios. Don’t fall into this easy-to-miss trap.

Although there are plenty more ways in which over-concentration can sneak into your financial portfolio, these are just a few common scenarios for which to watch out.

When to Stay the Course or Bail Out

Long-term programs take time to develop. That may be an easy concept to think about, but it’s certainly a hard one to experience and endure. Realistically, however, sticking to a program requires more than just faith. It often requires some pre-planning, objective monitoring, and in worst-case scenarios, intervention.

Let’s break it down.

Preplanning Through Diversification

To put it simply, don’t allocate more funds into a commodity trading program than you can afford to lose, and don’t put all of your eggs into one program. This applies to any investing scenario, whether stocks, bonds, real estate, or cash.

If your total financial portfolio is well balanced, then any drawdown in you commodity trading program’s performance may not hurt your financial standing as badly, since you are prepared for it and have allotted an acceptable amount for potential loss.  In this case, you may be able to stay the course.

Monitor Your Program’s Stats

Here’s one way to monitor stats. If your futures trading program touts a Profit Factor or 2-to-1 (2:1), meaning that it generally makes double the profit of any loss, yet it has consistently made less than 1-to-1 for a reasonable period of time (which depends on the program), then you might have to begin questioning whether the program is still relevant in today’s economic environment.

Sure, programs respond differently during bull or bear conditions, expansion or recession scenarios. And this is where it helps to know how the program performed during these periods. Hopefully you are able to monitor this history.

Another thing to consider is the Worst Historical Drawdown. Let’s suppose your program’s worst historical drawdown is -35%.  This doesn’t mean that the program won’t exceed this figure sometime in the future. But what if it has a drawdown of -65%? This is where you have to decide whether the drawdown is something of an anomaly, an error, a matter of mismanagement, or a warning that the strategy is no longer relevant on a macro trend level.

If you’re diversified and prepared for these unfortunate scenarios, you may be able to not only withstand the drawdowns and potential losses, you may also have the wiggle room to make adjustments or rebalancing efforts (shedding a few futures programs for others only when absolutely necessary).

The Bottom Line

You should always have a plan for when your futures trading program works favorably or unfavorably. Although we cannot predict the markets, we can always strategically position ourselves to participate in potential market opportunities while mitigating potential risks. As an investor–i.e. “speculator”–this may be the best you can do…but often, it’s good enough.