Commodity Watch

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Basic Trade analysis for metals, mining and basic materials

On 5/4/12, Zenith put out a post on the FPA(Financial Planning Association) website to garner a discussion with respect to the commodity producers given the European uncertainty and a slowdown in China. At that time we examined and passed on a beaten down investment in the S&P Global Materials ETF (MXI).

On 5/14/12, Zenith put out a post on the FPA website reiterating our disdain for this area of the equity markets as we reviewed all three of the ETFs mentioned below.

Zenith continues to be risk averse especially in the asset classes with the most volatility and ties to global growth. We continue to avoid commodity indexes and are finding little value in the aggregate base materials company stocks.

XME-S&P Metals and Mining


90% Basic Materials

P/E 14.88x and 12.48% EPS Growth

P/CF 7.83x and .87% Cash Flow Growth

P/REV .59x and 7.56% Sales Growth

Book Value Growth 4.48%

MXI-S&P Global Materials

Canada14,UK13, Aus 12, US 23

90% Basic Materials

P/E 11.61x and 9.07% EPS Growth

P/CF 6.76x and -29.91% Cash Flow Growth

P/REV .86x and -30.53% Sales Growth

Book Value Growth 5.36%

IRV-S&P International Materials Sector

90% Basic Materials

Can 22, Aus 18,UK17, Jap 14, Germ 8

P/E 11.56x and 9.82% EPS Growth

P/CF 7.07x and -30.57 Cash Flow Growth

P/REV .8x and -31.6% Sales Growth

Book Value Growth 3.28%

While some of the metrics do appear reasonable sales and cash flow growth are both terrible and there is simply to much uncertainty with regard to Europe and the Chinese “slowdown”.

Each of these instruments is down considerably since we first advised against them and while they may rebound, the climate is too uncertain for a high octane bet. We do not recommend a placement at this time.

The fundamental metrics provided by Schwab


Diversification Benefits Strained

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This piece is for portfolio managers and financial advisors that are attempting to add diversification to their portfolio or examine current diversification positions. Zenith believes that diversification is thought of as non-correlation with many firms. We also believe that additional investments into various segments of the equity market is more of a relative value bet although the intent many times is diversification.

Within the stock market, there are many sectors, capitalizations, regions and country exposures. If one holds a mostly large cap domestic portfolio and adds exposure to a basket of Latin American Stocks, additional risks and potential rewards have been introduced into the portfolio.

However, another long only stock position is not true diversification but rather a relative value bet. The hope might be that if theUSmarket goes down, then perhaps the Latin American Fund may offset the loss as it may appreciate. It will perform relatively better or poorer depending in part on its valuations and growth prospects.

Zenith believes the firm may have added more risk to the portfolio in the name of diversification. If it is a long only equity fund or ETF, the market risk (beta) remains.

The placement can turn out to perform very well, and that is the hope, but true diversification is also supposed to dampen portfolio volatility.

If we look at the market action on 5/15/12, we can see that a placement toLatin Americaincreased portfolio volatility and performed relatively worse.

An equal dollar placement to six Latin American ETFs would have a produced an equal-weighted daily negative performance of 2.28% on 5/15/12. The S&P500 was down .57% on the same day. The basket was calculated using the following ETFs: I-Shares MSCI Mexico (EWW), I-Shares S&P Latin America (ILF), I-Shares MSCI Brazil (EWZ), Global X FTSE Columbia (GXG), I-Shares MSCI Chile (ECH), Global X FTSE 20 Argentina (ARGT).

The time period was extremely short and the basket of ETFs is only one of many that could be created to set against the S&P500.

Zenith’s aim is to encourage advisory firms to test their portfolio’s diversification merits and to examine the absolute legitimacy of any equity placement. The following material is meant to help in that process.


Stocks and Commodities


Commodities are touted as an asset class that has properties able to diversify a portfolio over time. While academic research exists to support this over exceptionally long periods of time, the real time reality can be very painful for investors expecting diversification and instead experiencing large losses and heightened volatility.


Zenith will examine two reasonably short time periods to gauge the benefits of commodity exposure in a portfolio.


One year returns through April 2012

Broad Based Commodity Basket -17.01%

PIMCO Commodity Real Return Strategy Fund Institutional Class PCRIX -14.93%

S&P 500 tr +4.76


That asset class provided a unique return stream that moved opposite the S&P500, unfortunately, in a magnitude that is more than simply a negatively correlated asset class. It clearly is moved by different factors, although substituting one risk for another is not good diversification.


May 17th-October 3rd 2011

This is the period in 2011 that saw huge drops for the equity markets in general and a good time to hold a diversified portfolio of various asset classes. That was the thought at least, at the time.


PCRIX-  Negative 19.33%

S&P500- Negative 17.45%


At the time investors needed the diversification the most, exposure to broad-based commodity indexes provided major losses and no diversification benefits.


Zenith does not believe that a broad based commodity index is appropriate simply as a portfolio diversification tool. The factors that drive this segment of the capital markets are powerful and disparate. They range from supply/demand equations in areas such as energy, agriculture, base metals and precious metals. In addition, the currency market dynamics play a role in this asset class performance.



Stocks and High Yield Debt


High Yield Debt is touted as a way to earn equity-like returns with less volatility. There is some evidence of that; however its modest diversification properties should not be confused with non-correlation.


May 17th-Oct 3rd 2011


HYG-iShares iBoxx $ High Yield Corporate Bond Fund- Negative 12%

S&P500- Negative 17.45%


One year

S&P 500 +4.76%

HYG +5.7%


This asset class can exhibit similar volatility and does reduce interest rate risk and pure equity risk but does not hedge a portfolio in times of crisis. It should not be viewed as a pure hedge but rather a relatively less volatile way to gain exposure to reasonably high expected returns.



Stocks and Stocks

A natural instinct for many in the quest to diversify a portfolio involves a placement in additional segments of the equity market. A domestic large cap portfolio is thought to need additional areas of the global market and Zenith believes there is merit to that as long as expectations are realistic going into the trade and diversification (non-correlation) is not a goal.



1YR Performance through 4/12  +4.6%


Emerging Markets

DEM- Wisdom Tree Emerging Markets Equity Income Fund with a focus on Emerging Markets

1YR Performance through 4/12 -8.4%




1YR Performance through 4/12  -17.10%


These investments provided exposure to three different slices of the global stock market. If the starting point was the SPY ETF, then diversification accomplished the opposite of it’s intent and that is to dampen volatility. The investments gave exposure to different companies and their specific risks although the main stock market risk remained and in these cases, the specific risk unique to those sectors provided diversification in the form of losses. The relative performance hurt overall portfolio safety.


Zenith believes in placements in segments of the same market that appear to offer a compelling case for appreciation based on fundamental analysis and not simply for the supposed diversification benefits.














Emerging Market Local Currency Bonds

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In this piece, Zenith examines a few issues with regard to the local currency emerging market bond asset class for portfolio managers. Investment committees and advisors who are currently in this space or who are contemplating a potential placement should consider these factors.

This asset class has been in a structural upturn over the last few years due in part, to improving balance sheets and relatively high real yields. The middle class of these countries has strengthened although it is a struggle for many as the gap between rich and poor persists.

Initially the Emerging Market Countries, (EMC) story consisted of the “BRIC” countries that include Brazil,Russia,India and China, however, it is now expanding to include South Korea, Indonesia and Turkey among others.  Many of these countries have a different set of yield curves and varied monetary and fiscal policy.

Most of these countries has the ability to issue bonds in their own currency to better reflect the economic reality in their own country. This local currency bond market created a new opportunity set for investors.  Credit upgrades, currency appreciation and high real yields offered a “risk to reward” that was too appealing to pass up for investors. All of these factors are not as strong as in the past; although, a selective investment to Emerging Market Debt (EMD) can continue to be an additive component to a portfolio.


  • Expanding opportunity set as more countries develop their debt markets and corporations obtain funding through their own currencies.
  • Participation in the Emerging Market Growth (EMG) potential with potentially less volatility than equities.
  • Under allocation in many institutions asset allocations may allow for an allocation lift in valuations.


  • The Emerging Market world continues to suffer from political unrest and in some cases a slow evolution to democracy.
  • Hot money trade
  • Some Emerging markets are extremely dependant on commodity markets.
  • Less true real yield opportunities

Local currency bonds such as Brazilian Debt issued in the “Real” is seen as a way to diversify away from the dollar and garner a better yield. The sources of return and risk should be dissected.

A. Currency appreciation:

This is one portion that is taken as a given by much of the investment community. The belief is that the dollar is headed down and so the simplistic assumption is that Emerging Market Currencies will hedge the portfolio. The problem with that is EMC; while generally growing faster than the United States, all have currency issues to deal with especially those with fragile export sectors. This portion of the return expectation should be tempered and managed carefully.

B. Duration:

This is difficult to assess as each yield curve in the world has various segments that are more attractive than others. We do not believe that a broad based “Beta Bet” will work in today’s environment since the opportunity set needs careful examination from a seasoned manager.

C. Credit:

This has been a positive driver of returns over the last few years as many EMC’s have been upgraded. Potential for upgrades remain, however in a slowing global economy, this “asset class” return potential should also be tempered. Given the complexities of sovereign debt credit analysis, we recommend a placement with an astute manager.

D. Risk-on trade:

This “asset class” does not perform well in a risk averse environment; therefore, it’s diversification benefits may be muted at a time that a portfolio needs a non-correlated asset class.

It is important to understand the rationale behind a placement in this asset class is just as important, whether the strategy is actively or passively managed.  One needs to determine if the placement is a tactical or strategic move.

It is difficult to make a strong case for a strategic placement that is passively managed as the currency and debt markets are too dynamic to leave to a passive strategy.

While Emerging Market bond and currency exposure also makes sense to a degree, the specific risk is very high. A comprehensive global bond portfolio with active currency management adds significantly more potential alpha and portfolio Sharpe enhancing qualities.


I-Shares-Emerging Markets Local Currency Bond Fund

Sec 30 Day Yield 5.23%

Duration 4.11

Rated BBB

Country Weights

South Korea21.74%




Market Vectors Emerging Market Local Currency Bond ETF

SEC 30 Day yield 5.56%

Duration 4.89

Country Weights




South Africa9.11%

Brazil8.98 % 5.15%


Wisdom Tree Emerging Markets Local Debt Fund

SEC 30 Day yield 4.57%

Duration 4.48

Country Weights




Brazil9.99%  5.15%

Since these ETFs are paid in US dollars, the yield minus the current US CPI is an appropriate gauge of the real yield. Since the US CPI is approximately 2.7%, the real yield carry is over 2% for all of these ETFs.

That carry is not free; however, the differential can be wiped out very easily by currency movements. Unless your firm has a clear conviction on the forward looking basket of currencies versus the U.S. dollar in any of these instruments, Zenith recommends that these funds be avoided.


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Duration or interest rate risk is on the mind of many portfolio managers and investment committees.  We provide a basic outline of what duration risk is able to garner and where it might be best appropriately applied.

Duration has been a powerful tailwind for many debt classes over the last year. TLT the I-Share 20yr plus ETF has provided a return well in excess of 20%. That return demonstrates the power of the Treasury rally based in part on a flight to quality.

Credit has not fared as well with high yield generally providing a flat to negative return depending on the fund while investment grade debt gave investors a return of approximately 6%.

In relative terms it has been a worse bet to pare back duration and increase the risk of the credit portfolio. As we move forward in an environment of reasonably robust corporate cash flow coupled with massive macro headwinds inEurope, duration and credit can both be held prudently in a portfolio.

How the world unfolds for the remainder of the year will determine what slices of the credit and duration world succeed. Lets take a look a future that involves a continued modest slowdown in the largest EM countryChina, European political and economic inertia and reasonable but slowing and below trend growth in theUS.

The Treasury market is a massive liquid voting machine and right now it is collectively more worried about the European debt issues over potential inflation here in theUS, in effect buying negative yields.  They believe that duration is a more prudent investment given the European debt issues that will remain a potential problem for at least the remainder of the year. There are simply too many banks and sovereigns with credit issues for it to be solved overnight.

This gives me a decent amount of confidence that duration will not be abandoned en mass unless there is an unanticipated spike in inflation and an inflation premium is assigned to the yield curves globally. While I will complete a different piece on inflation, I will offer that inflation will not be a major risk over the rest of the year. Still, getting a negative real yield is not too appealing for an investor.

As mentioned, credit and duration are the answer but only when working together. If I focus on theUSmarket I can garner a positive real yield by investing in TLT(I-Share 20+year Treasury) at over 3%. So I am barely positive with a CPI of 2.7%. That is not much carry for a duration of close to 8. That bet only works if the three factors mentioned above deteriorate in the months ahead. That is the pure duration bet and while the credit quality of the US Gov is a risk with that placement, it is on the backburner for now.

Credit exposure also gives an investor the chance to garner real yield assuming CPI is accurate at 2.7%. Here the carry opportunities are more apparent as investment grade debt is around 3-5% depending on the funds quality and duration, while high yield is in the 7% range. Here is the dilemma. Investment grade has been propelled in part by solid cash flow generation and duration. If both weaken, then the trade unwinds significantly. For instance, LQD is generating a yield of approximately 3.45% with a duration of 7. That is not a risk to reward that I believe is appropriate. The investor is only receiving 60 basis point of real yield in the hope that the 7 duration does not work against them. Sell and take your profits if you have a position and Zenith does not recommend a new placement at this time with a broad based ETF investment grade product.

The I-Share ELD is one that represents to various weights the EM local currency index. It is largely advocated as a diversification tool. It does provide an investor with a different risk to reward profile however, it does guarantee an enhanced optimized allocation.

In this case the 4.42% yield provided by this ETF comes with a hefty 7.37 duration. That is massive interest risk for a modest 4 or so yield. If the EM world were in an upsurge and immune to global macro risks that might be advisable. However, even though the EM world has matured, it remains to some degree a simple risk off trade sale candidate when there are global concerns.  The duration that allows for a strong upside when EM risk is bid up works in reverse in a decelerating world economy and heightened European risks. The duration portion could lend support as many foreign central banks are in ease mode, however a broad based ETF passive placement is not worth the risk.

Zenith does continue to advise that firms hold current or add selectively in dollar denominated debt that offer a more favorable risk to reward in the current environment. The Mortgage Backed I-Share(MBB) has an approximate yield of 3.41% with a duration of about 1.52. While spreads have come in, this is a favored space for many institutions that are simply unable to move out on the credit spectrum but who need carry. This for now is a reasonable space for some risk capital. Given the complexities of the mortgage backed market Zenith recommends a position with a seasoned manager who can navigate prepayment, extension and legislative risk as opposed to an ETF.

Our select manager in this space has been DoubleLine Total return run by Jeff Gundlach. The credit quality is much less than the ETF, however that carry will continue in spite of the issues with housing that we believe will persist. It has a yield of approximately 7% and a duration of about 2.5. That is a risk to reward we feel is prudent for a remainder of the year. It does have a fee for sales within 90day so if you want a more flexible tactical move, then an ETF may make more sense.

A fund with a similar duration is Osterweiss Strategic Income Fund. 66% corporate debt, 10% convertible debt and a little in the preferred space. There flexibility holds appeal and they have been consistent over the years. A major downturn in the factors mentioned above this fund will suffer as well, however I would rather have my risk capital with this manager than with a passive exposure to HYG or JNK, two high yield ETFs with much more volatility.

While we only covered a small slice of the fixed income market, the hope is that your investment committee will assess your firms credit and duration exposure in order to actively dial down unnecessary duration or  poorly compensated credit risk.