By Chuck Jaffe
Sunday, August 8, 2010
Jon in Tacoma, Wash., has been thinking that commodity funds might diversify his portfolio in these tough economic times, putting him into hard assets or real assets that are not a part of the standard mutual fund.
He’s ready to take the plunge now because he read somewhere that the recent financial reforms signed into law will give him extra protection in commodity funds, taking an asset class where the volatility often scares the average investor and making it into something that Ma and Pa Investor feel comfortable with.
He’s right about the first part - commodity funds adding diversification to a portfolio - but wrong about the second, involving regulation making investing in commodities funds notably safer and less volatile.
In fact, if anything, the regulatory picture over funds that invest in commodities may be more cloudy and confusing than ever.
The financial reform package largely sidestepped the fund industry, and Jon appears to be confusing it with a different proposal that would leave commodity funds that invest in futures facing increased attention not only from the U.S. Securities and Exchange Commission (SEC), but also from the U.S. Commodity Futures Trading Commission (CFTC).
The National Futures Association, an industry group for futures investors, proposed in June that mutual funds investing in futures contracts register not only with the SEC - as they’ve been doing for decades - but with the CFTC as well. Industry insiders believe that dual registration will increase disclosure to investors about what the funds invest in, making fees and costs more readily apparent. It would not change what the funds can buy, nor the recourse investors have if things go wrong.
That means it’s not much help to average investors because those people don’t read those disclosures; they will no more know what’s in their commodities fund than they do today. They do pay the freight on expanded fund costs, and there are estimates that funds which trade commodities futures could rack up an additional $1 million per year in compliance costs.
Just because these funds are for sophisticated investors does not mean the issue won’t affect average investors, even those who never go to get a commodities fund on their own.
Commodities issues now routinely are part of target-date funds, absolute-return funds and any issue where fund companies pre-package several issues into a fund-of-funds offering a smooth ride. The thinking of the sharpies running the fund is no different than Jon’s; the current best practice in asset-allocation models suggests that a small slug of commodities dampens risk and improves diversification. By keeping the allocation small, the volatility inherent to commodities funds should not overwhelm the portfolio.
If the rules proposal goes through, fund firms without a commodities fund may just farm out the money management, or could create a fund-of-funds that is mostly house issues, supplemented by commodities exchange-traded funds to make sure the entire investment spectrum is covered.
There’s also a lot of potential problems at the sales level; brokers or advisers who sell commodities funds could, under CFTC regulation, be forced to take several proficiency exams on commodities. Rather than go through that hassle for what amounts to a small portion of client portfolios, the advisers will either ignore the commodities segment or get commodities exposure through an asset-allocation or other fund that has some commodities futures exposure, enough to diversify but not enough to require major re-education.
But no one should think that extra regulation here will make commodities funds, on their own, any safer or less volatile. Nothing in the rules proposal would force fund managers to change the way they invest in futures, would force them to unload high-risk securities or would change portfolio management.
And investors would only be protected against cases of fraud, same as they are now.
From Boston Herald.COM published on Sunday, August 8, 2010