How to Guess Right on Commodities and Still Lose; Some investors who bet correctly that prices would fall didn’t profit as expected

How to Guess Right on Commodities and Still Lose

Some investors who bet correctly that prices would fall didn’t profit as expected

LIAM PLEVEN

Updated Dec. 4, 2013 4:01 p.m. ET

Skeptical investors who concluded a few years ago that the decadelong commodities rally was running out of steam have been vindicated, and the timely bets they placed on falling prices have often paid off. But in a handful of cases, investors learned a painful lesson: You can be right about the big picture, but little things can still erode your returns.The big picture has been broadly negative for commodity prices since early 2011. The Dow Jones-UBS Commodity Index, which tracks futures contracts for nearly two dozen raw materials, is down 11% this year through November. Barring a rebound, the index will drop for the third straight year for the first time since its launch in 1998.

The declines were largely driven by rising supply and tepid demand, as some savvy observers foresaw. Producers had ramped up output of materials such as cotton and copper in response to China’s rapidly expanding appetite, but then growth slowed in emerging markets and weak economies in the U.S. and Europe failed to soak up the surplus.

Plenty of investors saw the opportunity. Funds that short commodities took in $361 million in 2010 on a net basis, and $472 million in 2011, according to researcher Morningstar Inc.MORN +0.01% Last year, investors yanked out $375 million, but they have poured back $222 million this year through November.

Why Returns Suffer

Some of the funds that short commodities have performed as might be expected, logging significant gains amid the pullback. Since the end of 2010, for instance, Pimco CommoditiesPlus Short Strategy has risen 20.7% through November, almost mirroring the 23.4% decline over that period in the index that it tracks, according to Morningstar. Similarly, the PowerShares DB Gold Short DGZ +1.31% exchange-traded note–which caters to investors who think the precious metal will lose some shine—gained 39.8% from when gold prices peaked in August 2011 through November of this year, according to Morningstar, a period in which prices fell 33.8%.

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But investors in some other funds could have fared less well, in some cases because they were betting on a different basket of goods, and in others because commodity funds often pay a premium when switching to new monthly futures contracts from expiring ones.

Returns have also sometimes suffered because of risks associated with funds that place leveraged bets, as many popular commodity-shorting funds do.

The PowerShares DB Commodity ShortDDP +0.25% ETN tracks a commodity index, just like the Pimco fund. But its index includes just six materials: U.S. crude oil, heating oil, aluminum, corn, wheat and gold.

Prices for a number of those materials have often held up better than others as the commodities rally faltered. In 2011, for instance, gold climbed 10%, crude oil 8%, and corn 3%. Last year, aluminum, corn, wheat and gold all rose. Mostly because of those rising prices, the fund lost 3.4% in 2011 and 2.2% in 2012, according to Morningstar. The fund stopped issuing new shares last year.

Regularly switching to new monthly contracts also can take a toll. In funds that go long commodities—or bet on rising prices—returns can suffer when new contracts are more expensive, a phenomenon known as contango, which generally reflects the cost of storing materials over time. By contrast, investors can benefit when new contracts are cheaper—or in backwardation—which typically means there is a near-term shortage pushing up prices for immediate delivery.

The dynamic reverses for funds that short commodities—contango becomes an investor’s friend, and backwardation the enemy.

Take the returns of U.S. Short Oil,DNO -0.29% which shorts U.S. crude. Oil prices fell 7.1% in 2012, but the fund gained only 4.9%. That year, oil futures were often in backwardation, and that caused much of the gap, says John Hyland, chief investment officer of U.S. Commodity Funds LLC, which runs the fund. Fees, which were 0.82% that year, also consumed some gains, he says.

The results suggest that for investors shorting oil “for longer periods of time, say six months, a year, or more, it certainly helps if [oil] is in contango,” Mr. Hyland says. This year through November, crude is up 1%, and the fund is down 4.7%, according to Morningstar.

Risks of Leverage

Over long periods, the results of leveraged funds that short commodities can diverge even more from what price swings might suggest. Leveraged funds aim to magnify price swings, letting an investor basically pocket $2, or even $3, for every $1 decline in value.

The funds generally rebalance their exposure every trading day, which is where things get tricky. A fund may return 4% on a single day when the benchmark is down 2%. If the benchmark reverses course the next day and goes up 4%, the fund’s return slides by 8%—far more than the first day’s gains. If the benchmark gyrates for a while, the price of the underlying material might end up close to flat, but the fund’s returns could be a lot worse.

For instance, in a one-year period ended on Feb. 26, an index tracking the price of Brent crude oil, a global benchmark, fell 3.4%. But the VelocityShares 3x Inverse Brent Crude OilDOIL 0.00% ETN, which aims to deliver a 3% gain for every 1% decline in the index for a single day, didn’t rise roughly 10% over that same period, as an uninformed investor might expect—it actually fell 21%, according to IndexUniverse, which analyzes funds.

Fund companies alert investors to the risk of holding a leveraged fund more than a day. The prospectus for the ProShares UltraShort Gold GLL +2.84% fund, for instance, states that compounding “can dramatically and adversely affect its longer-term performance during periods of high volatility.”

But many investors don’t get it, says Dave Nadig, chief investment officer at IndexUniverse. “The evidence is in my email box,” he says. He adds that he also gets phone calls and questions at conferences from investors who ask, “How come I didn’t get what I was expecting?”