LSC Commodity ETN Tries to Minimize Risk

This absolute-return product could help offset volatility in the commodities portion of a portfolio.
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The Rydex Managed Futures Strategy Fund (RYMFX) - Get Report, which was launched a little over a year ago, has lived up to its billing since inception, as the chart below shows.

RYMFX goes long and short various commodity and financial futures based on technical indicators, with the intention of providing an absolute return without much correlation to the to U.S. stock market.

There is now a similar product in the exchange-traded arena with the

ELEMENTS Linked to the S&P Commodity Trends Indicator Total Return


. The index underlying LSC has fixed allocations to energy 37.5%, grains 23.00%, precious metals 10.50%, industrial metals 10%, livestock 10% and softs (things like coffee, cocoa and sugar) 9%.

In looking at the chart of the 16 subsector breakdown, based on the index's technical method, it will either be long or short the 2% weight, for example, to cocoa.

Similar to RYMFX, when technical conditions call for shorting energy, the index will instead have no position -- this is a means for reducing volatility because the oil market can be prone to upward price shocks due to geopolitical concerns in a manner that is not common with other commodities.

The index will go long "when a sector's current price is equal to or greater than an exponential average of the past seven monthly price inputs." It will go short, or flat in the case of energy, when the current price is less than the seven month exponential average.

Coincidentally, the strategy behind RYMFX also focuses on a seven-month moving average, though RYMFX uses it slightly differently.

The target weights for the various components of LSC are subject to change annually based on any changes in global production. The weightings, as opposed to the target weights, for the index are subject to monthly rebalancing. LSC will charge a 0.75% fee which is much cheaper than the 1.77% charged by RYMFX.

Like most ETNs, LSC will pay no interest -- also it is a debt obligation (all ETNs are debt obligations of the issuer) of



that matures in 2023.

There is a potential tax issue to be aware of with LSC. In general terms, futures markets are subject to the 60/40 tax structure, which means you may have to pay taxes even if you have not sold the fund. The prospectus says that the intention is to treat the notes "like pre-paid cash settled financial contracts," which would bypass the 60/40 issue. However, it is possible that in the future the IRS will rule against that concept and the notes would be subject to less-favorable tax treatment.

LSC uses only commodity futures, while RYMFX uses commodity and financial futures. Commodity futures tend to be more volatile than financial futures, which creates the potential for LSC to be more volatile than RYMFX. The ELEMENTS Web site does not provide information on volatility from the backtest, so we can't know which one will be more volatile until LSC gets some time under its belt.

LSC, and for that matter RYMFX, potentially plays an important role in a diversified portfolio. These two vehicles exist because they use a rules-based methodology that has had success in the past and nothing (or very little) to do with the stock market.

Absolute return could play an increasingly important role in portfolio construction because of how poorly domestic index investing has done in this decade. Even more trouble may be ahead.

U.S. indices may continue to do poorly, but putting an entire portfolio into narrower and more volatile themes, like agriculture or emerging markets, would create a risk profile that most folks could not live with. Absolute-return products like LSC can help offset some of that volatility as portfolio construction evolves.

At the time of publication, Nusbaum was long RYMFX on behalf of himself and clients, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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