Is This the Next Long Term Capital Management?

With hundreds of new exchange-traded funds coming out every year, ETFs have to do everything they can to stand out from the crowd. The big question for one new commodity ETF, however, is whether investors will see having a Yale professor on board as a valuable asset or as a precursor to the Nobel laureate-led disaster of the 1990s, Long Term Capital Management.

This fund won't flunk out
The U.S. Commodity Index Fund should soon join the ranks of dozens of commodity ETFs. One of the ways that USCI aims to stand out from the crowd is by having Yale professor Geert Rouwenhorst on board as a director. Rouwenhorst is credited with having done research that helped establish commodities as a viable asset class that individuals could include as part of their asset allocation strategies.

The fund's strategy is also compelling. Rather than trying to mimic already well-established commodity indexes, USCI will have a proprietary computer model pick commodities that its managers believe are especially prone to see large price jumps due to relatively low spot inventories. That should help improve the chances of particularly strong returns, despite the fact that increased volatility may give some investors a bumpier ride than other commodity investments. The particular commodities chosen by the ETF will change each month.

But will the ETF's academic credentials prove to be its downfall? To answer that question, let's take a closer look at what happened with LTCM.

Too smart for their own good?
In simplest terms, the trouble that even the brightest investors face is that the behavior of the markets doesn't always conform to theoretical models, no matter how robust they may seem. For LTCM, the theory behind taking advantage of arbitrage opportunities in the international bond markets made perfect sense and worked well for years. But when its success led to an influx of capital, LTCM and its masterminds suddenly found themselves short of good investment ideas. In trying to branch out to take advantage of what seemed like similar opportunities in different markets, LTCM raised its risk level, taking on extraordinary amounts of leverage. What eventually brought LTCM down was a simple truth: Markets were irrational longer than LTCM could remain solvent.

It seems unlikely that USCI will share the same fate as LTCM. Granted, any commodity investment involves substantial risk, and the ETF's strategy of following price momentum in commodities with above-average volatility seems tailor-made for a potential implosion if markets turn against the ETF's positions. But with the ETF's commitment to spread its investments across 14 different commodities every month, diversification should give the fund at least some protection from an unexpected catastrophic downturn in any one market. In fact, the new ETF may be more diversified than other existing commodity ETFs, as it's unlikely to have as strong an emphasis on energy markets as funds that track the popular GSCI commodity index.

A better way to play
Commodity ETFs have gained in popularity in recent years. Some specialized funds in hot areas have drawn immense demand; SPDR Gold (NYSE: GLD  ) has attracted more than $50 billion and owns more than 1,300 tons of the yellow metal. But most investors can get the same sort of exposure by owning commodity-related stocks -- with the added benefit of receiving a return on their money.

For instance, the stock prices of natural gas giants Chesapeake Energy (NYSE: CHK  ) and Devon Energy (NYSE: DVN  ) don't track gas prices perfectly, but if gas prices move up from recent lows, you can pretty much count on seeing shares rise with them. Meanwhile, shareholders get a dividend of 1% or more from each -- a far cry from the value-destroying contango that has wreaked havoc on direct investments like United States Natural Gas ETF (NYSE: UNG  ) .

Similarly, many see the price of copper as an important signal of economic activity. Freeport-McMoRan (NYSE: FCX  ) and Southern Copper (NYSE: SCCO  ) rise and fall with the base metal's price, making a dedicated copper commodity ETF largely unnecessary. Even less popular commodities usually have good stocks to invest in, with uranium producer Cameco (NYSE: CCJ  ) a good example of how those who are bullish on the future prospects of nuclear energy can seek to profit from the trend.

What the future will bring
It's easy to try to draw comparisons between USCI and LTCM based on the academic qualifications of the individuals involved with the fund. In reality, though, the mistakes of LTCM are unlikely to be repeated with USCI's experience. Nevertheless, that doesn't make the new ETF a must-buy -- and in fact, you can get much of the benefit of commodities without ever leaving the stock market.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger is no stranger to heavy metal. He owns shares of Chesapeake Energy, which is a Motley Fool Inside Value recommendation. The Fool has opened a diagonal call spread position and written puts on United States Natural Gas. The Fool owns shares of Cameco, Chesapeake Energy, and Devon Energy. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy dropped out of college with Bill Gates but graduated from the school of hard knocks.


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