Thursday, November 5, 2009

Indexes Often Mask Underlying Trends

It’s an accepted practice in the world of investing to report investment performance or trends based on broad indexes. That’s why you typically hear media outlets reporting the Dow Jones Industrial Average or the S&P 500 Index as representative of the overall stock market. While there’s certainly nothing wrong with that, simply focusing on these broader indexes can mask important underlying trends taking place. For example, the S&P 500 Index consists of 10 broad sectors. So far this year, the top performing sector (using sector ETFs) is Technology, with a 36.6% return. On the other hand, the worst performing sector is Utilities, with a mere 1.3% gain. Of course, if you take this a step further and focus on the individual stocks, the discrepancy is much, much wider.

The same holds true with commodities. We’ve owned a broadly diversified commodities fund that tracks the Dow Jones/UBS Commodity Index for several years. The index consists of 19 underlying commodity futures contracts. The security we own (which is an Exchange Traded Note) has performed fairly well this year; it’s up 15.8% so far. But since we know that several individual commodities are up much more than that, we were curious what's been holding it back. As shown on the chart below, it turns out that the very economically-sensitive base metals (aluminum, copper, etc) have performed the best in response to the unfolding economic recovery, energy (oil, gasoline, etc) and precious metals (gold, silver) have also done very well, but the agricultural commodities (corn, wheat, soybeans, etc) have lagged.

The point here is that drilling down below the surface can often reveal important underlying trends that can be much different than what’s implied at the broader index level. And with a growing number of more targeted investment choices, we have more options than ever to try and take advantage of this effect, which may provide additional opportunities to add value for our clients.

Chart - Base Metals (red), Energy (blue), Precious Metals (green), Agriculture (pink)