Use ETFs to ride the commodity wave

Exchange-traded funds offer retail investors access to the currently hot commodity sector. However, not all of these funds are created equal.

By TheStreet Staff Jan 25, 2011 3:36PM

thestreetBy Daniel Dicker, TheStreet


With commodities flying high, everyone is looking for the best way to get in on these fast-gaining assets.


There are many different ways to try to capture the seemingly daily gains in oil, copper, coffee, cotton and corn -- but like other investments, each kind of commodity play has its own pluses and minuses.


Let's look at what is probably the most accessible vehicle for the retail investor -- commodity exchange-traded funds -- and lay out the best ideas and avoid the ones that can sink your portfolio and your wallet.


Commodities are traded on futures exchanges, and investment through futures is the most obvious and direct way to gain exposure to changing prices. But, as a 25-year veteran of the futures markets, I can say with authority that trading in individual futures is usually inappropriate for retail investors.

Wall Street, however, has been quick to offer exchange-traded funds that look and trade like stocks while attempting to mirror the gains and losses of the futures markets. Commodity ETFs have been incredibly popular, and issuers are constantly offering new ETFs tracking baskets of commodities, commodity sectors and individual commodities.


It's important to make a distinction between two categories of commodity ETFs: 1) those that buy and sell futures or stockpile physical commodities; and 2) those that buy and sell shares of companies engaged in developing or producing commodities.


In the first category, the ETFs that engage in the use of futures and swaps to mirror commodity prices are often at a major disadvantage to ETFs that can stockpile physical assets. Many problems can emerge when an ETF uses futures to track commodity price changes. It's not possible in this short article to describe the "rolling" of positions and the shape and quality of the commodity price curve. The bottom line, however, is that these issues are ultimately profit-dissolving hurdles.

It's not really the funds' fault, because stockpiling certain commodities, such as oil and corn, for investment is as impractical as it is impossible. In contrast, the SPDR Gold Shares ETF (GLD), the world's largest commodity ETF with more than $55 billion in market cap, is backed entirely by physical bullion and therefore perfectly represents gold's price changes -- minus, of course, the fund's management fees.


The second category, ETFs that buy stocks of commodity companies, does not mirror commodity prices directly, but the underlying companies often do, and those stock prices are an excellent proxy for futures market changes. This is a powerful alternative to commodity exposure without resorting to derivative products.


I've written many articles, and it is a major thesis of my coming book Oil's Endless Bid, stating that passive investments in oil (and other commodities) unnecessarily inflate prices and that we'd all have more reliable and lower commodity prices across the board if we could eliminate ETFs that use futures and physical stockpiling and instead invest solely in ETFs that use stocks.


However, the intense growth we've seen in both kinds of ETFs over the last three years makes it seem that no one is about to take my advice anytime soon.


We all want to invest in a responsible way, but first and foremost, we want to make money. Therefore, in order of preference, I suggest playing the commodity trade primarily with stock-based ETF's, then physically backed ETFs and lastly futures- and swaps-backed ETFs (only where they are appropriate, and only for very short-duration trades).


For Oil: Use the SPDR Energy Select Sector (XLE) and Oil Service HOLDRS (OIH) rather than the US Oil Fund (USO), Proshares Ultra Crude (DIG) and Proshares Ultra Short Crude (DUG).


For Gold: Use the Market Vectors Gold Miners (GDX) rather than the SPDR Gold Shares (GLD).


For Copper and Other Base Metals: Use the Global X Copper Miners (CPX) rather than the IPath/DJ/UBS Copper ETN (JJC).


Many of the new commodity ETFs are great products. Just be sure you are using the right one for the job.


TheStreet's Daniel Dicker will appear on PBS’s Nightly Business Report Tuesday (check local listings) to discuss investing in commodities through ETFs and the common pitfalls to avoid.


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