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By Abraham Bailin

As evidenced by the assets flowing into the commodities space, the idea that they are an asset class has taken root. Total net assets of commodities-focused exchange-traded and open-end funds have been growing rapidly since the market collapse, increasing from $38.5 billion in October 2008 to nearly $129.7 billion today.

From bubbles to position limits, contango to excessive volatility, the subtleties of investing in commodities funds has come under scrutiny as of late. There are, however, some strong arguments for allocating a permanent segment of your portfolio to this asset class. Through broad-based commodity index funds, many of the arguments against commodities can be laid to rest. Below, we'll consider the various types of broad commodity indexes, their advantages, and their disadvantages.

Why Commodities?

With low correlation to a stocks/bonds portfolio, commodities offer the benefits of diversification and historically have provided a good hedge against inflation. The latter seems more pressing today given the Federal Reserve's recent exercise of a second round of quantitative easing. Many fear that the continued expansion of the Fed balance sheet introduces the long-term potential for higher inflation, making exposure to commodities advisable for its use as a hedge. Others warn that the current runup in the prices of several commodities (most notably precious metals) is unprecedented and that sustained inflows across the space have created a bubble.

Discussion of the vehicles investors can use to gain commodities exposure--and whether they're using that exposure strategically or tactically--may help the investor decide how to wend their way through these disparate perspectives.

Types of Exposure

Within the ETF space, there are several ways for investors to gain exposure to these markets. A number of funds provide exposure through investment in the equity securities of companies dealing in a particular commodity space. While this can be useful when speculating on upward movements of particular commodity prices, we do not believe that these funds serve a useful asset-allocation role. The commodity price is but one of a number of factors that drives the performance of these companies, and so equity-based funds are not pure-plays on the price of commodities themselves. These companies are subject to many of the same capital market risks present in other equities, so often these companies suffer during a market pullback. This downside correlation is precisely what investors are seeking to avoid if their aim is to lower the volatility of their entire portfolio.

Several of the largest and most popular exchange-traded funds on the market provide their investors exposure by holding stores of the physical commodity. Notable examples include SPDR Gold Shares (NYSEARCA:GLD), the second-largest ETF on the market with roughly $56 billion in assets under management, and iShares Silver Trust (NYSEARCA:SLV), which commands over $8.7 billion.

By virtue of direct ownership of the targeted commodity, these "physical shares" funds offer the most accurate reflection of spot prices attainable through a liquid investment vehicle, but are not without their limitations. Due to storage costs, this type of fund structure is relegated to use with commodities of very high value-to-size ratios, like precious metals. Additionally, many commodities are perishable and can not be stored for any length of time meaningful to investors.

To gain exposure, the majority of commodity funds turn to futures contracts. In many ways, using futures contracts is more convenient way for institutions to take a position in these markets than taking direct physical possession. But here, too, there is a catch. The futures curve--the prices of contracts at progressively distant expiration dates--can take an upward or downward slope. Changes in the curve can cause futures and spot returns to decouple, exposing funds to what is known as basis risk, and in the case of certain commodities, like precious metals, to the carrying costs implied in its curve.

Tactical Versus Strategic

Commodities-futures markets are extremely volatile, and countless fortunes have been made and lost through tactical market activity. Those inclined to speculate in commodities-futures markets will find a number of single-commodity ETFs appealing. Those looking to capitalize on the benefits of the commodity asset class over all, however, should look to strategically utilize an ETF tracking a diversified basket of commodities futures.

Price Holdings is a company staffed with experts in the commodities-futures space and a leading provider of full-service electronic trading, asset management, and consulting services. Founder and chief executive officer Thomas Price, and director of alternative investments Alan Konn discussed their perspective on commodities as an asset class, both explaining their strong support of indexing.

"It's hard to find an active manager in the futures business using commodities only, as opposed to financials or currency futures, that can consistently deliver performance better than that of a broad index over a full market cycle," Konn said. "During 2008, for instance, a number of active managers saw good returns using long-short strategies to add value, but few have records proven to maintain returns over the long term, and their returns aren't necessarily indicative of the broad asset class."

The benefits of diversification in the commodities space are plenty. While price performance in individual markets can be extremely volatile, a diversified basket of commodities should moderate price volatility. There are, however, a number of indexes offering such exposure.

Frequency of Rebalancing

In their search, Price identified the Rogers International Commodity Index as a reliable bellwether. One of the primary reasons is the frequency with which RICI rebalances.

"A broad basket of commodities, coupled with frequent rebalancing, at least monthly, tends to smooth out the returns," Price said.

The impact of rebalancing becomes apparent when contrasting the RICI with the S&P Goldman Sachs Commodity Index. Both the RICI and GSCI are well diversified, holding futures of 37 and 24 different commodities, respectively. The GSCI only rebalances annually, however, so a runup in the price of a constituent commodity can become an oversized driver of the index's returns for a significant length of time until the basket is reset. By rebalancing monthly, the RICI allows constituent commodities to be deleveraged as they boom and leveraged up as they bust.

The Continuous Commodity Index takes Rogers' frequent-rebalancing principle a step further by rebalancing every day. The CCI is an equally weighted index of 17 commodities, well diversified across the various commodity sectors. The fund purchases six consecutive months of futures contracts, beginning with the front month, in each commodity.

All these indices have exchange-traded vehicles tracking them. ELEMENTS Rogers Intl Commodity (NYSEARCA:RJI) tracks the RICI. The fund holds roughly $520 million in net assets and trades more than 550,000 shares daily. IShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG) tracks the GSCI. The fund is substantially larger, with nearly $1.6 billion in net assets, and trades around 510,000 daily. Both funds levy a 0.75% net expense ratio. GreenHaven Continuous Commodity Index (NYSEARCA:GCC) tracks the CCI and holds just over $435 million. While spreading its exposure across so many commodities-futures contracts with multiple maturities can serve to mitigate the impacts of contango and provide diversification, it also results in higher brokerage fees than its peers'. Accordingly, GCC levies a 0.85% net expense ratio.

Regulatory Safety in Diversification

Commodity ETFs that use futures contracts have come under heavy scrutiny for allegedly affecting the mechanics of the commodities markets in a detrimental manner. Some ETFs became very large very quickly and violated long-standing futures-contract position limits established by the Commodities Futures Trading Commission. By distributing their assets across a number of commodities, (and in the case of the CCI, among contracts up to six months out) diversified commodities futures funds all look to grow much larger before suspicions of manipulation muster.

While some claim that the large influx of long-only investment demand provided by futures-based commodity funds has caused the market to shift into a persistent state of contango, Price's Konn such concerns are groundless.

"Because commodity-price movements have no correlation to backwardation and contango, the level of backwardation or contango within the market at any given time does not offer predictive value," he said. "Over the long run, fully collateralized futures positions benefit from interest income at the T-bill rate. This interest income, coupled with returns from rebalancing, tends to offset the negative roll yield."

Long-Only Not the Only Option…

Those worried about the effects of contango in the near term can turn to an index using a long-short or long-flat solution. Tracking a diversified basket of 16 commodities, the S&P Commodity Trends Indicator index used a moving average based long-short strategy to successfully circumnavigate the 2008 downturn. ELEMENTS S&P Commodity Trends Indicator--Total Return (NYSEARCA:LSC) tracks the CTI but has failed to gather over $70 million in net assets since its June 2008 inception. The fund charges the same 0.75% annual fee as RJI and GSG.

LSC outperformed the two long-only funds since its inception, but much of that ground was given up as the fund underperformed the broad commodities space in 2009 and 2010. Beginning in 2007, a growth of $10,000 shows that both the CTI and the RICI provide a nearly identical returns through today. While the RICI peaked and fell throughout the volatile market of 2008-09, the CTI provided a much smoother return schedule. It offered a higher risk-adjusted return over the period, but while it was up during the collapse of 2008, its momentum based strategy has failed to deliver since.

The RICI was up by 26% in 2009, and is up 6% so far in 2010. Over the same periods, LSCs momentum-based methodology has returned negative 12.82% and negative 16.7%, respectively.

Broad Commodity ETF Key Players

While the aforementioned GSG, RJI, and GCC, stand, respectively, as the third-, fourth-, and fifth-largest funds in the broadly diversified commodity-ETF space, we would be remiss not to mention the space's largest players.

Commanding nearly $4.5 billion in net assets, PowerShares DB Commodity Index Tracking (NYSEARCA:DBC) stands as the largest broadly based commodity ETF on the market. The fund provides diversified exposure to a basket of 14 commodities using Deutsch Bank's "Optimum Yield" strategy. The long-only strategy looks to minimize the losses associated with contangoed markets and to maximize gains of those in backwardation by putting on futures contracts as far out as 13 months. DBC tracks the Deutsche Bank Liquid Commodity Index, which includes energy, industrial metals, precious metals, and agricultural contracts. Each weighting is rebalanced annually in November to target levels of 55%, 12.5%, 10%, and 22.5%, respectively. DBC levies an annual fee of 0.75% and anticipates that additional transaction costs will average to 0.08%.

IPath DJ-UBS Commodity Index TR ETN (NYSEARCA:DJP) weighs in as the second-largest broad-basket commodity offering on the market with more than $2.4 billion in net assets. This exchange-traded note tracks a long-only index of 19 broadly diversified commodities, while charging a 0.75% fee. Unlike the larger PowerShares offering, DJP is structured as an ETN and does not directly hold commodities-futures contracts. ETNs are essentially promissory notes that guarantee the return of the underlying index, making them a convenient and cost-effective method of gaining exposure. The structure does, however, expose shareholders to the credit risk of the backing bank, not an unfair consideration given how banks were affected through the recent downturn.

In Summary

Whether you fear that continued expansion of the Fed balance sheet will spark a stiff bout of inflation or feel that commodities have been priced into a bubble, diversified baskets of commodities will allow you to take a strategic stance while tempering exposure to the price volatility of any single commodity.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Asset Allocation With Broad Commodity ETFs