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By Abraham Bailin

Commodities and hard assets have been beneficiaries of the consistent demand for the diversification and inflationary hedging benefits that they provide. At the same time, fundamental drivers are poised to provide positive pressure over the long run. While the proliferation of exchange-traded products has afforded investors convenient exposure to the space, there are a number of ways to gain access to that exposure.

Most broad commodity offerings turn to the use of futures contracts. Some, like Market Vectors RVE Hard Assets Producers ETF (NYSEARCA:HAP), use equity securities. There are benefits and downfalls to each. Futures-based offerings can provide very good short-term tracking of target commodities. Those looking to benefit from a level of operational leverage and cash flow, however, may want to consider an equity-based offing.

HAP holds the most powerful names in the commodity production space and can be used as an alternative to futures-based broad commodity vehicles. The equity securities that HAP holds don't suffer from the roll-yield drag phenomenon that has plagued futures contract-based products in recent years. Additionally, using equities to gain commodities exposure can introduce investors to levels of operational leverage that provide extra sensitivity to commodity price movements under the right circumstances. These can be substantial advantages. The DJ UBS Commodity TR Index has rallied an impressive 54% since the market bottom in March 2009. Despite high volatility, HAP rallied 92% over the same period.

HAP allows investors to procure exposure to fundamental commodity demand growth, though we advise investors to keep an eye on the offering's market exposures. The portfolio has moved in lock step with the S&P 500 over the past year, and purchasing HAP may serve to bolster established positions. As we examine longer periods, however, HAP appears to maintain ever-higher correlations to the emerging markets.

We are satisfied with HAP for its one-stop-shop nature because it can allow an investor to very conveniently smooth out his portfolio weightings to the commodities space. Segmenting HAP's selection is likely to damp the high correlation to broad equity indexes, so active investors may consider buying individual hard-assets-focused offerings to gain heavier exposure to the smaller end of the market-capitalization spectrum.

Potential investors in HAP's portfolio will have an investment thesis that rests upon a very positive outlook for future commodity demand. Economic and population growth in the emerging markets will continue to place greater strain on ultimately limited supplies of the world's natural resources. The U.N. projects an 11% global population increase by 2020 and a 20% increase by 2030. At the same time, the global middle class' surging growth will compound the demand for food and energy as diets and transportation habits become more like the West's.

Ongoing geopolitical tumult has driven the energy space, and valuations look slightly attractive. Agricultural prices have benefited from increased import demands, a string of weather-related obstacles, and low inventory that look to continue. These are certainly positive for HAP, as energy and agriculture claim the fund's two largest weightings, with 40% and 31%, respectively.

We also see a confluence of factors driving up metals prices. While industrial-metal equities have seen strong demand and sit at attractive valuations, a global economic resurgence could lead to a correction in the precious-metals space. For now, however, precious metals seem to be rallying support from U.S. and European debt worries, and given that precious-metal equities constitute a mere 7% in HAP's portfolio, we don't feel it to be a make-or-break concern for the over-all portfolio.

The largest threat to HAP's story is a major slowdown within emerging markets, namely China. The nation is a chief demand-side driver of virtually all commodities. The communist nation has staked its legitimacy on sustained 8% gross domestic product growth and has engaged in a tremendous infrastructure binge to keep up the pace. If that pace slows and the "Chinese-bubble" pops, the lightened commodity demand could provide substantial headwinds for HAP's holdings.

While the offering maintains a slate of hundreds of securities, more than 30% of HAP's assets fall into its top 10 holdings. There are benefits and downfalls to this breakout. On the downside, HAP faces concentration risk. On the upside, seven of the top 10 holdings maintain economic moats. Firms with moats have the ability to consistently earn back their cost of capital and tend to have steadier revenues, which may alleviate some of the stress associated with the heavy gearing to commodity price volatility that moatless firms face.

Portfolio Construction
Tracking the Rogers Van Eck Hard Assets Producers Index, HAP looks to invest no less than 80% of its assets in companies that derive more than 50% of their revenues from the production of commodities. Furthermore, the fund will invest no less than 80% of assets in accordance with its index.

The index holds roughly 340 securities across all six hard-assets sectors. Sector weightings are determined by global annual consumption and are rebalanced quarterly. In line with its energy- and agriculture-heavy tilts, the United States and Canada grab the largest national weights within HAP's portfolio.

Fees
HAP charges a fee of 0.59% per annum, which puts it on the expensive side when compared with other ETFs specific to the hard-assets sector.

Alternatives
SPDR S&P Global Natural Resources (NYSEARCA:GNR) is the most similarly focused alternative. GNR charges a 0.40% annual fee and provides exposure to 57% of HAP's portfolio, though the two offerings move in virtual lock step. GNR's lower fee is enticing, but it holds 90 securities as opposed to HAP's 340.

Those interested in broad commodity exposure via futures contracts, instead of equities, may consider PowerShares DB Commodity Index Tracking (NYSEARCA:DBC). It attempts to maximize implied roll yield in the futures markets of a broad selection of commodities. It is far and away the largest and most-liquid offering of its kind and charges an 85 basis-points fee.

DBC's competition, United States Commodity Index (NYSEARCA:USCI), does not set sector or commodity target weightings, which allows it to maneuver toward the most enticing areas of the commodity space while providing broad exposure. Its peers' target weightings tend to render higher volatility because of sector-concentration risk. USCI charges 95 basis points on top of fund level brokerage costs.

Those inclined to gain more exposure to the smaller equity names in the hard-assets space may consider purchasing ETFs that focus on each hard-assets sector.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade 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: ETF Spotlight: Market Vectors RVE Hard Assets Producers