Cutting Beneath the Surface of a Timber ETF

| About: Guggenheim MSCI (CUT)

While market volatility is up, commodity exchange-traded funds keep chugging along. But why isn't the same holding true for the lone timber ETF listed in the U.S.? After all, it's considered another hard asset, isn't it?

On the surface, that might appear to be the case. But returns this year indicate otherwise. The Claymore/Clear Global Timber Index (AMEX: CUT) has lost more than 14% so far in 2008. Compare that with the iPath Dow Jones-AIG Commodity Index exchange-traded note (NYSE: DJP), which is up by double digits.

"A common misconception is that because it's a hard asset, timber acts like commodities," said Andrew Corn, chief executive of Clear Indexes LLC, the firm that put together the index used by CUT.

But that's just not true, he notes. "Timber is a unique asset class," Corn said. "But it's totally different than commodities."

The Clear Global Timber Index tracks stock from leading timber companies from around the world. That includes firms that manage and own timberland. It also covers companies that own or manage timberland and use those properties as a resource for something else they produce.

The benchmark includes 13 so-called tier one stocks, or ones where their primary business is timber. It also tracks 14 other stocks called tier two providers that own timberland as raw material sources for other parts of their businesses.

So investing in CUT involves more than just owning timber. It also means you're buying real estate and wood-based products, like packaging, paper and even furniture to go with lumber products.

But investors are also getting involved in land-use issues. That's due to the fact that many lumber companies also lease out part of their properties for recreational and other uses.

And after they cut down trees, in many cases timber providers find other natural resources to harvest. "It's pretty common for timber companies to find anything from coal to silver on their land," Corn said. "Sometimes they'll decide it isn't worth it economically to harvest those other resources. So there's a lot involved with the timber industry other than just timber-related issues."

In his research to put together the index, Corn found a United Nations study on the dispersion of trees globally. "Once a year, we rebalance and reconstitute the index based on the dispersion of trees around the world based on UN reports," he said.

There's one other competing index for timber in the world, and that's put together in Europe by Standard & Poor's. Barclays Global Investors sponsors an ETF based on it in overseas markets. But it doesn't figure UN data and tree dispersions into its weightings.

Per-Country Availability

"We didn't want to country-weight based on market cap or some random measure," Corn said. "We wanted to keep the index representative of how many trees are available in each different country around the world."

The index for CUT implements a rules-based methodology that adjusts its portfolio weightings quarterly. Since the ETF launched on Dec. 19, 2007, two stocks have been cut. "The turnover rate should be very low over the long term," Corn said.

Companies in the U.S. comprised 29.24% of the index heading into 2008. The next biggest country was Canada at 13.39%, followed by Japan (12.01%) and Brazil (10.30%). Other markets represented in single-digit weightings were Sweden, Australia, South Africa, Spain, Finland, Ireland and Hong Kong.

To be considered for the index, timber stocks must average daily trading volume of 75,000 shares or more, and trade at least $500,000 on typical days over the past month. Candidates must also have market caps of $200 million or more, and no individual name can make up more than 4.5% of total weightings.

Investors should note a few caveats about the ETF. One is that CUT is dominated by companies that traditionally are categorized as materials players. That sector made up 82.90% of the fund at the end of last year. Financials were 12.94% of the portfolio, and the rest could be categorized as consumer discretionary.

With homebuilding and construction down, those sector affiliations would seem to explain CUT's fall this year. Corn agrees that has been a drag on his index's performance lately. But he says that's not the whole story.

"When a tree is chopped down, odds are it's going to be used for packaging rather than lumber. So the whole perception that timber is closely tied to construction isn't accurate," Corn said.

The impact of timber is much more widespread, he adds. And backtested data of the index's performance over the past five years serves as a good example, Corn suggests.

The Clear Global Timber Index hypothetically produced an average annualized return of 15.48% from 2002 to 2007, according to such research. That would've compared to 9.06% for the Dow Jones World Forestry & Paper Index.

"This is something you can stick in your IRA and not worry about," Corn said. "Long term, timber shows low correlation to the broader stock market. And there tends to be lower volatility as well."