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By Tony Daltorio

The world of commodities was not accessible to most average investors just a few short years ago. But today, there are exchange-traded funds that allow investors to gain exposure to many commodities, both as an asset class and as a way to participate in the movements of an individual commodity, even rather obscure ones, without a futures account.

Take cotton, for example, which has historically shown very low correlation to equities making it appealing to investors as a way to hedge stocks. It is part of everyday life for people around the world thanks to being the most widely used natural fiber cloth in clothing today. But it can also be a moneymaker for investors.

Cotton 101

The cotton plant is a shrub native to tropical and subtropical regions of the globe including the Americas, Africa, and India. China is recognized as the world's largest producer, consumer and importer of cotton. The second-biggest producer is India, but it also consumes much of its crop domestically. The largest exporter of the fiber is the United States.

Cotton is usually a rather boring commodity, but in the last few years volatility has risen greatly. Its price rarely traded above $1 a pound over the past three decades, giving the clothing industry price stability. Even from 2000 to 2010, it traded between 40 cents and 80 cents a pound. But then last year - due to supply shortages, the lowest inventories in 15 years and strong demand from Asian textile mills - the price soared to over $2 a pound, peaking at $2.27 a pound. This was the highest level since the Civil War! The high price seemed to accelerate the trend toward the use of more oil-based synthetics in the clothing industry.

Probably the two most important countries driving the price of cotton are the world's two biggest exporters of the fiber: the United States and India. One thing investors in cotton need to be aware of is the amount of acreage U.S. farmers devote to cotton planting. Since it is lower in price than grains like corn, wheat and soybeans, it usually has much less acreage planted. This is particularly true if the price of grains is soaring due to drought or other weather conditions.

Investors also need to pay attention to events in India. Again, weather can play a factor if, for instance, the monsoon rains fail in India. But politics also come into play; quite often India will impose an export ban on its cotton crop in order to ensure that its domestic textile mills do not run short of cotton. So India is not as reliable supplier of cotton as is the United States, which is a plus for U.S. growers.

Investing in Cotton

For most U.S. investors the easiest way to play cotton is through the use of exchange-traded notes (ETNs).

Consider the iPath Dow Jones-UBS Cotton Subindex Total Return ETN (NYSEARCA:BAL). The index is set up to reflect the returns that are available through an unleveraged investment in a cotton futures contract. BAL will not exactly replicate the movement of spot cotton prices, but rather the performance of a futures-based strategy. That means returns can be affected by the slope of the futures curve and also the level of interest rates (the cash collateral is invested into U.S. Treasury bills). In addition, an ETN is a debt instrument, so there is there the credit risk of the issuer to consider, in this case Barclays Bank [see also The Ten Commandments of Commodity Investing].

Another exchange-traded note investors can consider is the iPath Pure Beta Cotton ETN (NYSEARCA:CTNN). The index is intended to reflect the returns available to investors through an unleveraged investment in cotton futures contracts. CTNN is also a debt instrument of Barclays Bank and once again the cash collateral is invested into Treasury bills.

However, there is a major difference in the futures rollover strategy, which Barclays believes will help to mitigate the effects of contango and backwardation. Most commodity indexes roll their exposure to the corresponding futures contract on a monthly basis on a pre-set schedule. This particular index can roll into one of a number of futures contracts with varying expiration dates, as selected by using Barlcays' proprietary Capital Pure Beta Series 2 Methodology.

In addition, investors can gain some exposure to cotton through other ETNs from iPath that cover the broad spectrum of so-called soft commodities. The iPath Dow Jones-UBS Softs Subindex Total Return ETN (NYSEARCA:JJS) and the iPath Pure Beta Softs ETN (NYSEARCA:GRWN) both have roughly 20% allocated to cotton while the remainder is divided between coffee and sugar. Finally, the ELEMENTS Rogers International Commodity Index-Agriculture (NYSEARCA:RJA) has about 12% exposure to cotton.

Disclosure: No positions at time of writing.

Disclaimer: Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets. Read the full disclaimer here

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Source: The 5-Minute Guide To Cotton ETFs