Where to Get Commodity Exposure via ETFs in 2010

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Includes: DJP, GLD, LSC, USO
by: Morningstar

By Jeremy Glaser

Originally published on 12/10/09

After a roller-coaster decade of returns in traditional asset classes like stocks and bonds, many investors have started looking to alternative assets, like commodities, to help round out portfolios. Of course, adding commodities to an asset allocation strategy is no silver bullet. Buying natural gas futures doesn't give you a stake in the cash flow of a business like stocks or the steady income stream from bonds. And the correlation between commodities (particularly oil) and the broader economic cycle seems to be rising. Still, commodities can make sense as a small part (~5%) of a portfolio.

So how should investors who are looking to gain some exposure in 2010 go about it? For years, getting this exposure was extremely difficult for individual investors. The growth of ETFs has democratized commodities and allowed individuals to slice and dice the market in any number of ways. But it is important to do your research, know what each of these funds actually invests in, and be aware of some potential problems that could arise.

Many investors believe that when buying a product like United States Oil (NYSEARCA:USO), they are gaining access to the day-to-day fluctuations of the spot price (price for delivery of oil that day). In fact, USO buys short-term oil futures contracts that must be rolled over on a constant basis as the fund has no desire to take physical delivery of barrels of oil. If the futures curve implies that the price of oil will either be higher or lower than the current spot price, investors' returns will be skewed away from the simple change in the spot price. ETF analyst Bradley Kay delves into the mechanics of this in this article.

Other funds, like SPDR Gold Shares (NYSEARCA:GLD) physically hold the commodity (in this case gold) in a vault. Each share of the ETF represents a fraction of that gold, and so the price of each share tracks the spot price of the commodity. Investors in these types of funds don't need to worry about the issues with futures contracts discussed above. However, many of these funds may have an unpleasant tax surprise. The IRS taxes the ownership of gold like a collectable, so investors don't get preferential capital gains treatment when they sell.

Another potential roadblock in 2010 for commodity ETF investors is the Commodity Futures Trading Commission (CFTC). The CFTC believes that some of the turmoil in the commodity markets in the last few years was caused by speculators. Since most ETF investors aren't hedging raw costs for a business, or desiring to take delivery of a commodity, they are viewed as speculators (read our take here). The CFTC instituted position size limits to cut down on this perceived market manipulation. This is making it more difficult for large ETFs to roll futures contracts, and has even led to several funds being denied regulator approval to issue more shares. ETF providers are already adjusting to the new rules, and for most investors, it shouldn't be an issue, but it's still something worth having on the radar screen.

Our ETF team has two favorites for gaining commodity exposure in 2010.

ELEMENTS S&P CTI ETN (NYSEARCA:LSC)
From the Analyst Report:

ELEMENTS S&P CTI ETN is an intriguing but little-known investment that could provide superior performance with the same diversification benefits as a long-only commodities core holding. It tracks the Standard & Poor's Commodity Trends Indicator Index, which is a long-short index meant to capture the roll yields and momentum of a wide variety of exchange-traded commodity futures in order to produce a more stable return with little correlation to traditional asset classes. It is essentially a hedge-fund-lite strategy available at ETF prices, and it could prove to be a valuable addition to any core asset-allocation portfolio. Commodities have historically provided a hedge against inflation and nearly 0% correlation with equities, which makes them a worthwhile diversifier despite very low long-term returns. However, this fund has potential to provide better long-term returns while keeping its diversification value.

iPath Dow Jones-AIG Commodity Idx TR ETN (NYSEARCA:DJP)
From the Analyst Report:

IPath Dow Jones-AIG Commodity Idx TR ETN, an exchange-traded note, provides a one-stop-shopping experience for investors seeking broad commodities exposure. Easily the largest ETN on the market, this fund accounts for roughly half of all assets in the ETN space. Its index covers 19 specific commodities, which represent approximate weightings of 35% toward energy, 28% agricultural, 18% industrial materials, 10% precious metals, and 9% in livestock. This broad diversification serves to both lower the ETN's relative volatility and increase its risk-adjusted returns compared with owning a small sampling of handpicked commodities. Thus, we believe this fund can be viewed as a core holding by asset-allocation-conscious investors at a weighting between 4% and 10%.