The Case for Commodities

Posted 08/24/2009, 9:00 am EST by Staff from ETFguide.com

Commodity Basics Like stocks, bonds, and real estate, commodities are an important asset class. Commodities are tangible assets used to manufacture and produce goods. Products like agriculture, energy, livestock, metals, timber and textiles are examples of commodities. The agriculture segment, for instance, includes familiar commodities like cotton, corn, coffee, and wheat.

Why Commodities? Adding commodities to an investment portfolio provides greater diversification and can help to reduce portfolio volatility. Commodities can also offer a way to protect against inflation. Historically, commodities have had low correlations to stocks and bonds. One contributing factor to low correlations is because commodity prices are affected by different risk factors, such as storage capacity, supply, demand, delivery constraints and weather.

Investing in Commodities Investing in commodities can be done by directly purchasing the physical asset, investing through futures contracts, options or buying commodity linked investment vehicles. The latter choice has made it convenient to obtain portfolio exposure to individual commodities and commodity baskets.

Owning physical commodities presents formidable challenges. Even though it offers direct exposure to a commodity, the cost of delivery, storage, and insurance can be awkward and cost prohibitive.

Using futures or derivatives to obtain commodity exposure is frequently used by large institutional investors that have the resources and tools to monitor such investments. For most individual investors, such commodity based strategies are far too sophisticated and risky.

As such, obtaining commodities exposure via the growing number of exchange-traded vehicles has become a popular alternative. Some of these products are formed as partnerships, commodity pools, or structured notes. These products often follow the performance of single commodities as well as commodity baskets. They obtain their exposure by owning the underlying physical commodities or by using a combination of commodity futures and derivatives.

Single Commodities vs. Baskets of Commodities Owning exchange-traded vehicles tied to a single commodity can be considerably more risky and volatile versus owning a diversified basket of commodities. Below are a few examples of popular commodity ETFs. Ultimately, investors will have to determine the commodity strategy that best suits their financial objectives.

  • � iShares S&P GSCI Commodity Indexed Trust (Ticker: GSG)
    The commodities in GSG�s index are production-weighted to reflect their relative significance to the world economy. 24 different commodities are represented including corn, gold, live cattle, oil, natural gas, soybeans, and wheat. Crude oil dominates the index's weighting.
  • � PowerShares DB Commodity Index Tracking Fund (Ticker: DBC)
    DBC�s underlying index tracks a small basket of six commodities using futures contracts. The amount invested in each of these commodities is weighted and reset annually in the following manner: 35% light, sweet crude oil, 20% heating oil, 12.5% aluminum, 11.25% corn, 11.25% wheat and 10% gold.
  • � SPDR Gold Shares (Ticker: GLD)
    The Gold Shares are designed to shadow the ounce price of gold bullion. Each share represents a fractional undivided interest and is based upon 1/10th the price of an ounce of gold. The trust is backed by physical gold bullion in the form of London Good Delivery bars (400 oz.) and is stored in a secure vault.

Contango vs. Backwardation Commodity ETFs that invest in commodity futures rather than physical commodities must roll their futures positions every month into new contracts as the old contracts expire. If future commodity contracts are more expensive than spot prices, this creates a situation known as �contango.� In this case, the commodity fund�s performance is likely to produce negative returns, as it replaces expiring contracts with higher priced contracts.

When spot commodity prices are more expensive than future prices, the opposite of contango occurs. This situation is known as backwardation. Steep backwardation often indicates the marketplace perception that an immediate shortage of a particular commodity is at hand.

Commodity Sectors Another way to obtain market exposure to commodities is by owning equity ETFs that follow commodity related industry sectors. Examples of commodity sectors include agriculture, basic materials, energy, mining companies, timber, along with oil and gas producers.

Despite the more favorable tax treatment on long-term gains for stocks, the performance of equities in commodity sectors will often deviate from the actual performance of commodities.

Taxes Generally speaking, commodity linked products that utilize futures to obtain their market exposure receive special tax treatment by the U.S. Internal Revenue Service. Regardless of the holding period, 60% of gains are taxed at the long-term capital gains rate while the remaining 40% of gains are taxed as short term profits, which are subject to the investor's ordinary income tax rate. For investors in the highest tax bracket, this 60/40 split creates a maximum blended capital gains tax rate of 23%. The tax burden is reduced for investors in lower income brackets.

Also, the taxation of exchange-traded notes (ETNs) is not necessarily the same as commodity linked trusts or ETFs. For general rules, see our educational module on ETNs. Always consult a tax advisor for specific advice.