In the past, investing in commodities was a strategy only sophisticated investors would dabble in. But the explosive growth of exchange-traded products has made it possible for the average investor to invest in everything from oil, to gold, to corn with the click of a mouse.
As a whole, the commodity asset class has been one of the top performers over the past decade. The Dow Jones UBS Commodity Index is up over 50 percent in that period, while the S&P 500 has returned only 5 percent.
Investing in the entire commodity sector has been a favored strategy for individual investors using ETPs, but in the past few years, the introduction of subsector or individual commodity ETPs has exploded.
In short, the menu of choices is growing, so it's harder to keep up with what's available.
Choosing The Best One-Stop Commodity ETP
If the goal is to buy one ETP that gives an investor exposure to a wide-ranging basket of commodities, there are several options for investors. One of the most popular is the PowerShares DB Commodity Index Tracking ETF (NYSEArca:DBC), which invests in 14 of the most heavily traded and important physical commodities it the world.
The ETF's largest holdings include Brent Crude, RBOB gasoline, heating oil and light crude. The top four holdings make up about half of the entire ETF, with the remaining 10 in the other half. Precious metals only make up 10 percent of the ETF and are heavily underweight, as the energy commodities are overrepresented. As popular as the ETF may be with investors, it doesn't offer true diversification across a spectrum of various commodities.
The iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca:DJP) is composed of only 10 commodities and is also heavily weighted toward energy, but not as much as DBC. Energy makes up 35 percent of the ETN, and agriculture accounts for 28 percent. Again, the precious metals are underweight with a mere 15 percent in gold and silver.
Not only can it be confusing to investors trying to pick a broad-based ETP due to allocation, but there's also performance. For example, this year through May, DBC is up 10 percent, and DJP is up only 2.5 percent. Due to the allocation, the performance of the various broad-based ETPs will differ greatly.
Another broad commodity ETF that has performed well since its launch last summer is the United States Commodity Index Fund (NYSEArca:USCI). Its index strategy was developed by Yale Professor K. Geert Rouwenhorst, the father of modern commodity indexing, who co-authored the landmark paper, "Facts and Fantasies about Commodities Futures" with Gary Gorton, and revealed commodities as a viable new asset class. Year-to-date, it's up 3.6 percent.
Narrowing It Down
Investors who have the extra time or resources to drill down further into the commodities sector have a plethora of options.
These days, you can invest in ETPs that track sectors, such as agriculture or the softs, or find individual ETPs that only track a single commodity. Of course, the more micro the approach becomes, the higher the risk due to the lack of diversification.
One of the best performers in 2011 has been the iShares Silver ETF (NYSEArca:SLV), racking up a gain of 25 percent through the end of May. That said, SLV has just been through a sharp sell-off, and it's still about 20 percent off its peak it reached earlier this spring. It lost about 28 percent of its assets in May alone.
Another top gainer was the iPath Dow Jones-UBS Cotton Index ETN (NYSEArca:BAL), up 20 percent. Both ETPs were leaders through the first five months, but, as I said about SLV, BAL is also well off its high set earlier this year.
As strong as SLV and BAL have been, if investors opted for the ETFS Physical Palladium ETF (NYSEArca:PALL) or the iPath Dow Jones-UBS Livestock Index ETN (NYSEArca:COW), the results would have been much worse. The two ETPS are down 4 and 9 percent, respectively, through May.
Selection Is Crucial
The point I'm trying to make is that ETP selection is crucial when deciding which commodity is the best for your portfolio. This has been especially true in 2011 and will likely stay this way for the foreseeable future.
During the first decade of the 21 st century, it was similar to throwing darts when picking commodities-the rising tide lifted all ships.
But, that fun has ended, and investors must now take into consideration the fundamentals behind each commodity, as well as technical analysis, the supply-demand situations, and other commodity-specific factors.
Once they've chosen a basic approach, investors must then choose the best specific ETP, whether it's focused on a single commodity, such as SLV, or a broad-based commodity product, such as DBC.
I'm not trying to scare or discourage anyone from finding the right commodity ETP, but I want to make clear there are major differences in makeup and performance. That said, with a little hard work, it's definitely possible to be on the right side of the trade.
Matthew D. McCall is editor of The ETF Bulletin andpresident of Penn Financial Group LLC, a Ridgewood, N.J.-based wealth management firm specializing in investment strategies using ETFs.
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