There is a new way to invest in the oldest investment vehicle around - commodities. With the introduction of exchange-traded funds (ETFs) that track specific commodity futures, investors now have easy access the asset class.
In the past the only means of investing in commodity futures was through a futures account that was separate from a normal stock trading account. Because most investors hadn't taken the time to open an independent account, they lacked exposure to a very important asset class. (For a refresher on ETFs, read Introduction To Exchange-Traded Funds and Active Vs Passive Investing In ETFs.)
How They Work
The commodity ETFs are very similar to the other ETFs you are familiar with, except they are composed of commodity futures versus stocks. There have been commodity mutual funds and ETFs around for years, but until recently they were solely composed of commodity-related stocks. Investors must exercise due diligence before buying commodity ETFs to ensure they are invested in commodity futures.
The mechanics behind the commodity ETFs involve buying commodity futures to track either a specific commodity or a related index. For example, the PowerShares DB Gold Fund (AMEX: DGL) tracks the gold futures and the PowerShares DB Base Metals Fund (AMEX: DBB) follows an index that is composed of the futures contracts of copper, aluminum and zinc.
The annual expense ratios on the commodity ETFs range between 0.6% and 1.0%, which is a reasonable amount to pay for what they provide. Most do not pay dividends and if you are out for income, this is not the appropriate investment.
Lower Risk and Increase Reward
If you have not been exposed to commodities over the last few years, there is a good chance your portfolio has underperformed. A number of futures have more than doubled over the last four years (silver, gold, oil, platinum, and corn). Therefore, the exposure to commodities would have increased the return of the portfolio and at the same time lower risk with added diversification.
The beauty of the commodities market is its autonomy. If the stock market falls, commodities have a better chance of trading independent of the trend than an individual stock does. On the other hand, the majority of commodities have risen along with the stock market since 2003. From its low in 2002, the Dow Jones AIG Commodity Index is up over 90%, beating the return of the S&P 500 in the same period.
Emerging Markets and Commodities
The No.1 reason for the boom in commodities has been the increasing demand from emerging countries such as China and India. China in particular has been hording commodities from gold to copper to oil. As the surge in building continues, the construction industry will be demanding base metals like copper, aluminum and steel. Agricultural commodities will be needed to feed to growing population of Chinese citizens.
Not only is China increasing its importing of such commodities, it is now lowering exports. Coal was always a net export for China until this past year, and now it is a net importer. This is only one example of how China and other emerging countries could keep the commodities in a bull market for the remainder of the decade.
The PowerShares family of ETFs offers a number of commodity ETFs that cover the most heavily traded contracts. An investor that would like to gain exposure to this asset class with a single purchase could consider the PowerShares DB Commodity Index Tracking ETF (AMEX: DBC). The ETF has exposure to six of the most heavily traded commodity futures: oil 35%, heating oil 20%, aluminum 12.5%, corn 11.25%, wheat 11.25% and gold 10%.
The only issue I have with this ETF is the overexposure to energy commodities. The top two holdings make up more than half of the entire allocation. Along the same lines, the ETF only gives investors 10% exposure to the precious metals, which can be a great hedge against geopolitical issues and a falling U.S. dollar.
To fix the problem, investors can branch out into other PowerShares ETFs. The PowerShares Precious Metals ETF (AMEX: DBP) is composed of 80% gold and 20% silver. And if it is agriculture you are after, the PowerShares Agriculture ETF (AMEX: DBA) is evenly split between corn, wheat, sugar and soybeans.
At the end of the day, most investors should have some exposure to commodities in their portfolio to help diversify and increase the return potential. With the commodity ETFs now available there is no reason the average investor cannot go out and improve their portfolio.
To learn more, see The Importance Of Diversification and Diversification Beyond Equities.
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