Oil trades north of $100 a barrel; gold has ventured over $1,000 per ounce, and irate shoppers around the globe are fed up with the skyrocketing prices of food. While households fret over their food and gas expenses what you really want to know is: what's the best way to get in on this action?

One readily available method is via Exchange-Traded Notes (ETNs), an innovative security traded like any other common stock. Barclays (NYSE:BCS) offers a variety of ETNs under its iPath product suite that provide commodity exposure including:

  • General commodities: iPath Dow Jones-AIG Commodity (NYSE:DJP)
  • Agriculture: iPath DJ-AIG Agriculture (NYSE:JJA),
  • Grains: iPath DJ-AIG Grains (NYSE:JJG)
  • Crude oil: iPath S&P-GSCI Crude Oil (NYSE:OIL)
  • livestock: iPath DJ-AIG Livestock (NYSE:COW)

With ETNs you are not buying the common stock of an oil or agribusiness company - you are gaining exposure to a commodities futures index like the Dow-AIG Commodities Index or the S&P-GSCI Total Return Crude Oil Index. (To learn a simple way to bring the benefits of derivatives into your portfolio, read Understanding Structured Products and Exchange Traded Notes - An Alternative To ETFs.)

ETNs are not ETFs
ETNs and their better known cousins Exchange-Traded Funds (ETFs) look like any common stock - you buy and sell them through exchanges, you can take short positions and so forth. However there are some important differences between ETNs and ETFs.

An ETN is a variant of an instrument called a "structured product". It consists of an unsecured debt instrument issued by a financial institution (for example Barclays PLC) where the payoff is linked to the price change in some underlying indicator, for example: a commodities index, or currency or stock index.

In other words if you make a $1,000 investment in DJP, which is linked to the Dow-AIG Commodities Index, your investment will rise or fall in line with the index. For example the one-month return for DJP as of February 29, 2008, was 12.37% and for the underlying index was 12.28%. The 12-month return was 30.69% while the index returned 31.31% for the same period. The performance differences between the ETN and the index reflect tracking errors and expenses; ETNs charge management fees similar to ETFs and mutual funds.

Commodities in Good Times and Bad
Commodities have fared well recently for a handful of reasons including the voracious appetite of China and other growing markets, the demand for agriculture-based alternative fuel sources, and the enduring appeal of precious metals like gold as a safe haven in volatile economic times. Despite the U.S. economy's current woes, the International Monetary Fund still forecasts global growth of 3.7% for the next year, with much of the strength continuing from those commodities-hungry developing economies.

As of April 3, the Lehman Brothers Commodities Index was up 12.37% year to date while the major U.S. equity markets continued to languish in the red. That kind of divergence is actually more the norm than the exception - and one of the key advantages to holding commodities regardless of prevailing market trends. In portfolio management this is called diversification - ensuring that really bad things don't happen to all assets in a portfolio in the same way at the same time.

For example over a 15-year period from December 1992 through December 2007, the correlation between the S&P-GSCI Total Return Crude Oil Index and the S&P 500 Stock Index was -0.03. A measure of 1.0 means perfect correlation, while -1.0 is a perfect inverse (same magnitude, different direction). Practically speaking, this means that if you invest in OIL (the ETN that tracks the S&P-GSCI Crude Oil Index) you can reasonably expect your performance to have little or nothing to do with how stocks fare - a good way to hedge your portfolio's risks.

Conclusions
Commodities are a rare bright spot in today's market. In addition to the fundamental economic forces keeping upward pressure on the price of oil, corn, gold and others, their inclusion in investment portfolios provides good diversification benefits. Commodities-linked ETNs provide a viable way for investors to access this market and perhaps take the edge off their next trip to the dairy aisle or the gas pump.

Learn how to reduce risk and increase returns through diversification in Commodities: The Portfolio Hedge and Modern Portfolio Theory: An Overview.

Related Articles
  1. Mutual Funds & ETFs

    7 Best ETF Trading Strategies for Beginners

    Exchange-traded funds are ideal instruments for beginning traders and investors. Learn the seven best strategies for trading ETFs.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR Dow Jones International RelEst

    Learn how the SPDR Dow Jones International Real Estate exchange-traded fund (ETF) is managed and for whom the ETF is most appropriate.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  4. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
  5. Mutual Funds & ETFs

    ETN Analysis: Rogers Intl Commodity Energy Total Return

    Learn more about the Rogers International Commodity Total Return, which is an exchange-traded note that tracks a broad index of commodity futures.
  6. Mutual Funds & ETFs

    ETF Analysis: Schwab US Large-Cap

    Discover how the Schwab U.S. Large-Cap exchange-traded fund is managed, the index it tracks and the investors for which it is most appropriate.
  7. Investing Basics

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
  8. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  9. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Nasdaq Biotech

    Obtain information about an ETF offerings that provides leveraged exposure to the biotechnology industry, the ProShares UltraPro Nasdaq Biotech Fund.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  5. Best To Deliver

    The security that is delivered by the short position holder in ...
  6. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!