Capture The Commodity Boom With ETNs

By Katrina Lamb | April 02, 2008 AAA

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.

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