The volatility of the last two years has investors searching for investment vehicles that can help diversify their portfolios from the wild swings of the stock market. The old-school method often involves buying stocks in different asset classes (small, large, etc.), but even that would not have protected your portfolio in the treacherous recession of 2008.

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An asset class that has attracted great fanfare the last decade has been the commodities. This explosion of popularity has to do with the performance of many of the commodities as well as the expansion of commodity ETFs. Until a few years ago, it was not easy for the average individual investor to invest in gold bullion or sugar futures. Today that can be accomplished using the same process as buying a stock online. (For related reading, check out An Overview Of Commodities Trading.)

Commodity ETFs Breakdown
Before delving further into commodity ETFs it is imperative to first explain the difference between ETFs that track commodity stocks and those that track the underlying commodity itself. The SPDRs Energy ETF (NYSE:XLE) is composed of a basket of stocks that do business in the energy sector. Many of the stocks will benefit from an increase in the rise of the price of oil, but there are other factors that affect each individual company.

The United State Oil ETF (USO) actually own oil futures contracts that will move based on the price of oil. From 2007 through 2009, USO lost 24% as XLE only fell by 3%; a big difference considering the close connection the two ETFs have with each other. Investors must be aware of what an ETF invests in, stocks or the underlying commodity, before considering buying. (For related reading, check out A Guide To Investing In Oil Markets.)

Commodity ETFs in Bear Markets
This section will focus on commodity ETFs that track the price of the underlying commodity and not the commodity-related stocks. Investors can invest in single-commodity ETFs such as the iPath Dow Jones Sugar ETN (NYSE:SGG) or an ETF that is composed of a basket of commodities like the PowerShares Agriculture ETF (NYSE:DBA).

There are several key reasons to own commodities, but the strongest factor is diversification. Consider in 2008 when the S&P 500 fell by 38.5%, the SPDRs Gold ETF (NYSE:GLD) rose by 5%. Not only is gold considered a hedge in a bear market, it also does well when the U.S. dollar falls and during inflationary periods. There were not many long ETFs that did well in 2008, so even losses less than the overall market were viewed as positive for many commodity ETFs; DBA fell 20.5%, beating the S&P 500 by 18%.

...And in Bull Markets
In 2009 the S&P 500 rose by 23.5% and a number of commodity ETFs were able to beat that performance handily as investors looked to diversify and protect their portfolio from another downturn in stocks. A few unknown commodity ETFs led the gains in 2009. The iPath Dow Jones Lead ETN (NYSE:LD) gained 137% as the industrial metal flew under the radar.

A more heavily followed commodity, copper, also saw a big gain with the iPath Dow Jones Copper ETN (NYSE:JJC) surging 132% as demand for the metal from China increased. At the same time, not all commodity ETFs enjoyed a strong 2009. The iPath Dow Jones Livestock ETN (NYSE:COW), which invests in live cattle and pork bellies, fell by 16% in 2009. (For more, see 5 Ways To Find A Winning ETF.)

Looking Ahead
With more volatility expected in the stock market in 2010 and into 2011, the key will be diversification among asset classes and the ability to pick the best stocks and ETFs. Within the commodity ETF arena there are three investments worth considering for investors looking to gain exposure to the sector.

The gold ETF, GLD, could be a hedge against inflation in the coming years as well as a way to play a sinking U.S. dollar. Another area that will benefit from both situations mentioned as well as a recovering economy is the PowerShares Energy ETF (NYSE:DBE). This ETF is composed of five commodities: light crude, brent crude, heating oil, gasoline and natural gas.

The third and final ETF would be DBA, also mentioned above, as a play on growing demand for grain and agricultural commodities. A growing demand for food from emerging markets and inclement weather around the globe could be the spark that sends this ETF higher regardless of the actions of the stock market.

The Bottom Line
Keep in mind all three ETFs mentioned could underperform the market in certain situations, but the goal is to diversify and attempt to increase reward and at the same time lower risk. (For more, see ETFs: How Did We Live Without Them?)

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