Commodity Exchange Traded Funds (ETF) For Turbulent Times
by Malcolm Katt, Associate Editor
June 23, 2008
It's been 15 years since exchange-traded funds (ETFs) have been sold in the U.S. ETFs have opened up new areas for retail investors, such as overseas markets and commodities that were difficult to invest in if you weren't very wealthy or an institutional investor. An exchange-traded fund is a cross between a closed-end fund (with a fixed number of shares outstanding) and an open end (whose sponsor continually sells shares to newcomers while cashing out departing customers). It trades, like a closed end, with a bid-and-ask spread on a stock exchange, and when you buy or sell it you pay a brokerage commission.
Because of their low cost structure, tax efficiency and ability to access hard-to-reach areas of the market, investors have taken a strong liking to these vehicles. According to the Investment Company Institute's latest survey, there are 634 ETFs that trade on U.S. exchanges, up from 432 a year ago. Assets of these funds grew 29% in 2007 to $559 billion.
When markets are in turmoil, using ETFs can help investors redeploy their capital in a hurry. Trading-oriented investors might use them to buy into an oversold sector, such as the financials or home builders, hoping for a rally. Dozens of "inverse" ETFs move in the opposite direction of their underlying index or basket of securities. Some move twice as much as the index. Others give investors access into commodities markets or let them buy a group of commodity producers.
Oil and gold have produced some very nice-sized returns for investors over the past year. Their performance has helped many portfolios, providing some relief for those investors trying to find a haven from a stalled U.S. economy and a weak stock market.
Investors hoping to cash in on commodities have increasingly turned to ETFs, which offer an efficient and easy way for investors to buy and sell a whole basket of securities with a single transaction. An advantage to an ETF as a way of speculating on commodities is that it is available at a reasonable cost. An oil future on the NYMEX has a contract size of 1,000 barrels, worth $110,000. Another advantage is that ETFs don't expire like a future, so an investor can make a single trade and sit on the position indefinitely.
There are plenty of commodities ETFs to choose from, but the key considerations for investors are two-fold: whether commodities can continue their run-up and how to choose the right ETF within the group.
Over the past 12 months, through April 8, the Dow Jones Industrial Average is up just 0.12% and the S&P 500 is off about 5%. But during the same time period, the Dow Jones AIG Commodity Index has moved higher by over 23%.
There was a mid-March correction in commodities. In the past month, the Dow Jones AIG Commodity Index has declined about 4%. But Brian Wesbury, chief economist at First Trust Portfolios, thinks that despite this recent downturn, commodity prices should stay strong.
Wesbury believes that the direction commodities go from here depends primarily on moves made by the Federal Reserve.
"It's easy to figure out what drives commodities," says Wesbury. "Yes, there is supply and demand. But the number one driver of commodity prices over time is monetary policy," he states, using the 1970s as a good example.
"That was the last time the Fed was this easy," he says. "What happened? Oil prices ran up. But then Fed Chairman Paul Volcker came in and jacked up rates. And oil came back down to $9 per barrel. Gold, which had climbed to $800, came back down to $300. It wasn't until 2001 that commodity prices started to surge again."
Wesbury believes that the Fed will continue to cut rates, given the perception of a fragile economy. He’s bullish on commodities, which he thinks could make a run to new highs. Wesbury adds that his position could change based on what Ben Bernanke and the rest of the Fed decide to do with interest rates. A rise in rates will depress commodity prices.
Kevin Kerr, president of Kerr Trading International and editor of Resource Trader Alert, agrees with Wesbury that commodities should go higher, though he gives more credit to supply and demand than Fed’s interest rate policy.
"What we see is a growing middle class globally, clamoring for better food and higher-quality meats, and of course, more energy to produce all this stuff," Kerr says.
These fundamental drivers--market forces and monetary policy--have fueled the upsurge in commodities as an asset class. And then you also have speculation, which tends to serve as an accelerant in a strongly trending market.
Kerr says those curious about commodities need to be selective. "Be nimble. You can't be one-sided," he says. "It's not a “bargainfest” anymore. Three years, ago, we bought corn for $2.50 a bushel. Now, it's $6. It's still a buy, but it's not as attractive. So there are no longer the deals. There is more risk involved. This is tougher trading."
One way to play commodities is through the ETFs, which have drawn a lot of attention from investors. In 15 months, TrimTabs Investment Research reports that the assets of commodities ETFs are up 84%. The sheer number of ways to invest has exploded, with investors now able to put money into ETFs that track everything from livestock to wheat.
One of the reasons these funds have attracted so much cash is that they are what's called an "uncorrelated asset." Commodities tend to do well during inflationary times or when the stock market is tanking.
Two reasons explain this increasing number of commodities ETFs, says Jeffrey Ptak, director of ETF research at Morningstar.
"One, this is about feeding the beast," he says. "There is a lot of demand out there. There is this thirst for commodity-related instruments. Also, what we are seeing is some garden-variety performance-chasing going on. Returns have been most impressive in commodity areas. The reality is that you launch products in areas where there is interest. Commodities have been the hot area."
An ETF probably feels safer than playing the futures market for the average investor. A lot of market participants are just looking for a relatively cheap, easily understood method of playing commodities.
Other added advantages of buying a commodity ETF, rather than a single, stand-alone commodity, include convenience, relatively low costs and ease of diversification, says Ptak.
"Invest in a basket, and then add it to a traditional portfolio," he says. "Commodities aren't strongly correlated with other asset classes, so it brings aggregate risk down."
Ptak also says to keep a close eye on expense ratios with commodity ETFs. "Anything higher than 0.85% for an expense ratio is pushing it," he says.
One broad commodity index he views as a possible candidate is PowerShares DB Agriculture (DBA). "It costs 83 basis points (0.83%), which isn't cheap. But it's not outrageous."
Ptak cautions investors to keep in mind, though, that an ETF won't shield you from some of the unfavorable tax attributes that come along with investing in some commodities. Invest in bars of gold, for example, and that's treated as a collectible for tax purposes and taxed at a 28% rate.
That may come as an unpleasant surprise for investors who sold profitable positions in gold bullion-based ETFs like the streetTRACKS Gold Shares (GLD) and iShares COMEX Gold Trust (IAU)"An ETF won't magically protect you," Ptak says. "It's no refuge from those types of tax issues."
Alternatively Ptak says to consider investing in exchange-traded notes (ETNs), a type of debt security that enjoys more advantageous tax treatment. Like an ETF, an ETN trades on major exchanges during normal trading hours. If an investor holds it to maturity; based on the value of the underlying index, profits are taxed at long-term capital gains rates. An ETN that Ptak recommends is the iPath Dow Jones-AIG Commodity Index (DJP), which tracks an unleveraged investment in the Dow Jones-AIG Commodity Index.
Of course, bull markets always come to an end. The problem is that no one expert can predict when that will happen. And commodities are extremely volatile. An accident at a factory, terrorism, geopolitical upheaval and Mother Nature can each wreak their own havoc on the marketplace. You will need to keep a close eye on these investments. "You don't want to get caught up in the buying once it's already run," says Tom Lydon, editor of ETF Trends, an online newsletter that covers the industry.
Some advisors I talked to are using commodities as a long-term hedge against downturns. Those positions constitute 5% of a well-diversified portfolio. Others, though, were thinking in the short term. They were using small, aggressive bets on narrow parts of the market to get extra returns. Not sure which camp you fit in? Lydon gave me a few tips both types of investors can use. If an ETF decreases 8% or drops below its 200-day moving average, then it's time to re-evaluate. Don't forget you can use stop-loss orders, too.
For a listing of commodity ETFs and ETNs go to: http://seekingalpha.com/article/30369-commodity-etfs-and-etns