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The Case for Commodities

Where does this important asset class fit in?

Rising global demand for basic commodities has driven up prices and grabbed the attention of the entire world.

For investors, this signals opportunity. Commodities offer a way to protect against inflationary risk and to capture capital appreciation.

With the introduction of commodity linked trusts, exchange-traded notes (ETNs) and other exchange-traded vehicles, gaining access to both individual commodities and commodity baskets has never been more convenient.

Commodity Basics

Like stocks, bonds, and real estate, commodities are an important asset class. Commodities are tangible assets used to manufacture and produce goods or services. Specific examples of basic commodity categories include agriculture, energy, livestock, metals, timber and textiles. In the agriculture segment, familiar commodities include cotton, coffee, and wheat. In the energy area, examples of commodities include natural gas and crude oil.

Why Commodities?

Adding commodities to an investment portfolio provides greater diversification and can help to reduce portfolio volatility. Historically, commodities have had low correlations to stocks and bonds. One contributing factor to low correlations is because commodity prices are affected by different risk factors, such as disease, storage capacity, supply, demand, delivery constraints, and weather.

How to Invest in Commodities

Investing in commodities is most commonly done by purchasing and storing the physical commodity, investing through the futures or derivatives market or buying commodity linked vehicles or mutual funds.

Owning physical commodities presents challenges for many investors. Even though it offers direct exposure to a commodity, the cost of delivery, storage, and insurance can defeat the benefits.

Using futures or derivatives to obtain commodity exposure is often used by institutional investors that have the resources and tools to monitor such investments. For most individual investors, such commodity based strategies are far too sophisticated and risky.

As such, obtaining commodities exposure via the growing number of exchange-traded vehicles has become a popular alternative. Some of these products are formed as partnerships, commodity pools, or structured notes. These financial tools can track both single commodities as well as commodity baskets. They obtain their exposure by owning the underlying commodities directly or by using a combination of commodity futures and derivatives.

Single Commodities vs. Baskets of Commodities

Owning exchange-traded vehicles tied to a single commodity can be considerably more risky and volatile versus owning a diversified basket of commodities. Below are examples of financial products tracking both areas. Ultimately, investors will have to determine the commodity strategy that best suits their financial objectives.

• iShares S&P GSCI Commodity Indexed Trust (Ticker: GSG)

  The commodities in this index are production-weighted to reflect their relative significance to the world economy. 24 different commodities are represented including corn, gold, live cattle, oil, natural gas, soybeans, and wheat. Crude oil dominates the index’s weighting.

• PowerShares DB Commodity Index Tracking Fund (Ticker: DBC)

  This Deutsche Bank index tracks a small basket of six commodities using long futures contracts. The amount invested in each of these commodities is weighted and reset annually in the following manner: 35% light, sweet crude oil, 20% heating oil, 12.5% aluminum, 11.25% corn, 11.25% wheat and 10% gold.

• streetTRACKS Gold Shares (Ticker: GLD)

  The Gold Shares are designed to shadow the price of gold bullion. Each share represents a fractional undivided interest and is based upon 1/10th the price of an ounce of gold. The trust is backed by physical gold bullion in the form of London Good Delivery bars (400 oz.) and is stored in a secure vault.

Source: ETFguide.com