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Reviewing Broad Commodity ETFs

Asset allocators have a plethora of ETF choices for broad-based commodity exposure.

Abraham Bailin, 11/29/2010

As evidenced by the assets flowing into the commodities space, the idea that they are an asset class has taken root. Total net assets of commodities-focused exchange-traded and open-end funds have been growing rapidly since the market collapse, increasing from $38.5 billion in October 2008 to nearly $129.7 billion today.

From bubbles to position limits, contango to excessive volatility, the subtleties of investing in commodities funds has come under scrutiny as of late. There are, however, some strong arguments for allocating a permanent segment of your portfolio to this asset class. Through broad-based commodity index funds, many of the arguments against commodities can be laid to rest. Below, we'll consider the various types of broad commodity indexes, their advantages, and their disadvantages.

Why Commodities?
With low correlation to a stocks/bonds portfolio, commodities offer the benefits of diversification and historically have provided a good hedge against inflation. The latter seems more pressing today given the Federal Reserve's recent exercise of a second round of quantitative easing. Many fear that the continued expansion of the Fed balance sheet introduces the long-term potential for higher inflation, making exposure to commodities advisable for its use as a hedge. Others warn that the current runup in the prices of several commodities (most notably precious metals) is unprecedented and that sustained inflows across the space have created a bubble.

Discussion of the vehicles investors can use to gain commodities exposure--and whether they're using that exposure strategically or tactically--may help the investor decide how to wend their way through these disparate perspectives.

Types of Exposure
Within the ETF space, there are several ways for investors to gain exposure to these markets. A number of funds provide exposure through investment in the equity securities of companies dealing in a particular commodity space. While this can be useful when speculating on upward movements of particular commodity prices, we do not believe that these funds serve a useful asset-allocation role. The commodity price is but one of a number of factors that drives the performance of these companies, and so equity-based funds are not pure-plays on the price of commodities themselves. These companies are subject to many of the same capital market risks present in other equities, so often these companies suffer during a market pullback. This downside correlation is precisely what investors are seeking to avoid if their aim is to lower the volatility of their entire portfolio.

Several of the largest and most popular exchange-traded funds on the market provide their investors exposure by holding stores of the physical commodity. Notable examples include SPDR Gold Shares GLD, the second-largest ETF on the market with roughly $56 billion in assets under management, and iShares Silver Trust SLV, which commands over $8.7 billion.

By virtue of direct ownership of the targeted commodity, these "physical shares" funds offer the most accurate reflection of spot prices attainable through a liquid investment vehicle, but are not without their limitations. Due to storage costs, this type of fund structure is relegated to use with commodities of very high value-to-size ratios, like precious metals. Additionally, many commodities are perishable and can not be stored for any length of time meaningful to investors.

To gain exposure, the majority of commodity funds turn to futures contracts. In many ways, using futures contracts is more convenient way for institutions to take a position in these markets than taking direct physical possession. But here, too, there is a catch. The futures curve--the prices of contracts at progressively distant expiration dates--can take an upward or downward slope. Changes in the curve can cause futures and spot returns to decouple, exposing funds to what is known as basis risk, and in the case of certain commodities, like precious metals, to the carrying costs implied in its curve.

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