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Avoid These ETFs

When it comes to new ETFs, the latest isn't always the greatest.

Sonya Morris, 09/26/2006

This month, Morningstar launched Morningstar ETFInvestor. In the following article, Sonya Morris, the newsletter's editor, analyzes some of the newest specialized exchange-traded funds.

With most of the equity universe covered two and sometimes three times over by broad-based exchange-traded funds, ETF providers have had to become more creative to distinguish their newest offerings from what's already on the market. But many of these newfangled ETFs stray from the original aims of indexing and traffic in risky market segments that most individual investors are better off avoiding.

Single-Commodity ETFs
Perhaps the most obvious examples of ETFs that no one needs are those that offer exposure to a single commodity or a small basket of commodities. Commodity funds started out admirably enough. The oldest offerings in the group provide investors exposure to a wide range of commodities and, thus, have the potential to add valuable diversification to a portfolio. But ETF providers have begun to offer funds that focus on narrower niches of the commodity market. While one might make an investment case for dedicating a small portion of assets to a gold ETF as a diversifier or an inflation hedge, it's difficult to see the investment merit of other pure-play commodity ETFs.

Given the media fervor surrounding the price of oil, it's not surprising that one of the first single-commodity ETFs focused on that market segment. United States Oil USO, which provides exposure to West Texas Intermediate Light Sweet Crude, was the first pure-play oil ETF launched. And it's proved popular with investors, growing to more than $400 million in assets since its April debut.

Not to be left out of such a popular niche, Barclays recently introduced iPath Goldman Sachs Crude Oil OIL, an exchange-traded note that provides exposure to crude.

And Barclay's isn't stopping with oil, either. It has filed with the SEC to offer ETFs that provide exposure to other commodities, including industrial metals and livestock. Deutsche Bank also has a slate of commodity ETFs awaiting SEC approval, including an oil ETF, a base metals ETF, and an agriculture ETF, which provides exposure to corn, soybeans, sugar, and wheat.

I think these pure-play commodity ETFs have little to offer the long-term investor and are primarily aimed at speculators interested in making short-term bets on the direction of capricious commodity prices. That's a perilous game to play and one that very few investors can pull off successfully with any consistency.

What's more, these niche ETFs court volatility. In fact, US Oil shareholders just got an unpleasant reminder that oil prices don't always go up. The fund has plunged more than 10% in just the last month as the price of oil slid off its highs.

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