Top Options for Commodities Exposure

Last week, I discussed the pros and cons of adding commodities to one's investment mix. In short, the asset class has historically had a low correlation to stocks and bonds, which means that over long time periods, it has tended to do well when stock and bond markets are slumping. In addition, unlike stocks and bonds, commodities often benefit from inflation, which is why they are considered a "hedge" against inflation. In other words, when the value of a dollar declines it eats into the real return offered by stocks and bonds, but because the prices of commodities actually rise during inflationary periods, having a stake in commodities can offset the deleterious effects of inflation in one's overall portfolio.

But all of these potential benefits come at a price--volatility. By that we mean commodity prices can be a wild ride: The asset class can put up stunning gains but can also take pretty dramatic nose dives. Because gains and losses can be magnified, a little goes a long way. We recommend that investors allocate no more than 5% to 10% of a diversified portfolio to commodities. And most important, the full diversification benefits from commodities are achieved when investors hold on to their small allocation for a long time--10 years or longer, depending on your time horizon. This means riding out the highs and not pulling the plug during the lean times. It's a lot easier said than done!

With that in mind, let's turn our focus to some of the ways investors can invest in commodities.

The Basic Features of Commodities Investments
Investing in commodities is usually done through futures contracts, which are traded on an exchange and guarantee the delivery of a certain commodity at a predetermined price on a future date. These contracts can be settled by delivering the physical commodity itself, or they can be settled in cash, which means that there is a cash payment between the buyer and seller in the amount of profit or loss rather than the physical delivery of a commodity. Because trading commodities futures can be a complex business and requires sizable amounts of cash, individual investors have not traditionally invested in commodities markets. In fact, unlike some other traditional inflation hedges such as real estate investment trusts, you are unlikely to find commodity futures in traditional mutual funds.

But institutional investors have been onto the potential diversification benefits that commodities offer for a while now, and small investors are increasingly jumping on the bandwagon. That's because there are more investments that give investors direct exposure to commodities than ever before. Here are the basics on how they work.

There are three ways these investments make money: Spot-price movements, roll yield, and collateral income. The mechanics behind how these elements work are very complex, but here's a brief overview: A commodities investor benefits if there is an increase in a commodity's spot price, which is the price one would pay to buy the commodity in the market today. Investors can also benefit from the roll yield. Roll yield adds to a fund's returns when the commodity's futures price is lower than its current spot price, as is often the case. As the futures contract approaches its delivery date, the contract's value converges to the new spot price. It then rolls over into a new contract with a lower futures price. So, the investor picks up the yield between the lower futures price and the higher spot price. Finally, investors benefit from collateral income as well. The funds don't have to devote much money to buying actual barrels of crude oil or bushels of wheat. They use some form of a derivative contract, mainly structured notes (where the fund agrees to exchange a set payment for the total return of the index at a later date), to mimic the returns of the index. That only requires a small amount of assets, so the funds have cash left over to buy bonds. Those bonds can add incremental return.

Finally, before getting into the specific types of investments available, it's important to understand the basic differences between the two major benchmarks for commodities, the Dow Jones-AIG Commodity Index (DJAIG) and the Goldman Sachs Commodity Index (GSCI). That's because most of the commodity investments available to retail investors track one or the other of these indexes. Both indexes are diversified across a broad spectrum of commodities, but the big difference between them boils down to energy. The GSCI has a lot more energy exposure than the DJAIG. Both indexes attempt to weight each individual commodity within the index proportionally with the production of that commodity in the world economy. So, for example, energy is currently a major player in both indexes. However, in order to reduce volatility and keep a single commodity or sector from dominating the index, the DJAIG puts maximum and minimum thresholds (33% and 2%, respectively), on related groups of commodities (for example, energy or precious metals) while the GSCI does not; its energy weighting is currently about 75%.

Mutual Funds
For commodity exposure, one could go with one of the open-end mutual funds in the space. Not only is the process of buying a mutual fund simpler and more convenient than trading futures, but commodities mutual funds offer exposure to a diversified collection of commodities (many track either the DJAIG or GSCI).

Among the few open-end mutual funds that invest in commodities, we particularly like  PIMCO Commodity RealReturn , a fund that invests in derivative instruments that seek to replicate the performance of the Dow Jones-AIG Commodity Index. Because the fund can gain full exposure to the index with only a portion of assets, the remaining assets are invested in Treasury Inflation-Protected Securities (TIPS). One detractor is this fund's 1.24% expense ratio, which we think is too high considering the fund's $12 billion asset base.

But investors beware: These types of funds tend to pay out their income in the form of capital gains to shareholders, which can really take a bite at tax time. PIMCO Commodity RealReturn currently has a 17.6% yield! The PIMCO fund pays most of its distributions out in the form of ordinary income, which is taxed at your personal income tax rate. For this reason, we would recommend that investors hold them in a tax-advantaged account. (In addition, it's worth noting that this yield fluctuates wildly depending on how commodities have been performing. So, if you're enticed by the current high yield, be aware that it is sure to erode in periods when commodity prices are flat or negative.)

Exchange-Traded Funds
Exchange-traded funds, or ETFs, may appeal to speculators trying to take advantage of the price swings in the commodities market because shares trade on an exchange, just like a stock. But ETFs are also useful for long-term investors because they often have expense advantages over traditional mutual funds. That said, if one is dollar-cost averaging into commodities--in other words, building the position slowly with regular investments over time--one has to be mindful of brokerage fees, as they could eventually erode any expense advantage over a traditional mutual fund.

The first commodity ETF, Deutsche Bank Commodity Index (DBC), debuted on the American Stock Exchange in February 2006. While this fund may have the first-mover advantage, at 0.95% it's not cheap to own. Further, the index it tracks is not as diversified or robust as the more widely followed DJAIG or even the GSCI. The index the fund tracks, the Deutsche Bank Liquid Commodity Index, follows only six commodities: sweet light crude, heating oil, aluminum, gold, wheat, and corn. We think it leaves out some important commodities, such as natural gas and cattle.

Last year, Barclays filed a proposal with the Securities and Exchange Commission for iShares GSCI Commodity-Indexed Trust. If this ETF makes its way to the marketplace, its 0.75% expense ratio will provide some strong price competition for the aforementioned funds. One thing to keep in mind here is the GSCI index's huge weighting in energy-related commodities, which have dominated the world economy over the past few years. If you want a more diversified array of commodities, this isn't for you.

In addition, for the same reasons that traditional mutual funds are not tax-efficient, ETFs aren't either. They are best held in a tax-deferred account.

Exchange-Traded Notes
If tax-friendliness is a major concern, you might want to check into Barclays' new exchange-traded notes, or ETNs, that link to either the GSCI (iPath GSCI Total Return Index ) or the DJAIG (iPath Dow Jones-AIG Commodity Index Total Return (DJP)). Basically, these funds are structured notes, which are really just 30-year debt securities whose ending value is tied to the total return of one of the indexes minus fees. At 0.75%, they are reasonably priced, and they trade on the New York Stock Exchange, so they are convenient to buy and sell. Investors are taking on some credit risk because they are essentially buying a debt instrument backed by Barclays Bank PNC, whose debt is rated AA. What's more, the ETNs look like they are going to be far more tax-friendly than conventional mutual funds or ETFs because they don't make distributions. Instead, investors pay capital gains tax depending on when they bought and when they sold.

Conclusion
There are more types of investments than ever before that allow investors direct investment in commodities. And given the red-hot performance of the commodities markets lately, it's likely that the number of available products competing for shelf space will only continue to increase. Of all the available options, we prefer the PIMCO fund. Aside from the fact that it tracks a well-diversified commodities index, it also adds value with its TIPS. What's more, PIMCO has experience in the structured notes market. That said, we think the ETNs are ones to watch, primarily because of their tax-friendly nature and cheaper expenses. Quite frankly, however, they haven't been out long enough to judge, and we don't know enough about them to pound the table for these securities. But we are keeping them on our watch list.

In short, handle these red-hot assets with care. As we stated in the first installment of this article, it's our strong bias that investors will have a more rewarding experience if they pick a sensible and reasonably priced fund in which to invest, and then hold on for the long term--preferably in a tax-deferred account. On top of that, dollar-cost averaging into the fund is a wise way to buy in.