If you want to hold commodities in your investment portfolio, what's the best way?
The simplest investments follow various indexes. You'll find a wide choice of exchange-traded funds (ETFs), exchange-traded notes (ETNs) and traditional mutual funds. There’s no standard index that all the funds follow. Some tilt toward energy. Others tilt toward gold or grains. Yet others treat all commodities equally.
The fund you choose isnít just a bet on commodities, it’s a bet on a particular asset mix.
Commodities have just come off a five-year boom. From 2003 to mid-2008, energy prices soared 320 percent in dollar terms, metals and minerals gained 296 percent and foodstuffs rose 138 percent, according to the World Bank. They crashed last year, along with everything else, rebounded from March through May this year and then eased off again.
The World Bank says the boom is over, due to slower global population and income growth. But commodities still attract dollar bears -- often, such assets rise in price when the dollar declines and vice versa. They also appeal to inflation pessimists, even though commodities arenít a reliable hedge against rising prices.
Michael Crook, an investment strategist for Barclays Wealth in New York, says inflation is unlikely to surge anytime soon.
There's plenty of spare capacity in the system, unemployment will probably stay high and central banks are discussing when to pull back the money they have thrown at the global credit crisis, he says.
But the huge budget deficits are still creating expectations of inflation, with “hyperinflation” on some lips. That concern alone might be enough to drive up commodity prices, Crook says, for a while, at least. Price pressure will also arise from the growth of developing countries, where goods production still trumps services, and the population is increasing its consumption of protein.
Diversification is the best argument for holding some small percentage of your money in commodities -- say, 5 percent. Their prices generally move up when stocks move down and vice versa. Over time, commodities are no more volatile than equities and yield a slightly lower return, Crook says.
If you buy, do you want an ETF or an ETN?
Commodity ETFs invest directly in commodity futures. They are usually structured as interests in a limited partnership, so at tax time in the United States they generate a Schedule K-1. Any annual income and profits are taxed.
Precious metals ETFs are trusts that hold the metal itself. When you sell, you are taxed at a maximum rate of 28 percent on long-term gains.
Failure of issuer
An ETN is a promissory note. It tracks an index but is backed only by the credit of the issuer. When Lehman Brothers Holdings Inc. failed, so did its ETNs. You aren't taxed on any profit until you sell.
This brings me to the various investment possibilities. In the short run, some commodities indexes do better than others, depending on what's hot.
If you like energy, you'll love the iShares S&P GSCI Commodity-Indexed Trust. This ETF follows the Goldman Sachs index, a production-weighted benchmark that reflects each commodity’s relative importance in the global economy. Currently, it’s 69 percent in energy, mostly oil.
The ETN for this index is iPathís S&P GSCI Total Return Index, backed by Barclays Bank.
Selection of funds
The largest trading volume occurs in the PowerShares DB Commodity Index Tracking Fund ETF. It follows a Deutsche Bank AG index and can run 50 percent to 60 percent in oil.
Other indexes avoid overweighting energy. The iPath Dow Jones-UBS Commodity Index Total Return ETN groups commodities into three baskets -- energy, agriculture and metals -- none of which are allowed to exceed one-third of the index.
The Greenhaven Continuous Commodity Index Fund ETF, a continuation of the old Commodity Research Bureau index, invests in 17 commodities equally. That underweights the most popular commodities that are gaining value and overweights those that have been declining. In theory, you are buying low and selling high.
Although these indexes diverge in the short run, they trade in the same general direction in the long run. Crook advises a fund thatís well diversified, without emphasizing energy.
For a different type of product, consider the new S&P CTI ELEMENTS ETN, based on S&Pís Commodity Trends Indicator. It tracks price changes in 17 contracts -- going long on contracts that show upward price momentum and shorting those whose price is moving down. (Exception: it never shorts energy, due to the risk of extreme upward movement.)
Off a cliff
The fund rallied late last year when the other commodity funds fell off a cliff. This year it's underperforming, tugged down by the short sales it tracked during the spring rally.
Paul Justice, ETF analyst for Morningstar Inc. in Chicago, thinks the fund will outperform long-only funds. “The research on the long/short strategy is pretty convincing,” he says.
Mark Willoughby, a principal in Modera Wealth Management in Old Tappan, N.J., buys commodities for diversification. He prefers the mutual funds. Fund expenses are higher than for ETFs but he likes to avoid the K-1 forms. They are more complicated than 1099s and typically donít arrive until late March, he says.
To Brad Zigler of HardAssetsInvestor.com, gold is a better diversification than any broad-based commodities index. He likes SPDR Gold Shares ETF, the most widely traded gold fund, or iShares Comex Gold Trust ETF. Gold hasn't been a great inflation hedge -- historically, oil is better, he says. But when stocks collapse, gold is more likely to give your portfolio support.
Quinn, a leading personal-finance writer and author of “Smart and Simple Financial Strategies for Busy People,” is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.