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The One, Two, Three Commodity Knock-Out

Posted: Dec 02, 2008 08:59 AM by Aaron Levitt

Tickers in this Article: SYT, CVX, XOM, DBC, DJP, IGE, MOO

While the market is in its current state of flux it is important to think long term. This requires investing in broader trends that affect our global economy. One trend is our growing and longer living world population, and the notion that we, as a global society, are just using way too much "stuff". From base metals to corn, we are just consuming everything in our wake which presents a buying opportunity in the current turmoil.

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As emerging markets grow and become richer, the demand for more quality goods amplifies, appetites change and energy consumption increases. With the global stalling of the worlds economies, commodity prices have plummeted. This temporary pit stop on the long journey represents a buying prospect for the next bull run.

Why Invest in Commodities
Besides the aforementioned increase in the use of natural resources by our exploding population, commodities can provide other benefits for an investor's portfolio. Commodities offer diversification from stocks and bonds. Providing low correlation to other asset classes, natural resources can outperform other investments in down periods and reduce the overall volatility of a portfolio. This could help explain why Barclays estimates commodity assets under management globally were approximately $211 billion in Q3. This is up 2007's $175 billion but down from $270 billion in Q2.

A Simple Investing Strategy
The easiest way for regular retail investors to participate in the commodity markets is through exchange traded funds (ETFs). ETFs offer instant diversification, tradability and low expense ratios. From this we can create a simple commodity portfolio that be expanded to suit an investor's sophistication and risk level.

Step 1 - Begin with a Base
Rung one on our simplified exchange traded portfolio is to purchase a broad based fund that owns the companies that physically pull the hard assets out of the ground. The iShares Trust S&P GSSI Natural Resources Sector Index Fund (NYSE:IGE) invests in wide variety of domestic and Canadian natural resources companies. These include investments in energy, metals and mining, timber and forest products. Currently, the fund holds 141 stocks with a heavy tilt toward oil and natural gas. Consumable fuels makes up 70% of the index. Top holdings as of November 28, 2008, include Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). The fund was created in October of 2001 and has had annualized returns of around 9% to October 31 of 2008. Trading volume is good with a 1.03 million share three-month average. This prevents tracking errors within the index. Expenses for North American were a modest 0.48% and the fund yields 1.59% (Learn more in ETFs Provide Easy Access To Energy Commodities.)

Step 2 - Go Beyond Energy
The second phase is to invest in a broad based agriculture company fund. This gives an investor access to the other half of the commodity spectrum. Van Eck Global's Market Vector Agribusiness ETF (NYSE:MOO) fits the bill. The fund owns 42 U.S. and foreign companies that operate across the wide agriculture segment. These include investments in chemical/fertilizers, equipment such as tractors, livestock and plant products, and the bio-fuel/ethanol marketers. Top holdings include seed engineer Syngenta AG (NYSE:SYT), tractor stalwart Deere & Co. (NYSE:DE) and Norwegian fertilizer giant Yara International (OTC:YARIY). MOO tracks the DAX Global Agribusiness Index which had an annualized five-year return of around 17% as of October 31, 2008. The fund is down around 53% year to date. Fees run a modest 0.65%.

Step 3 - Add Physical Goods
Once an investor is comfortable with owning the companies that produce commodities, they can move on to owning the physical goods themselves. There are quite a few ways for regular investors to get there hands on the stuff. Several single commodity ETFs exist; however, I prefer a broad based index. Powershares DB Commodity Index Tracking Fund (NYSE:DBC) is a one such fund. The fund owns futures contracts on the six most heavily traded commodities: crude oil, heating oil, gold, aluminum, corn and wheat. The underlying index has returned 17.30% since its inception in February 2006. Expenses run 0.75%. Investors may want to talk to their tax advisors before purchase, as the fund is set-up like a limited partnership, meaning you will receive a K-1 statement. There are also certain tax rules specifically involving the gains on commodity futures.

For investors who want to own materials futures, but who do not want the hassle of a K-1 statement, Barclay's has introduced an exchange-traded note based off of Dow Jones-AIG Commodity Index; the note is called the iPath Dow Jones-AIG Commodity Index Total return ETN (NYSE:DJP). The note owns contracts on 19 different resources futures and has returned a negative 8.53% since inception in 2006 and will mature on June 12, 2036. Annual expenses run 0.75%. Again, investors should consult their financial advisors before buying the ETN as there are tax risks and other risks associated with these kinds of financial instruments. (To learn more about ETNs, read Exchange-Traded Notes - An Alternative To ETFs.)

Bottom Line
Taking a long term view can help investors avoid worry over daily market gyrations and help them position themselves nicely for the long term trends affecting our world. Over an extended period of time, commodity prices and demand have risen due a rising population. Now would be a great place to start building a materials portfolio for the long haul. The ETFs we have covered offer a quick and easy way to do just that.

For related reading, check out How To Invest In Commodities and our ETF Tutorial.

By Aaron Levitt

Aaron Levitt is an accountant with a non-publicly traded real estate limited partnership. He received his Bachelor of Science degree in economics and international business from Pennsylvania State University and is currently working on his master's degree. Levitt advocates long-term value investing within a global framework.

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