ETF Basics: How to Invest in Commodities

Most commodities ETFs don’t perform as advertised. Know which ones to avoid.

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Commodities are one asset class that has recently become acceptable to most financial advisers as part of a globally diversified portfolio. A large number of the most controversial exchange-traded funds invest in commodities. Most commodities ETFs do not perform as advertised. That's why it's important to know which ones to avoid.

A commodity is something for which there is demand, but which is supplied without any real difference across a given market. Commodities prices are determined as a function of their market as a whole. Generally, these are agricultural products, energy, gold and silver, and industrial metals.

Commodities can be an important hedge against inflation and devaluing currencies. The continuing strong growth in the global economy has created strong demand for a variety of raw materials, from oil to metals to lumber. That demand, in turn, puts upward pressure on the prices of those commodities. Because commodities prices usually rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation.

[See ETF Basics: How to Invest in Emerging Markets.]

Commodities have offered superior returns in the past, but they carry a higher risk than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, you can actually decrease the overall portfolio risk. That's because commodities have a low correlation to other asset classes.

With such volatility in mind, we add commodities as an asset class on our more aggressive equity-biased portfolios and only invest in commodities that are in permanent limited supply: energy and gold. Our portfolios include the iShares S&P Global Energy Sector (IXC) and SPDR Gold Trust (GLD).

The iShares fund gives you ownership of 86 energy companies worldwide—about half in the United States and half in countries like the U.K., Canada, and China. You'll own the major companies that produce oil and gas, distribute oil and gas (Exxon, Chevron, Petrochina), as well as those that service the industry (Schlumberger), and others like Murphy Oil and Canadian Oil Sands Trust.

The profits generated from these businesses tend to directly correlate with the price of oil and gas, which is how you get exposure to the underlying commodity prices. Commodity ETFs are cheaper than many traditional commodity mutual funds. High-priced energy mutual funds like the Calvert Global Alternative Energy Fund (CGAEX), which charges annual fees of 1.85 percent; Fidelity Advisor Energy (FAGNX), which carries fees of 1.45 percent; or ICON Energy (ICENX), which charges 1.26 percent, all levy about three times the fees of IXC (0.48 percent) because investment pros are trying to pick the winners. But with IXC, you own a broader mix of companies and you will make more money over time just because of the savings in fees.

In the case of gold, silver, and other precious metals, before the advent of ETFs, investors had to own the physical metal. The GLD fund enables anyone to own a part of an index based on the physical metal stored in secure warehouses. Most mutual funds charge two to three times more than GLD's 0.4 percent fee, like First Eagle Gold (FEGOX), which has annual fees of 1.21 percent, and Franklin Gold and Precious Metals (FKRCX), at 1.02 percent.

Most negative publicity surrounding ETFs focuses on commodity funds. They can be very dangerous for retirement-focused investors (rather than traders) because many of these ETFs are composed of baskets of commodity futures instead of physical commodities or actual companies. Long-term, passive investors should avoid some popular index products like the United States Oil Fund (USO), the United States Natural Gas Fund (UNG), iPath Dow Jones-UBS Commodity Index (DJP), and others that hold futures contracts. Investors including hedge-fund operator Michael Masters have been actively lobbying regulators to rid the market of these ETFs because they distort prices and artificially drive up prices. They are both damaging to the system and to the retirement investor's portfolio.

Consider ETFs like the Energy Select Sector SPDR (XLE), Oil Services HOLDRs (OIH), and iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ) that hold shares of real operating businesses. Also, buy commodity ETFs from only the three largest sponsors: Vanguard, iShares, and State Street (SPDR).

[See Gold May Rise, But Is It Safe?]

The original ETFs were simply baskets of stocks that represent a widely known index (like the S&P 500), wrapped into a single security that could be traded like any other stock on the exchange. For a variety of reasons, the financial industry has been manufacturing exotic ETFs at a feverous pace, stretching the meaning of the term "index," and these ETFs are designed for active traders. For investors seeking a common sense, low-cost, globally diversified portfolio for retirement, there are only 20 or so ETFs that are needed to gain exposure to most asset classes, and the two mentioned earlier in this article should give you all the exposure you need to commodities.

Mitch Tuchman is CEO and Founder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater piece of mind knowing that they are leveraging the best thinking of Nobel Laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.