Investor In The Woods: Exploring ETFs

Editor's Note: Robert Levin is a good reporter and a smart guy, but before he started writing for HAI, he knew very little about commodities. In fact, that's why we hired him.

One of the defining features of the current commodities boom is that it is bringing a wide array of investors into the commodities market for the first time.

Our challenge to Levin: Starting from square one, try to figure out if and why he (and others) might add commodities exposure to a portfolio ... and then report back to us.

What follows is the third installment of a regular feature, "Investor In The Woods," where Levin explores the commodities market from a fresh perspective.

 

After speaking with commodity brokers, financial advisors and market watchers, and reading just about all I can handle (the eye-glaze factor places a strict limit on daily intake for me when it comes to financial writing), one thing shines clear as day above everything else: There's a lot of people out there investing in what have proven to be seriously booming commodity markets.

Maybe you're thinking of joining in. The fact of the matter is, it's easier than it has ever been for the retail investor (that's you and me) to gain exposure to the world of real goods.

Little pieces of commodity futures markets - the esoteric worlds of long straddles, call options, contango and backwardation - can now be bought and sold like stock shares. They're available for anyone willing to shell out a trading commission to an online trading site or ... gasp ... to an old-fashioned, human broker.

So, whether you think the price of something is going to rise or fall, whether you want to buy in straight or to leverage your funds (greater possible rewards but equally greater risks), exposure to the real goods of your choice is just a click away.

There are several ways to buy these shares, but the most popular, by far, seems to be through ETFs, or exchange-traded funds. Since their inception in the early 1990s, these stock-like vehicles have ballooned in number, with more coming onto the market every day. From coffee to cotton, oil to gas, to broad indexes that cover many markets, there is an ETF out there that is designed to suit your desires.

Very simply put, commodity ETFs are baskets of securities that are traded by the share, like stocks. And they go in every direction. You think oil and gas prices are going to go down (you rascal!)? There's a short oil and gas ETF that produces inverse returns to the Dow Jones oil and gas index. As of July 11, you could buy a share for $30.48.

Sans Management

And that's just one of many, many examples of ETFs that are out there. They're not actively managed; ETFs just follow the direction, or opposite direction, as the case may be, of whatever sector they identify with. Others allow options purchases and more complex maneuvers, but that's another topic altogether.

So, you're ready to buy some commodities. But how do you know which ETF is right for you?

"First and foremost ... I would not make as the first priority the wrapper [i.e., whether you buy an ETF, an ETN, a mutual fund or another type of financial product]. I would make the exposure the first priority," says Roger Nusbaum, Chief Investment Officer with Your Source Financial of Phoenix, Ariz.

David Fry, founder and publisher of ETF Digest, thinks a broad approach makes the most sense for the beginner. "I would say, for the average investor to add commodity exposure, they should look at an overall tracking index, like DBC [PowerShares DB Commodity Index Tracking Fund]," he says. "That's the oldest and most tested one in terms of dealing with complex issues." We'll look at DBC a little more in depth further on in this column.

Roger Nusbaum happens to like gold. For him, it is the true "gold standard" of a safe haven during times when company values fall as they have done these past couple of years. "The external shock protection provided by gold - I haven't found anything better than that," he says.

Both men advise investors to take careful consideration of whatever they are thinking of getting involved with. "With commodities, crops fail, there are seasonal factors with grains, there's droughts in Australia ... It's a global supply-and-demand issue," Fry notes.

So, once you have selected a sector or single hard asset that you like, or don't like, as the case may be, which ETF do you choose?

"That's the biggest challenge investors face right now in ETFs," Fry says. For him, the most popular funds, with the longest history and the most liquidity, are usually the best bets. "This is a market where structure matters," he adds, "but, at the same time, he who was there first wins, generally."

It is clear that while a broad index of stocks has lost value over the last year, the price of most hard assets has gone straight through the roof. Now, some people think this will continue, in general, for the immediate future; others think a big correction in certain sectors, especially energy, is on the way. Figure out just what's going to happen in any specific area and invest accordingly, and you'll be sitting pretty.

Backtesting

In order to get a sense of how an ETF buy in 2006 or 2007 might have fared, let's take a look at some of the most well-known commodity ETFs and see how they did over the past year or two.

First up is the PowerShares DB Commodity Index Tracking Fund (DBC), the broad index recommended by David Fry.

The $2.67 billion in assets held by the fund is proportioned according to historic levels of the world's production and supply of the following goods (in round numbers): 36% West Texas Intermediate crude oil (when you hear about the price of a barrel of oil, this is what they're talking about); 21% heating oil, 13% corn, 11% aluminum, 11% wheat, and 8% gold.

Since DBC's inception in February 2006, the value of shares in the fund have risen immensely, as you could have guessed when you last bought a loaf of bread or filled up your tank. The fund came out of the gate with an adjusted closing price (adjusted for dividends and splits) of $22.18 per share. On July 11, 2008, DBC had an adjusted close of $45.93 per share, over double the value that it had two years ago.

In fact, DBC share prices dropped only 10 out of the 30 months since the fund came online, with the biggest monthly drop in share price topping out at $1. One-year total returns for DBC top out at 44.36%. If that doesn't scream commodities bull market, I don't know what does.

Popular Choices

Investors have certainly caught the DBC bug. The average volume of shares traded in February 2006 was 536,900. This number hit a low of 250,800 in August 2007 before climbing to a high of 1,281,000 in July 2008.

Another popular index tracked by PowerShares, the DBA fund, covers agricultural commodities. DBA holds, in round numbers, 27% corn, 24% soybeans, 23% sugar and 23% wheat.

Over the past year, shares of the $2.56 billion DBA fund have seen a whopping 46.68% return, rising in price from $26.03 in June 2007 to $40.68 in June 2008.

Looking at oil, we see a similar story. From June 2007 to June 2008, the price of one share of United States Oil (USO), rose from $53 to $113.66. The past year's total returns for USO shares were 52.50%.

The amount of money being traded in the oil market has jumped accordingly, rising even more dramatically than prices. Average trading volumes rose from 3.42 million shares in June 2007 to 7.74 million in March 2008, to an astounding 12.7 million in May, 14.75 million in June and 16.47 million in July.

Lastly, let's see how gold bullion fared over recent months. SPDR Gold Shares (GLD) holds actual gold in a vault, the value of which has been on a nearly steady incline since the fund's inception in November 2004. Coming out of the gate at $45.12 per share, GLD rose to $64.27 in June 2007, and kept climbing to reach $95.16 this month. One share equals approximately 1/10 of an ounce of gold.

One-year returns for the $17.01 billion GLD fund were $37.53/share this year, or close to 50%.

Compare And Contrast

As a comparison, take a quick look at the value of the Standard and Poor's (S&P) 500, a stock market index covering the 500 leading companies in leading industries of the U.S. economy. The iShares S&P 500 Index (IVV) is an ETF that passively follows the performance of the S&P 500. The picture here is nowhere near as rosy as in the commodities sector.

Past-year total returns for IVV are actually down, by -5.28%. The $128 share price in June 2008 was significantly lower than the $149.12 a share fetched in June 2007. Going back two years, to June 2006, the price was at $126.31.

Basically, we can see that after rising steadily for many years, the S&P 500 has been falling in value more or less over the past year, with values now flat with those of two years ago. Commodity values, on the contrary, have risen significantly over this time, making the case for what both Nusbaum and Fry recommend, which is having a distinct portion of your investment dollars allocated to the commodities sector.

Jury Still Out

While ETFs are often compared to mutual funds, there are several key differences that affect investor costs and tax liability. Of the two, many analysts favor ETFs, but the debate is by no means settled. That, though, will have to serve as fodder for another installment of "Investor in the Woods," as we're out of space for today.

Now, the question of whether prices are going to continue their meteoric rise inevitably comes to mind at this juncture. I mean, who wants to have the dumb luck of going long on oil, or wheat, or copper on its most expensive day ever?

Sadly, I can't provide any help with that issue. Look around, though, and you'll find there is more than enough advice floating around out there, although plenty of it is conflicting in nature. Where a certain market, or a spectrum of the market is going to go, when it will go there and how fast it will travel, well ... that's, as they say, speculative.

 Note: All figures from Yahoo Finance

 Be sure to read the first and second installments of HardAssetsInvestor's "Investor In The Woods" column.