Morning Call: Gold Struggles, Brent At 1-Month Low As Dollar Spikes To 12-Year High; Stocks Skid

Written by Robert Levin | July 15, 2008

Investor In The Woods: Exploring ETFs

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A primer on why buying exchange-traded funds provides such easy access to the commodities market.

• Booming popularity
• Priority No. 1: gaining exposure
• Escalating price of hard assets

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?