Commodity investments tend to attract more investor attention when inflation fears start to mount.

What are commodities?

Traditionally, commodities referred to physical products like oil, grain, beef, gold and precious metals, and natural gas. Technological advances have also led to new types of commodities being exchanged in the marketplacefor example, cell phone minutes and bandwidth.

In general, commodities are closely tied to the economys health and inflation. Many commodities are quickly consumed, and have prices that are tied to the cost of living. Therefore, commodities prices tend to rise during inflationary periods.

For that reason, commodities investing is often viewed as a way to protect your portfolio against inflation.

In addition, commodities prices do not closely correlate to the stock and bond markets; therefore, commodities are viewed by some as a helpful portfolio diversifier.

How It Works

A basic concept behind commodities trading is that there is little differentiation between commodities from one producer to anothergrain is grain no matter where it came from. This allows for investing to take place without the physical transfer of the actual commodity from a specific producer.

The sale and purchase of commodities is usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. The biggest exchanges in the U.S. that trade commodities include the New York Mercantile Exchange and the Chicago Mercantile Exchange, both part of the CME Group.

Types of Products

There are a number of ways investors can invest in the commodities markets. However, some are more practical and appropriate for individual investors than others.

Futures Contracts

A futures contract is an agreement to buy or sell a specified quantity of a specified commodity at a specified price some time in the future. You can trade futures contracts on a number of exchanges, but in general, institutional investors, hedge funds and speculators make up the majority of the participants in this market.

Futures trading requires highly specialized knowledge, margin accounts and high minimum balances, and is not a very practical approach for most individual investors to get exposure to the commodities markets.

Managed Futures (Commodities Pools)

Managed futures products pool money from individuals to invest in commodity futures and options; they are managed by a licensed commodity trading advisor. These products tend to have very high management fees and expenses, as well as high minimum investments and net worth requirements, and can be difficult to evaluate. Many use leverage and other non-traditional investment approaches (many hedge funds are basically commodities pools). These products, as well as the advisors, are regulated by the CFTC, not the SEC.

Stocks of Commodity-Based Firms

Investing in individual stocks of companies that directly deal with commodities can be one way for individual investors to gain exposure to the commodities market. You can search for stocks in various sectors using a stock screening program. Commodity stocks are easy to trade and most discount brokers have low commission rates. However, individual stocks require research and data analysis before investing and commodity-specific companies may have additional risks to consider.

Mutual Funds

There are several ways to use mutual funds for investors interested in commodity exposure. One is to invest in mutual funds that hold shares of individual companies that operate in commodity-related industries. These can be sector specific or a more broad-based commodities strategy. A second way is to invest in a commodity-linked index type mutual fund that invests in futures contracts and commodity-linked derivatives.

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Exchange-Traded Funds

There are many exchange-traded funds that track commodity-based indexes. Most do not hold physical inventory but some will invest in futures contracts. Just like mutual funds, some commodity ETFs are sector specific while others follow broad commodities indexes. A few ETFs, primarily precious metals ETFs, do hold the physical commodity.

Commodity-Linked Exchange-Traded Notes ETN

Unlike ETFs, ETNs dont own anything. An ETN is basically a bet on the change in value of an index. It is purchased at a price (either at issue or on the secondary market) that reflects the current value of an index, with the issuer promising to pay the full value of the index at maturity, minus management fees. Investors will find ETNs for a number of commodity-based indexes. For more information about ETNs, refer to the October 2008 Offbeat Offerings column. You can find it on-line by going to www.aaii.com/journal .

How to Purchase

You can purchase ETFs, ETNs, individual stocks and mutual funds through numerous brokers. Mutual funds may also be purchased directly from the fund company.

Investor Suitability

Investing in commodities can be a way to diversify holdings and hedge against inflation. Individual company stocks, sector-specific ETFs and mutual funds are a practical way to gain exposure to markets that are otherwise hard to invest in.

However, there are risks involved and commodities should at most be only a small portion of your well-diversified portfolio of investments.

Tax Consequences

Because of the numerous ways to invest in commodities, tax liabilities vary greatly. For any investment, you should receive a tax statement at the end of the year. A tax professional can help you understand the different tax consequences of various investments.

The Pros

Investing Options

There are numerous avenues for investing in commodities, some are more practical and require less specialized knowledge than others.

Hedge Against Inflation

Due to the nature of consumption of commodities, prices tend to rise as inflation rises, with many commodity investments increasing in value as well.

Portfolio Diversifier

Commodities prices do not always correlate closely with the stock and bond markets, and therefore may provide diversification benefits.

The Cons

High Risk and Product Complexity

Investing in commodities can be risky and volatile, and many commodity investment products are complex or require specialized knowledge. In addition, many products also tend to have higher average fees and expenses. Mutual funds and ETFs offer more traditional practical approaches to commodities, but be sure you know exactly how the mutual fund or ETF is investing. Keep in mind that if you choose a sector fund, you are making a big bet on a very small area of the economy.

www.morningstar.com

Morningstar offers a database of over 24,000 mutual funds and over 300 data points for research and screening on each fund. The subscription-based Premium Fund Screener has over 300 data fields for screening. You can screen for mutual funds based on their composition. The site includes data on ETFs and an ETF screener.

CME Group

www.cmegroup.com

The CME Groups Web site includes data on commodities activity and guides to trading. For those interested in buying futures and options, you can research the various investment products offered at the site.

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