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Playing Commodities With ETFs

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By Tom Taulli
April 29, 2005

Famed investor Jim Rogers made a fortune by investing in commodities during the 1970s. Now, Rogers is back in commodities, and he's giving individual investors advice in his new book, Hot Commodities (Random House, 2005). His thesis is that the world is in the midst of a bull market in commodities. He believes that the boom started in 1998 and will last for roughly 20 years.

True, such predictions are never a sure thing. Sometimes, they don't pan out at all. But regardless of whether there really is a major bull market for commodities, it is still a good idea for investors to have some in their portfolio. Commodities represent a unique asset class and can add diversification to a portfolio alongside other asset classes, such as equities, bonds, and cash.

Unfortunately, it is not easy for individual investors to get involved. The most common approach to participating in commodities is through the buying and selling of futures contracts. And futures can be quite volatile, since an investor puts only a small portion of cash against the total value of the contract. This leverage can mean significant returns if the commodity price increases, but it can also mean substantial losses if the reverse happens. If a futures contract goes south, you will need to put up more cash. It can be brutal.

With an exchange-traded fund, or ETF, there is no leverage. But since it is in the form of a listed stock, you can borrow money from your account to purchase one. An investor can also short an ETF, if he or she believes the index value will fall. Essentially, an ETF is a cost-efficient way to mimic an index, and an investor can buy or sell an ETF whenever the market is open, as opposed to mutual funds, which can be purchased only once every business day.

Commodity-type ETFs are not without volatility, though. Given the nature of the commodity business, stomach-turning falls in value are virtually inevitable -- just look at some of the oil stocks this week, for example. A major change in weather or in the global economy can have a significant impact on commodity.

What are some commodity-type ETFs? There is the Materials Select Sector SPDR Fund (IGE), for one. As the name implies, the fund focuses on the materials sector as defined by the S&P 500. This sector includes industries that work in packaging, containers, construction materials, chemicals, mining, paper, and forest products. Some of the better-known companies are Alcoa, Dow Chemical, and International Paper.

Another ETF is the Energy Select Sector Index (XLE). Nearly all of this portfolio is in energy stocks. With some of the biggest holdings being Apache (NYSE: APA), Burlington Resources (NYSE: BR), and ExxonMobil (NYSE: XOM), holding a basket of energy stocks is similar to holding, well, barrels of oil or other energy.

A change in a company's commodity price will have an immediate impact on these funds. In other words, the ETF can act as a proxy for a commodity, as companies' revenue and profit stream mirror underlying commodity prices.

But keep in mind that current ETFs have stock holdings, not the actual commodities. For example, a great ETF would be one that owns the commodities in, say, the Commodity Research Bureau Index (CRB).

But even great ETFs like the CRB Index carry risk, even in a commodities bull market. For example, in 1977, the CRB Index increased 22%. A year later, it declined by 15%.

But, with the growing popularity of ETFs and recent strength in commodities, we will likely see new commodity-type ETFs hit the market. When there is demand, Wall Street always finds a way to create new product quite fast.

Fool contributor Tom Taulli does not own shares mentioned in this article.