In case you didn't know it, commodities are very risky. Global commodity exchanges facilitate trading in all kinds of things, such as interest rates, currencies, metals, crude oil, gasoline, cotton, lumber, sugar, coffee, wheat, corn, and pork bellies. According to The Wall Street Journal, "Investing in commodities and financial futures is about as extreme as you can get on the risk scale."
As Gail MarksJarvis noted in the Chicago Tribune, "Commodities are notoriously volatile. The Oppenheimer [commodities-based] fund climbed 26.4% last year and has returned about 20% or more for each of the last four years, according to fund-tracking firm Morningstar. But in 2001, the fund lost 31%. And in 1998, the loss was 45%."
Investors are drawn to commodities because of the great leverage available. You can sometimes buy items by paying only about 10 percent of their value. In an extreme example, if you buy $50,000 of pork bellies for $5,000 and they double in value, you've made a lot of money by investing just a little. Of course, if pork bellies fall in value, you can lose your entire invested amount -- and then some! You can lose much more than you invest with commodities and futures. Smart people have lost a lot of moola this way.
Fortunately, most of us don't even know how to go about investing in commodities, and those of limited means may have trouble even trying, as you typically can't get involved with small sums. That was then, though -- this is now. There's a new development that you may want to know about -- if only, perhaps, to avoid it.
The first commodity-based exchange-traded fund (ETF) has just been launched: The Deutsche Bank Commodity Index Tracking Fund (AMEX: DBC ) . Open it up and you'll find futures contracts tied to various commodities, in the following approximate proportions: oil, 55%; aluminum, 12.5%; corn and wheat, 11.25% each; and gold, 10%. That's right -- no orange juice, no pork bellies. In fact, lots of other items are also excluded.
So why is this ETF here? Well, commodities have been, pardon the pun, hot lately. Compared with the S&P 500's gain of about 5% last year, the Dow Jones AIG Commodity Index rose some 21%. But that index contains a much wider mix of commodities than DBC shares.
What's the advantage of investing in such items? Well, sometimes the rising cost of raw materials can put pressure on companies' bottom lines. If you invest in the raw materials themselves, you can benefit from the inflation.
There are plenty of disadvantages to this investment, too. For starters, remember that it's focused on just a small subset of the commodity world. Remember also how volatile many commodities are. The price of oil, for example, has certainly demonstrated that. And if it falls, it will take much of this ETF with it.
Here's the bottom line: You have alternatives to commodities and this ETF.
- You might fight inflation and/or diversify your portfolio with inflation-protected bonds and real estate.
- You might look into some of the many other ETFs that may be more compelling. (Our ETF Center can get you up to speed pronto.)
- You might invest in the stock of companies that produce and sell commodities. SmithfieldFoods (NYSE: SFD ) , for example, is a major pork producer. Stephen Simpson had some kind words to say about it a while back. He has also covered copper specialists such as Phelps Dodge (NYSE: PD ) , Southern Copper (NYSE: PCU ) , and Freeport McMoRan (NYSE: FCX ) , all of which have experienced strong advances in the past year. And Will Frankenhoff recently delved into the future of oil companies such as ExxonMobil (NYSE: XOM ) and Chevron (NYSE: CVX ) .
- And if you really must, consider some managed mutual funds that focus on commodities, such as the Pimco Commodity Real Return fund.
You can learn more in our ETF Center, including how ETFs stack up against mutual funds, how to develop an investment strategy with ETFs, pitfalls to dodge, and how to avoid ETF imposters. These articles may also be of interest:
- Mutual Funds vs. ETFs
- Three Things to Know About Your ETF
- Buy the Whole Mall
- The Age of the Exchange-traded Fund
- ETFs and Falling Fund Fees
LongtimeFoolcontributorSelena Maranjiandoes not own shares of any companies mentioned in this article.