The Better Way to Own Commodities

During the big rally from the early 2009 lows, few asset classes have attracted more attention than commodities. At the same time, one of the most popular investment vehicles over that time frame is the exchange-traded fund. So it's only logical to think that commodities and ETFs would go together like peanut butter and chocolate.

As it happens, though, commodity ETFs have left a sour taste in investors' mouths. While some ETFs that own commodities have exploded in popularity, most investors prefer another way of participating in the commodity craze -- one that doesn't leave them exposed to obvious manipulation by professional traders.

Picking the right investment
Data from mutual fund research company Lipper shows that when it comes to putting their money broadly into commodities, investors have a big preference toward using traditional mutual funds rather than ETFs. During 2010, broad-based commodity mutual funds pulled in around $11 billion in new assets, compared to just $1 billion for similar commodity ETFs.

The exception to the rule, however, comes with precious metals funds. There, ETFs vastly outdraw mutual funds, with SPDR Gold Trust (NYSE: GLD  ) coming in as the most popular commodity ETF with $6 billion in inflows last year. New ETFs have also proven to draw investor interest. ETFS Physical Platinum (NYSE: PPLT  ) and ETFS Physical Palladium (NYSE: PALL  ) were among the top new ETFs in 2010, pulling in more assets than any other ETF coming to market last year.

So what's behind investor aversion to broad commodity ETFs? The answer lies in the transparency that ETFs give investors -- as well as those who seek to take advantage of their passive strategies.

Knowing what's going to happen
Commodity ETFs run into a number of problems. Two stand out as big ones that in some cases have combined to hit particular ETFs.

First, because ETFs have to report their holdings on a daily basis, it's immediately evident to anyone who's paying attention what trades they're making. With commodity investments, being an open book can prove disastrous. Second, the price structure of some futures markets almost ensures that consistently rolling positions forward over time will slowly but surely erode shareholders' capital.

You can see two good examples of this phenomenon in the United States Oil ETF (NYSE: USO  ) and the United States Natural Gas ETF (NYSE: UNG  ) . In the case of the oil ETF, shares originally started trading for approximately the same price as a barrel of oil. Yet even as oil prices have risen sharply over the past two years, from around $40 to near $90, ETF shares have gone up less than 8% annually. Meanwhile, with natural gas prices staying close to unchanged in recent years, the natural gas ETF has created huge losses for investors, with shares falling by nearly two-thirds since early 2009.

In particular, these ETFs face an uphill battle. Each month, they have to roll forward their futures contracts to the next month, and they explicitly give the public a range of possible dates on which those roll-forwards will happen. Even worse, nearly every month that they roll their contracts forward, they had to pay a little more on the next-month contract than the price of the current-month contract. Over time, those small monthly hits added up to take away big gains from the oil ETF and cause big drops in the gas ETF.

Precious metals ETFs have avoided this issue by holding the physical metal itself. That way, investors only pay storage costs. But precious metals are well-adapted to this strategy because you can concentrate large amounts of wealth in relatively small amounts of metal. When other physical commodities ETFs come to market, they'll likely face a bigger challenge in storing their commodities in a cost-effective manner.

Going active
In contrast, active commodity funds don't suffer from being so predictable. They can come up with their own unique strategies for maintaining exposure to the commodity markets they track, and they can even be the ones to take advantage of those rule-bound ETFs.

Some ETFs are trying to fight back against these challenges. For instance, the popular PowerShares DB Commodity Index ETF (NYSE: DBC  ) tracks an index that itself picks the most efficient futures contracts. The new United States Commodity Index ETF (NYSE: USCI  ) has even been billed as a "contango-killer" fund, as it deliberately chooses commodities with the most attractive price structures. In that way, the indexes are themselves trying to become more active.

Not going away
As long as commodity prices continue to climb -- and they have climbed very far lately -- investors will stay interested in them, and new funds and ETFs will keep trying to improve upon past performance. If you want to stay ahead of the game, you need to understand the market forces these funds have to overcome and make sure you buy only the funds that do the best job of doing that.

Learn about the best ETF prospects for your portfolio. Read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."

Fool contributor Dan Caplinger thinks there's a place for both ETFs and mutual funds. He doesn't own shares of the investments mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is a hot commodity.


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