ETFs Bring the Bling

Want to add some shine to your portfolio -- some bling, perhaps? You're in luck. Commodity ETFs now come in gold, silver, and black -- as in oil -- and some even track a diverse basket of commodities. Compared with your typical ETFs, these funds track very distinctive types of investments, ones with market cycles and histories unlike any of your other holdings. And that makes these funds, for the most part, well suited for truly diversifying your portfolio.

Add some glitter to your portfolio
For the past couple of years, gold has been, well, golden as an investment. In late 2004, the streetTRACKS Gold Shares Fund (NYSE:GLD) became the first ETF that tracked a commodity. This fund gives investors a cheap and easy way to invest in gold and has accumulated billions of dollars in assets. Success breeds imitators, and in early 2005, Barclays Global Investors followed up with its own gold fund -- the iShares COMEX Gold Trust (AMEX:IAU). (Glad they didn't use the ticker IOU.)

In April 2006, Barclays provided investors another opportunity to shine up their portfolios when it launched the iShares Silver Trust. The SLV fund can be traded just like any other ETF, while the precious metal that the fund holds is safely secured in a vault.

Black gold ... Texas tea
As crude prices surge on concerns over supply and demand, don't you want to benefit the way the big oil companies have? Until recently, you could buy energy ETFs such as the PowerShares Oil Services Fund (AMEX:PXJ) or the Energy Select Sector SPDR (AMEX:XLE). However, these funds are still subject to the stock market's random swings and the earnings of the companies that make up their portfolios -- factors not directly tied to the price of crude oil.

Now, there's the United States Oil Fund (AMEX:USO), which provides direct access to the performance of crude oil by investing in energy-futures contracts and other similar instruments. USO allows investors to take a long position in the commodity by purchasing the fund, or hedge against losses by shorting it. Individual investors have had access to mutual funds that invest in energy companies, but this oil ETF provides far more direct exposure to crude prices. Now you, too, can profit like an oil baron when the cost of petroleum rises.

Diversity is nice, twice
Two other ETF options exist for investors who want a more diverse basket of commodities than just oil: the PowerShares DB Commodity Index Tracking Fund (AMEX:DBC), launched by Deutsche Bank in January 2006, and the iShares GSCI Commodity-Indexed Trust (NYSE:GSG), from Barclays six months later. The differences between the funds might sway your preference to invest in one or the other: DBC tracks a Deutsche Bank index made up of six commodities, while GSG follows a Goldman Sachs index that holds 24 commodities. At first blush, GSG might seem to be more diversified than DBC. That's a bad assumption, though, since the index that GSG follows weights commodities by world production. That means that GSG currently has close to a 75% stake in energy, much more than DBC at around 50%.

With their concentrations in oil and energy, these funds offer a way to play the energy market. However, their real value is that they open the door, at a low cost, to a broad basket of commodities. That adds diversification to an investment portfolio from a market that was previously closed, or difficult to get exposure to, for most investors.

Potential risks
Commodity markets are marked by longs and shorts, and unless you're able to short commodity ETFs, you're deprived of the full benefits of these securities. But don't take shorting ETFs as a given, since it's usually difficult to short anything other than the largest funds. Keep in mind also that market prices of commodities also tend to be driven by supply-and-demand factors, both real and perceived. Unlike stocks, commodities have no earnings per share or other fundamentals to drive prices. Instead, commercial hedging activities and speculators tend to dominate the commodity markets. Gold price fluctuations, in particular, can be driven by speculators and governments selling off their stockpiles.

Even with their risks, commodities have such low correlations to U.S. equities or bonds that adding them to your portfolio can reduce volatility and increase your returns. As with all investments, some commodity ETFs might turn out to be fool's gold, just pure glitter, while others are the real thing. Learn about the risks involved before you invest.

To learn all about ETFs, visit our ETF center.

For more ETF Foolishness:

• Going Global With ETFs
• Get Emerging-Markets Exposure via ETFs
• Big Yields From ETFs

This article was originally published on Aug. 16, 2006. At that time, Fool contributor Zoe Van Schyndel did not own any of the funds mentioned in this article. The Motley Fool has a disclosure policy.