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Do Commodities Belong in Your Portfolio?

Do Commodities Belong in Your Portfolio?
By Ron DeLegge, Editor
July 27, 2009

SAN DIEGO (ETFguide.com) – Most financial professionals agree that obtaining a diversified investment portfolio is a prudent strategy. And while many investors have exposure to stocks and bonds, one particular asset class is overlooked by many. What is it? Commodities.

The term “commodities” typically refers to basic products like food, gasoline and raw materials – items that we use every day. In the past, investing in commodities was usually limited to using individual futures contracts or options. Today, commodity ETFs offer an easy and convenient way for gaining commodities exposure.

How do commodity ETFs work? 

ETFs that follow commodity indexes are based upon total return indexes which are designed to benchmark the return of fully collateralized commodity futures. How is the return determined?

“The total return is the price return on the commodity futures, plus the difference in price between old futures contracts near expiration and new futures prices on the day the contracts are rolled to the next month, plus income from the Treasury bills where the collateral sits,” explains Richard Ferri, CFA author of The ETF Book (2008, Wiley).

Let’s evaluate three broadly diversified commodity ETFs: 

iShares S&P Commodity Indexed Trust (NYSEArca: GSG)
With $1.4 billion in assets, GSG is one of the largest broadly diversified commodity ETFs. The fund’s performance is tied to the S&P GSCI index, which was originally created by Goldman Sachs in 1991 as a measure of commodities performance. S&P GSCI contains 24 commodities from major commodity sectors including energy products, industrial metals, agricultural products, livestock products and precious metals.

Through the first six months of 2009, GSG has gained 8.76%. In 2008, GSG declined 47.47% and the fund’s annual expense ratio is 0.75%. 

PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC)
DBC follows the Deutsche Bank Liquid Commodity Index - Optimum Yield Excess Return Index. The index enters into long futures contracts and collateralizing those contracts with U.S. 3-month Treasury bills. The index is composed of futures contracts on six commodities and weighted the following way: Light sweet crude oil (35%), Heating Oil (20%), Gold (10%), Aluminum (12.5%), Corn (11.25%), and Wheat (11.25%). Throughout the year the precise weighting of each commodity in the index will change based upon price changes. The index is rebalanced annually to the base weights every November.

DBC has $3.2 billion in assets and year-to-date has gained 6.94%. In 2008, DBC declined 31.77% and the fund’s annual expense ratio is 0.75%. 

Greenhaven Continuous Commodity Index Fund (NYSEArca: GCC)
GCC’s performance is linked to the Continuous Commodity Index-Total Return (CCI-TR).The CCI-TR is an equal weighted index of 17 commodities plus the yield of short-term Treasury bills. Because of the equal weighting, GCC offers significant exposure to grains, livestock, and soft commodities and a lower energy weighting than many of its peers. In addition, GCC is rebalanced every day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.

With $128 million in assets, GCC has gained 5.97% for 2009. The fund was launched in January 2008 and its annual expense ratio is 1.09%. 

Conclusion
For most people, taking delivery of physical commodities is simply not feasible. (Where are you going to store pork bellies or natural gas?) Along similar lines, broadly diversified commodity ETFs invest in futures contracts on commodities and thus avoid taking physical delivery of the goods. After the commodity contracts expire, they’re rolled over into new contracts with new expiration dates.

Should you own commodities in your portfolio?

For individual investors, owning a broad commodity ETF can help to compliment an all equity or bond portfolio. Even though they sometimes move in unison with each other, commodities are often impacted by different economic factors, such as global supply and demand along with weather patterns.

While commodities are frequently used as a hedge against future inflation, they don’t have earnings and they don’t pay dividends. For this reason, some financial experts recommend a small allocation of just 5 or 10% exposure to commodities.

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