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3 Tips for Investing in Commodities

3 Tips for Investing in Commodities
Ron DeLegge, Editor
August 18, 2009

SAN DIEGO (ETFguide.com) Ė Most financial professionals agree that obtaining a broadly diversified investment mix is a prudent strategy. But many investors are missing market exposure to one overlooked category: Commodities. 

Like stocks, bonds, and real estate, commodities are an important asset class. Commodities are tangible assets used to manufacture and produce goods. Products like agriculture, energy, livestock, metals, timber and textiles are examples of commodities. The agriculture segment, for instance, includes familiar commodities like cotton, corn, coffee, and wheat.

Many commodity ETFs follow total return indexes which are designed to benchmark the return of fully collateralized commodity futures. Others invest in a single commodity by taking physical delivery.

Letís examine three tips for investing in commodities. 

Avoid Problem Products
The U.S. Natural Gas Fund (NYSEArca: UNG) is a perfect example of how not to manage a commodity fund. The investment demand for UNG was so great, the fundís general partner (because of poor planning and lack of foresight) ran out of shares to issue. An appeal to the S.E.C. yielded a belated approval for an increase in creation units, but thus far no action has been taken by UNGís manager.

Particularly worrisome is that UNG hasnít been fulfilling its principal investment goal of following the price of natural gas. The August 17th edition of the Wall Street Journal correctly observed that UNG has fallen 75% in value while Nymex front-month natural gas prices are down around 50%.

The United States Oil Fund (NYSEArca: USO) is another example of poor management. USO is supposed to benchmark the price of West Texas Intermediate (WTI) light sweet crude oil. While the price of WTI September crude futures is around $66.75, USOís share price trades in the vicinity of $36 or almost 50% away from next monthís oil prices! For investors that want accurate exposure to crude oil, they best look elsewhere.

Coordinate Your Commodity Investments
Many commodity ETFs come with a bundle of tax surprises, not to mention complicated taxation rules. As such, coordinating your commodity investments into a tax-deferred account, like a traditional or ROTH IRA is one way to lower your tax liabilities.

Generally speaking, commodity linked products that utilize futures to obtain their market exposure receive special tax treatment by the U.S. Internal Revenue Service. Regardless of the holding period, 60% of gains are taxed at the long-term capital gains rate while the remaining 40% of gains are taxed as short term profits, which are subject to the investor's ordinary income tax rate.

The long-term gains for commodity ETFs that own physical commodities like the SPDR Gold Shares (NYSEArca: GLD) and the iShares Silver Trust (NYSEArca: SLV) are taxed as collectibles at a 28% rate. Itís a good idea to consult a tax professional or financial advisor for specific tax advice.

Choose Diversified Baskets
Owning exchange-traded vehicles tied to a single commodity can be considerably more risky and volatile versus owning a diversified basket of commodities. An alternative solution is to stick with broadly diversified commodity ETFs.

The iShares S&P GSCI Commodity Indexed Trust (NYSEArca: GSG) follows are production-weighted index to reflect the performance of 24 different commodities including corn, gold, live cattle, oil, natural gas, soybeans, and wheat. Energy commodities like crude oil dominate the index's weighting.

If you want a more balanced exposure to commodities, see the GreenHaven Continuous Commodity Index Fund (NYSEArca: GCC). While GCC follows 17 different commodities, its weighting strategy gives an equal representation to each commodity so that no one commodity dominates its performance. Each commodity is assigned a 5.88% (1/17) index weight and rebalanced daily.

Conclusion
Adding commodities to an investment portfolio provides greater diversification and can help to reduce portfolio volatility. Commodities can also offer a way to protect against inflation.

If you decide to invest in commodities, avoid problem products, coordinate your investments to lower your tax bill and stick with diversified commodity baskets.

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