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How to Invest in Commodities With a Commodity ETF

March 22, 2012 | Comments: 0 | Views: 95

If you investigate the returns of unique assets such as equities, bonds, and real estate, you'll discover that they generally are not highly correlated to commodities. Therefore, by adding commodities to your portfolio, you're diversifying it, and decreasing the probability that the value of all your holdings will decrease simultaneously. This is great news when stocks are volatile and declining. It also makes perfect sense: commodities represent another "basket" and you diversify by not putting "all your eggs in the same basket." If you're an investment guru, like Warren Buffett, then you don't need to worry about this. For everyone else, diversification is simply a requirement. Because of the fact that not all assets zig and zag in unison, it guards your portfolio from inevitable market declines.

It used to be challenging to participate in the commodities market. You either needed to be a high net worth individual (due to the large minimum investment amount necessary to establish an account), or you had to be familiar and comfortable with trading commodity futures. This is no longer required. Any retail investor may now allocate part of his portfolio to commodities by buying a commodity ETF. These exchange traded securities can be traded on a stock exchange and are available through regular brokerage accounts. They trade intra-day, and are bought and sold in the same way that stocks are.

There are now more than one hundred different commodity ETFs, so how do you decide which one to buy? For most investors it makes most sense to buy a broad commodity index fund. One widely followed commodity index is the S&P Goldman Sachs Commodity Index (GSCI), which tracks 24 different commodity futures contracts. With this single investment, you can track the price of all the most common physical commodities in the world.

When owned as a diversified basket, commodities often have lower volatility than other risky asset classes such as stocks. For example, during the global financial crisis just a few years ago, equities were more than twice as volatile as the S&P GSCI commodity index. A commodity ETF is an un-leveraged way to benefit from rising prices of commodities. This is very different from trading commodity futures contracts, which involves a lot of leverage: a moderate change in price of the underlying commodity can wipe out your account. This makes commodity ETFs much more suitable for a typical investor.

Other than individual investors, who else invests in commodities? Hedge funds are very active in this market, as are pensions and insurers. Even university endowments participate. For example, did you know that Yale university's endowment calls for over twenty percent of its investments to be allocated to commodities? And Yale is not an exception, many other university endowments invest in commodities or similar real assets such as timber forests.

There is something to be said for "following the smart money." There is no reason why a normal investor should not have an allocation to commodities. They nicely complement the stocks and bonds that form the cornerstones of the majority of investment portfolios. I would not be surprised if in another decade or two, commodity investments are just as normal as those in bonds and stocks.

Even though commodity ETFs have become popular in recent years, some investing experts still advise against investing in this market. The common criticism is that commodities don't provide ownership in something that has inherent value, unlike say a stock, which represents real ownership in a potentially growing enterprise. Well-known investment author and portfolio manager William Bernstein has compared commodity investing to "picking up nickels in front of a steamroller." In his words, "the risk of getting crushed is enormous." Another well-known writer and advisor, Rick Ferri also pooh-poohs them, saying you should stick instead to tried and true stocks and bonds.

In summary, it may be worthwhile adding a commodity ETF to your investments, if you haven't already done so. But don't just take my word for it. Do your own homework before making any investments!

Widespread availability of the commodity ETF has opened up a world of possibilities for investors interested in diversifying their portfolios beyond a simple stock and bond allocation. Learn all about it on

Source: EzineArticles
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