Investing in Commodities (from WSJ)

Commodity-Based Funds Earning Favor
Corn or Oil in ETFs
Can Add Stability,
But Ratios Matter
By IAN SALISBURY
August 14, 2008; Page C13

Investors have taken to commodity exchange-traded funds, but choosing a fund isn't easy: Design hurdles mean seemingly similar funds can have quite different holdings -- and different returns.

Most stock indexes weight companies based on market capitalization, or the total value of their shares outstanding. This calculation isn't feasible for commodities, so index designers have to estimate or take an entirely different approach -- and they come up with widely varying results.

To take one example: The iShares S&P GSCI Commodity Indexed Trust has 78% of its assets in energy and just 2% in precious metals, according to a recent report by Morgan Stanley.

As a result, this ETF has shot the lights out over the past year, gaining 40% despite the recent decline in oil prices. By contrast, the Greenhaven Continuous Commodity Index ETF has 47% of its assets in agriculture and just 18% in energy. It's up 2% since hitting the market in late January.

Other commodity index funds have splits that lie between these two extremes.

Commodity ETFs and their close cousins, exchange-traded notes, have been gaining traction with investors, collecting more than $40 billion since the first one hit the market in 2004, according to Morningstar Inc.

Commodity Cushion

As events this summer have shown, prices for goods like oil and corn can surge even as stocks plunge. Many financial advisers now believe keeping a small portion of investors' assets in commodities can smooth a portfolio's overall volatility.

"Most people use commodity ETFs as part of their asset allocation" plans, says Kevin Rich, managing director at Deutsche Bank AG, one of the companies that offers commodity ETFs. "We see people with 1%, 3%, 5% in commodities."

While it's relatively easy to decide what to include in commodity indexes -- usually crude oil, agricultural goods and precious metals -- it's difficult to come up with a rationale for how much to include of each one. It's not as simple as with stock indexes, which typically go by market value of the companies.

One solution is to estimate how much of a commodity is produced a year. The purest production-oriented approach is taken by the S&P GSCI Index, which bases weightings on average production levels for 24 commodities over a five-year period.

"Commodities aren't like equities," says Eric Kolts, director of commodity indexes at Standard & Poor's. "The closest you can get to market capitalization is what we do with production."

Two Barclays PLC investments, $1.1 billion iShares S&P GSCI Commodity Indexed Trust and $292 million iPath S&P GSCI Total Return ETN, are based on this benchmark. A drawback for many investors, however, is that this method puts a big focus on oil, which represents more than 70% of the index.

Lowered Energy

For that reason, two other investments, one from Barclays and one from Deutsche Bank, have attracted more money from investors by tweaking their methods to reduce energy exposure. The $3.9 billion iPath Dow Jones-AIG Commodity Index Total Return ETN bases weightings on production and trading volumes but caps energy exposure to 33% once a year in January. It's currently drifted up to about 36%. (News Corp.'s Dow Jones & Co. publishes The Wall Street Journal.)

The $3 billion PowerShares DB Commodity Index Tracking Fund is based on production and inventory levels, but designers also "redistributed some of the exposure from energy into metals and specifically precious metals" to make it more diversified, according to a spokeswoman.

About 61% of the ETF is in energy, according to the Morgan Stanley report.

Finally, the above-mentioned $29 million Greenhaven Continuous Commodity Index ETF puts the entire focus on diversification, doing away altogether with the notion that the fund ought to reflect a commodity's role in the economy. It weights 17 commodities, including gold, orange juice, and crude oil, equally.

Because so many individual commodities are agricultural, these represent almost half the index, according to Morgan Stanley.

Write to Ian Salisbury at ian.salisbury@dowjones.com