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Sensible Commodity ETF Investing

Don Dion

07/08/10 - 06:01 AM EDT

NEW YORK (TheStreet) -- Many investors may hold a risky amount of commodities exposure in their portfolio due to cross exposure between various asset classes.

Most commodity exposure comes from equity, futures and physical commodity ETFs. Popular equity-based funds such as Market Vectors Agribusiness ETF(MOO) and iShares Dow Jones U.S. Oil Equipment and Services Index Fund(IEZ) track baskets of firms dedicated to the production of various hard assets.

Funds such as United States Natural Gas Fund(UNG) and PowerShares DB Agriculture Fund(DBA) track the price movements of futures contracts, providing investors with more direct exposure to physical commodities.

Finally, investors can gain pure access to a physical stockpile of precious metals using products such as SPDR Gold Shares(GLD) and ETFS Physical Palladium Shares(PPLT).

While I believe having some exposure to commodities is essential to playing the current global economic arena, it is very easy for an ETF investor to take his interest in hard assets too far. To exemplify, allow me to introduce you to Commodities Rex.

The Commodities Rex has a passion for all things commodities. Whether it is gold, coal, oil, natural gas, or agriculture, this investor craves it and looks for any way possible to get exposure to it.

Unfortunately, oftentimes, the Commodities Rex's desire for commodities will cause fuels, precious metals and agriculture to creep into all aspects of his portfolio

When asked if his portfolio is adequately diversified across equities, international positions and defensive plays, the Commodities Rex will stand by his portfolio. He will point to a collection of holdings including MOO and Market Vectors Coal ETF(KOL) as evidence of strong equity positions and use funds such as Market Vectors Russia(RSX) or iShares MSCI Australia(EWA) to satisfy his need for international exposure.

Finally, a physically-backed gold ETF such as GLD will round out the portfolio, providing the investor with welcomed protection against inflation and market jitters.

Separately each of these funds is strong and boasts adequate liquidity. However, when it comes to diversification, the Commodities Rex misses the mark. By lumping all of these holdings together this investor may think that he's taking a diversified approach to playing the markets when in fact he has constructed a portfolio that has overwhelming exposure to the commodities market and ultimately ignores other important facets of the global markets.

RSX, which is advertised as a product designed to track the broad Russian markets, is heavily focused on the energy industry, with gas and oil companies representing nearly half of its portfolio. EWA has less direct commodities exposure, but commodities play a significant role in the country's economy and its currency.

If you feel you encompass the qualities of the Commodities Rex, there is no need to fret. There are a number of simple changes you can make to create a more stable portfolio.

For one, the Commodities Rex needs to pare down their focus on commodities to a few select holdings. Oftentimes, this means holding one long-term position such as GLD while leaving some wiggle room to play short-term commodity trends using funds like IEZ and KOL one at a time.

Second, when it comes to international ETFs, it is essential to examine the underlying breakdown of the various funds. While many of these instruments claim to approach their respective nations with a broad brushstroke, it is not hard to get caught holding industry-concentrated ETFs such as RSX.

In order to avoid overexposure to an individual slice of the market, it is essential to have a good understanding of the underlying make up of any international product you consider buying. This can easily be done by visiting the fund provider's website and looking at the fund's index.

The simplicity of owning commodities using exchange traded funds has made it increasingly simple to become a Commodities Rex. While I consider commodities to be an important aspect of any well diversified portfolio, investors shouldn't over do it.

-- Written by Don Dion in Williamstown, Mass.

via thestreet.com

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