Commodity And Currency Etfs

This is an area where the naysayers really get worked up in negativity. And yet this area has been one of the biggest areas of sector investment opportunity that I've seen in nearly 35 years.

Commodity trading or speculating has a poor public image conjuring up negative images of wild pork belly trading. Currency trading has suffered by a similar image since heretofore investing in commodities or currencies was intimidating to the average investor and carried with it the stigma of a poor image. Yet intuitively most investors know there's money to be made when dealing in both areas. The problem has been how to do it easily and minimize the perceived risks.

Previously to trade either market one needed to trade commodities directly or in some commodity or futures pool or fund. These funds were operated by Commodity Trading Advisors [CTAs] and Commodity Pool Operators [CPOs]. Having been one myself, there are some serious negatives that investors needed to overcome. First were high fees associated with the funds that may have run more than 5 percent and included high fees charged by CTA advisors to the fund, plus a fixed percentage of 1 percent to 3 percent plus incentive fees from 15 to 25 percent of net profits. Further, many funds would allow you in or out only once per month or even only quarterly. Second, with these funds heavy leverage is often employed amounting to perhaps 5 to 10 times the equity. Unlike with the Ultra issues from ProShares and Rydex where only two times the index was used, with CPOs extreme leverage can bring utter failure and fund closure.

So high costs, a lack of liquidity, and heavy use of leverage turned average investors off.

The positive benefits however are dominated primarily by the benefit of adding true uncorrelated portfolio diversification, which actually reduces risk. The authoritative academic study issued in 1983 by Harvard professor John Lintner which outlined the benefits of adding managed futures assets [also known as "alternative investments,'' which include both commodities and currencies] to average investment portfolios. The study concluded that by adding this asset class to a conventional portfolio showed that the return/risk ratio of a portfolio of managed futures funds is higher than a well-diversified stock/bond portfolio. Come again? Well, most FAs and individual investors are taught to believe that just having a balanced stock and bond portfolio, for example, achieves diversification and reduces risk. This is not necessarily so since both markets can and do trend in the same direction. Further some pundits have advocated adding combinations of value and growth styles to achieve additional diversification. But if all these sectors are trending in the same direction you haven't accomplished any risk reduction but have just spread it around needlessly and in a costly manner.

Lintner's work proved that the asset class that added most risk reduction and better overall performance contained assets that were "uncorrelated" [moving in opposite directions generally]. The study went on to demonstrate instances when stocks and bonds suffered but managed futures performed well, given their ability to move short or long in these uncorrelated markets. In fact, it was noted that by allocating as much as 14 percent of assets to managed futures an equal percentage reduction of standard deviation [volatility] was achieved.

So enter ETFs based on both commodities and currency. This is exciting because it allows investors to conveniently add these issues to their portfolios without having to join expensive and complex CPOs or using any leverage. Now average investors can truly diversify their conventional portfolios using these products. Given the lack of leverage in the ETFs some of the benefits that Lintner noted may be lessened. But the emotional craziness often associated with futures and commodity trading has also been eliminated making it palatable for average investors. Some popular currency and commodity ETF products include:

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