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How to Invest in Commodities Sensibly

Stocks in this article: DJP UNG USO

For investors for whom the high cost of admission of index funds is daunting, there is the option of commodity exchange-traded funds. They include full-basket ETFs such as the iShares GSCI ETF (GSG), the iPath DJ-UBS commodity ETN (DJP) as well as commodity-specific ETFs such as United States Oil (USO) and the United States Natural Gas (UNG).

These funds offer immediate and easy access for retail investors, as they are traded and priced just like stocks. They are, however, uniformly horrible investments. The fund fees tend to be high. What's more, these funds are forced to use front-month commodity futures to correlate the fund's price to commodity prices. They're also forced to "roll" their futures positions every 30 days, a profit-robbing contrivance for shareholders. At best, commodity ETFs represent value for a just few days and are best used as a daytrading tool. Any long-term investment in these ETFs will vastly underperform the commodity basket's movement, whether up or down.

The final method for accessing commodity exposure is through managed futures funds -- like the doomed Peak Ridge and Amaranth funds. This is clearly the riskiest method for retail investors as you do not necessarily track the basket of commodity prices. You are, in fact, betting on a trader and his ability to outsmart a market, as with any other hedge fund. You do avoid the "roll premium" implied by most ETFs, but of course you also risk a possible "blow up" that wipes away all of your investment.

So what is the takeaway? If all three direct investment vehicles have unique handicaps, how should you invest?

My advice is to commit to stocks that are directly correlated to commodities. In commodities such as gold and copper you can invest in mining stocks, and in oil and natural gas you can invest in energy producers.

Unfortunately, there's no way to gain access to many of the soft commodities such as corn and coffee using this method.

Of course, the human element of greed will ensure that we continue to see commodity funds raising easy capital from investors looking to capture some outsized gains, and we'll continue to see some of them explode, taking all the investor money with them. That's how inviting this overheated commodity market looks right now.

At the time of publication, Dicker had no holdings in stocks and ETFs mentioned, but positions can change at any time.

Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks.

Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years.

Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals.

Dan obtained a bachelor of arts degree from the State University of New York at Stony Brook in 1982.

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