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Commodity ETFs Surge in Popularity

Correlation Risks Might Not Be What They Seem


NEW YORK - Investors and money managers looking to diversify their portfolios by getting into commodities and commodity exchange-traded funds should keep in mind the volatile nature of these products, as well as the wide range of possible risks, experts say.

"The only way to make money on commodities is to buy and sell them," said Victor Sperandeo, president and CEO of Alpha Financial Technologies, at the Inside Commodities Conference held earlier this month at the New York Stock Exchange, hosted by IndexUniverse.

A common challenge for investors is that they get too emotionally attached to their investments and stay with them for too long, said the longtime trader, known as "Trader Vic."

"Commodity investors need to have an unemotional attachment," he said.

Experts say the ability of ETFs to trade throughout the day makes them better suited for the volatile nature of commodities than the buy-and-hold strategy favored by many investors.

"A lot of my clients are pushing me to get into commodities," said Matt McCall, founder and president of the Penn Financial Group. "We're going to see a long-term bull market for commodities."

McCall said ETFs have opened a whole new avenue of trading. "I believe inflation will be a concern, and I want to be ahead of the curve," he said.

Commodity exchange-traded products have exploded in popularity since their introduction in 2006, with more than 800 such products now floating around the marketplace. Some are based on actual, physical commodities, while others are invested in commodity producers and companies involved in the commodity business.

"Commodity ETFs have a lot of different packaging methods," said Lisa Dallmer, executive vice president of global index services and exchange-traded products at NYSE Euronext.

Companies that are in natural resources operations, like gold miners, have incredibly tight correlations to other resources sectors and may also have a lot of risks unrelated to the physical commodities they pull out of the ground, she said.

"While being partially driven by the underlying commodities, such companies are, in fact, operating companies and not purely commodity-based companies," Dallmer said. "As a result, they are exposed to a number of different additional risks that potential investors should be aware of when determining their investment allocations."

These include operating risks, such as the exposure to costs like exploration, extraction, shipping and storage; foreign exchange risks to currencies associated with various regions; management risks from a company's board of directors; and the risk that many mineral-rich countries may nationalize their resources.

Exchange-traded products, which package exposure to physical commodities into equity share holder stakes, also have different fees, margin requirements, tax treatments and counterparty risks than futures, Dallmer said.

Commodity advocates stress that their products are uncorrelated with stock market activity and can provide additional diversity, but opponents argue that commodities are just as correlated with the regular economy.

"Correlations among asset classes are off the charts," said John Brynjolfsson, managing director and chief investment officer at Armored Wolf, LLC. "Inflation expectations are accelerating, and this makes holding cash less attractive. Commodities tend to lead inflation and are the canary in the coal mine."

As the economy drops, manufacturing slumps and the demand for commodities drops. Hedge funds, institutional investors and other speculators may be forced to sell their commodities to make up for losses in equities, bringing commodity prices down as well.

In today's global economy, the age-old economic model of supply and demand doesn't always make sense. Mineral-rich countries can upset the global equilibrium with a sudden influx or removal of a necessary commodity.

"The global recession was triggered by $145-a-barrel oil," said Nouriel Roubini, chairman and co-founder of RGE Monitor. "This was the tipping point; $145 oil was a massive shock for the U.S., Japan and India. Oil and energy prices are destructive to global growth, especially when they are not based on fundamentals."

Roubini said the demand for oil is still down at 2005 levels, though in the last year and a half, the price has gone from $70 a barrel to $145 to $30 to $80.

"These swings in volatility are extremely destabilizing to the real economy," he said.

Some economists think the price of oil accurately reflects the demand.

"China is demanding more oil today that ever," said David Greely, vice president and senior economist at Goldman Sachs. "The leading edge of the recovery has been China and the emerging markets. The global supply of commodities is underdeveloped. As the economy recovers, we will be putting strains on commodities."

Of all the commodities to choose from, perhaps no other is as intrinsically bound to the human emotions of fear and greed as gold. As of press time, gold was climbing towards $1,200 an ounce, continuing to break record levels.