Keep a Toe in Commodities Despite Pullback

When it became apparent that Hurricane Gustav came and went without causing major damage to the energy platforms in the Gulf of Mexico, traders came back from the long Labor Day weekend and proceeded to sell off their positions in crude oil and natural gas. Indeed, the price for a barrel of black gold has fallen almost $8 the last three trading sessions to settle at around the $108 level; natural gas has pulled back almost 20%. The prices appear to be going lower, too.

Commodities investors have always had to endure roller-coaster rides when Mother Nature decides to send a storm or two roaring into the Gulf. But there is another plot line brewing behind these recent selloffs. After enjoying a record run-up in commodities prices earlier this year traders are beginning to fret that a strengthening dollar, tighter credit and a global economic slowdown could impact demand. It's one thing to see the price of a commodity pop or drop every time a storm rumbles through. A global slowdown, though, is something much more serious for investors to consider.

Commodities have always had the distinction of being an investment that was out of reach of most retail clients. That has changed the last several years as specialized exchange-traded funds have enabled a whole new generation of investors and their financial advisors to include every type of commodity in a portfolio, from oil and natural gas to wheat, soybeans and corn. And by all accounts, those positions paid off as the funds rose in value. Now, though, they are coming back down and that same group is wondering whether the good times are over or whether this is just a minor dip.

That predicament is the classic investing conundrum. And to make an intelligent decision means investors need to do homework. There are two themes that have been influencing the prices of all kinds of commodities: New emerging middle classes around the globe, and rising energy demand that is outpacing production. There is no denying the dramatic growth in places like China and India. The considerable populations in these two countries can afford to eat healthier diets, buy more expensive gadgets and drive around in fancier cars. Meanwhile, the governments are building all kinds of infrastructure, including power plants, roads and bridges. These themes will play out not over the next few years but over the next few decades.

Meanwhile, investors have to weigh whether they can take the swings that come with shorter-term impacts. Both China and India are dealing with escalating inflation. China's GDP growth rate, which hovered between 10% and 11% for much of the last decade, should slow to around 9% this year. That's still a healthy clip but a downturn from what most people expect from a country with 1.3 billion people. And it appears Europe is in the midst of enduring the same credit and housing crises that has wreaked havoc on the U.S. market the last 15 months. Of course, there are also wildcards to consider, like OPEC and, of course, another storm.

Advisors like James Shelton, chief investment office of Kanaly Trust, an investment management company in Houston that oversees $2 billion, have already made up their minds about the direction of the market. A few months ago he pared back his commodities positions. What gave him pause was the dramatic increase in prices that occurred across the board. "We got a bit concerned about the run-up in prices," said Shelton. Now all that's left is a small gold investment. It seems that many advisors are following suit. They aren't completely bailing on commodities. But they are making tactical moves to take some money off the table in anticipation of some kind of correction in prices.

Shelton is constantly looking for a way back in, especially because he likes the inflation hedge commodities provide. He suggests that if other investors are thinking of following suit they would be smart to buy a diverse basket of commodities. We agree -- at least for a few percentage points of an overall portfolio.

There are several ways to get commodities exposure. We like the idea of pulling not only from energy, but precious metals and agriculture, too. Some of the most popular energy ETFs come from the United States fund family, home to United States Oil (USO), United States Natural Gas (UNG), United States Gasoline (UGA) and United States Heating Oil (UHN). These funds track the percentage price increase of their respective underlying commodities. PowerShares is in this space with its DB Oil ETF (DBO). Be warned, though, these funds are favorites of sophisticated investors. You will be playing alongside the big boys.

PowerShares also offers an agricultural ETF, PowerShares DB Agriculture (DBA), that tracks futures contracts on corn, soybeans, wheat and sugar. The iPath family of exchange-traded notes, or ETNs, a sister lineup to the iShares ETFs, has funds that track cocoa (NIB), coffee (JO), cotton (BAL) and sugar (SGG), to name just a few. Of course, more so than energy these funds rise and fall on the weather forecast. So keeping an eye on Mother Nature and crop yields is imperative.

Another approach is to go broad. The iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP) is one of the most diversified commodities funds on the market. It has weightings in 19 commodities including oil, natural gas, soybeans, copper, cattle, sugar, hogs and cotton. The iPath S&P GSCI Total Return (GSP) is similarly diversified.

Holding a basket of commodities might insulate your portfolio a bit from any downturn in one of the bunch. Shelton, though, thinks there is a back-door approach that may be smarter, at least until the global economic picture becomes clearer. Instead of owning commodities directly, Shelton is looking to invest in the companies that get them out of the ground. "The picks and shovels," says Shelton.

For example, the SPDR S&P Oil & Gas Equipment & Services ETF (XES) tracks an index of companies like Schlumberger (SLB), an oilfield services provider, and Transocean (RIG), an offshore drilling contractor. The Market Vectors Gold Miners (GDX) owns 31 companies that mine the precious metal. Market Vectors also has a brand-new fund, called Hard Assets Producers (HAP), that tracks a diversified index of 321 companies. It was designed with the help of noted commodities guru Jim Rogers. The index spans a wide range of commodities players, from the usual (oil and gold) to the less common (solar and wind).

Individual investors need to take a hard look at maintaining at least some exposure to commodities, even as the years-long boom shows signs of fatigue. Long-term fundamentals favor demand for commodities, though short-term trends certainly give reason to worry. With inflation putting a damper on the economy and stock market, one of the best places to be is in one of the few sectors that can actually benefit from rising prices. Commodities ETFs make it easy to pick your spots.