Uncorrelated Commodity ETFs Offer Downside Cushion

The impact of triple-digit crude doesn't bode well for many investors, especially those that pull up to the pump every day. Some, though, have found a silver lining in the recent spike. A new breed of investor is buying exchange-traded funds that track crude's price movements or ones that own the firms that actually get it out of the ground and sell it at the corner filling station. These ETFs have been gushers for their owners. The United States Oil ETF (USO), a fund that buys oil futures, is up 63% in the past year.

In the past, the typical investor had little choice but to play a particular commodity by purchasing the shares of a major name in a given niche. Exxon Mobil (XOM), for example, would have served as a proxy for the energy business. The ETF industry has taken that idea one step further by launching funds that give shareholders purer exposure to everything from agricultural crops and precious metals to livestock and, of course, oil. Although these funds are relatively new — most have been around for less than two years — they have quickly garnered a following. Over $30 billion sit in their coffers. (Most of it is in gold funds like StreetTracks Gold Shares (GLD).)

One of the reasons these funds have attracted so much cash is that they are what's called an "uncorrelated asset." Commodities tend to do well during inflationary times or when the stock market is tanking. Company share prices may be falling. However, they still need to make products and consumers still need to buy them. So as product prices are rising the smart play is to buy the raw materials that go into making them. Think about it this way: You'll be paying more at the supermarket checkout line but at least your retirement account will be gaining some ground. "This asset class will provide you returns that come at different times than the rest of your portfolio," says Stephen Barnes, of Barnes Investment Advisory in Phoenix.

Adds David Fry, founding editor of the online publication ETF Digest: "Sometimes it's better to own oil instead of oil stocks. When the market goes down the selling can be indiscriminate. Just own the commodity and don't worry about the complexities of having to own the stock."

Another catalyst — perhaps a more important one — is that the world is in the midst of a commodity bull market. Countries like China and India are using millions of tons of industrial metals to build out their road systems, bridges and skyscrapers. Meanwhile, the biofuel craze and burgeoning middle classes around the globe that can afford better-quality food have reduced inventories of wheat and corn to some of their lowest levels in years. Indeed, wheat recently hit an all-time high and other commodities are trading well above their 2007 levels. As prices have escalated, ETFs have benefited. The PowerShares DB Agriculture ETF (DBA), which invests in corn, sugar, wheat and soybeans, is up 53% in the past year.

"It's elementary supply and demand," says Tom Lydon, editor of ETF Trends, an online newsletter that covers the industry. "A lot of it is coming from emerging markets. They have better qualities of life so they can afford to eat better."

Of course, bull markets always come to an end. The problem is that no one expert can predict when that will happen. And commodities are extremely volatile. An accident at a factory, terrorism, geopolitical upheaval and Mother Nature can each wreak their own havoc on the marketplace. You will need to keep a close eye on these investments. "You don't want to get caught up in the buying once it's already run," says Lydon.

Some advisors we talked to are using commodities as a long-term hedge against downturns. Those positions constitute 5% of a well-diversified portfolio. Others, though, were thinking in the short term. They were using small, aggressive bets on narrow parts of the market to get extra returns. Not sure which camp you fit in? Lydon gave us a few tips both types of investors can use. If an ETF decreases 8% or drops below its 200-day moving average, then it's time to re-evaluate. Don't forget you can use stop-loss orders, too.