Secular Bull - Focused Investments

Since the very day of the 2000 SPX high through current, the Energy, Materials, Utilities, Consumer Staples, Industrial, Consumer Discretionary, Health Care, Financial, and Technology Select Sector SPDR Funds have had returns of 154%, 75%, 68%, 55%, 19%, 5%, 5%, -5%, and -67% respectively.

Not surprisingly the top-performing sectors can all attribute their successes to this commodities bull. XLE and XLB have had outstanding returns of 154% and 75%. Even XLU is an offshoot to the commodities bull and has returned 68% itself. Imagine how bad the SPX would be performing if it weren’t for commodities stocks! Regardless, with this success these first commodities-based ETFs became the launching pad for many more to come.

With the advent of commodities-based ETFs, it has never been easier to gain exposure to an asset class that throughout history seemed off limits for the average investor. Any stock trader now has the ability to diversify away from the major indexes and add commodities to his portfolio. And the classic ETF benefits apply.

Not only do ETFs offer trading flexibilities like any other stock, they are transparent and low-cost compared to the rival and fading mutual funds. ETFs also offer safety in numbers. Since many ETFs are benchmarked to an index of stocks, this alleviates individual company risks. This is especially important for conventional investors considering the inherently risky nature of commodities stocks.

The companies that do business anywhere in the commodities complex are not only slave to the price volatility of their underlying commodities, but geological, geopolitical, operational, and environmental risks among the many. Drilling and mining companies for example cannot choose just anywhere to perform their operations. These companies must go wherever in the world the natural resources reside. And innumerable factors can derail the profitable development and extraction of resources.

At Zeal we recognize that this has been an exceptionally difficult time to navigate the markets, especially in the volatile commodities arena. Yet our research still leads us to believe that commodities will remain the most promising and rewarding asset class for many more years.

And in these turbulent times we are finding that ETFs not only open up new and exciting investment strategies, but they offer a level of safety. There is no arguing that an individual company bears much more risk than a potpourri of companies that comprise an index or fund. This concept alone has made mutual funds, and now ETFs, more attractive to investors.

In our newsletters we’ve been using commodities ETFs to supplement our long-term, speculative, and leveraged trades in order to broaden our own horizons. And with the growing popularity of ETFs, even in the relatively small and unloved-by-mainstream commodities sector, we are finding that there is a growing number to choose from.

Therefore we must be more discerning in which ones we decide to trade. So in order to discover those that have a higher probability for success among their peers, I embarked on a mission to not only identify the total pool of commodities-based ETFs, but to uncover the best-of-the-best.

After sifting through the 700 or so ETFs in existence today, I found that there are over 80 that have particular focus on commodities. And most commodities ETFs are still relatively new. Three-quarters of them weren’t around before 2006 and over 20 had their inceptions just in the last year. But even in their youth, commodities ETFs already command over $60b in total assets.

Though this number seems quite large, nearly half resides in only four ETFs. GLD, XLE, OIH, and SLV are the four largest commodities-based ETFs. XLE and OIH are two of the oldest and are popular depots for investors (both institutional and individual) to park their capital in oil and gas exploration, production, equipment, and services stocks. GLD and SLV are of course the venerable gold and silver ETFs that invest in the physical metals.

And of these four ETFs, GLD commands the lion’s share of the assets. SPDR Gold Shares is not only the largest commodity ETF, it is one of the largest ETFs in the world. In fact its assets even recently exceeded those of the fabled NASDAQ 100 QQQQ’s! At Zeal we have written extensively about GLD, both publicly and in our newsletters, and this first-of-its-kind ETF has taken the markets by storm.

So while capital is indeed finding its way into these 80+ commodities ETFs, outside of the top four the rest are still relatively obscure in the grand scheme of the markets. With most of these ETFs not well known, next came the arduous task of learning about each one and deciding which of them were worthy of investment capital.

The first thing I did was categorize these commodities ETFs. The main categories I identified were oil and gas, metals and mining, basic materials, agriculture, alternate energy, and miscellaneous commodities. And within each of these categories there is a myriad of ETFs to choose from. In peeling apart the layers of each ETF the first thing investors should identify is what it is attempting to track.

ETFs invest their assets in stocks, bonds, futures, or derivatives with the goal of reflecting the returns of an underlying index, commodity, or investment strategy. As far as the commodities ETFs go, over three-quarters of them invest in stocks that are benchmarked to an underlying index with the rest investing directly in futures or derivatives that leverage an underlying index.

For the stock-based ETFs I took a close look at the indexes these funds were benchmarked to. Along with an even closer look at the individual stocks that heavily weight each index. Overall I tend to favor those ETFs that are heavily weighted in stocks with maximum commodities exposure and leverage.

Next I consider the primary exchanges where these stocks reside and what their index exposure is. I do this because many of the large commodities stocks, in the US in particular, are colored by their index memberships. They tend to have high correlations to the performances of the general markets.

Interestingly most of the big commodities stocks have a lot of exposure to institutional buying and selling, which can get them caught up in cyclical downtrends. These stocks should outperform their peers on the major indexes on balance through the course of the commodities bull, but when the markets sell off, commodities stocks that reside on say the S&P 500 index will sell off regardless of their stellar fundamentals. If index funds need capital for redemptions they sell across the board so their funds can stay balanced.

Take the oil and gas ETFs for example. Many of these ETFs are heavily weighted in the big guns of this industry. And these behemoths happen to be heavily weighted in the S&P 500. Well when the markets are rising stocks such as XOM, COP, and CVX do perform well. But when the markets are falling these stocks are indiscriminately sold off with the rest of the constituents in the major indexes.

To take this example even further, energy ETFs XLE, IYE, IXC, and VDE all have very heavy weightings in XOM. But while this Dow 30 component and heavily-weighted S&P 500 stock is the biggest and baddest oil company in the world, its size actually works against it. So far in 2008 XOM is down 17% compared to an S&P 500 loss of 20%. It has been more of an S&P 500 proxy than an oil proxy! So with these four ETFs weighting XOM at 18.8%, 25.3%, 16.4%, and 19.4% of their holdings respectively, it is no wonder they have been underperformers.

This major-index-weighting analysis works for any category of stock-based ETF. And because of this major-index influence on the large commodities stocks, I tend to favor those ETFs that have higher weightings in mid- and small-cap stocks as well as those with more international exposure. Anecdotally we can see this play out in raw performance numbers.

For example in the basic materials category DBN and MXI have particular focus on indexes that heavily weight their holdings in stocks that have primary or sole listings on foreign stock exchanges. In 2007 these two ETFs outperformed XLB and IYM, the two largest basic materials ETFs. Ultimately these internationally-diversified ETFs reduce exposure to the growing stock bear in the US. Other countries are likely to endure bears of their own, but they may not be as severe.

In addition to stock-based ETFs, there are commodities ETFs that offer direct futures exposure. Stock volatility, especially on the commodities front, is giving the historically renowned volatility that comes with trading futures a run for its money. And many commodities-stock sectors are experiencing disconnects with the positive leverage they should have to the appreciation of their underlying commodities. So if investors want to steer clear of stocks and invest directly in commodities there are now several options in the ETF world.

Currently there are over 15 ETFs that directly invest their assets in commodities futures. Since these ETFs are not designed to take delivery of whatever commodity they hold, the custodians of these funds carefully manage the rolling of futures contracts so that the returns mirror the price movements of a specific commodity or basket of commodities.

It is simply incredible that ordinary stock traders can now participate in futures trading. With these avant-garde ETFs Joe stock trader now has the opportunity to speculate in an asset class that was for the longest time reserved only for the most sophisticated traders.

Also new and exciting to the ETF realm are the leveraged products. ProShares offers a suite of “ultra” ETFs that are growing very popular among stock traders. And the commodities-based “ultra” ETFs have become a speculator’s best friend.

Via a combination of futures contracts, options on futures contracts, swap agreements, forward contracts, and equity and index options, these leveraged ETFs give traders the ability to attain short, double-short, and double-long positions on commodities stock indexes without having to sell short, use margin, or worry about options expirations. Interestingly there is even a suite of 3x leveraged ETFs that have prospectuses filed with the SEC. Talk about leverage!

Today these last two ETF features, futures and leverage, have been taken to a whole new level by a new breed of investment vehicle, ETNs. And exchange-traded notes are radically revolutionizing stock trading. On top of the 80+ commodities-based ETFs, there are over 60 commodities ETNs available to traders.

While ETNs do have some similarities to ETFs, there are vast differences. And the biggest difference lies in the name. When you buy an ETN, you are purchasing a ‘note’, or debt, from the underwriting institution. ETNs are in effect senior, unsecured, unrated, unsubordinated debt securities that have a maturity date and are backed solely by the creditworthiness of the issuing bank.

Whereas ETFs invest their assets in actual stocks, bonds, and futures, ETNs are debt notes that don’t own any underlying assets. They are tracking vehicles. ETNs are designed to simply mirror the performances of their given benchmarks or strategies. In effect you are loaning money to a bank in return for its promise to pay you back with returns reflecting the underlying performance of a given investment strategy.

In addition to the credit risk that ETNs hold, these vehicles are still so new to the markets that there are also liquidity risks that must be considered. The very first commodities ETNs hit the markets just over two years ago, with the lion’s share coming onto the scene just within the last year. Therefore many of their market capitalizations and trading volumes are low.

So considering these risks, my rule of thumb for throwing capital at an ETN is uniqueness compared to ETFs. I am only interested in an ETN if there is not an ETF of like kind. And there are plenty of innovative ETNs out there that provide legions of opportunities for stock traders.

Even though ETNs are so fresh and new, there are a myriad of commodities-flavored notes that until recently only futures traders could claim exposure to. These ETNs range from individual commodities exposure to the likes of nickel, platinum, and cotton, to baskets of commodities that span the softs and/or hards. But the most intriguing commodities ETNs are those that employ leverage.

Whereas leveraged ETFs use such vehicles as swaps to offer double-short or -long exposure to a stock index, leveraged ETNs offer direct short, double-short, and double-long exposure to the price movements of the actual raw commodities. If you are looking for leverage on the long or short side of say gold or grains, there are 2x leveraged ETNs that utilize these strategies.

ETNs, as well as ETFs, also allow investors to hedge long or short positions they may have in almost any given commodities sector. For instance, if an investor is heavily long oil as a core strategic position, he can hedge his bet and reduce his risk by acquiring a position in a short or double-short oil ETN. This way if oil corrects, or crashes, the gains from his alternate short ETN position will hedge the losses on his longs.

Overall commodities-based ETFs and ETNs have been a huge boon to the commodities markets. Investors who might not have shifted capital directly into commodities or the stocks of the companies that are leveraged to this sector now have a plethora of options to participate in these bulls from their stock trading accounts.

Ultimately in my quest to identify the best commodities-based ETFs and ETNs, I was astonished to find that there is a universe of nearly 150 in existence today. These innovative and still relatively new investment vehicles are indeed taking the markets by storm. And the flow of capital is finding its way into these vehicles with nearly $75b of collective assets.

As for my research, once I established the universe of commodities ETFs and ETNs I took an in-depth look at each of them and uncovered what I believe are those with the highest potential in their respective sub-sectors. At Zeal we perform such research not only to gain knowledge for ourselves, but to pass it on to our newsletter subscribers and use it to foment new and exciting trading ideas.

In the process of working on a project like this we package our research into a report format that profiles our favorite commodities ETFs and ETNs. This just-published research report is 30 pages of action-packed information that is designed to help stock traders of all levels of experience to better navigate the exciting commodities markets. To have this report with the profiles of our favorite 57 commodities ETFs and ETNs at your finger tips, please purchase it today!

And today might be as good of time as any to redeploy or establish a strategic position in commodities. We’ve just weathered the sixth and largest correction of this entire commodities bull. And if we are at the bottom of this correction like we think we are, then now could be one of the greatest buying opportunities of this bull. With fear percolating through the markets like it is today, there are bargains to be had.

The bottom line is commodities ETFs and ETNs broaden the opportunities for stock traders to invest and/or speculate in the great commodities bull of the 21st century. These innovative investment vehicles offer a wide array of strategies. With the same ease as trading any stock, traders can use commodities ETFs/ETNs to mirror the performances of stock sectors, stock sub-sectors, individual commodities, and baskets of commodities. And the leveraged products offer unique speculative opportunities.

Now there is still an important place for individual stock picking for those investors and speculators willing to do the necessary research and analysis. But considering market volatility these days, ETFs and ETNs serve the needs of experienced traders looking for new and innovative investment strategies as well as new traders looking to venture into the commodities arena.

Scott Wright

October 3, 2008

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com . Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!