The Hottest Commodity on Earth

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For years, investors who've gotten tired of losing tons of money in the stock market have looked to commodities to try to preserve and grow their capital. Providers of exchange-traded funds were more than happy to grab on to this trend, providing new ways to buy into the commodity craze.

But past attempts to tailor ETFs to capture commodity profits have often met with utter failure. Now, a new ETF seeks to avoid all the problems that its predecessors have faced -- but it will soon meet plenty of competition as other ETF providers race to get into what is turning into the next gold rush among commodity investments.

The other yellow metal
Investors seeking safe havens amid falling stock markets have often looked to gold, especially over the past 10 years as the yellow metal has seen its price move from less than $300 per ounce to as high as $1,900. But more recently, commodity investors have turned to copper as a way to play a combination of favorable macroeconomic trends, ranging from investor demand for real tangible assets to the continuing infrastructure buildout in emerging-market countries around the world. Moreover, with labor problems facing major producers including Freeport-McMoRan Copper & Gold (NYS: FCX) and Southern Copper (NYS: SCCO) , supply constraints have also played a role in keeping prices relatively high. Other miners, including Taseko Mines (ASE: TGB) and Ivanhoe Mines (NYS: IVN) , also have taken advantage of high copper prices to boost production and development activity.

But in the stock market rout back in August and September, that rosy outlook got a little less clear. Copper prices collapsed by about 30%, and many copper miners suffered even worse drops. With Chinese growth called into question and the troubles in Europe supporting gains in the U.S. dollar, which typically hurts commodity prices, the bull case for copper looked much less certain. Since then, prices have gained somewhat but are still well off their highs.

Gimme an E! Gimme a T! Gimme an F!
With this backdrop, the ETF company United States Commodity Funds rolled out its United States Copper Fund (CPER) last week. Rather than investing in mining companies that produce copper, the ETF holds direct positions in copper futures contracts.

At first glance, this seems like a very efficient way to get copper exposure. The problem, though, is that past ETFs from this provider, including United States Natural Gas (NYS: UNG) and United States Oil (NYS: USO) , have run into a huge problem stemming from a peculiarity in the pricing of futures contracts, known as contango. In a nutshell, because future-month futures contracts had higher prices than current-month contracts, these ETFs consistently suffered minor losses every month when they rolled their positions forward before contracts expired. In the oil ETF, the phenomenon turned big gains for oil into much less lucrative gains for the ETF. In natural gas, the effect was even worse, as the ETF lost the vast majority of its value despite gas prices not falling nearly as dramatically.

A new solution?
The new copper ETF seeks to avoid this problem by providing rules that help fund managers pick the best futures contracts for efficient copper exposure. Again, in simplest terms, the formula results in the ETF picking the futures contracts that will produce the smallest losses in unfavorable markets while maximizing gains when markets are more favorable.

Whether and how well the strategy will work remains to be seen. But after several years of commodity ETFs basically ignoring the problem entirely, it's encouraging to see ETF providers taking steps to protect their investors from the vagaries of the futures markets.

The simplest of all
Expect to see more ETFs join the ranks of copper investments in the near future. Both iShares and JPMorgan (NYS: JPM) plan to release products that will actually own physical copper. By avoiding the futures markets entirely, these funds hope to grab the same success that metal-backed gold and silver ETFs have enjoyed for years -- although with the sheer mass of metal involved, storage costs will be far more onerous than with precious metals.

For investors, the best way to own copper may well still be through mining companies. With the potential to earn dividends as well as capital gains from higher copper prices, miners give you chances to make the most from copper's rise. That's a combination that's as good as gold.

The right combination of ETFs can give you a winning portfolio. Be sure to check out The Motley Fool's free special report on ETFs and get yourself the funds you need to succeed.

At the time this article was published Fool contributor Dan Caplinger likes shiny things. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy polishes up your portfolio real nice.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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