How to Invest in Commodities, Carefully

All through the year, commodity prices have been rising: Copper has soared 24.5% since 2010 began, while gold is up 23%. Wheat, corn and oil also have continued to climb. Unsurprisingly, that growth has attracted many investors. Is this a good time for small investors, too, to put some money in commodities?

Adrian Day, a financial adviser who has just published a book about commodities called Investing in Resources, cautions small investors that commodities are incredibly volatile. "Trying to play commodities in the short term is a recipe for disaster," he says. Commodity prices have already climbed so high in the last couple of months that he has become a "little bit cautious," he adds.

But Day remains bullish about using long-term commodities investments to diversify portfolios, even for the little guy. After all, some good fundamentals are behind the commodities' growth, including the continuing strength of the Chinese economy -- which has created huge demand for many commodities -- and signs that the U.S. starting to improve. "With many metals, they're unable to increase production, and the price is just continuing to go up" as demand increases, Day says.

First Steps

How can small investors best tap into this trend? There are myriad ways to invest in commodities, of course, such as via futures and options offered by CME Group. But those types of commodities futures and options require sophisticated knowledge and can be very risky for a novice investor, Day warns.

Instead, he recommends that small investors start with stocks of commodity-producing companies and exchange-traded funds and notes.

For investors who are either just starting out or who have between $5,000 and $10,000 to invest, Day recommends a mutual fund that covers a broad range of commodities. The Global Resources Fund (PSPFX), for example, currently has 33% of its assets in oil exploration stocks and 14% in gold mining. The Pimco Commodity Real Return Strategy (PCRAX) is another broadly diversified fund.

For those with more money to invest, Day suggests focusing on individual sectors. He particularly likes Freeport-McMoRan (FCX), a mining stock that closely tracks the price of copper, which has grown more than 20% this year. China's booming economy has created huge demand for the metal, and supplies are stretched, Day says. Freepport-McMoRan, the largest publicly traded copper company, pays a 2% dividend.

The Gold Standard

Day is also a big fan of gold, even though it's at a decade high. While not in demand in China, gold is attractive because it offers insurance against an economic downturn. "I think you want to pick the most defensive companies you can find, that either buy gold itself, or one of the royalty companies," Day says.

A note of caution: Gold buyers are subject to a collectibles tax of 28% on long-term capital gains, which is considerably higher than the 15% capital gains on stocks.

That discrepancy is one reason Day favors so-called "royalty stocks" like Franco Nevada (FNNVF) and Royal Gold (RGLD), which primarily focus on gold and precious metals. They're called royalty stocks because the companies don't actually mine the minerals, but instead purchase a royalty for another company's mine. These companies have no operational risk and consequently yield very high profit margins.

Royalty stocks offer the same long-term capital-gains benefits as any other stocks. But before buying, investors should ask their accountants whether companies such as Canadian-based Franco Nevada have been declared a passive foreign investment company for tax purposes.

Commodity ETFs Can Get Tricky

Overall, the easiest way to buy gold is to purchase shares of SPDR Gold Shares (GLD), which is the largest of many gold ETFs now on the market. ETFs, and exchange-traded notes (ETNs), which are debt securities linked to a market index. They're now available for virtually every conceivable commodity -- and they rank among the best-performing shares of the year. The iPath Dow Jones-UBS Cotton ETN (BAL) is up 121% this year, for example.

But Day advises caution about commodity ETFs that don't physically own the commodity. (GLD buys gold bullion and keeps it in a vault.)

Most commodity ETFs, Day notes, invest in commodity futures, which experience a phenomenon called contango -- the difference between the future price and the spot price when the future price is higher. (When the future price is lower than the spot price, it's called backwardation.) Many ETFs roll over their futures every three months, so if the futures price is higher each time, it could be a sizable drag on returns, he says.

Just What's in That ETF?

Investors also should be wary of leveraged ETFs, which borrow money in order to increase returns. That leveraging has kept one oil ETF down 11% this year, in spite of a 4% rise in crude prices. If an ETF loses heavily just after making its initial investment, the leverage reduces the investment's value far more than the commodity price, so that a gain of equal size doesn't bring the fund back to even ground.

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Another reason for concern is that, in some cases, it's not always clear what's in a commodities ETF. The PowerShares Agricultural Fund (DBA) is intended to track the Deutsche Bank Liquid Commodity Index-Optimum Yield Agricultural Excess Return Index, but it's almost impossible to find out what investments that index includes at any given time, Day says. "When I buy something, I like to know what it owns." That transparency is something investors should scout out before they buy.

Amid all that advice, here's the moral of this story for small investors: Buy stocks of commodities companies first and then clean, simple ETFs that own a basic, physical commodity like gold or oil. When you start to add leverage or dabble in futures, things start getting tricky very quickly.