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How to hop on the commodities train

From specialized funds to managed futures, there are plenty of ways to invest. But hold on tight.

Most investors have undoubtedly noted that commodity stocks have been the place to be the past few years. Lucky are those who jumped on what was then a slow-moving freight train at the bottom of the commodity cycle around 2001 and then hung on when the pace of that train sped up dramatically.

But stocks aren't the only way to play what some are sure is a commodity supercycle. There are alternatives, some more esoteric than others. They range from mutual funds through specialized funds, exchange-traded funds and managed futures all the way to holdings of the actual commodities themselves.

Some are suitable for the average investor; some may not be. When looking for a way to play the rally in commodities, most investors, seeking something beyond commodity stocks, will likely turn to tried and true specialty mutual funds or an ETF.

Patricia Lovett-Reid, senior vice-president of TD Waterhouse Canada Inc., says, "I think probably the easiest way for most retail investors to have exposure [to commodities] would be through sector mutual funds" like an energy fund, a resource fund or a base metal fund.

That way, an investor gets the benefit of professional management and the convenience as well as the diversification that buying a few stocks wouldn't provide.

The Altamira Resource Fund, for example, has been around since 1989 and since then has produced an average annual return of 12.49 per cent.

Some others have been around for shorter periods. The Sentry Canadian Resource Fund was launched in March, 2000, and has since posted an average annual return of 29.7 per cent.

But there can be a downside to specialty mutual funds -- namely, their high management expense ratio, Ms. Lovett-Reid notes. With sector funds, the MER can be north of 2.5 per cent, she says.

Ms. Lovett-Reid says her preferred route to play the commodity cycle would probably be exchange traded funds. Their MER is much lower than that on a specialty mutual fund and they can be purchased in real time at any point in the trading day.

There are 22 ETFs listed on the Toronto Stock Exchange. They accounted for less than 1 per cent of the TSX's total volume last year. The TSX was a pioneer in the ETF field, having introduced its first ETF in 1990.

Among them are four whose fortunes are tied to commodities -- the iUnits S&P/TSX capped energy index fund, the iUnits S&P/TSX capped gold index fund, iUnits Materials Sector Index Fund and iShares COMEX gold trust.

Given the rise in energy prices -- with oil topping $70 (U.S.) a barrel last fall -- the energy i-units that trade under the symbol XEG have been a hot number.

They climbed from $50.27 at the end of 2004 to a high close of $93.25 on Feb. 6 of this year and then dropped back, closing recently at $87.56.

It's clear that the price of the i-units doesn't necessarily track movement in the underlying commodity price.

The gold i-units have also done well, rising from $51.80 a unit at the end of 2004 to a high of $74.70 at the end of January. They too have since retreated, ending at $69.09.

There are non-Canadian ETFs as well. Ms. Lovett-Reid cites the MSCI iShares of non-Japan Asia "as a great way to participate in a really cost-effective" but indirect way to gain exposure to commodities. The attraction there is that much of the demand that is fuelling the rise in commodity prices is coming from China and India.

Income trusts are another route to play the commodities. They have become a staple of many investors' portfolios, especially those seeking income.

By turning themselves into an income trust, corporations can distribute profit to investors without having to pay income tax or paying little tax at the corporate level. But choose carefully: A weak trust may, for example, lower distributions (which also affects its unit price) or it may even stop paying altogether.

So Ms. Lovett-Reid recommends investors stick with quality trusts.

Investors should also be aware that commodities are a cyclical play and so too are the trusts established in those areas, she notes.

There are alternative methods of playing commodity cycle. Investors can of course buy the physical gold or silver through their bank, a specialty bullion dealer or their broker. But that entails costs for safekeeping and storage.

There are a number of more exotic vehicles, derivatives, some of which can offer superior returns but also entail higher risk. Canadian Imperial Bank of Commerce offers a principal protected note that has a portfolio of seven equally weighted commodities: aluminum, oil, gold, natural gas, copper, nickel and zinc. The CIBC Commodity Growth Deposit Note, Series 1, is a short-term note with 3.5 years to maturity.

At maturity, the holder receives the principal invested plus variable interest. The latter is calculated by multiplying the principal times the weighted returns from the commodities. And if the total of the returns is not positive at maturity, no interest is paid. Minimum investment is $5,000.

Ms. Lovett-Reid says investors in such a product need to remember that they are not going to get the full upside of the underlying commodities because of the downside protection they are receiving. The price quoted to buy back the notes before maturity may be considerably less than par, she said.

Investors can also opt for managed futures, a rapidly growing form of investment.

Just the mention of futures will scare many investors. But in this case, the investment is made through a management team, not directly as conventional futures would be. Robert Dzisiak, president of Man Financial Canada, compares the managed futures, which his firm offers, to mutual funds in that they both have professional managers.

There is some disagreement over how suitable this product is for the average retail investor.

Mr. Dzisiak said the managed futures are for individuals who don't have the time, expertise or risk tolerance to invest in futures directly.

The futures have the added advantage that their performance tends to be negatively correlated with the stock market.

But Ms. Lovett-Reid isn't so sure. "As someone on the personal finance side . . . I don't think you should ever invest in anything you don't fully understand, and this is not only understanding the upside potential but understanding also the downside risk."

If the investors do understand the various options, she thinks that maybe 10 or 15 per cent of a $150,000 (Canadian) portfolio might be placed in alternative investments by aggressive investors. The minimum deposit for the Man Financial managed futures investment is $10,000 (U.S.).

Kelly Poncelet, account executive with the company, said the actual investment would vary with an investor's comfort level. A person with a $1-million portfolio may feel comfortable putting $50,000 or $100,000 in managed futures, whereas someone with a $100,000 portfolio might prefer to start with a $10,000 investment.

Man Financial Canada was formed when Man Financial Inc., a subsidiary of Man Group PLC, took over Refco Inc.'s regulated commodity futures business in the United States, Britain, Asia and Canada.

© The Globe and Mail

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