With interest in commodities surging in recent years, it is not surprising that financial advisors are increasingly looking to the commodity sector as an important way to create well balanced portfolios for their clients. As part of a comprehensive investment strategy, investing in commodities not only mitigates risk, but allows for appreciation in value at a time when the global population is growing rapidly and the demand for some critical resources has the potential to grow exponentially.  No wonder that many advisors have come to the conclusion that exposure to commodities is essential.

Futures trading may be the most effective way to gain direct exposure to the commodity sector, but let's face it, most clients prefer and understand how to trade stocks, not futures, and only the most sophisticated of investors (including financial advisors) are capable of trading futures effectively without actually adding risk to a portfolio. Most advisors are seeking easy to understand--and easy to explain--investment vehicles through which they can gain direct commodities exposure for their clients. Exchange-traded products ("ETPs") offer just such a vehicle.

ETPs are experiencing tremendous growth, and for good reason. They generally are highly liquid, transparent, affordable instruments through which advisors and their clients can gain exposure to a variety of commodities for both diversification and "profit-generating" purposes. ETP fees are usually a fraction of those charged by mutual funds, and ETPs have price transparency throughout the trading day.

Types of ETPs

The ETP sector includes products structured as both exchange-traded notes ("ETNs") and exchange-traded funds ("ETFs"). ETNs are credit instruments dependent upon two variables: first, the creditworthiness of the issuer and, second, the price movement of an underlying benchmark. Many advisors feel the combined risks of both credit exposure to the issuer and price exposure to the underlying commodity make ETNs less attractive as core portfolio holdings than ETFs--which have little or no credit risk--segregated assets in custodial accounts and, in most cases, transparency of holdings.

ETFs can be securities-based or commodities-based. Securities-based ETFs provide indirect exposure to the commodity sector by investing in the securities of companies in the commodities business, rather than in the commodities themselves.

ETPs offering direct exposure to commodities generally hold either physical commodities or futures contracts. Precious metals ETFs can easily buy and store the underlying commodity, so they generally own the actual commodity. This results in a very accurate tracking of the "spot price" or the physically delivered price, of the commodity.

On the other hand, energy, agricultural, and industrial commodity ETPs must own futures contracts, since their underlying commodities take up a tremendous amount of space relative to their dollar value, are difficult to store, and generally have a limited storage life. These products are subject to the effects of "contango" and "backwardation" which means their performance is less likely to precisely track the spot price of their underlying commodity, but, short of entering the futures markets or trading the commodities themselves, these ETPs offer extremely effective exposure to asset classes critical to constructing a well-balanced portfolio.

Many recently launched ETPs directly address the issues of contango and backwardation; advisors and their clients would do well to research those best suiting their investment needs. In general, ETPs that concentrate their futures holdings in a single futures contract are best suited for short-term trading, and those ETPs with futures holdings that are more diversified across the futures curve - or specifically designed to mitigate the effects of contango or backwardation - are better suited for longer-term investing purposes. Both the websites of sponsors of ETPs, as well as many independent online sources, can provide advisors and their clients with the information they need to make an informed decision about which ETP best suits their investment goals.

Portfolio Diversification (Beta) and Absolute Returns (Alpha) using ETPs