As you know from the gas pump, the grocery store and the headlines, commodity prices are on the rise. The price of crude oil is flirting with $100 a barrel, gold has breached $900 an ounce for the first time, and corn, soybeans and wheat are heading for the sky.

Yes, commodities are a volatile asset class. But we at Kiplinger's Personal Finance think some should be in your portfolio -- maybe 5% of your total -- using exchange-traded funds and notes.

Why? A weak dollar, rising inflation and lax monetary policy in the U.S. encourage many investors to view gold and other hard assets as a more secure store of value than U.S. dollar-denominated assets.

Meanwhile, booming demand for energy and industrial metals in emerging markets such as China -- autos sales in China jumped 22% in 2007 to 8.8 million vehicles -- has not been accompanied by a corresponding increase in supply. Result: Prices for commodities such as petroleum have risen dramtically because it takes a long time to increase production.

Commodities, however, are one of the few investments whose movements are negatively correlated with stocks and bonds -- and positively correlated with inflation, according to research by Ibbotson Associates.

This means that when returns from stocks and bonds decrease, commodity returns increase. In isolation, commodities are volatile, but as part of a diversified portfolio they reduce risk and enhance performance, according to Ibbotson.

Purchasing stocks of commodity producers, such as ExxonMobil and Archer Daniels Midland, is one way to invest in natural resources. But over the long run, shares in commodity companies tend to track movements in the stock market, not commodity markets.

A better way to achieve diversification is to invest in commodity futures themselves, which is relatively easily achieved these days through exchange-traded funds or notes, which trade on stock exchanges just like stocks.

Here are three ETFs and ETNs that are designed to track major agriculture indices. There are a few reasons we particularly like agriculture, beside the fact that energy and gold have already had an enormous run-up in price (for more on investing in gold, see Time to Buy Gold?).

Demand for meat, dairy and animal feed grains made from corn and soybeans is rising in populous developing countries, such as China and India, as a result of improving diets and rising incomes there. Plus, the U.S. government has mandated the use of ethanol, made from corn, in autos. Europe similarly mandates increasing use of biofuels, made principally from vegetable oils, and Brazil is a gigantic consumer of its own sugar crop for ethanol.

If you add this huge new source of demand for food crops from the energy industry to the demand for food from emerging markets, you have a bright picture for agricultural commodity prices.

PowerShares DB Agriculture (symbol DBA) is designed to track the Deutsche Bank Liquid Commodity Index. This ETF is split nearly equally among corn, soybeans, wheat and sugar futures.

An even broader fund is Elements Rogers International Commodity Agriculture (RJA), an ETN based on an agricultural commodity index devised by famed commodities investor Jim Rogers. This fund holds futures contracts in 20 commodities, including cotton and coffee, which are consumed worldwide.

If you prefer a narrower focus on the grain trade, iPath Dow Jones-AIG Grains (JJG) is an ETN that tracks soybeans, wheat and corn.

All three of these funds levy a 0.75% annual fee. Because the IRS policy on taxation of ETNs appears to be in flux, you're probably better off holding these instruments in tax-deferred accounts. The IRS eliminated the tax advantages of currency ETNs December 7 and may do so with other ETNs.

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POSTED BY: Renee (January 23, 2008 12:13 PM)
Which is the safest commodity fund?

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