Commodities

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 are marketable items produced to satisfy wants or needs. Economic commodities comprise goods and services.

In terms of financial markets, commodities are raw materials that are traded on futures trading markets. Examples include oil, crops and precious metals.

The primary purposes of commodities futures trading are:
 * 1) Hedging - locking in future commodity prices by farmers, industry and other parties.
 * 2) Speculation - attempting to profit on commodity price movement by speculators.

In terms of individual portfolio management, there are also mutual funds and exchange-traded funds (ETFs) that attempt to track and capture future price appreciation of commodities.

Regulatory
The Commodity Futures Trading Commission (CFTC) is the federal government agency that regulates the commodity futures, commodity options, and swaps trading markets.

The Commission was established as an independent agency in 1974, assuming responsibilities that had previously belonged to the Department of Agriculture since the 1920s. The Commission historically has been charged by the CEA with regulatory authority over the commodity futures markets. These markets have existed since the 1860s, beginning with agricultural commodities such as wheat, corn, and cotton. Over time, these commodity futures markets, known as designated contract markets (DCMs) regulated by the Commission, have grown to include those for energy and metals commodities such as crude oil, heating oil, gasoline, copper, gold, and silver. The agency now also oversees DCMs for financial products such as interest rates, stock indexes, and foreign currency.

Risks
Direct trading of commodities via the futures markets tends to be very risky because commodity prices can be volatile. In addition leverage is typically used when speculating with financial futures. Direct trading in commodity futures is not ordinarily a part of an individual investor's portfolio.

Commodities investments via mutual funds and ETFs are comparatively safer and more appropriate for individual investors, but still come with material risks:
 * Commodities have significant price volatility and can have positive or negative multi-year periods of return, but over the very long term tend to have low or no real inflation adjusted return. By themselves their risk return relationship is not particularly attractive.
 * Commodity prices are often sensitive to economic cycles, and may experience price declines at the same time as stock/equity investments.
 * Commodities are traded via futures and do not exactly equal the current "spot" prices. Thus returns on commodity based funds may have material variances in returns vs. popular commodity price indices. The causes of this are "contango" and "backwardation". These result due to rollover of futures contracts because individual investors do not want to take delivery of the actual commodities.
 * Commodity funds tend to have higher expense ratios than comparable stock and bond funds.
 * Some commodity ETFs issue K-1 tax forms which can complicate and delay individuals annual tax return filings.

Role in a portfolio
Commodity spot prices, as an asset class, over the very long term, have not generated a significant real return. Commodity mutual funds and ETFs invest in futures contracts that derive excess returns over the risk free rate of return from two sources:
 * 1) Changes in futures prices
 * 2) The roll yield—which can be either positive or negative—that results from replacing an expiring contract with a further out contract in order to avoid physical delivery yet maintain positions in the futures markets.

Some individual and institutional investors include commodities as part of their portfolio for purposes of diversification of returns and inflation protection. Commodities do provide some level of protection against unexpected inflation. Protection against expected protection is more modest.

Open-ended mutual funds

 * PIMCO CommodityRealReturn Strategy Fund Institutional (PCRIX) is an open-ended mutual fund which tracks Bloomberg Commodity Total Return Index  with collateral in inflation-indexed bonds. Expense Ratio 0.79%. Available at Vanguard Brokerage Service for $25,000 initial investment and a transaction fee.
 * Vanguard Commodity Strategy Fund Admiral Shares (VCMDX) relies on commodity derivative securities to maximize inflation protection by seeking to outperform its benchmark and reduce the long-term volatility of a well-diversified, balanced portfolio. The commodity-linked exposure will be collateralized with a mix of short-term Treasury inflation-protected securities (TIPS) and Treasury bills (T-bills). The fund has a lower expense ratio (0.20%) than most peers and a more modest allocation to energy commodities than some others. $50k minimum required.

ETFs

 * Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF(PDBC) offers exposure to commodity futures without the tax hassle of a K-1. The fund is actively-managed, and tries to avoid “negative roll yield,” a well-known problem of passive commodity funds that can substantially erode returns over time. PDBC has the most assets and trading volume in this class. Expense Ratio 0.59%.
 * PowerShares DB Commodity Index Tracking Fund (DBC) is an Exchange Traded Fund which tracks the Deutsche Bank Liquid Commodity Index - Optimum Yield Excess Return. The Index is a rules-based index composed of futures contracts on six of the most heavily-traded and important physical commodities in the world - crude oil, heating oil, gold, aluminum, corn and wheat. Expense Ratio 0.85%.
 * iShares S&P GSCI Commodity-Indexed Trust (GSG) is an Exchange Traded Fund which tracks the S&P GSCI Total Return Index. Expense Ratio 0.76%.

Source: Top 26 Commodity ETFs, ETF.com

ETNs

 * iPath Dow Jones–UBS Commodity Total Return Index ETN (DJP) is an Exchange Traded Note which tracks Dow Jones–UBS Commodity Total Return Index. The note is issued by Barclays Bank PLC. Expense Ratio 0.75%.
 * ELEMENTS RICI-Total Return (RJI) is an Exchange Traded Note which tracks the Rogers International Commodity Index - Total Return. The index is composed of futures contracts of 36 different commodities and is weighted based on global commodity consumption. The note is issued by the Swedish Export Credit Corporation. Expense Ratio 0.75%.

Articles

 * On Stuff by William J. Bernstein, September 2006
 * Robert Greer Discusses the Benefits of Commodity Investing by Robert J. Greer, 03/01/2004
 * What the Price of Gold Is Telling Us by Congressman Ron Paul, 04/25/2006
 * Going Long on Commodities: Six ways to invest in commodities by Will Acworth, 05/15/2005
 * A Rediscovered Asset Class: Commodity Futures by raddr, 02/04/2006
 * Commodities As An Asset Class by Frank Armstrong, CFP, AIF, 07/15/2004
 * Not All Commodity Indexes Are Created Equal (Part One of a Two Part Series) by Richard Feldman, CFP, MBA, AIF, 06/02/2006
 * Are Commodities Futures Too Risky for Your Portfolio? Hogwash! by Knowledge@Wharton, 04/05/2006
 * Contango, backwardation, and all that good stuff by Prof. James Hamilton, 06/12/2005
 * CRB Indexes by CRB
 * The Great Commodities Debate Part I and Part II, Feb 13 and 14, 2008. An interview with Larry Swedroe and Rick Ferri on Seeking Alpha. Subscription required if viewed on more than one page. Disable your browser's javascript to view on a single page.
 * The Great Commodities Debate Part I and Part II, Feb 13 and 14, 2008. An interview with Larry Swedroe and Rick Ferri on Seeking Alpha. Subscription required if viewed on more than one page. Disable your browser's javascript to view on a single page.