Lehmann's Look at ETFs

03/31/2006 12:00 am EST

Focus:

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

"As each month goes by, the world of ETFs gets a little more complicated," notes Richard Lehmann, who has launched an industry leading publicationThe ETF Investor that, as its name implies, focuses solely on this market. Here, he looks at resource plays.

"An interesting development among ETFs is from Deutsche Bank for a commodity-linked fund based on the Deutsche Bank Liquid Commodity Index which is also brand new. The fund, called the DB Commodity Index Tracking Fund (DBC ASE), invests in futures contracts in light, sweet crude oil (35%), heating oil (20%), aluminum (12.5%), corn (11.25%), wheat (11.25%), and gold (10%). It also holds some cash in US Treasuries. The ETF uses leverage to buy short-term and long-term futures contracts. The positions may be rebalanced annually.

"This entry into commodities is probably only the beginning of a trend. The use of leverage is a new wrinkle to ETF investing which may have appeal to all those daytraders out there. Imagine buying a leveraged ETF that buys commodity contracts (already a leverage play in and of themselves) on margin! The attraction being touted here seems to be that this basket of commodities has a low correlation to US stocks and bonds. It’s not cheap to own, the expense ratio is 1.5%, but where else can you play in the commodities market this cheap.

"I would caution that this type of ETF is dangerous because it can easily be misunderstood. ETFs were created and are represented to be for investors looking to minimize risk through diversification. Commodity contracts are high risk by definition, not mitigated to any large degree by being bought in a basket. Investors should also not be lulled by the low correlation to stocks argument. That can mean you loose your shirt while everyone else is getting rich.

"Meanwhile, oil has had a bit of a pull back both in the price of oil and the valuation of companies in the oil business. The drop in oil related equities exceeded the drop in actual oil price. We think both phenomena are temporary, with oil staying near $60 a barrel. We don’t expect oil related equities to stay this low for long. We first recommended the Oil Service HOLDRs Trust (OIH ASE) in June of ’05 at a price of $101.50. Since then, the fund has hit a high of $157.86.

"We are now re-recommending the Oil Service HOLDRs at its current price of $137. HOLDrs are baskets of stocks selected by Merrill Lynch and don’t follow an index. The ten largest holdings in this HOLDRs trust account for 78% of the fund value, so this is not a very diversified fund. Their largest holdings are Baker Hughes, Halliburton, Transocean, and Schlumberger."

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