HardAssetsInvestor

Written by Matt McCall  |

October 19, 2010

Cotton Exposure Through ETFs

Details

Cotton prices haven't been this high since Reconstruction. So if you're looking to share in the good times, what's the smart way to do it?

Over the last three months, the price of cotton futures has risen over 50 percent, propelled by speculation that demand will outstrip supply. Just last week, the price for a pound of cotton hit $1.198, the highest level since the New York Cotton Exchange was created—back in 1870.

The reason supply concerns have hit such panic stages is due to inclement weather around the globe. China, the No. 1 producer of cotton, will see its crop fall by 5.4 percent in 2010, drowned out by a series of heavy rains. Pakistan, the No. 4 producer, also had to cope with devastating floods that ravaged the nation.

Add in the increasing demand from emerging markets around the world, and it's no wonder the final equation equals higher cotton prices. (Of course, don't forget the investors playing the momentum for short-term gains; that helps add to the magnitude of the recent rally, too.)

ETFs For Cotton Investors

For the investor who believes more upside in cotton awaits, exposure to the soft commodity can be found through the iPath Dow Jones-UBS Cotton Subindex ETN (NYSEArca: BAL). BAL tracks a single-commodity index consisting entirely of near-month cotton futures, rolling it into the next month's contract whenever it nears expiry. The ETN charges an annual expense ratio of 0.75 percent.

BAL's popularity over the last month is obvious when you look at the unusual rise in its daily trading volume. In August, the ETN traded approximately 8,000 shares per day on average. Within two months, that number has quadrupled. And for a few days in September and October, BAL breached 100,000 shares per day.

Chart followers might identify the sudden surge in volume as a bearish indicator; after all, when too many investors are in one side of the trade, it becomes crowded and suggests a bubble may be ready to burst. But on the other hand, the price of cotton has lain dormant for years; this sudden breakout could be just the beginning of a much bigger, sustained move over the years to come.

Along with direct exposure to cotton, BAL also helps add diversification to a portfolio. If the holy grail of diversification is finding assets with independent returns, then you'll want to note that BAL's correlation to the S&P 500 is just 0.43—meaning BAL and U.S. stocks tend to move in the same direction just 43 percent of the time. Even within a commodity portfolio, BAL offers some measure of diversification; for example, the ETN only has a 0.64 correlation to the all-encompassing Dow Jones-UBS Commodity Index.

Cotton Not The Only Soft

Of course, if your goal is to lower the correlation to U.S. stocks while at the same time getting exposure to cotton, you might want to think more broadly.

The index for the iPath Dow Jones-UBS Softs Subindex ETN (NYSEArca: JJS), for example, has one-third of its assets in front-month cotton futures, 39 percent in coffee and 28 percent in sugar. The ETN charges an annual expense ratio of 0.75 percent.

JJS does not give investors pure exposure to cotton, but the addition of coffee and sugar helps instantly boost diversification while lowering the risk associated with too-narrow exposure. The correlation of JJS to the S&P 500 is a mere 0.2.

Why is that? Simply put, softs are on a tear recently. Both coffee's and sugar's strong runs have relied on many of the same weather factors that have helped cotton rally. You can see the good times reflected in the fortunes of the iPath Dow Jones-UBS Sugar Subindex ETN (NYSEArca: SGG), which has more than doubled from the low in early May; and the iPath Dow Jones-UBS Coffee Subindex ETN (NYSEArca: JO), which is up 30 percent in 2010.

Investing In Cotton Today

Despite cotton's large moves, is now really the right time to invest in it?

For those investors considering BAL or JJS, the one bit of advice I have is patience. A quick look at BAL's chart shows the recent volatility after months of narrow daily moves. So the key is to wait for weakness, and buy when the ETN pulls back to support levels.

Support for BAL is in the $50 to $52 range, and investors who wait set themselves up for a higher percentage gain. The same can be said for JJS and most commodity ETNs at this time.

So don't get stuck chasing performance. If you wait for a good entry point, you can increase your reward-to-risk ratio the smart way.

If you liked this article, then check out:

• What's Behind Cotton's Rise?
• Podcast Episode: Sugar And The GMO Debate
• Zeroing In On An Ag Stock