How to trade red-hot commodities

A strategy

Commodities are notoriously cyclical. That means it's probably a bad idea to assume that crude oil and natural gas will continue to outperform other commodities.

Instead, diversification should be the name of the game. Yes, you'll probably miss a big move by diversifying, but investing success is more about avoiding big losses than it is about scoring home runs.

Here's a list of investable categories and my favorite ETFs for tracking them. I picked them based on longevity, returns, expense ratios and daily trading volumes. (I avoided lightly traded ETFs.)

Diversified commodities

iShares S&P GSCI Commodity Indexed Trust (CSG, news, msgs) tracks an index of 24 commodities weighted according to the proportion of the commodity flowing through the economy. The index is composed of 55% crude oil, 22% other energy products, 12% agricultural commodities, 7% industrial metals, 3% livestock and 2% precious metals. Expense ratio: 0.75%. 52-week return: 65%. Year-to-date return: 26%.

PowerShares DB Commodity Index (DBC, news, msgs) is similar to iShares S&P GSCI but with less emphasis on energy. It tracks an index composed of 35% crude oil, 20% heating oil, 12% wheat, 12% corn, 11% aluminum and 10% gold. Expense ratio: 0.83%. 52-week return: 59%. Year-to-date return: 25%.

iPath Dow Jones-AIG Commodity Index Fund (DJP, news, msgs) puts even less emphasis on energy. It tracks an index composed of 34% energy, 33% agricultural, 16% industrial metals, 9% precious metals and 8% livestock. Expense ratio: 0.75%. 52-week return: 27%. Year-to-date return: 16%.

Diversified energy

PowerShares DB Energy Fund (DBE, news, msgs) tracks crude oil in two markets, heating oil, gasoline and natural gas.

Expense ratio: 0.75%. 52-week return: 76%. Year-to-date return: 33%.

Crude oil

United States Oil Fund (USO, news, msgs) tracks the futures prices of West Texas intermediate light sweet crude. Expense ratio: 0.50%. 52-week return: 108%. Year-to-date return: 32%.

iPath S&P GSCI Crude Oil (OIL, news, msgs) also tracks the futures prices of West Texas intermediate light sweet crude. The expenses are higher than with United States Oil, but its returns are in the same ballpark. Expense ratio: 0.75%. 52-week return: 110%. Year-to-date return: 32%.

Natural gas

United States Natural Gas Fund (UNG, news, msgs) tracks natural-gas futures contracts traded on the New York Mercantile Exchange. Reflecting natural-gas prices in general, returns were nothing to shout about last year, but they have taken off this year. Expense ratio: 0.60%. 52-week return: 5%. Year-to-date return: 50%.

PowerShares DB Agriculture (DBA, news, msgs) is a pure play on the most widely traded agricultural commodities: soybeans, corn, sugar and wheat. According to PowerShares, tracking these four commodities reflects the performance of agricultural products in general. Expense ratio: 0.50%. 52-week return: 48%. Year-to-date return: 12%.

Precious metals

StreetTracks Gold (GLD, news, msgs) tracks the price of gold bullion. Expense ratio: 0.40%. 52-week return: 26%. Year-to-date return: 4%.

iShares Silver Trust (SLV, news, msgs) tracks the price of silver. Expense ratio: 0.50%. 52-week return: 23%. Year-to-date return: 12%.

• Video: Getting in on the commodity action

One warning: Over the years, some very smart people have gone broke playing commodities. So, don't use the money that you'll need for retirement or to put your kids through college.

Also, experts advise that you should never allocate more than 25% of your funds to any one sector. Given that commodities are particularly risky, I advise reducing that limit to 10% or 15% for them.

At the time of publication, Harry Domash held a position in the PowerShares DB Commodity Index Fund.

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