Precious metals ETF holders would own an interest in a fractional amount of the physical commodity. The small investor may consider physical ETFs over holding the physical commodity because of costs associated with storage of the commodity. In ETFs backed by physical metals, all you need to do is show up and buy a share. The rest is taken care of for you.
Potential investors should also note that profits in bullion-based ETFs are taxed at 28% capital gains since the IRS considers such an investment a collectible. The bullion holdings in these funds are subject to regular audits and the results are posted on the ETF provider’s website
Most commodities are traded on futures exchanges. A future is a promise to buy, or sell, a commodity for a set price at a set date in the near future. A majority of the future contracts traded on the exchange floor are settled or swapped for cash before the expiration date.
Futures also add a time component to the price: when tomorrow’s cost is higher than today’s, it’s called contango; the inverse called backwardation. Investors should note that some ETFs have blind front-month roll strategies, but most ETFs now buy futures months in advance. None of these ETFs claim to deliver the spot price of the underlying commodity.
The majority of these funds buy the near-month contract, selling it before expiration and buying the next month’s contract, and so on. If the price of the next month’s contract is higher than the current month’s, it’s a situation called contango, and it could cost you money when the contracts are rolled over. A negative roll yield (contango) could cause the net asset value (NAV) of a fund to deviate even further from the spot price of its underlying commodity. The opposite situation is backwardation.
One way to mitigate the effects of contango is to look for ETFs that hold contracts throughout the year. However, there are just two such funds available: United States 12-Month Oil (NYSEArca: USL) and United States 12-Month Natural Gas (NYSEArca: UNL). The purpose of a 12-month strategy will help protect futures investors from the problem of contango. Two weeks before the expiration of the nearest-month contract, the fund will roll forward another month, picking up the then-12-months-out contract.
Futures-based ETFs are usually reported on K-1 tax forms. The profits are taxed at 60% long-term capital gains at the investor’s income class and 40% short-term capital gains rate, regardless of how long the ETF is held. These commodities ETFs are operated as partnerships, which means that they “pass through” any profits or losses to the partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return. On the IRS’s website a form called Partner’s Instructions for Schedule K-1 (Form 1065) can be found. The K-1 basically gives allocation for any gains or losses within the fund.
Swaps recently entered the ETF conversation when the popular United States Natural Gas (NYSEArca: UNG) turned to them in order to gain exposure. Generally, ETFs that invest in swaps receive the benchmark performance through the swap. The use of swaps gives investors exposure to areas of the market that can be difficult to target.
However, there are some drawbacks. Swaps aren’t listed on exchanges. Additionally, liquidity and transparency are sometimes an issue. Since swaps are agreements between two parties, they may also include counterparty risk. In typical swap transactions, the two parties agree to exchange the returns. The risk is that the counterparty could default on its obligation.