Looking for a commodities exchange traded fund (ETF) for your clients? Commodities have provided an invaluable source for investments over the years, but they were once only restricted to trading on the commodities exchange. However, ETFs have provided a very easy way to track all the major commodities in the markets.
ETFs have provided the average investor with a low-cost way to trade asset classes like commodities and currencies that were previously only available to institutional investors and sophisticated traders.
But what needs to be understood is that not all commodity ETFs are created equal. There are some key differences between them that could have tax implications and performance implications for your clients. This is one area where it’s definitely beneficial to fully understand before you buy.
The Big Picture
Some commodity ETFs, particularly those that are backed by physical bullion, have altered the supply and demand picture some by creating a new market for the commodity. For example, platinum investing demand was negligible before platinum group metal funds launched; now it accounts for 11% of total demand.
Commodities ETFs have given investors new ways to hedge inflation, protect their portfolios and diversify across asset classes in a convenient and easy-to-use format.
The beauty of commodity ETFs is that you have multiple ways to get your exposure. You can buy funds that hold futures contracts, funds that are physically backed or funds that hold the stock of commodity producers. Each type has its benefits and drawbacks.
Equities
Equity-based commodity ETFs are funds that hold mining companies and other companies involved in the production of various commodities. Be aware that the performance of these companies is not always correlated to the underlying commodity. In the case of coal, steel and other commodities, sometimes equity-based commodity ETFs are the only way to gain exposure to these assets in an ETF. Long-term capital gains rate on equity-based ETFs is 15%.
ETFs that hold the stock of companies that mine, explore and produce commodities have a variety of benefits:
- There’s no need to be an expert on any given commodity; the person running the company will do that for you. It’s incumbent upon them to know more than just about anyone else.
- There is less volatility in these funds. They’re not as sensitive to day-to-day price movements in various commodities because their focus is all about the big picture.
- When commodity prices are far above the cost of production, price declines aren’t as imminently troublesome.
- ETFs that hold futures contracts or physical commodities are treated differently, tax-wise. Long-term capital gains rate on equity-based ETFs is 15%, but be sure to consult your tax professional for further guidance.
But there are drawbacks, too:
- Like any other company, these firms can have things go wrong, including mismanagement, corruption, environmental disasters, labor strikes, lawsuits and more.
- Companies also hedge their exposure to commodity price oscillations by using futures contracts to lock in prices, which means that the company may not benefit if commodity prices rise.
Physical
Physical ETFs hold the actual physical commodity. These ETFs tend to correlate more closely to the spot price than commodity funds that hold equities or futures.