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.
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
Futures-Based
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-Based
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.