Interest in commodity-based ETFs has exploded and shows little sign of abating. In the commodity space, there are 4 basic ways to gain exposure:
- Physically backed funds
- Equity funds
- Futures-based funds
- Exchange-traded notes (ETNs)
Each of these varieties has advantages and drawbacks. As you contemplate which fund is right for your portfolio, you need to be particularly discerning about a fund's objective and how it pursues that goal. Does the ETF hold the physical commodity, or does it use futures contracts to replicate exposure? Does it hold equities of companies that are engaged in the production of a particular commodity? Your investment decision needs to be based on far more than just the name of the ETF. Just because a fund's name includes "oil," "natural gas," "gold," etc., you can't be sure how that fund accomplishes exposure to that particular commodity. In order to make the best choice to fit your portfolio, you must mine the options and see where and how you can pursue pay dirt.
Physical commodity ETFs
As the name implies, physical commodity ETFs actually own the underlying commodity. A visit to the website for SPDR Gold Trust (GLD) (see http://www.spdrgoldshares.com) makes the point visually. A colored photo on the site shows gold bars stacked on pallets. Investors who buy shares in this ETF are gaining an ownership stake in the fund’s stockpile of gold bullion, without having to deal with physical delivery or with logistics such as storing and insuring physical gold. Other ETFs backed by bullion include iShares Comex Gold Trust (IAU) and ETFS Physical Swiss Gold Shares (SGOL).
One caveat for investors who want access to physical gold is the tax implication. Unlike other ETFs, gold-backed funds are taxed up to 25% as collectables. Therefore, these funds are better suited for long-term investors looking to diversify a broader portfolio.
Equity-based commodity exposure
Another way to gain exposure to commodities is through the companies that produce, transport, and store them. An equity-based commodity ETF offers "leverage-like" exposure to commodities through the stocks of companies involved in natural resources and other raw materials. These equity funds are viable alternatives to futures-backed ETFs, which may be subject to trading limits and other regulatory restrictions. Further, equity-based commodity ETFs have better tax implications than ETFs that hold physical stockpiles of precious metals.
For example, for investors looking to gain exposure to gold, there are equity-based alternatives such as Market Vectors Gold Miners (GDX) and Market Vectors Junior Gold Miners (GDXJ). GDX provides exposure to worldwide companies that are involved primarily in mining for gold, including large-, mid-, and small-cap stocks. GDXJ tracks small- and mid-cap companies involved in gold and/or silver mining. Both funds are treated like stocks for tax purposes which makes these funds more suitable for short-term players in the gold market.
Futures-backed commodity fund
Futures-backed commodity funds are designed to produce exposure to the targeted commodity through the use of futures contracts, forward contracts, and swaps. There is a good deal of investment uncertainty surrounding these types of ETFs because their need to buy and sell large amounts of futures contracts sometimes puts them into the position of influencing futures prices, rather than simply tracking prices. Fearing the possibility of commodity bubbles, the Commodities Futures Trading Commission recently proposed position limits on futures contracts which forced some of these funds to create new mechanisms for tracking their underlying commodities.
Using ETNs to gain access to commodities
The fourth way to gain access to commodities is by using ETNs, which are senior, unsubordinated, unsecured debt issued by an institution. ETNs are linked to a variety of assets, including commodities and currencies. ETNs are designed to have "no tracking error" between the product and its underlying index. Owners of an ETN such as iPath Dow Jones-UBS Commodity ETN (DJP) will get the return of the index, minus the management fees.
Commodity ETNs also offer a more favorable tax treatment over commodity ETFs. Investors who hold a commodity ETN for more than one year only pay a 15% capital gains tax when they sell a product. Futures-based commodity ETFs are taxed like futures and gains are marked to market every year. This 23% vs. 15% tax difference has helped attract investors to ETNs.
With so many advantages, especially the tax treatment of commodity ETNs, why isn't this category booming? One of the concerns about ETNs is credit risk of the issuing bank. Post-financial crisis it isn't so hard to imagine bank failures which, not that long ago, would have seemed to be a rare, once-in-a-century occurrence. On top of the credit risk, ETNs that track futures also have regulatory risk. Just as we saw with futures-backed ETFs, regulatory restrictions on a fund's involvement in the futures market can also impact an ETN.
Commodity exposure: a cautionary tale
In general, the further away you are from your desired market, the greater the potential that the investment instrument will not exactly track the underlying commodity. Physically backed funds in gold, silver, platinum, and palladium reflect the forces of supply and demand in the market for the physical material and, as such, track market prices very closely. Of course, such exposure is not possible with all commodities.
Equity-based commodity funds can still give you exposure to the commodity—whether gold, natural gas, oil, or another substance—through the companies that produce, process, and transport them. Even though it's not the same as a physically backed fund, the equity alternative restores transparency and takes away the possibility of regulatory limits that could affect trading.
Futures-backed funds and ETNs may offer certain advantages over physically backed and equity funds; however, those advantages come at a cost: namely, tracking discrepancies with the underlying commodity, regulatory risk, and potentially even credit risk. Investors need to be aware of these issues in order to make the best selection in accordance with their goals and risk tolerance.