Journal of Financial Planning; October 2014
Tom Lydon is editor of ETFtrends.com and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
For an added layer of diversification, investment portfolios can include a broad basket of commodities. However, financial advisers seeking to include a commodity ETF in their lineup must be aware, as these ETFs are not your typical stock fund.
From 1970 to 2004, commodities showed a negative correlation to other asset classes like global equities and domestic fixed-income securities. However, the correlation between commodities and the broader stock market did spike after the financial crisis, but it has since diminished, according to Morningstar data.
Investments in commodities used to be limited to futures markets. Now, anyone can gain exposure to commodities through ETFs and ETNs, which come in several shapes and sizes. And there are two common types: futures-based and physically backed.
Commodity ETF Options
Commodity-specific plays have been very rewarding. For instance, coffee has surged this year on severe drought conditions in Brazil, the world’s top producer of coffee. Natural gas prices jumped as Americans turned up the heat to fight off the bitter cold last winter. It may be fun to play these types of short-term market moves in the commodities market, but investors have to deal with the slightly different taxes associated with the investments.
Physically backed ETFs, like the popularly observed SPDR Gold Shares (NYSE Arca: GLD), are treated as if investors held the physical bullion. Physically backed metal ETFs are taxed as collectibles with long-term gains at a maximum 31.8 percent tax rate and short-term gains taxed up to a 43.4 percent rate.
Commodity-related ETNs should not be confused for ETFs. ETNs are a type of bond or debt security issued by an underwriting bank and subject to the credit risk of the issuer. Gains in stock, bond, and commodity ETNs are taxed at a maximum long-term 23.8 percent rate.
Funds that use futures contracts to gain exposure to a market are structured as limited partnerships. Consequently, investors may have to fill out a Schedule K-1, and they may incur Unrelated Business Taxable Income (UBTI). However, most ETFs provide K-1s in a timely manner and typically do not generate UBTIs.
Futures-backed ETFs, unlike equities and stock-based ETFs, are based on the so-called 60/40 rule, or 60 percent long-term gains at a maximum 23.8 percent rate, and 40 percent short-term gains at a maximum 43.4 percent rate, depending on the tax bracket, regardless of how long the investor holds the ETF. At the end of the year, the ETFs must also “mark to market” all outstanding contracts and treat them as if the fund sold those contracts, so investors would realize those gains for tax purposes.
Contango and Backwardation
Commodity ETFs and other funds that invest in futures contracts are susceptible to contango, which occurs when the price on a futures contract is higher than the expected future spot price, creating the upward sloping curve on future commodity prices over time. While this phenomena is normal in the futures market, contango can have a negative effect in ETFs.
In a contangoed market, the ETF loses money each time it rolls contracts to a costlier later-dated contract (the fund would technically sell low and buy high). In a contangoed market, futures-based commodity ETFs can experience heavy losses even if the underlying commodity’s spot price rises. For example, the United States Natural Gas Fund (NYSE Arca: UNG) and the United States Oil Fund (NYSE Arca: USO) have experienced long-term losses due to contango, but they have been fine over the short-term.
On the other hand, a backwardated market—when near-term contracts cost more than later-dated contracts—can help bolster futures-based ETF returns, because the funds roll contracts by selling near-maturity contracts high and buying later-dated contracts low. This year, exchange-traded products like coffee and natural gas have benefited from the backwardated futures markets.
Commodity ETFs help advisers gain exposure to assets that typically zig when their equities and fixed-income positions zag, providing another layer of portfolio diversification. Nevertheless, while ETFs help investors easily access the commodities space, people should still take the time to understand that these products may act differently than one is used to.
Disclosure: Tom Lydon’s clients own shares of GLD.