A Guide To Commodity ETFs And ETNs

Feb. 28, 2010 8:38 AM ET24 Comments1 Like
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What Are They?

  • Commodity ETFs (exchange traded funds) attempt to track the price of a single commodity, such as gold or oil, or a basket of commodities by holding the actual commodity in storage, or by purchasing futures contracts. Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.
  • Commodity ETNs (exchange traded notes) are non-interest paying debt instruments whose price fluctuates (by contractual commitment) with an underlying commodities index. Because they are debt obligations, ETNs are subject to the solvency of the issuer.
  • Commodities-related ETFs generally track the producers of commodities, such as mining companies. While the financial performance of those companies -- and thus their stocks -- may be highly leveraged to the underlying commodity, other factors can impact the profitability of production. The ETFs, therefore, may not reflect the performance of the underlying commodity. For example, gold miners are highly leveraged to the discovery of gold deposits, exchange rates and their relationships with the countries where gold deposits are found.

Why & How To Use Them

  • Commodities are a separate asset class from stocks and bonds, so they provide extra diversification in a portfolio.
  • The case for commodities: The industrialization of the China and India and the integration of Russia and Eastern Europe into the global economy are boosting demand for commodities, driving up prices. Many people believe that this will result in a long term uptrend ("super cycle") in commodity prices.
  • The case against commodities: In contrast to stocks and bonds, commodities are not income generating. So ownership of commodities, including via ETFs or ETNs, is a pure bet on prices, ie. supply and demand. And the expenses charged by the ETF and ETN providers and in the cost of storing hard assets or trading futures eat away at the underlying value of the fund.
  • Commodity ETFs and ETNs can also be used as a hedge. For example, if you consume a large amount of gasoline and heating fuel and are concerned about the impact on your income of a rise in oil and gas prices, buying an oil and gas ETF can help offset your exposure.

What to Look Out For

  • Commodities ETFs that use futures have diverged significantly from the price of the hard commodities themselves. ETNs, in contrast, track the price of the commodity closely. See the articles in the Further Reading section below.
  • There are dramatic differences in structure of these ETFs and ETNs, even for the same commodities, leading to potential differences in performance and tax treatment.
  • ETFs and ETNs are treated differently for taxation purposes. Current opinion is that all gains on ETNs held for longer than one year are treated as long-term capital gains, whereas an investor owning a futures-based ETF is taxed on any capital gains on the underlying futures held by the fund using the taxation convention for futures, ie. at a hybrid rate of 60% long-term, 40% short-term each year on all gains, even if the investor doesn't sell the fund. (Check this carefully with your accountant.)
  • You can track commodity performance on Seeking Alpha's Commodities Data Dashboard.

Further Reading

This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.

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