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Commodity Investing: ETFs or ETNs?

Commodity Investing: ETFs or ETNs?

By Ron DeLegge, Editor

December 15, 2008

 

SAN DIEGO (ETFguide.com) – Earlier in the year, it appeared that commodities would be a rare haven in 2008’s downward spiraling financial markets. Then, out of nowhere, the Jim Rogers commodity bus got blindsided.

 

One of the broadest measures of commodity performance, the iShares S&P GSCI Commodity Index Trust (NYSEArca: GSG) has fallen a steep 44.10% since the beginning of the year. The underlying index is heavily weighted towards energy commodities (68.39%) with agriculture, metals and livestock accounting for the balance. The dramatic decline in crude oil prices to under $50 a barrel from around $150 has contributed to GSG’s fall.

 

Will commodities bounce back?

 

Leveraging Commodities

Toward the end of November, the ProShares launched a series of commodity ETFs and currency ETFs that leverage and short various commodities along with currencies. The Bethesda, MD-based company is probably best known for its long/short equity funds, like the UltraShort Financials (NYSEArca: SKF) and the Short S&P 500 (NYSEArca: SH).

 

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The new ProShares ETFs allow investors to use leveraged and short strategies in a previously unavailable ETF format. For example, bullish gold investors have the potential to capture 200% the daily upside performance of gold via the ProShares Ultra Gold ETF (NYSEArca: UGL). Conversely, if you think gold is going to fall from its $820 per oz. pedestal, the ProShares UltraShort Gold ETF (NYSEArca: GLL) allows you to profit from any slide in gold prices.

 

ETNs or ETFs?

Up until the ProShares launch, exchange-traded notes (ETNs) were the only way to obtain leveraged and short exposure to commodities. (Of course, without shorting or leveraging them yourself via a futures brokerage account.) The 19 commodities-focused PowerShares/Deutsche Bank ETNs were really the only game in town, but not anymore. (See comprehensive comparison of ETFs. vs. ETNs.)

 

Instead of using the PowerShares DB Crude Oil Double Long ETN (NYSEArca: DXO), now investors can use the ProShares Ultra DJ-AIG Crude Oil (NYSEArca: UCO). Both investment products have the same investment strategy of trying to double the daily upside performance of crude’s move by 200%. However, UCO does not carry any credit default risk like DXO.

 

The annual fees on the PowerShares/Deutsche Bank ETNs are a lower 0.75% versus the 0.95% for the ProShares leveraged/short commodity ETFs, but don’t overlook the other important details.

 

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For an additional 0.20% in annual costs, the ProShares ETFs do not carry any issuer credit risk. The fall of Lehman Brothers and the subsequent collapse of the company’s three ETN products was a nasty real-life lesson about the danger of credit default risk. Clearly, all of the other benefits of ETNs like their lack of tracking error and their favorable tax treatment (which is being reviewed by the IRS and could end at any moment) are completely undermined by ETN credit risk. What good are all of these benefits, with the chronic threat of corporate failure? For that reason, we have consistently warned our readers about the danger of ETNs.

 

The Obscure Product Structures behind Commodity ETFs

Most commodities focused ETFs follow a grantor trust or partnership product structure and are not registered under the Investment Company Act of 1940 like most equity and bond funds. Instead, many are registered under the Securities Act of 1933.

 

One such example is the SPDR Gold Trust (NYSEArca: GLD). With almost $20 billion in assets, GLD is the most popular single commodity ETF. GLD follows a grantor trust product structure and its share price is hinged to one-tenth the ounce price of gold bullion. Also, GLD does not use gold commodity futures, but holds physical gold bars in a secured vault.

 

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Since many commodities ETFs don’t own the physical commodities, but instead futures or options on them, their tax treatment is quite different compared to a stock or bond ETF. Gains and losses in commodity ETFs that use futures contracts are taxed as 60% long-term and 40% short-term. This creates a blended tax rate ceiling of 23% for investors in the highest tax bracket.

 

As we’ve mentioned before, the ideal place for commodity ETFs is inside a tax sheltered account like an IRA, ROTH IRA, or 401(k) plan. Simply put, they aren’t very tax efficient held elsewhere.

 

Decisions, Decisions

If you’re interested in investing in commodities what should you do? Do you choose ETFs or ETNs?

 

Before you can make an informed investment choice, you first need to identify the exact product structure behind the ETF or ETN. It’s impossible to make the right choice without first knowing this. One of the financial tools that will help you is ETFguide’s online database, which is one of the few places that aggregates this data into one location. Under the “Basic Fund Data” and “Fund Structure” of each ETF or ETN we identify what type of product structure it uses.

 

It’s important that you weigh both the advantages and disadvantages of ETFs and ETNs. Once you’ve done your own due diligence, then you can make an educated decision about which product structure best matches your investment goals.