From the December 2006 issue of Wealth Manager Web • Subscribe!

Commodity Choice

Commodities may be the oldest form of wealth, and recent academic work has concluded that over long periods of time, an investment in commodities has produced returns equal to equities. Interestingly, though, commodities correlate inversely with equities and positively with inflation. Now, several new products may allow investors to approach indexed commodities more simply and cost-efficiently than ever, with some nice tax advantages.

"Facts and Fantasies About Commodity Futures," a working paper from the Yale International Center for Finance by Gary Gorton and K. Geert Rouwenhorst, concluded that an equally weighted index of fully collateralized commodity futures offered the same return as equities, but the stock portfolio had a higher standard deviation. Also, commodity futures correlated negatively with equity and bond returns and positively with inflation.

And in a 2000 Office for Futures and Options Research working paper titled "Indexed Commodity Futures and the Risk and Return of Institutional Portfolios," Kent Becker and Joseph Finnerty found that, from 1970 to 1990, the addition of indexed commodities to stock and bond portfolios improved the risk and return performance of the overall portfolio.

Fortunately, the markets offer a growing cornucopia of commodities products, including physical commodities, companies that produce and own commodities, commodity futures, commodity-based mutual funds and commodity-indexed exchange traded funds that aren't really "funds" at all.

Early in 2006, Deutsche Bank launched a grantor trust of futures as an ETF that tracks a commodities index. Later, Barclays Bank launched three innovative commodity-indexed exchange traded notes (ETNs), and Barclays Global Investors issued a very clever commodity ETF that's really a commodity pool. Both Deutsche Bank and Barclays have filed with the SEC for the right to launch several additional sub-sector commodity ETFs. There has also been an explosion of filings and several launches of funds based on single commodities.

The Barclays iPath product is an ETN linked to a commodities index guaranteed by Barclays and due in 2036. There are iPath notes on the GSCI Total Return Index, the Goldman Sachs Crude Oil Total Return Index and the Dow Jones-AIG Commodity Index Total Return Index. Unlike mutual funds, iPath ETNs make no distributions, so investors retain control over when they realize their gains (or losses). Like ETFs, the notes have a redeeming mechanism for market makers and, so far, have traded decently against their underlying indices. Management fees are 75 basis points, and there are commissions to trade.

No tax is owed until the product is sold or matures. Theoretically, if the laws don't change, you could hold these notes without current taxation until they mature in 2036, and then your profits would be treated as long-term capital gains. If the notes are held to death, the step-up in basis would eliminate the gains tax. If you go short, the profits will always be taxed as short-term gains.

Alternatively, the PowerShares Deutsche Bank Commodity Index Tracking Fund (DBC) is an ETF that invests in futures to track the Deutsche Bank Liquid Commodity Optimum Yield- Excess Return Index. Because it is a grantor trust that invests in futures, the "ETF" receives [IRS Code] 1256 tax treatment, creating a blended tax rate of 23 percent, regardless of whether you are long or short and regardless of the holding period. But these futures are marked to market at yearend, causing yearly taxable income. Total costs are 87 basis points plus commissions to trade.

A direct investment in futures would produce the same tax treatment and no management fees. Alternatively, there are managers that invest in futures to track one of the indices.

The Barclays ETF is really a commodity pool; like the DBC, it is not a mutual fund. It follows the same Goldman Sachs Index as the first Barclays ETN. Unlike the Deutsche Bank fund, which invests in "regular" futures, the Barclays fund employs a commodity excess return futures (CERF) contract, which is a longer-dated futures contract on the Goldman Sachs Index. This vehicle has no trading history and thus might create tracking errors, but is expected to reduce transaction costs and taxes. The management fee for the Barclays ETF is 75 basis points, and there are commissions to trade.

Research by my firm, Twenty-First Securities, suggests that an investor can add substantial value by utilizing the commodities product that offers the best combination of low cost and positive tax treatment.

An important variable is your time frame. For investments lasting less than one year, the best approach may be the Deutsche Bank ETF or futures if you're comfortable with them. (If not, there are managers that can be hired to replicate the indices with futures.)

For more on ETFs, see "Fees, Taxes and ETFs" in the July/August issue of Wealth Manager.

Robert N. Gordon is the president of Twenty-First Securities Corporation and the author (with Jan Rosen) of Wall Street Secrets for Tax-Efficient Investing.

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