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December 20, 2012

The Commodity Wave

As an asset class, commodities have always been like Rodney Dangerfield; they can’t get any respect. For years, they’ve lagged behind stocks and bonds in terms of adoption rate by the investing public.  

Investing in the commodities market has been difficult and expensive for most investors. Traditionally, commodity investing was done through futures contracts, master-limited partnerships or by purchasing physical precious metals. But the tide has changed.

A wave of both diversified and single commodity ETPs have launched over the past nine years. How can financial advisors make the best choices for their clients when adding commodities exposure? 

Commodity Equity ETPs

Investing in stocks closely tied to the performance of commodities is one way to obtain commodities exposure.

For instance, oil and gas stocks (OIH) will generally follow the price of crude oil along with other energy products like gasoline and natural gas. Instead of making a bet on the price of the energy commodities, energy ETFs like OIH or IYE allow investors to participate by owning stocks closely tied to their performance.

One drawback of most commodity equity sectors is their tendency to be overly concentrated. One good solution is a diversified ETF like the SPDR S&P Global Natural Resources ETF (GNR). The fund takes a broader approach, by owning 90 global stocks within various commodity sectors like agriculture, energy, and mining. GNR charges a modest annual expense ratio of 0.40%.  

Finally, the correlation between commodity equity ETFs and commodities themselves is rarely perfect. This is another potential caveat. One example is how the Market Vectors Gold Miners ETF (GDX) declined 16% in 2011 while gold prices gained around 10%. Although correlation discrepancies do at times occur, they aren’t indefinite.    

Futures Based ETPs

Another way to get commodities exposure is through futures based ETPs. These types of products trade in and out of futures contracts on commodities. 

One ETP that’s a good candidate as a core commodities position is the GreenHaven Continuous Commodity Index Fund (GCC). The fund avoids distortions in its holdings by equal weighting and index of 17 different commodities. Because of its equal weighting approach, GCC offers significant coverage to grains, livestock and soft commodities and a lower energy weighting versus competing funds. In addition, GCC is rebalanced every day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.

For more concentrated plays, PowerShares and Deutsche Bank manage a menu of commodity sector funds linked to agriculture (DBA), energy (DBE), precious metals (DBP) and base metals (DBB).

The PowerShares DB funds employ a technique called “optimum yield,” which aims to minimize the effects of negative roll yield when markets are in contango and to maximize the effects of positive roll yield when markets are in backwardation. The funds enter into long exchange-traded commodity futures positions and generate interest income through short-term U.S. Treasuries held as collateral for the futures contracts they own. 

Drawbacks to commodity ETPs using futures contracts are index tracking error and contango. The latter condition occurs when the price of forward or futures contracts are trading above the expected spot price at the contract’s maturity.

Physical Commodity ETPs

Most physical commodity ETPs are limited to precious metals. Chief among these is the popular SPDR Gold Shares (GLD), whose share price reflects 1/10 the ounce price of gold bullion. GLD, like other bullion backed ETPs, holds its physical metal in secured vaults. 

The ETFS Physical PM Precious Metals Basket Shares (GLTR) takes a more diversified approach by holding gold, silver, platinum, and palladium together. GLTR’s diversified approach can be a much smarter, especially for an advisor that wants to eliminate the guesswork of which precious metal will outperform. 

Currently, precious metals are taxed as collectibles and have a maximum long-term capital gain rate of 28%. Compared to equities, this puts them at a slight disadvantage. 

Other Factors

There are many important factors in deciding which commodities road to travel and taxes, of course, top the list.

Even with an expected and rising increase on long-term capital gains for equity investors, tax rates for commodity focused equity ETFs are still lower compared to the 28% tax on physically backed commodity ETPs like the SPDR Gold Shares (GLD) or the iShares Silver Trust (SLV). 

Another big factor is the type of product structure a commodity ETP uses.

For instance, ETNs, unlike ETFs or grantor trusts, carry an added dimension of credit risk. If that’s not something you want your clients to have, then you should avoid using ETNs.

Also, the tax treatment for ETNs is different. Under current tax law, commodity and equity linked ETNs are taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption or maturity of their note. If held to maturity, the future payment of the contract is dependent on the value of the underlying securities or benchmark index. 

Finally, asset location is another crucial consideration. Where will the client hold the commodities? In a taxable or tax-deferred account? 

Generally speaking, commodity linked products that use futures contracts to obtain their market exposure are taxed at a 60/40 rate. Regardless of the holding period, 60% of gains are taxed at the long-term capital gains rate while the remaining 40% of gains are taxed as short term profits, which are subject to the investor’s ordinary income tax rate. For investors in the highest tax bracket, this 60/40 split creates a maximum blended capital gains tax rate of 23%. The tax burden is reduced for investors in lower income brackets. 

Commodity equity ETFs are tax-efficient, so holding them in a taxable account makes good sense. On the other hand, futures based and physical commodity ETPs are less tax efficient, which means holding them in tax-deferred accounts can lessen the tax bite. 

Summary 

Although commodities are often misunderstood, they represent a big opportunity. If there’s one asset class that individual investors probably lack exposure to—it’s commodities. And that means investors may not be as diversified as they think. Why not see how many prospects or existing clients have adequate exposure to commodities?  

Helping your clients to add commodities using affordable and transparent ETPs is smart. Your approach —whether it’s through equities, futures contracts, or physical commodities—will largely depend on your client’s needs. But with your expertise, they are sure to make the right investment choices that leads them closer towards their goals.

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