Why Commodities are Different
This ariticle was also posted at ETFMarketPro.com
Commodity ETFs are different than traditional, plain vanilla ETFs and investors need to be made aware of the risks.
Exchange-Traded Funds come in many different “flavors” and therefore, are useful in many different ways for a large variety of investors. Commodity ETFs and Exchange-Traded Notes have different legal and regulatory structures that make them unique ETF and ETN products.
Commodities are in themselves different investments that require a different structure to be used as ETFs. Some commodities, like gold, can be directly held with only limited costs since it can be stored in vaults. Other commodities, like wheat, cannot be stored because of its limited useful life, or are inefficient or extremely difficult to store like oil or natural gas.
For hard to physically hold commodities, investment through futures contracts is more appropriate. Futures contracts are simply a contract to buy something in the future at a future price. Futures contracts come in many different duration lengths where the market determines the future price.
Trusts and Taxes
Commodities inside of ETFs are generally structured as Grantor Trusts and the tax consequences may surprise some investors. The typical tax structure for traditional ETFs tends to be highly tax efficient, and investors typically only need to incur tax consequences from buying, selling and funds distributions. For these trusts, investors will receive tax documents as partners in the trusts. Simply, commodity ETFs have not-so-simple tax structures that investors need to understand before investing, going much further than the simple discussion above.
The trusts’ structures are different from other ETFs. For example, iShares gives this warning on their website for the iShares COMEX Gold Trusts, IAU.
The iShares® COMEX Gold Trust (“Gold Trust”) is not an investment company registered under the Investment Company Act of 1940 or a commodity pool for purposes of the Commodity Exchange Act. Shares of the Gold Trust are not subject to the same regulatory requirements as mutual funds. This information must be accompanied by a current prospectus.
Exchange-Traded Notes
ETNs are a way for commodities to be packaged into an exchange-traded product structure, while being free from some of the complexities trusts have. ETNs are debt notes issued by investment banks to give the investor the total return of an index. The investor does not actually own anything but a promissory note for the total return of the index. ETNs, despite having counterparty risks, have no tracking error other than their expenses.
Commodities are Strategies
The way commodities get represented in commodity indexes and inside ETNs and ETFs are typically through rolling futures contracts. Returns from these contracts come from the change in the expected future price of the commodity; this price is very different from the actual price of the commodity that can be bought today, which is the spot price.
Many investors were surprised this year when the oil fund they thought was tracking oil prices was actually tracking the expected future price of oil. Below is a growth chart of the S&P GSCI Crude Oil Spot Index shown by the blue line and the United States oil fund (USO) shown in green.
Source: Morningstar, Inc 12/31/2008-9/8/2009
Structural Risks of Futures
With the style of rolling futures contracts, they are specific risks in certain market conditions. These passive investment vehicles will renew the futures contracts held by the fund in a systematic way. For example, an ETF may use three month futures contracts, so every three months the fund management renews and rolls the fund’s assets into new, three month contracts. The potential for issues is when the market has conditions that systematically erode value.
Contango and Backwardation
Investing in funds that are continually rolling into new futures contracts before expiration can face positive or negative roll yield. Roll yield is the gain or loss caused by rolling into higher priced or lower priced contracts.
A term call Backwardation is where there is a positive roll yield from buying cheaper contracts, meaning that prices are lower as the investor buys contracts to take delivery farther out in the future. Rolling future contracts in this market condition can be profitable as the fund is able to purchase more contracts at lower prices. The risk is if the market moves into a condition where prices are higher for contracts taking delivery further out. This market condition is called Contango and negatively affects funds with a rolling futures contract strategy. This will cause the contracts to depreciate in value.
In this way, investors can gain or lose value in these types of market conditions from positive or negative roll yield. The roll yield can affect the ETFs investing this way and is a risk of these kinds of products.
The graph above, displaying how the United States oil fund (USO) has been veering away from the spot, is not being helped by the Contango market where it must purchase more expensive future contracts even as the market continues to be volatile. These negative roll yields hurt investors and make tracking movements in the spot price difficult. In the oil market, this is especially frustrating for investors who thought they would see returns as the spot price of oil, and in turn, gas prices, increase.
Careful analysis is required when investing and understanding the structural risks in the marketplace in each particular asset class.
Share This Story, Choose Your Platform!
Wiser Wealth Management, Inc (“Wiser Wealth”) is a registered investment advisor with the U.S. Securities and Exchange Commission (SEC). As a registered investment advisor, Wiser Wealth and its employees are subject to various rules, filings, and requirements. You can visit the SEC’s website here to obtain further information on our firm or investment advisor’s registration.
Wiser Wealth’s website provides general information regarding our business along with access to additional investment related information, various financial calculators, and external / third party links. Material presented on this website is believed to be from reliable sources and is meant for informational purposes only. Wiser Wealth does not endorse or accept responsibility for the content of any third-party website and is not affiliated with any third-party website or social media page. Wiser Wealth does not expressly or implicitly adopt or endorse any of the expressions, opinions or content posted by third party websites or on social media pages. While Wiser Wealth uses reasonable efforts to obtain information from sources it believes to be reliable, we make no representation that the information or opinions contained in our publications are accurate, reliable, or complete.
To the extent that you utilize any financial calculators or links in our website, you acknowledge and understand that the information provided to you should not be construed as personal investment advice from Wiser Wealth or any of its investment professionals. Advice provided by Wiser Wealth is given only within the context of our contractual agreement with the client. Wiser Wealth does not offer legal, accounting or tax advice. Consult your own attorney, accountant, and other professionals for these services.