Exchange-traded funds (ETFs) have been a popular vehicle to gain exposure to the commodities markets. As of 2009, there were some 1,500 ETFs in existence globally, across all asset classes, including commodities. However, it’s important to understand there are distinct differences between investing in an ETF, and buying or selling commodity futures. Investors who feel they are getting diversification through an ETF may face a potentially higher tax bill, and lower returns than trading commodity futures contracts directly. And, you are subject to constraints of the fund structure as well as management issues that may be detrimental to you as an investor. When you trade commodity futures, you are in control of your own investment, based on your own view of the market.
The idea behind the new commodity-based ETFs, even those which invest primarily in the futures markets, is that they move in lockstep with the underlying commodity price. But it doesn’t typically work out that way. Most popular commodity-based ETFs do not directly track the price of the underlying commodity, and the returns also may vary significantly. In addition, demand for a particular ETF vs. another ETF can impact its price, irrespective of the price of the actual underlying commodity.
For example, consider one of the most popular oil-based ETFs, which was trading at $40 in November 2009, far below the spot price for NYMEX crude oil futures at $80 a barrel. If you had bought this ETF at the start of the year for $32, your year-to-date return would be just over 25 percent. On January 5, NYMEX crude oil futures were priced at $47, returning 70 percent year-to-date (net of fees/commissions). That doesn’t even consider leverage, which individual investors are free to employ’or not–by trading commodity futures directly.
Your commodity-based ETF may result in a higher tax bill than you might expect. If you are a highly active trader, you are likely to be taxed at short-term capital gains rates for most ETFs. Those backed by gold or silver can be subject to tax treatment as “collectibles” putting them in the 28 percent bracket. You could face even higher rates and/or penalties if investments deemed “collectibles” are included in an IRA or other types of self-directed retirement accounts.
Futures are lumped together and reported on a single Form 1099 at year-end, and any profits in commodity-based futures (regardless of the holding period) are taxed at the “60/40” rate; 60 percent taxed at the favorable long-term rate and 40 percent taxed at the short-term rate. Of course, tax laws change, but this has been the rule. It is important to know the tax consequences of your investments, as each individual’s situation is unique. We encourage you to consult a qualified accountant to discuss these issues in further detail.
Investors have more control over the day-to-day decisions in regard to their commodity futures positions, and are not reliant on the capability of the ETF manager(s) to achieve a return comparable to that of the actual commodity. Unlike most ETFs, you also have the flexibility of trading options on futures for further control over your strategy, including hedging mechanisms.
When you trade futures as an individual investor, by law your funds are kept in a segregated account. That means they may only be used by you, and are not at risk even in the event your broker is facing financial difficulty.
That’s not to say futures are the right investment for every individual. Like any investment, one needs a thorough understanding of the risks. Investors who wish to employ leverage can lose more than their initial investment. That is why it’s paramount to know all the facts, no matter you are investing in.
Commodity futures trade nearly 24 hours a day on an electronic marketplace. Most ETFs do not. You have more opportunities to trade, day and night, with futures. Some commodity-based ETFs have faced regulatory and structural constraints that have even forced them to stop issuing shares, and/or restructure their holdings to include unregulated investment vehicles. When you trade commodity futures, you get access to a transparent, regulated marketplace.