The demand for commodity-based ETFs has skyrocketed and shows no signs of slowing down. There are four fundamental strategies to obtain exposure in the commodity space:
- money with physical backing
2. Investment funds
3. funds based on futures
4. Notes sold on exchanges (ETNs)
These kinds all have benefits and cons. Think carefully about a fund’s mission and how it achieves that objective as you consider which fund is best for your portfolio. Does the ETF own the actual commodity, or does it mirror exposure through futures contracts? Does it own shares of businesses involved in the manufacture of a certain good? You should base your investing choice on much more than just the ETF’s name. You can’t be certain how a fund achieves exposure to a specific commodity just because the name of the fund includes terms like “oil,” “natural gas,” “gold,” etc. You need to explore your possibilities and choose where and how you can look for gold in order to make the greatest decision for your portfolio.
ETFs that invest in physical commodities As their name suggests, these ETFs actually hold the underlying commodity. A look at the webpage for SPDR Gold Shares for SPDR Gold Trust (GLD)
The tax implications are one consideration for investors who desire access to actual gold. For taxation purposes, investments in physically backed ETFs are treated the same as investments in physical metal and are viewed as collectible investments. They are taxed up to 28% if held for a year or more. Ordinary income is taxed on short-term gains. Therefore, long-term investors wishing to diversify a larger portfolio would be better served by these products.
Exposure to Commodities Using Equity
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The businesses that manufacture, transport, and store commodities are another method to become exposed to them. An equity-based commodity ETF provides “leverage-like” exposure to commodities by holding the equities of businesses engaged in the production of raw materials and natural resources. Alternatives to futures-backed ETFs, which might be subject to trading restrictions and other regulatory limitations, include these equity funds. Additionally, equity-based commodities ETFs have more favorable tax consequences compared to ETFs that store physical reserves of precious metals.
GDX offers exposure to large-, mid-, and small-cap stocks of international businesses engaged largely in gold mining. GDXJ tracks small- and mid-cap firms engaged in the mining of gold and/or silver. Because both funds are considered like stocks for tax purposes, they are more suited for short-term gold market participants.
Commodities Fund Backed by Futures
Using futures contracts, forward contracts, and swaps, futures-backed commodity funds are intended to produce exposure to the target commodity. These kinds of ETFs are surrounded by a lot of investment uncertainty. This is due to the fact that they frequently find themselves in the position of affecting futures prices rather than merely observing prices due to their need to acquire and sell huge quantities of futures contracts. The Commodities Futures Trading Commission proposed position limitations on futures contracts out of concern for the risk of commodity bubbles, which pushed some of these funds to develop new systems for tracking their underlying commodities.
Futures-based funds have special tax consequences; 60% of any gains are subject to a 20 percent long-term capital gains tax. No matter how long shares are held, the remaining 40% is taxed at the investor’s ordinary income rate. The combined maximum capital gains rate as a result is 28 percent.
ETNs as a means of accessing commodities
Using ETNs, which are senior, unsubordinated, unsecured debt issued by an institution, is the fourth option to obtain commodities. Several other assets, including commodities and currencies, are connected to ETNs. With regard to the product and the underlying index, ETNs are intended to have “no tracking inaccuracy.” Owners of ETNs like iPath Bloomberg Commodity Index ETN (DJP) receive the index return less management costs.
Additionally, compared to commodity ETFs, commodity ETNs offer a more favourable tax treatment. When selling a product, investors who have held a commodity ETN for more than a year only have to pay a 20% capital gains tax. Commodity ETFs with a futures component are taxed similarly to futures, and annual profits are marked to market. Investors have been drawn to ETNs in part because of this tax differential of 28 percent vs. 20 percent.
Why isn’t this category booming if there are so many benefits, especially the tax treatment of commodity ETNs? Concerns regarding ETNs include the issuing bank’s credit risk. Bank collapses, which considered unusual and only to occur once every century before the financial crisis, are now easier to imagine. ETNs that track futures have regulatory risk in addition to credit risk. Regulatory constraints on a fund’s participation in the futures market can have an influence on an ETN, as we witnessed with futures-backed ETFs.
Exposure to Commodities: A Cautionary Story
In general, the likelihood that the investment instrument will not closely track the underlying commodity increases the more you are from your desired market. The forces of supply and demand in the market for the physical metal are reflected in the pricing of physically backed funds in gold, silver, platinum, and palladium, which closely follow market rates. Of course, not all commodities allow for this kind of exposure.
The companies that produce, process, and transport the commodity—whether it is gold, natural gas, oil, or another substance—can nevertheless provide you with exposure to it through equity-based commodity funds. The equity alternative restores transparency and eliminates the risk of regulatory restrictions that could have an impact on trade, despite the fact that it is not the same as a physically backed fund.
Over physically backed and equities funds, futures-backed funds and ETNs might have some advantages. However, those advantages come at a price: tracking inconsistencies with the underlying commodity, regulatory risk, and perhaps even credit risk. In order to choose the best option for their goals and risk tolerance, investors need to be aware of these factors.
