Trading in commodities used to be strictly for the pros, but the recent proliferation of commodity exchange-traded products is opening the door to the average investor. It's easy to see why demand is growing for these funds:crude oil is back over $100 a barrel; gold and silver are hitting new highs; and food prices are rising.
But if you're considering investing in commodity funds in a taxable, nonretirement account, it helps to understand the unique structures and tax implications associated with these funds. In fact, the fund structure can even help you choose the right product, depending on your investment objectives and personal preferences.
Commodity ETPs currently come in one of three structures:grantor trusts, limited partnerships and exchange-traded notes ( ETN ). All three structures are registered under the Securities Act of 1933, in contrast to most equity funds, which are structured as open-ended funds and registered under the Investment Company Act of 1940.
Grantor trusts and limited partnerships are considered exchange-traded funds, while ETNs are not. Thus, the term ETP is used when referring to all three structures.
|Popular Commodity Funds And Their Structures|
|State Street Global Advisors||ETF Securities||BlackRock||Deutsche Bank***||US Commodity Funds||Merrill Lynch||UBS||Barclays Capital|
|Product Line,||SPDR||ETFS||iShares||iShares S&P GSCI||PowerShares DB**||US Commodity Funds||ELEMENTS RICI||E-TRACS||iPath Dow Jones-UBS, iPath S&P GSCI|
|Tickers||GLD||SGOL, SIVR||SLV, IAU||GSG||DBC, DBA, DBO||USO, UNG||RJI, RJA||DJCI, UCI, UAG||DJP, JJA, OIL|
|Holdings||Physically Held||Physically Held||Physically Held||Futures||Futures||Futures||N/A||N/A||N/A|
|Legal Structure*||Grantor Trust||Grantor Trust||Grantor Trust||Limited Partnership||Limited Partnership||Limited Partnership||ETN||ETN||ETN|
|Current Tax Implication||LT taxed at 28% ("collectible")/ ST taxed at ordinary income rate||LT taxed at 28% ("collectible")/ ST taxed at ordinary income rate||LT taxed at 28% ("collectible")/ ST taxed at ordinary income rate||60% of gains taxed as LT gains/40% taxed as ST (ordinary income)||60% of gains taxed as LT gains/40% taxed as ST (ordinary income)||60% of gains taxed as LT gains/40% taxed as ST (ordinary income)||15% for LT gains/ Ordinary income rate for ST||15% for LT gains/ Ordinary income rate for ST||15% for LT gains/ Ordinary income rate for ST|
|*For ETNs, the issuer listed in the table may not be the issuing bank of the actual note. Investors should refer to the prospectus for details regarding issuer risk.|
|**PowerShares DB also offers a host of leveaged and inverse commodity funds structured as ETNs.*** Invesco PowerShares is the distributor of these Deutsche Bank products.|
Grantor trust structures are often used for "physically held" precious metals ETFs. These funds actually hold the physical commodity in vaults, giving investors exposure to spot prices of the underlying metal.
The largest funds are the SPDR Gold Trust (NYSEArca:GLD) and the iShares Silver Trust (NYSEArca:SLV). In fact, GLD is the second-largest ETF in the world, with over $58 billion in assets under management as of May 9. Other notable ETFs include the iShares Gold Trust (NYSEArca:IAU) and a number of other precious metals funds offered by ETF Securities.
Under current Internal Revenue Service rules, investments in these precious metals ETFs are considered "collectibles," and gains are taxed at a maximum of 28 percent if held for more than a year. In contrast, long-term gains in equity funds are currently taxed at 15 percent. Similar to equities, if they're held less than a year, gains are taxed at the individual's ordinary income tax rate.
Many ETFs hold futures contracts to gain exposure to commodities, and are structured as limited partnerships. This structure is used in funds for commodities that can't be easily stored in vaults, such as crude oil, natural gas, as well as agricultural commodities. While less common, some investors choose to invest in precious metals though futures-based ETFs.
Some of the largest limited partnership ETFs include the PowerShares DB Commodity Index Tracking Fund (NYSEArca:DBC), the United States Oil Fund (NYSEArca:USO) and the iShares S&P GSCI Commodity ETF (NYSEArca:GSG). DBC leads the pack, with over $6 billion in assets under management.
Most importantly, these funds have unique tax implications. Currently, 60 percent of any gains are taxed at the long-term capital gains rate of 15 percent, and the remaining 40 percent is taxed at the investor's ordinary income rate, regardless of how long the fund is held.
Limited partnership ETFs are considered pass-through investments, so any gains made by the trust are "marked-to-market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means you can be subject to pay taxes on gains made by the trust regardless of whether you sold your shares or not, depending on the duration and number of shares you own.
One other side note regarding limited partnership ETFs is that for tax purposes, they are reported on a Schedule K-1 form. While this isn't a bad thing, it can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.
For investors who don't want to deal with limited partnerships and K-1s, there's also a slew of commodity ETNs available. ETNs don't hold the physical commodity, nor do they hold futures contracts. In fact, they hold nothing-ETNs are unsubordinated, unsecured debt notes issued by banks that track a specific index or commodity. The bank is responsible for paying investors the returns of the index the ETN is tracking, end of story.
Some of the biggest commodity ETNs include the iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca:DJP), Elements Rogers International Commodity ETN (NYSEArca:RJI) and the iPath S&P GSCI Crude Oil ETN (NYSEArca:OIL). DJP is the leader in the pack, with over $3 billion in assets under management.
From a tax standpoint, ETNs have some distinct advantages. Commodity ETNs are currently taxed like equity funds and get reported on a 1099 Form-long-term gains are taxed at 15 percent (note that this is for commodity ETNs-currency ETNs are taxed differently). In any event, commodity ETN investors aren't taxed at all until one of three things happen:the investor sells; the note is called; or the note matures.
ETNs also have perfect tracking (though the index they track can still be affected by contango and backwardation if they're built on a futures-based benchmark). But there's a catch-ETNs have credit risk, meaning if the bank issuing the note goes bankrupt or defaults, the investor can lose his entire investment since ETNs don't hold any physical assets.
Leveraged And Inverse Funds
Invesco PowerShares and ProShares currently offer a host of leveraged and inverse commodity funds.
The PowerShares products are structured as ETNs, while ProShares funds are limited partnerships. Some of the largest leveraged and inverse funds include the ProShares Ultra Silver ETF (NYSEArca:AGQ), the PowerShares DB Gold Double Long ETN (NYSEArca:DGP) and the ProShares Ultra Short Silver ETF (NYSEArca:ZSL).
Choosing Between Funds
It's worth noting that there are many reasons besides tax implications for choosing between funds, such as holdings, expense ratios, liquidity, spreads, access to spot rates, tracking, credit risk and the effects of contango and backwardation in a futures-based fund.
But knowing the tax implications can certainly help investors make a decision. A commodity limited partnership ETF can be beneficial for a short-term trader compared to grantor trusts and ETNs because 60 percent of any gains are taxed at 15 percent, as opposed to 100 percent of gains being taxed at their ordinary income rate if held less than one year.
On the flip side, a long-term investor might gain an advantage with commodity ETNs because they are subject to 15 percent long-term gains, compared to the 60/40 blend of limited partnerships. The catch-22 is that ETNs come with credit risk which, in a post-Lehman world, is a turnoff for many investors.
Then there are tax reporting differences. The tax structure associated with limited partnerships can be challenging for investors who are accustomed to equity funds expecting only a 1099. For investors looking to simplify their taxes without K-1s, grantor trusts and ETNs might look more appealing.
As a side note for investors looking for tax efficiency without credit risk:ETF Securities currently has several non-precious metals commodity ETFs in registration with the Securities and Exchange Commission structured as grantor trusts. While the specifics of these upcoming funds are still limited, it's something to keep an eye on. We wrote about these tax-efficient commodity funds about a year ago.
As the popularity of commodities as an asset class increases, the number of products coming to market is expected to surge. The tax implications for some of these products can be complex, and investors have many factors to weigh in order to make an informed decision based on their investment objectives and personal comfort levels.
Commodity ETPs are unique products that can potentially enhance your portfolio returns and diversification.
But understanding the structural differences is important because they're taxed differently, and knowing this information ahead of time can save you unnecessary headaches when it comes time to pay Uncle Sam.
Disclaimer:We are not professional tax advisors and this article is not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes.
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