It's not an easy decision to make. The explosion of interest in commodities investing has been accompanied by an explosion in the types and styles of financial products available to investors. And though many of the products appear similar, they can be quite varied in their risks and reward profiles. Choosing one product type over another can dramatically influence both performance and tax considerations.

This article aims to help you understand the options.

Why Do Commodity-Linked Vehicles Exist?

Generally, commodity-linked vehicles are access products. They offer a window to the commodity markets that has not otherwise been available to retail investors.

As discussed earlier, for most commodities, you don't want to actually hold the physical goods. Commodity-linked vehicles bridge this gap by packaging commodities exposure in different ways and offering it to investors in easy-to-digest formats. And thank goodness for that.

Exchange-Traded Funds

The biggest new product to hit the commodities market in recent years has been the exchange-traded fund, or ETF. Two years ago, commodity ETFs simple didn't exist. Today, they hold more than $10 billion in assets in the U.S. alone, and investors can use them to purchase exposure to gold, silver, oil, individual commodity sectors and broad-based commodity futures indexes.

Why are the funds so popular? For one, they're easy: You can purchase an ETF like any other stock in your brokerage account. They're also cheap: In the past, most investors purchased commodity mutual funds, which charged high loads and sky-high expense ratios (often >2%). By comparison, ETFs are load-free (minus commissions) and charge around 75 basis points (0.75%) or less in annual expenses. In other words, they are pretty much a better mousetrap.

ETFs Linked to Individual Spot Commodities

As covered previously in Hard Assets University, there are two gold bullion ETFs in the U.S.: the streetTRACKS Gold Shares (AMEX: GLD) and iShares COMEX Gold Trust (NYSE: IAU). Both ETFs operate very simply: They buy gold and stick it in a vault. When you purchase shares, you get a stake in the gold: one-tenth of an ounce, to be exact. There is also a silver ETF, which operates on the same principle, called the iShares Silver Trust (NYSE: SLV); each share represents 10 ounces of silver.

All three of these bullion ETFs track the price of their given commodities, minus fees of 40 basis points per year (0.40%). These expenses are paid by liquidating a portion of the fund's assets - literally, selling 0.40% of the gold or silver each year. As a result, over time, each share's claim will represent a smaller and smaller amount of gold. (After 50 years, each share will represent just 0.082 ounces, compared to 0.1 ounces at launch.)

Gold and silver are currently the only "physical" ETFs available to investors in the U.S.; European investors have more choices.

Taxes

The IRS considers gold and silver bullion "collectibles," which means they come with a 28%  long-term tax rate; the same rule applies to these ETFs. That compares to the 15%  maximum rate applied to equity investments.

Advantages: Simple and direct exposure; low fees; easy to trade.

Disadvantages: Not tax efficient; no roll yield or collateral interest.

ETFs Linked to Individual Commodity Futures

Futures are the home for most commodity investors, and they are increasingly the home for commodity-linked ETFs. The first futures-based fund to hit the market was the US Oil Fund (AMEX: USO) from Victoria Bay Asset Management. USO holds long positions in West Texas Intermediate crude oil futures contracts, and rolls those contracts forward each month.

Like most futures investors, the ETF buys its futures with leverage, putting up just a small portion of the money to buy the contracts. The rest of the money is invested in Treasuries, which generates interest income for the fund.

All three factors - changes in the spot price, collateral interest income, and the "roll yield" - play important parts in determining the performance of USO and other single-commodity futures ETFs.

USO charges 0.50% in expenses, and the costs for other funds (like Natural Gas) are similar.

 Prev12Next