HardAssetsInvestor

A Survey Of Hard Asset Investing Vehicles: Part 2

(This continues our survey of commodity investment vehicles. For part 1, click here.)

Exchange-Traded Notes (ETNs)

One of the new kids on the commodities block is the exchange-traded note, or "ETN." Similar in many ways to ETFs, ETNs provide a few unique benefits ... and come with a few unique risks.

Technically, ETNs are senior unsecured debt notes that are designed to track the performance of different indexes ... including commodity indexes. They are bought and sold just like stocks, using a regular old brokerage account. They can also be leveraged, borrowed, and shorted just like ETFs.

As debt notes, however, the value of the ETN is supported by the underwriting bank. Essentially, the bank agrees to pay noteholders an amount tied exactly to the value of the underlying index, minus annual fees (typically 0.75%). As long as the bank doesn't default, investors will get the performance promised; if the bank defaults, they're out of luck.

Generally speaking, an ETN should offer slightly better performance than a comparable ETF, because it promises "perfect tracking" and will not incur any transaction costs from replicating the index. Although those costs are small, they do exist: the DBC ETF, for instance, estimates that these costs will run 8 basis points per year.

Currently, Barclays Bank offers a series of ETNs tied to the Dow Jones - AIG Commodity Index and its sub-indexes, and the Swedish Export Corp. offers ETNs tied to four Rogers commodity indexes. Deutsche Bank offers a variety of leveraged and short ETNs, letting investors make intense speculative bets.

Taxes

The big bonus for ETNs is that most observers believe that the notes will never have to distribute taxable income or capital gains; investors will only owe long-term 15%cap gains taxes when they sell the fund. Compared to the 60/40 annual tax hit for most futures-based investments each year, that would be a huge win. Note, however, that the IRS has not ruled on this, and it may assert an alternate treatment in the future; this is an area of great debate.

Advantages: Tax efficiency; zero tracking error; zero commission costs for the fund itself.

Disadvantages: Complicated trust structure; possibility, albeit slim, of default; no guarantee of liquid trading markets.

Mutual Funds

Before there were ETFs and ETNs, there were mutual funds. And, ever popular with investors, these funds continue to attract assets to this day.

There are several popular funds, including the PIMCO Commodity Real Return Strategy (PCRAX), which is linked to the Dow Jones-AIG Commodity Total Return Index, and the Oppenheimer Real Asset Fund (QRACX) and Rydex Commodities Fund (RYMBX), which are both linked to the GSCI Total Return Index.

All three mutual funds include the spot, collateral and roll yield in total returns.

Generally speaking, commodity mutual funds have higher fees than other vehicles that offer similar exposure. Not only do they have expense ratios that start at 1.25% and rise above 2.00%, they may also have "loads" that make short holding periods a very expensive proposition.

Taxes

As with ETFs, commodity mutual funds pass through interest income and must be marked-to-market at year-end.

Advantages: Familiar structure, experienced management.

Disadvantages: High fees, tax exposure.

MACROs

The newest entrant on the commodities scene, MACROs are the brainchild of Robert Shiller's MacroMarkets LLC, and are being marketed by closed-end fund expert Claymore Advisors.

The funds are very unusual, and bear explanation.

The first two MACROs, which launched in late November 2005, were tied to the price of crude oil. "Two" is an operative word here: all MACROs are launched in pairs. In this case, the "Up" Macro (AMEX: UCR) rose in value as the price of near-month crude oil futures went up, while the Down Macro (AMEX: DCR) sank in value when the price of crude dipped.

The two were intimately related, like a teeter-totter: the MACROs agree to trade assets back and forth based on the value of the underlying benchmark.

What's truly interesting about the MACROs is that they divorce the act of tracking a benchmark from actually holding ... anything. The MACROs' only assets are Treasury bonds, which generate interest income for shareholders. The funds tracked the price of oil because the funds teeter-totter assets back and forth between one another in much the way a futures contract does. And yet, these funds could be traded like traditional stocks. Of course, the teeter-totter has to have a bottom, and in April of 2008 the original oil MACROs hit the break point, and will be closing. The Oil Down Macro reached a Net Asset Value of zero.

Many experts believe that oil is just the first step, and that we could some day see MACROs based on housing, employment numbers ... anything at all.

The biggest downside of the new funds is their fees: 1.6%, or more than 2X the fees of the competing US Oil Fund (USO). The expenses will be paid out of interest income.