Avoid These Pitfalls in Commodity ETFs

 | Jun 08, 2012 | 3:00 PM EDT
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Exchange-traded commodity products have become quite popular over the last several years, and represent one of the great "democratizations" of investing that ETFs have brought on. The exchange-traded structure has made a once-hard-to-reach asset class easily accessible, and investors of all skill levels and degrees of sophistication have embraced these funds as new additions to their portfolios.

If used correctly, commodity exchange-traded products can be tremendously powerful tools, as they bring the potential for both diversification and return enhancement. But there are plenty of pitfalls when it comes to commodity ETFs as well -- if you don't know exactly what you're doing, it's easy to make a costly mistake. Below I'll run through three items to keep in mind when you're dealing with commodity ETFs.

Front-Month Funds Equal a Recipe For Disaster

Most investors, at this point, are well aware of the fact that the vast majority of commodity exchange-traded products do not offer exposure to spot commodity prices. Instead, they tend to utilize futures contracts in order to achieve their objectives, which introduces new elements into the equation. Specifically, the slope of the futures curve can have a big impact on bottom line returns -- generally in a direction that is unfavorable to investors.

Many of the "first generation" commodity funds hold only front-month contracts, and "roll" into new futures as their holdings approach expiration. That approach works well for capturing short-term price swings, but over the long haul it's a recipe for disaster. If you're looking to maintain longer-term commodity exposure, be sure to avoid funds that utilize only front-month futures contracts.

Watch Out For Energy Bias

In addition to the many resource-specific funds, there are also a number of ETFs that cast a wider net and deliver exposure to a broad basket of commodity futures. But there is a wide spectrum of diversification. Some "broad" commodity ETFs actually feature significant concentration in single commodities or commodity families.

The iShares GSCI Commodity Index Trust (GSG) is a great example. This fund, which has more than $1 billion in assets, includes exposure to more than a dozen natural resources, including precious metals, agriculture, livestock and industrial metals. But the bulk of the portfolio is allocated to energy: Oil and related contracts make up close to 70% of total assets. In some environments, that energy bias might work out quite well -- if oil prices climb, ETFs such as GSG will do quite well. But if you're seeking a more balanced portfolio, consider a fund such as GreenHaven Continuous Commodity Index ETF (GCC) instead.

Tax Burdens

When investors are fortunate enough to see one of their positions appreciate in value, they often begin to consider the related tax obligations. Tax liabilities are normally  incurred upon liquidation of a security, and investors have grown accustomed to setting aside some funds to cover upcoming payments. But many of the most popular commodity funds can create tax liabilities even before a position is ever sold -- which can put you in a challenging positions.

Commodity pools function in a generally similar way to ETFs, but they're actually quite different when it comes to taxes. Gains are taxed annually at a blended rate of 23%, even if the position remains intact and there was never a liquidation. That can be an unwanted notification for many investors. The easy alternative here is to utilize ETNs, which are taxed in the more traditional manner.

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