What You Need to Know About Commodity ETFs, ETNs, and Contango

The introduction of commodity ETPs cracked this volatile asset class wide open. What was once only available to active traders and futures investors can now be accessed by investors of all kinds around the world. Now, something like accessing physical gold bullion is as easy as a couple of clicks of the mouse. But for all that they have done for the commodity industry, there are still a fair amount of misconceptions about ETFs and ETNs that allocate their assets to commodities [for more commodity news and analysis subscribe to our free newsletter].

Exchange Traded Funds (ETFs)

These are the standard funds that everyone knows and loves: UNG, GLD, DBC, and many others. Commodity ETFs were the first products to be introduced to the markets, and are considered something of dinosaurs in this day and age. The majority of these products are futures-based and invest in front-month contracts on their respective commodities (though there are a number of exceptions). Below, we outline a few important factors to keep in mind when investing in a commodity ETF.

• Taxation: Your standard investing taxes, as it currently stands, charges 15% for long-term capital gains and 35% for short term capital gains. But ETFs, because they are structured as partnerships, will not behave in the same manner. Some funds charge 23%, others like GLD charge 28% on long-term capital gains. It should also be noted that commodity ETFs are notorious for issuing that pesky K-1 tax form that can be a major thorn in investors’ and advisors’ side [see also Does GLD Really Hold Gold, Or is it a Scam?].
• Tracking Error: One downside to using the ETF structure is that tracking error is a possibility. Tracking error, to put it in the simplest of terms, is when a fund fails to accurately track its underlier. This occurs when the NAV of the fund deviates from its price, and it can occur for a number of reasons, but it will only occur in ETFs.
• Tighter Bid/Ask Spreads: On average, the most popular commodity products out there are still those first generation ETFs like GLD, UNG, and SLV. As such, these funds will have much tighter bid ask spreads and will be much easier for traders to utilize. Some of the less popular ETNs can often have wide spreads that can leave you burned on a market order. Which brings me to my next point, never, ever use a market order when investing in ETPs!

Exchange Traded Notes (ETNs)

Exchange traded notes have become the most popular vehicle to utilize when issuing a commodity product these days. The majority of these products have little in assets, but offer compelling strategies that can be found nowhere else on the market. It should be noted that these products are structured as debt instruments, giving them a number of nuances to consider prior to investing [see also Three Things Wall Street Journal Didn’t Tell You About Commodities].

• Counter Party Risk: As a debt instrument, ETNs carry counter party risk, meaning that they are at the mercy of their issuer. Should the issuer go bankrupt, the fund would be in danger of shutting down and there is not a guarantee that all investors will get paid out. Though it is an extremely rare occurrence, Lehman Brothers had some ETNs prior to the 2008 crash that took a big hit.
• Tax Favorable: The majority of ETNs feature the standard 35/15 tax rate for short and long term capital gains, allowing you to accurately predict your expenses and takeaways at the end of each investment. Also note that an ETN will never issue a K-1, as a 1099 is the standard tax form for owning one of these products.
• Built For Traders: ETNs were built for active traders, as they feature a number of dangerous strategies that are only safe to use in an active manner. This includes a wide variety of leveraged and inverse products that allow investors to make speculative bets on their favorite commodities with relative ease.

Contango

Contango has long been an issue for commodity ETFs and ETNs as it has been known to burn a number of investors on their trades and positions. By definition, contango is the process whereby near month futures are cheaper than those expiring further into the future, creating an upward sloping curve for future prices over time. The reason behind this is most often attributed to storage costs; storing barrels of oil or bushels of corn isn’t cheap and the costs have to be passed down the line. Some commodities, like natural gas and crude oil, are known for exhibiting steep contango over time, while others may have very little evidence at all. See a full-fledged example of how contango in natural gas can impact you here.

In some cases, a commodity will present backwardation, which is simply the opposite of contango, when near month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time.

There are now a number of unique funds that aim to alleviate the effects of both contango and backwardation, like the “contango-killer” United States Commodity Index Fund (USCI). But it should also be noted that investors can use these phenomenons to their advantage when making trades. Just remember to always keep and eye on the futures curve as they can turn on their heads relatively quickly.

Don’t forget to subscribe to our free daily commodity investing newsletter and follow us on Twitter @CommodityHQ.

Disclosure: No positions at time of writing.