The commodities market has investors singing the blues, but a
new note leads some to follow the beat of a different drummer.

Almost a year ago, the world's first broad-based commodities exchange-traded fund was being heralded as a "Holy Grail" for the ETF industry: the first product to offer investors low-cost, diversified access to the "famous negative correlation" of commodity futures.

Since its launch in February 2006, PowerShares DB Commodity Index Tracking Fund, or DBC, has racked up about $700 million in assets and has emerged as a powerful tool for a number of financial advisors.
    "That they (the commodities ETFs) exist at all is generally a positive," says Roger Nusbaum of Your Source Financial, a wealth and portfolio management firm in Prescott, Arizona. "Regardless of returns, they offer diversification that used to be much more difficult to access."

That is undoubtedly true, but advisors have been a bit slow to embrace the funds. While $700 million is real money, it doesn't really live up to the "Holy Grail" billing. The streetTRACKS Gold Shares ETF (AMEX: GLD), for instance, garnered $1 billion in its first three days of trading, and now has more than $8 billion in assets. (Nusbaum, for the record, uses GLD in his clients' portfolios; he does not use DBC.)
    The biggest reason for the lukewarm reception is the uneven performance of the commodities sector since DBC's launch. While you can hardly open the paper without reading about the pending oil shortage or China's voracious demand for commodities, the truth is that commodities haven't been a great investment over the past year.
    It's wrong to extrapolate from short-term trends, but it's hard to escape the obvious: While stocks have marched smoothly to new highs, DBC has been ping-ponging back and forth with enough volatility to make Dennis Connor sea-sick. In fact, from its launch on February 6 through the end of 2006, DBC traded virtually dead flat for the year; meanwhile, the S&P 500 rose 12.6%.
    Is that a short-term hiccup or a long-term trend? A year into the commodities ETF revolution, it's time to take stock of what's changed in the industry, and to consider whether ETFs make sense for investors today.

New Products, Lower Fees

One of the biggest developments in the space over the past year is that investors now have many more choices for their broad-based commodities investments. While DBC was the first broad-based commodities ETF, it was quickly joined by the iShares Goldman Sachs Commodity Index Trust (NYSE: GSG). The fund tracks the popular (but energy-heavy) Goldman Sachs Commodity Index (GSCI), and it provides markedly different exposure to the commodities space than DBC (more on this later).
    One great thing about GSG is that it has sparked a price war within the commodities space. DBC originally launched with an expense ratio above 1.3%; today, both DBC and GSG charge just 75 basis points. Compared to the 2%-plus fee levied by many commodity mutual funds, 75 basis points is a bargain.

GSG is not the only innovation, either: Barclays Bank also has entered the fray with a new debt product that functions just like an ETF, and may be a better mousetrap. Called "exchange-traded notes," or ETNs, these products trade just like ETFs and track the performance of underlying commodity indexes. But rather than actually holding the underlying futures, the new ETNs are actually structured debt products. Barclays agrees to pay you the exact return of the underlying index (with zero tracking error), minus fees of 75 basis points.

The chief advantage-and it is a big one-is that Barclays believes that ETNs will never have to pay out capital gains distributions; investors will only owe taxes when they sell the notes. In comparison, most other commodities funds must pay out ALL their gains each and every year.
    Noteworthy is that futures-based investments receive unusual tax treatment by the IRS. Sixty percent of any gains are taxed as long-term gains, regardless of the holding period; that means that they are subject to the same 15% tax rate that applies to long-term gains on equity positions. The remaining 40% of gains are taxed as short-term capital gains, which are subject to the investor's ordinary income tax rate. This unusual 60/40 split creates a maximum blended capital gains tax rate of 23% for investors in the highest tax bracket; the tax burden is reduced for investors with lower incomes. Still, paying out 23% taxes each and every year is brutal. If the IRS agrees with Barclays' interpretation, ETNs may emerge as by far the most preferable product for taxable accounts.

"The ETN appears to be possibly the most cost-effective, accessible and transparent method for nonprofessional investors to gain access to a broad-based commodities index," says David Krein, president of DTB Capital, a structured investment boutique offering specialized advisory and brokerage services. "As long as they remain liquid and Barclays remains solvent-and the tax rulings break Barclays' way-ETNs could prove to be the vehicle of choice over the long run."

The downside of the ETNs is that, in the unlikely event that Barclays goes bankrupt, investors will be left holding the short end of the stick. They may also not be as liquid as traditional ETFs.
    Barclays currently offers two broad-based ETNs, one tied to the aforementioned GSCI index and one tied to the Dow Jones AIG Commodity Index (DJ-AIGCI).

Dancing The Contango
    So why haven't these commodity index ETFs exploded onto the scene? The $700 million in assets for DBC is a decent start, but given all the press that commodities have received, that number is still slightly disappointing.

The reason is "contango." An investment in commodity futures earns money three ways: 1) through changes in the spot price of the commodity; 2) through interest income earned on collateral cash (the cash not used to buy futures on margin); and 3) through "roll yield."
    Futures contracts aren't like stocks: they expire. So if you want to stay long, you (or your fund) will have to "roll" from one contract to the next, selling the expiring contract and buying the new one. Often, prices in the futures market for these "out month" contracts will be cheaper than for the expiring contract: oil may cost $62 per barrel today and $60 per barrel for next month. When this is the case, you effectively make money every time you roll the contract. It's called "backwardation," and for long investors, it's a glorious thing.
The reverse condition is called "contango." When you roll contracts that are in contango, you effectively lose money on every trade. It's a pernicious destroyer of returns.

Research shows that this "roll yield" is the largest single contributor to commodities returns. Unfortunately, for the past 18 months or so, most markets (and particularly energy) have been in "contango." So while investors have been reading about soaring commodity prices in the news, that hasn't translated into strong returns for commodity investors.
Figure 1 shows the dramatic impact of the roll yield on returns for the GSCI over the past 35 years; pay particular attention to 2005 and 2006.

Research shows that when markets are stuck in contango, investors may be better off stuck on the sidelines. Claude B. Erb of Trust Company of the West and Campbell R. Harvey of Duke University found that from 1992 to 2005, investing in the GSCI when markets are backdated has significantly outperformed investing in the GSCI when markets are in contango. In fact, during backdated markets, the GSCI posted compound annual returns of 11.25%, while during contangoed markets it has lost 5.01% per year.
    Different indexes are starting to take novel approaches to try to mitigate the impact of contango. The Deutsche Bank Commodity Index, for instance, now chooses from contracts dated out as far as 13 months to pick the contract with the best "roll yield." But you can't completely fight the market, and until we're back in backwardation, adding commodities to your clients' portfolios may be a losing proposition.

Choose Your Index Wisely

One lesson from 2006 is to watch your index closely. Some investors, conditioned by their experiences with stock indexes, expect commodities indexes to perform similarly. But the different commodity indexes hold vastly different futures in vastly different weights. Figure 2 compares the three different commodity indexes used by the aforementioned commodity ETFs and ETNS. Note the vast differences in weights for energy alone.

Strategic Choices
    Advisors who want to fine-tune their commodities exposure got a new option on January 5, when PowerShares launched seven sector-based commodity ETFs onto the American Stock Exchange. The new funds are:
    PowerShares DB Energy Fund (DBE)
    PowerShares DB Oil Fund (DBO)
    PowerShares DB Precious Metals Fund (DBP)
    PowerShares DB Gold Fund (DGL)
    PowerShares DB Silver Fund (DBS)
    PowerShares DB Base Metals Fund (DBB)
    PowerShares DB Agriculture Fund (DBA)
    Advisors can work with the funds in different ways. The most obvious use is to go long or short one particular sector-say, to make a bet on agriculture or base metals.
    Advisors can also use the funds to create a "paired trade" with a broad-based commodity index ETF. For instance, an advisor could buy the broad-based DBC but hedge against the negative roll yield in the energy sector by shorting the PowerShares DB Energy Fund.
    Finally, the gold, silver and precious metals funds will provide an interesting counterpoint to the existing gold and silver bullion ETFs. The bullion ETFs, like all physical precious metal holdings, are taxed as "collectibles," with a long-term capital gains tax rate of 28%. The new PowerShares funds, in contrast, enjoy the 60/40 tax treatment of all futures-based investments, creating a maximum blended tax rate of 23%.
    Advisors should be careful, however: just as broad-based indexing is often the best bet for equities, it also generally is a good policy in commodities, especially for clients unfamiliar with the space.

Watch The Tax Year
    One final reason why investing in the new commodities ETFs and ETNs may be in a holding pattern is that savvy advisors are waiting to see how the IRS treats new products like ETNs following the end of the 2006 tax year. Although the IRS is unlikely to issue a statement exempting these products from capital gains payouts, if early adopters aren't audited this year, that could give people confidence that the tax problem inherent to commodity futures has been mitigated.
    (Note: The "GSG" ETF uses a unique kind of long-term futures contract that may avoid the problem of taxable payouts as well; it bears watching.) While these payouts aren't an issue for nontaxable accounts, firming up the tax situation for all investors would be a good thing.

Advisors Watching Closely
    Whatever happens with commodities in 2007, we know one thing for sure: Advisors will be watching. A 2006 Morningstar survey of 70,000 advisors found that only 28% are currently using "alternative assets" in the bulk of their clients' portfolios. But fully 48% expect these assets to play a more important roll in the future.
    We also know that the ETF developers will continue to innovate. Two firms have filed papers with the Securities and Exchange Commission asking for permission to launch sector-based ETFs, for instance, allowing investors to tailor exposure to different slices of the commodities market: metals, agricultural products, energy, etc. These products will make it even more important that advisors stay on top of the latest developments.
    Now may not be the perfect time to gain exposure to the commodities space-history tells us to keep one eye on contango and wait for the music to stop-but with the long-term historical benefits and the improved access offered by ETFs and ETNs, that time will surely come.