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.

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