Another sticking point for both ETNs and ETFs that track commodities is that the Commodity Futures Trading Commission (CFTC) is looking at imposing position limits in U.S. futures markets to curb speculation. Such limits, already in effect for certain agricultural commodities, could distort market prices if the ETFs and ETNs that use futures contracts were forced to limit the number of outstanding shares.

Tax treatment is one area where the ETNs have a clear advantage. Exchange-traded funds such as SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV), which hold stores of precious metals in secure vaults, are structured as grantor trusts and treated as collectibles by the IRS for tax purposes. So any capital gains you make when you sell are taxed at a maximum rate of 28%, no matter how long you hold the ETF. During the holding period, the trust may also generate taxable gains from bullion sales used to pay operating expenses.

Those ETFs that use futures contracts, such as the iShares S&P GSCI Commodity Indexed Trust, are treated somewhat differently. Under IRS regulations, any annual income and profits they generate are taxable and reported on a Schedule K-1. Sixty percent of the gains are taxed as long-term and 40% as short-term.

The tax treatment of ETNs is much less complicated and more favorable, at least for now. Although the IRS has not come out with a formal ruling on tax treatment, ETN issuers argue that they are essentially prepaid contracts and subject only to ordinary capital gain or loss tax rates when they are sold.

The favorable tax treatment of ETNs came into question in 2007 when the IRS ruled that gains and losses associated with the sale of ETNs linked to a single currency are taxed at ordinary rates. Though the ruling did not extend to all ETNs, the IRS could easily change its mind in the future.

Another advantage ETNs have is their ability to track their indexes more efficiently than many ETFs, whose underlying investments in futures contracts make it difficult for them to precisely follow commodity indexes. The exchange-traded notes are simply designed to provide index returns, minus expenses.

Of course, precise tracking is a double-edged sword. When year-to-date results were recently tracked over one period, the iShares S&P GSCI Commodity Indexed Trust (GSG), an ETF, was a few percentage points behind both its benchmark and behind an ETN based on the same index, the iPath S&P GSCI Total Return Index. But over the one-year period, the tracking-challenged ETF held a performance edge over both the index and the ETN.

ETN Choices
A number of options are available to those who find the tracking and tax characteristics of ETNs appealing. Of approximately $6 billion in ETN assets at the end of June, $4.6 billion were attributable to commodity-related products representing both single commodity sectors as well as broader, diversified baskets.

Two popular options among the diversified group are the iPath GSCI Total Return Index and the iPath Dow Jones-UBS Commodity Index Total Return (DJP). The latter ETN covers 19 commodities segregated into energy (39%), agriculture (29%), industrial metals (21%), precious metals (12%) and livestock (7%). "This broad diversification serves to both lower the ETN's relative volatility and increase its risk-adjusted returns compared with owning a small sampling of handpicked commodities," says Morningstar analyst Paul Justice. He views the fund as a core holding that could represent 4% to 10% of an investor's portfolio assets. The iPath GSCI exchange-traded note focuses more on energy (66%), followed by agriculture (18%), industrial metals (7%), livestock (6%) and precious metals (4%).

For a different approach, the Elements S&P Commodity Trends Indicator ETN (LSC) invests long on commodities that are trending up in price and it shorts those that are moving down. Its ability to do the latter gave it a significant performance edge last year when commodities crashed. It is issued by HSBC, Europe's largest bank by market capitalization. PowerShares has a lineup of ETNs that cover either the long and short side in areas such as agriculture, base metals, oil, gold and broader commodities. Many of them are leveraged, creating double long or short exposure and, of course, ramped up volatility.