Fight over commodities in funds

There is a growing regulatory movement afoot aimed at reducing commodities exposure within mutual funds dramatically just as this alternative strategy is gaining popularity.

While this is something financial advisers will want to watch, it is not a reason to cash out of commodities- or managed-futures-based mutual funds just yet.

The complex and tangled issue could be summed up as part turf war, part political grandstanding and part ignorance.

The bottom line is that mutual fund investors have expressed a strong appetite for commodities exposure, and the fund industry has responded — and probably helped fuel that appetite — by launching nearly three dozen funds since 2003 that offer broad commodities market exposure.

The net investor flow into this tidy subcategory of less than $50 billion speaks for itself.

POPULAR AS A HEDGE

Over the past three years, as the commodities space has grown in popularity as an alternative strategy and inflation hedge, these mutual funds saw net inflows of $10 billion, $14 billion, and $10.5 billion, respectively.

Most of the funds are designed to track one of two broad commodities indexes, which have done fairly well.

The S&P Goldman Sachs Commodity Index, which has a 66% weighting in energy commodities, declined by 1.2% last year but gained 9% in 2010 and 13.5% in 2009.

The Dow Jones UBS Commodity Index, which caps energy exposure at 33%, gained 13.3% last year, 16.8% in 2010 and 18.9% in 2009.

This would sound like a wonderful diversification strategy — and the story could end there — if it weren’t for the fact that these funds now are the target of populist political banter and regulations gone wild.

The problem begins with the funds’ unique structure. Because the Investment Company Act of 1940 limits investment in commodities to no more than 10%, mutual fund companies have had to work around the law.

They’ve done that by setting up offshore corporations that invest in futures contracts on behalf of the mutual fund.

But to maintain the favorable tax treatment that applies to other mutual funds, which are taxed at the shareholder level and not at the corporate level, the commodities-linked funds have had to get private-letter rulings from the Internal Revenue Service.

That point was dissected last month at a congressional hearing held by the Permanent Subcommittee on Investigations, during which Sen. Carl Levin, D-Mich., grilled IRS Chairman Douglas Shulman.

Using phrases such as “sham corporations,” Mr. Levin insisted the fund companies are moving offshore to avoid corporate-level taxes.

Mr. Shulman, who said the IRS has suspended the issuance of private-letter rulings while the matter is under review, pointed out that taxes still are being paid at the shareholder level, just as they are at all other mutual funds, and that the IRS is not losing any tax revenue, because of these fund structures.

In the feisty debate, Mr. Shulman refused to accept Mr. Levin’s argument that the funds are avoiding taxes because mutual funds never pay taxes at the corporate level.

Drawing a parallel between fund flows and commodities prices, Mr. Levin also argued that the commodities-linked mutual funds are driving commodity price volatility.

Of course, there was no mention of the $116 billion in commodities-linked exchange-traded products as a possible driver of that same volatility. (Commodities ETFs are not considered 1940 Act products and are not subject to the 10% rule, so they don’t have to jump through the same hoops.)

“The [mutual fund] participation argument makes no sense,” said Abraham Bailin, an analyst at Morningstar Inc. “Increased participation makes markets more liquid and decreases volatility, not the other way around.”

Surprisingly, nobody seems to be asking why there still are rules restricting the use of commodities inside mutual funds. Without that rule, fund companies wouldn’t need to set up offshore companies to manage the funds.

A spokeswoman for Mr. Levin declined to comment.

Though much of Mr. Levin’s logic against commodities-linked mutual funds appears shaky, that doesn’t mean the funds won’t continue to face challenges.

CFTC EYES OVERSIGHT

A ruling by the Commodity Futures Trading Commission in 1985, and modified in 2003, essentially deferred oversight of funds investing in managed futures to the Securities and Exchange Commission. The CFTC is considering whether to bring commodities-linked mutual funds under its regulatory scope.

“There are a lot of things hitting the fan right now, and these funds are very vulnerable,” said Ken Steben, president and chief executive of Steben & Co. Inc., a $2 billion commodities pool operator.

As a seller of managed futures limited partnerships to 150 broker-dealers, Mr. Steben admits that these funds represent the competition.

“We could set up a mutual fund as fast as anyone,” he said. “But we just want Congress and the regulators to either say they’re OK with it or not.”

Don’t hold your breath.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]