Many ways to profit from resources

Adrian Day is the founder and president of Adrian Day Asset Management. This article was excerpted from his book, “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks” (John Wiley & Sons Inc., 2010).

There are various ways to gain exposure to commodities. You can invest in the commodities themselves or in the stocks of resource companies. You can invest directly or through mutual funds (or managed accounts that combine some of the benefits of funds with the advantages of investing in individual securities), or through futures or options.

If you invest directly in the commodities themselves, you gain direct exposure. You have no upside leverage from buying mining companies, but similarly, you have no downside beyond the commodity price. You don’t have to worry about the company’s management or balance sheet, or anything to do with running a mining business. It’s a pure investment in the commodity itself. On the other side, there are holding costs associated with owning physical commodities, including storage and insurance, that can be costly over time.

True, physical possession is feasible for only a handful of commodities: gold, silver and the other precious metals (platinum and palladium), plus diamonds and other stones. Others, such as copper and lead, are too bulky in amounts of meaningful value. Others, such as uranium, require special handling. And yet others, primarily the agricultural commodities, will rot.

Hedge funds have become particularly innovative and aggressive in buying physical commodities, which certainly offer their investors low-cost and more-direct exposure. However, increased speculative interest in the sector does present an added risk, at least a short-term price risk. If the hedge funds and speculators for some reason decide to sell — and they frequently move together in one direction — there is the risk of a sudden price collapse. We saw this at the end of 2008 amid the Lehman [Brothers Holdings Inc.] collapse, when margin calls and other factors forced hedge funds to dump commodities (as well as many illiquid junior shares), causing prices to collapse beyond any reasonable assessment of their fundamentals.

ETFS AND FUNDS

Beyond owning actual physical commodities, the next-most-direct investment would be a share in an exchange-traded fund, exchange-traded note or closed-end fund that tracks one or more commodities. There is now a proliferation of ETFs investing in commodities; at last count, more than 100 existed in the United States alone. Some invest in one commodity, others in a basket. Some are long, some are short, while yet more promise to double or even triple the unleveraged returns of the underlying commodity. They work in varying degrees and can be a suitable substitute if you don’t want to pay the costs associated with physical ownership, or if physical ownership is impractical, but there are pitfalls.

Best are the pure, unleveraged ETFs that hold the physical commodity itself. There are about a dozen available for gold and silver, even uranium. (The platinum ETFs own futures, not bullion.) The oldest and largest is the SPDR Gold Trust (GLD) — established by the World Gold Council — which holds gold bullion in bank vaults in London to match the investment in the trust. Its price, therefore, hardly varies from the price of gold itself. (One share of the trust equals one-tenth of an ounce.) Each share of the iShares Silver Trust (SLlV) ETF represents one ounce of the metal. Both trade on the New York Stock Exchange. The ETFs purchase (or sell) physical gold or silver to match holdings with the demand.

As of the end of 2009, the Gold Trust was the third-largest ETF of any type in the United States, with nearly $40 billion in gold bullion. These are the oldest and largest precious-metals ETFs. Their success spawned competing funds, and there are now five gold funds, four silver funds, two platinum funds and another two that invest in all of the precious metals. The newer funds are considerably smaller, however; compare the Gold Trust’s $40 billion in bullion with about $2.4 billion for the iShares Comex Gold Trust (AU) and less than $100 million for the Physical Swiss Gold Shares (SGOL).

Some of these other funds attempt to capitalize on suggestions that the Gold Trust does not really own the gold it claims, though these rumors normally are spread by interested parties. There is no credible reason to believe the trust does not own sufficient gold to match its assets, as its gold is held independently and audited regularly. For large quantities, trust holders can demand to take delivery of their gold, though that is an expensive and cumbersome procedure. One real drawback to the gold (and other) ETFs, however, is that the tax rules are unfavorable. As with owning physical gold itself, a shareholding in the ETF is treated as ownership of a collectible, meaning sales of shares are taxed at rates higher than capital gains: Shares held less than one year are taxed at ordinary rates and for shares held longer than that, the rate is 28%. However, bullion ETFs generally are exempted from the prohibition on ownership of collectibles inside IRAs.

CLOSED-END FUNDS

An alternative to ETFs is a closed-end fund. Although a closed-end fund trades on an exchange and can be bought and sold just like an ETF (or any other shares), a closed-end fund has issued a fixed number of shares and can trade at a premium or discount to its underlying value. In addition, the assets can be managed. Generally, such variations from the underlying value do not become too large or remain in place for a long period, if only because in cases of a premium, the fund often will issue new shares to capture that premium, while with a discount, arbitrageurs will buy the shares and sell the underlying asset to capture the difference.

One attractive closed-end precious-metals fund is the Central Fund of Canada (CEF), which trades on the New York Stock Exchange as well as in Canada. It holds both gold and silver — 1.2 million ounces of gold and 62.1 million ounces of silver — stored on a fully segregated basis in Canada, has low operating expenses and avoids the negative ETF taxation issues. From time to time, it issues new shares, but since these are issued at net asset value or a premium, there is no dilution to existing shareholders.

Other than funds holding the precious metals, however, the only current fund holding a physical commodity itself is the Canadian Uranium Participation Certificate (U), which holds uranium in different forms. Because storage of uranium is more complex than that of metals, the administrative costs tend to be a little higher. Available on the Toronto Stock Exchange, the certificates trade like a closed-end fund, i.e., at discounts or premiums to its net asset value. As with other similar funds, of course, the fund tends to trade at a premium when the market is hot and the price rising. For investors interested in exposure to uranium, this is a good direct play, particularly attractive given the paucity of solid investments in this resource.

PROBLEMS WITH ETFS

Most of the commodities ETFs, however, use futures rather than hold the physical commodity. And therein lie the problems. Typically, the funds purchase short-term contracts (to match spot prices more closely) and roll them over on a continuous basis. This adds costs, from the continuous buying and selling of contracts, but that is the least of the problems.

Future prices of commodities either can be higher or lower than spot prices. If they are higher, the difference between the spot price and future price is called the contango. When futures prices are lower, the commodity is said to be in backwardation. This typically occurs when there is a short-term physical shortage and customers push up the spot price for immediate delivery. More often, prices carry a contango, which is a carrying charge. Thus the ETF, in continually rolling over contracts, is forced to sell contracts and replace them at a higher price. Over time, this can act as a not-insignificant drag on the returns vis-à-vis the appreciation in the spot price. Of course, ETFs offer convenience at a low cost and can certainly be a valid way to invest in the commodities.

The most damning drawback affects those commodities ETFs that offer leveraged returns by promising two or three times the unlevered returns. The problem here is that returns are computed on a daily basis, so a short-term spell against the longer-term trend can wreak havoc. Investors have often found to their frustration that they were correct in selecting a particular commodity for a particular period but their returns from the leveraged ETF did not measure up to expectations.

Another drawback to commodities funds is the way they are taxed. As mentioned, gold bullion funds are taxed at a special — higher — capital gains rate for collectibles. Taxation for commodities ETFs is complex and higher than normal gains rates. One example is that the Internal Revenue Service requires open futures contracts to be marked to market at year-end. This means that the investor can owe taxes even if the fund has not sold its positions — let alone whether he or she has sold the shares in the fund. Worse, these phantom profits are taxed at a blend of short-term and long-term rates, currently 23%. Besides the actual tax, the instructions for preparing returns will flummox many tax preparers, in addition to giving investors an unwelcome surprise.

WHAT DO YOU OWN?

Perhaps the most critical thing for investors to know (as always) is what they are buying. The PowerShares Agricultural Fund (DBA), for example, is intended to track the Deutsche Bank Liquid Commodity Index-Optimum Yield Agriculture Excess Return Index. But after exhaustive research, all I can discover is that it includes “contracts on some of the most liquid and widely traded agricultural commodities.” The opaqueness is compounded since many of these multicommodity funds can change their allocation, so you may not own what you bought.

Because the ETFs are buying futures contracts, they are subject to the commodities exchanges’ various “limit-up” rules or size limitations, meaning that the funds sometimes cannot purchase sufficient contracts to match an inflow of shares. The commodities ETF market is in a state of flux at present, with ongoing proposals to limit investment in various commodities. The Commodity Futures Trading Commission has enforced maximum daily limits for various commodities, including many agricultural commodities, and is considering imposing absolute caps on investments in a range of commodities. The CFTC is particularly concerned about situations in which a single investor (or a fund) holds positions that breach certain overall levels.

The rules already in force, as well as fear of further restrictions, have led some funds to stop issuing new shares. BlackRock Inc. has stopped creating new shares for several of its iShares funds, including broad-based ones such as the iShares Commodity-Indexed Trust (GSC) and narrower ones such as the iPath Natural Gas ETN (GAZ). It certainly makes difficult the concept of an ETF, whereby there is continual issuance or redemption of shares to meet demand, with shares trading at NAV.

To avoid some of these problems, many of the commodities ETFs have moved to offshore locations where they can buy foreign commodities contracts, or if they are multiple-commodities ETFs, have altered their composition as one of the component contract reaches the limit. This, however, makes it difficult for the investor to know what he or she owns, and increases the tax consequences. Despite these drawbacks, however, for many investors, these ETFs represent the only feasible way to invest in various commodities. If you know what you are buying, and understand the characteristics and risks, then commodities ETFs offer a convenient and low-cost way of investing in these assets.

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