How New Commodity ETFs Really Work
Today’s press release from BlackRock trumpeting its brand-new iShares Commodities Select Strategy ETF (COMT) certainly sounds like a big deal:
BlackRock Launches the First ETF to Provide Long-Only Broad Exposure to Commodities in a ’40 Act Regulated Structure
After all, the biggest hassle for most investors looking to get exposure to commodities is that you get a “K-1 Partnership Income” form at the end of the year. That means your gains are taxed as if you personally were buying and selling futures. Specifically, you pay a 60 percent/40 percent blended capital gains rate, and your gains get marked to market at the end of the year. In other words, on an up year, you can pay taxes despite having received no income, and not having sold.
That’s a pain, to be blunt. So hey, this new fund is great. Someone solved the K-1 problem.
Except they didn’t. First Trust did a year ago, with the First Trust Global Tactical Commodity Strategy Fund (FTGC | C-66). BlackRock threads the needle here by sticking “Long-Only” into the headline of that press release. But there’s actually more unsaid in the headline than said. So let’s look at this new “’40 Act Commodity Fund” space.
The Problem
The reason these funds exist is because the Internal Revenue Service has rules about what kind of things a traditional mutual fund can hold, and most ETFs are, when you get under the hood, mutual funds. The IRS is the one that allows the mutual fund structure to exist tax free.
That is, the fund itself never pays taxes, it just passes on to the individual shareholder any income it generates, and the capital gains from any transactions it makes. That’s awesome, and it’s the main reason mutual funds work.
The only problem is, the IRS says that if you hold a giant pile of futures, you’re actually a futures trader, and you need to go through that line at the “pay lots of taxes” buffet.
That’s why most ETFs that hold commodity futures are structured either as “commodity pools”—which generate those pesky K-1s—or as exchange-traded notes. ETNs are just tradable pieces of debt, like bonds, and thus avoid this K-1 problem altogether, though they do introduce counterparty risk.
First Trust’s Innovation
What First Trust figured out a year ago—sorry BlackRock—was that the inherent leverage of commodity investing could solve this problem in a clever way. A futures contract to buy oil, for instance, is just a promise.
One oil contract is saying, “I will by 1,000 barrels of oil on Nov. 20 for $81.10 a barrel.” That notional exposure is $81,100. But you don’t hand anyone that much money. Instead, you put up what’s called the “initial margin,” which is $2,950. That margin amount changes regularly based on the value of crude, but it’s always a tiny fraction of the actual exposure.
That’s why, if you look under the hood at something like the United States Oil Fund (USO | A-70), you’ll see “notional” exposure of 100 percent to the front-month oil contract, but the actual holdings table looks like this:
The actual “value” of the fund—the thing you divide by the number of shares to get the net asset value of USO, is in fact, $721 million.
However, what the fund actually owns is 8,920 contracts and $736 million in cash. The discrepancy is likely the result of liabilities the fund has accrued, such as settlements pending, fees owed, commissions owed and so on. That’s an entirely normal fund accounting issue always explained in the semiannual report.
In other words, while the fund is notionally fully exposed to a single asset—oil futures—from an accounting perspective, it’s almost entirely cash.
The Solution
What First Trust leveraged was a little loophole in the IRS treatment of funds registered under the Investment Company Act of 1940. While you can’t invest in all those futures contracts as a mutual fund, you can always invest in companies. So First Trust—and now iShares—uses a subsidiary in the Cayman Islands to hold all the futures contracts.
Thus, they can make a tiny investment in the Cayman company, maintain all the cash and collateral on their books, and the accounting ends up looking like a single small investment in a company, and an enormous pile of cash and Treasury bills.
That means, you pass the IRS letter of the law and can just run the fund like Fidelity Magellan for tax purposes.
It’s hardly a free lunch, however.
The Crucial Catch
While it’s true you don’t owe taxes on marked-to-market implied gains, you do get any actually booked gains distributed out to you as ordinary income. So you give up the favorable 60 percent/40 percent tax treatment accorded to futures holdings, but you only owe on what you actually receive in cash.
It’s a clever ruse, and FTGC has racked up over $180 million in assets in the last year because of it. The fact that the use of an active management approach has outperformed naive commodity indexes like the GSCI hasn’t hurt either, I’m sure.
The Equity Play
Now, along comes the iShares Commodity Select Strategy ETF (COMT).
COMT is using precisely the same ruse to get the futures exposure, and it’s also actively managed. The giant difference is that it also invests in a ton of regular stocks. Holdings haven’t been published yet, but here’s the pie chart from the Day-1 fact sheet:
Back of the envelope, this looks very much like a classic production-weighted chart. The new fund has tons of energy, and so on. The big difference is each sector has a chunk of futures, and a chunk of equities. By my count, it’s 35 percent stocks, and 65 percent commodity futures.
There’s nothing necessarily wrong with that—and, in fact, the 48 basis point expense ratio for the fund is downright reasonable compared with FTGC’s 95 basis points. There’s ample evidence that a strategy like this can actually be quite effective at mirroring spot prices and removing the worst of contango in tough markets.
My issue, ultimately, is with the somewhat reach-y headline of the press release. The only reason it passes the “not actually wrong” test is the phrase “long-only.”
The truth is that FTGC can technically short futures contracts, as well as go long futures contracts. The First Trust fund isn’t currently short any commodities, and I don’t recall seeing them short. But the fact that FTGC has the capability of making a bear bet on commodities makes the COMT headline not technically a lie.
Missing from the headline, of course, is that COMT is actually a 35 percent natural resources equity fund. Of course, it discusses this in the body of the release, and in the appropriate documents. Still, it strikes me as trying to plant a flag on top of Mount Everest because you’re the first one that got there on a Thursday.
What’s Next
Skeptical investors might be concerned the IRS or the Securities and Exchange Commission will get involved and close down this little loophole. The day I worry about the IRS moving quickly is the day I become a monk. It might someday change, but I think there’s zero risk of a heartbreaking backtrack on this particular structure.
In fact, I think it’s only going to become more popular.
After all, U.S. Commodities Funds is getting in the game, and they’ve still got the big stick in the space. Now that First Trust has broken the ground, I’d actually be surprised to see a commodity futures strategy not taking flight to the Caymans.
At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at dnadig@etf.com, or on Twitter @DaveNadig.
