How New Commodity ETFs Really Work

October 17, 2014

iShares’ new commodity fund splits the finest of marketing hairs.

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.


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