Morningstar’s ETN Snub Overlooks Tax Advantage

Last week, Morningstar announced a number of changes to its ratings for mutual funds. The biggest change was to combine ETFs and mutual funds into the same peer group in the U.S. and Australia (they are already combined elsewhere).

Previously, Morningstar had separated ETFs from mutual funds when ranking products for performance, fees and other factors. The combination is a good thing, and should help put additional pressure on traditional funds to lower fees to compete.

One small change they made, however, struck me as unfortunate, and could lead investors to leave money on the table: As of Oct. 31, Morningstar will discontinue rating exchange-traded notes (ETNs) and exchange-traded commodities (ETCs). The firm explained the decision as follows:

“As unsecured or cross-collateralized debt instruments, insolvency of the issuing company or a failure in a cross-collateralized ETC can result in investors receiving materially less than the underlying investment returns, after operating and management expenses. These risks make these investments inappropriate to compare with fund structures.”

Why ETNs Can Be A Great Choice

That’s legal-speak for saying that ETNs are debt notes, and if the underwriting bank goes bust, investors will lose almost all their money. That’s of course true, and the credit-backed nature of ETNs is always worth remembering.

But I’ve long thought that ETNs were under-loved by investors—particularly in the commodity area. By eliminating the ratings on them, Morningstar is effectively saying they shouldn’t be considered in the same breath as funds and ETFs. That strikes me as wrong: At least for taxable accounts and commodities, ETNs are a great choice.

For example, consider the iPath Bloomberg Commodity Index Total Return ETN (DJP | C-18). The fund has a reasonable expense ratio (0.70%), although its tracking is imperfect—it misses its benchmark on average by 1.38% a year. That aligns with the performance of its largest ETF competitor, the PowerShares DB Commodity Index Tracking Fund (DBC | C-26), which has a median tracking difference of 1.30% a year.

DJP may not be for anyone. Its index caps exposure to any one commodity at 15% and any one commodity sector at 33%, creating a portfolio that biases away from energy compared with its peers.

But that’s a valid approach, particularly given the state of contango in the energy markets. Similarly, its policy of holding only front-month futures contracts is not for everyone; some may prefer a more dynamic approach. But still, it’s a valid product and reasonably run.

In addition, the returns this year for DJP and DBC are basically the same: 12.81% and 13%, respectively.

Chart courtesy of StockCharts.com

Which Brings Us To DJP’s Key Advantage: Taxes

When you buy an ETF like DBC, the Internal Revenue Service treats you like you own commodity futures … which, of course, you do. That means you have to “mark to market” your position, meaning you must pay taxes at the end of each year as if you sold the fund (even if you didn’t do so). Moreover, you pay tax at a 60% long-term/40% short-term basis.

By contrast, because ETNs are debt, they are taxed like debt. That means no mark-to-market tax treatment and no 60%/40% tax split. For high-income investors, the tax long-term investors pay on long-term holdings of commodity ETNs (20%) is significantly lower than the tax you pay for long-term holdings of commodity ETFs (upward of 28%). That’s very real.

By comparison, the default risk for ETNs is largely theoretical (and in the rare case where it may occur, avoidable through reasonable monitoring). ETNs retain their full value unless the underlying bank defaults. Fortunately, ETF.com—relying on FactSet’s ETF team—monitors this for you by keeping an eye on the credit default swaps for the bank that supports each ETN. In the case of DJP, for instance, you can look at the Efficiency tab at www.etf.com/DJP where the ETN counterparty is named (Barclays Capital Inc.) and its counterparty risk is monitored (currently “Low”).

If “Low” ever turns to “Medium” or “High,” you should sell immediately. Until it does, enjoy that tax benefit if you need taxable commodity exposure.

I understand Morningstar’s decision. It’s been a leader in breaking news about ETNs and the risks they entail—including credit risk and path-dependent fees—and they worry about unsophisticated investors buying products they don’t understand.

But for tax-aware investors, swapping a theoretical risk for a real one may not be a good deal. I’d hope more sophisticated investors look past Morningstar’s lack of ratings and consider ETNs where appropriate.

At the time of writing, the author owned none of the ETFs mentioned. Matt Hougan is the CEO of InsideETFs and can be reached at [email protected].