ETF Securities Files For Tax-Efficient Commodity ETFs

May 28, 2010

ETF Securities files to launch a slew of commodities ETFs that may just be serving up the sorts of tax advantages investors are hungry for.

ETF Securities has filed papers with the Securities and Exchange Commission for a series of commodity ETFs that may give investors long-term tax treatment that’s superior to competing funds.

The filing, dated May 27, covers 18 new ETFs, and would mark a significant expansion of ETF Securities’
lineup. The company currently has just four funds on the market in the
, with about $1.5 billion in assets under management. London-based ETF Securities is a dominant player in the commodities ETF space in
Europe, and has gathered more than $18 billion in assets.

The new
filing covers eight traditional long commodity funds, five short commodity funds and five leveraged funds. Each fund will track an index that aims to capture the performance of a fully collateralized rolling position in front-month commodity contracts. The leveraged funds aim to capture twice the daily performance of each index, while the short funds aim to capture the inverse of the index’s daily performance.

The funds are:

ETFS New Commodity ETF Filings
Long Leveraged Short
ETFS ex-U.S. Oil ETFS Short ex-U.S. Oil ETFS Leveraged ex-U.S. Oil
ETFS Natural Gas ETFS Short Natural Gas ETFS Leveraged Natural Gas
ETFS Copper ETFS Short Copper ETFS Leveraged Copper
ETFS Wheat ETFS Short Wheat ETFS Leveraged Wheat
ETFS Composite Agriculture ETFS Short Gold ETFS Leveraged Gold
ETFS Composite Industrial Metals
ETFS Composite Energy
ETFS All Commodities

The Potential Tax Advantage

The potential tax advantage is that these funds won’t invest in actual futures contracts, the way ETFs like the United States Oil Fund (NYSEArca: USO) or the iShares GSCI ETF (NYSEArca: GSG) do. Instead, they will enter into a special kind of swap agreement, which may boost the long-term tax efficiency of the funds.

ETFs are a pass-through mechanism: Investors holding ETFs are taxed as if they held the securities owned by the ETF itself. Futures contracts are treated differently from equities from a tax perspective, and those differences pass straight through to the ETF investor. As a result, no matter how long you hold a fund like USO, any gains will be taxed as 60 percent long-term and 40 percent short-term gains, just as a futures contract would be. That creates a maximum capital gains tax rate of 23 percent. Also, futures (and futures-holding ETFs) are “marked-to-market” at the end of each year, meaning you can’t defer gains, and will likely owe taxes on the fund each and every year. This has made owning futures-based commodity ETFs in a taxable account somewhat challenging.

The new funds will own swap contracts linked to futures rather than purchasing the futures themselves. The advantage is that the swaps in this case will be structured as “prepaid forward contracts.” That’s a magic word in commodities, as it’s the same word used to describe commodity exchange-traded notes.



Like ETNs?

Commodity ETNs have benefited from a tacit Internal Revenue Service understanding that they should be taxed like other “prepaid forward contracts,” which means they are taxed like equities. The notes are not marked-to-market at the end of each year, and more importantly, if you’ve held the notes for more than one year before you sell, any gains are taxed at the long-term capital gains rate, which currently maxes out at 15 percent.

The IRS has never officially acknowledged that ETNs qualify for this treatment, but it has never officially ruled otherwise, and this “pocket veto” has been seen as tacit agreement.

Unlike ETNs, however, the new ETFs will have limited credit risk. In an ETN, the full value of the note is dependent on the good faith and credit of the issuer. The swaps underlying these new ETFs will be fully collateralizing, meaning the opposing party will have to put up the full value of the swap in a separate account maintained by a third-party custodian. That should eliminate most credit concerns.

If the new funds can deliver the tax efficiency of commodity ETNS without the credit risk, they may be a big hit.

ETF Securities wouldn’t comment on the filing, as is the norm; ETF companies are essentially prohibited from commenting on funds still in registration.

Another SEC Filing

Separately, ETF Securities has filed for an ETF that would hold a basket of “white metals.” The fund will hold silver, platinum and palladium bullion.




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