Base metals rally but getting exposure can be tricky

Posted on: February 18, 2010 in: Uncategorized with 0 comments

Industrial metal prices are rallying after suffering sharp falls in January. Prices of copper, zinc and aluminum have climbed 12 to 13% over the last two weeks after falling 20 to 24% from early January peaks. In dollar terms, about half the losses have been recouped.

The prices initially fell because China took steps to slow its economy by tightening credit. That action also had global stock prices reeling. Then came the fear that Greece would default on its debt and set off a chain reaction in other weak Euro-zone countries such as Portugal, Italy, Ireland and Spain. There was even talk of the Euro currency falling apart.

How much of this has materially changed? Not much. China is still trying to slow its economy. Greece is still in trouble, with the rest of the Euro-zone countries offering only moral support for now. But nervousness has subsided and that, apparently, is reason enough for markets – equity and commodity – to rally, at least until the next panic attack.

For the brave souls considering base metals, keep in mind that there are two different products available: – exchange-traded funds such as the Powershares DB Base Metals Fund (Ticker DBB) and – exchange-traded notes such as the iPath DJ UBS Copper Total Return Note (Ticker JJC)

The two receive very different tax treatment. If you are buying for your RRSP or some other tax-deferred account then that won’t matter. But if you are buying outside your RRSP, here’s what you need to know.

The after-tax return on the note, JJC, will beat the return on the fund, DBB, assuming both have the same pre-tax return. Disclaimer: I am not a tax advisor. If you’re thinking of investing, talk to your tax advisor.

Exchange-traded products on commodities, including JJC and DBB, generally do not buy the actual commodity. Too much trouble. Instead, they earn the same return by buying futures on the commodity.

Two things about a futures contract: first, instead of payment in full, the buyer can post a small fraction of the contract value as collateral; second, gains and losses on the contract must be settled up daily.

For every $100 invested in DBB, the manager buys a $100 of US Treasury bills, takes $100 of exposure on equal parts zinc, copper and aluminum futures and posts maybe $10 of bills as collateral. JJC does the same except with only copper futures. But here’s where the two diverge.

DBB and most other commodity ETFs are legally structured as partnerships. Daily settlements on the futures contracts occur within the partnership and are treated as taxable income at year-end. That’s income, not capital gains. And while the income may be realized in the partnership, that doesn’t mean it is realized in your bank account. So you may end up funding a tax liability from other sources. (Many mutual fund investors have cursed about this.)

JJC and other commodity ETNs are structured as a debt instrument issued, in this case, by Barclays Bank, the manager of iPath ETNs. The futures gains and losses are realized by another entity within the bank. JJC holders realize a capital gain only when they sell their units. That’s capital gain, not income, and of course, that receives preferred tax treatment as well.

The downside to the ETN is credit exposure. The JJC ETN owns nothing except a promissory note issued by Barclays Bank so JJC holders are essentially unsecured, unsubordinated creditors of Barclays.

The DBB ETF on the other hand, directly owns the treasury bills. DBB holders have no credit exposure to Powershares.

To summarize: for products using futures contracts, the ETF will avoid credit risk but have taxable income each year the ETN will have credit risk but the tax on capital gains will be deferred until you sell.

Once again, I am not a tax advisor so please talk to your tax advisor before buying either of these products.

Questions and comments are always welcome.
Until next time,
Regards,
Vikash

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