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| Spot, Stock Or Future |
| Tuesday, 09 October 2007 17:21 | |
| Commodities aren’t like stocks or bonds; there are many different ways to approach the commodities markets, and each has its pros and cons.
This article will examine the three main “buckets” of exposure — spot exposure, equity exposure and futures-based exposure. Later, we’ll explore different kinds of financial products — ETFs, ETNs, mutual funds, etc. — and figure out which is best for different situations. So You Want To Buy… Let’s say that you’ve decided you want exposure to gold. We could just as easily choose crude oil, or corn, or even a diversified commodity index, but we’ll use gold to make it simple. You think gold is going up. Great … I hope you’re right. But how do you cash in on that idea? Well, here are your options…
Buy The Physical Commodity: The easiest way to gain exposure to gold? Just go buy it. Buying gold bullion gives you, by definition, 100 percent correlation with that magical gold price you hear about on the evening news. The only risks you face are physical theft (if you hold the gold) or financial shenanigans (if you store it with a custodian). The simplest way to buy gold is to walk down to your local bank and pay them for a 1 ounce American Buffalo coin. That gets you a nice walk, and a chance to say hi to your banker … but that’s pretty much it. The disadvantages pile up. On any given day, expect to pay 5 to 10 percent more than the spot price for your shiny coin. And if you misplace that coin, or mistake it for a Sacagawea dollar and use it to buy a cup of coffee … well, that’s a $700 cup of coffee, my friend. Fortunately, there are smarter ways to own the hard stuff. Online metals dealers like Kitco will sell you coins and bars at thin markups. And gold pools — there are thousands of them — will let you buy a stake in a pile of gold for about 1 percent more than the spot price. But now, thanks to exchange-traded funds (ETFs), we can do better than that. ETFs are mutual funds that trade like stocks, and increasingly, they are moving into the commodities space. There are currently two U.S. ETFs that hold gold bullion as their sole asset: the streetTRACKS Gold Fund (AMEX: GLD) and the iShares COMEX Gold fund (NYSE: IAU). These funds store gold in a vault — that’s all they do — and when you buy a share of the ETF, you’re buying a share of that gold. You can even see pictures of the gold bars on line. The cost? Just 40 basis points (0.40%) per year in expenses, plus your brokerage fee. The downside is that there are only bullion ETFs for gold and silver; for other commodities, you’re out of luck. And that raises an important point: While holding physical gold or silver may make sense, holding oil or corn doesn’t. What are you going to do with a barrel of oil, anyway? Taxes One big disadvantage of physical bullion is that the Internal Revenue Service (IRS) doesn’t consider it an investment. It calls gold and silver “collectibles” and slaps a 28 percent tax on any profits. That compares to a 15 percent long-term capital gains tax rate on equity investments. And yes, that tax rate applies to the ETF as well as physical bullion. One way around this is (theoretically) to buy exchange traded notes such as the Deutsche Bank series, which come in leveraged and short flavors. For the moment, it looks like these will be taxed as capital gains when sold. But pay attention, because that’s an issue still open for debate. Buy The Equities
Alternative #2? Buy the shares of gold mining companies. The thinking goes like this: You may know a little bit about gold, but the guy getting paid millions of dollars to run a gold mining company knows a lot about gold. So why not cast your lot with him? In some cases, it can make sense. But it’s important to know that equity investments and spot commodity investments aren’t the same thing. While the two returns are correlated much of the time, there are important differences. For one, when you buy a stock, you’re buying a company. And like any company, there are lots of things that can go wrong with a gold mining firm (or other commodity producer). The company can be mismanaged; the managers can be crooks; there can be environmental disasters, labor strikes or lawsuits. Complicating things further is the fact that many companies hedge their exposure to commodity price swings. After all, it’s hard to plan a business when you’re not in control of pricing. So gold miners and other commodity producers use futures contracts to lock in price for their product. That means that, even if commodity prices rise, your company may not benefit. Of course, equity investments have their advantages, too. For one, companies can make smart decisions, discover new mines or cut costs and boost profits. Also, companies often take out loans to pursue big projects. That effectively leverages your investment, giving you more bang for your investment buck. In fact, that’s often how commodity equities perform: They act like leveraged exposure to the underlying commodities, with their prices swinging 2-3 times as much as the underlying commodity. As with any equity market, there are mutual funds and ETFs that provide exposure to commodity-focused companies, including gold-focused shares. Taxes Equity investors get all the breaks: Long-term capital gains are set at just 15 percent. Buy The Futures
Options #3? Invest in futures. Futures are where many serious commodity investors find a home. What is a future? It is a promise between two investors. If you buy a gold futures contract, for instance, you promise to buy gold from someone at a certain price at a certain time in the future; they, in turn agree to sell it to you at that price. When the time comes, if the price of gold has gone up, you’ll feel like the smartest guy in the room. Here’s how it works. The most popular gold contract in the world is the COMEX Gold Contract. Let’s say spot gold is trading for $725/ounce today, and the COMEX Gold contract for June 2008 is priced at $750/ounce. Each contract covers 100 ounces, so the June contract costs $75,000. By buying the contract, you promise to pay someone $750/ounce for 100 ounces of gold on the third Friday in June. If gold goes up above $750 by June, you’ll make out handsomely. If not, watch out… The real beauty of the futures market is leverage. These are big contracts: $750/ounce X 100 ounces = $75,000. Fortunately, no one expects you to put up all that cash. In fact, for each contract, there’s a set amount of money you have to set aside as collateral. For the COMEX Gold contract, that amount is just $2,500 (although your broker may demand more). Leverage is a double-edged sword, of course. If you put down $2,500 and the price goes up $100/ounce, you’ve made $10,000 on a $2,500 investment. But if the price falls $100/ounce, you’re in trouble. (And you can expect a call from your broker, asking you to post more cash to your account.) Like any leveraged investment, this makes directly owning futures both exciting and terrifying. But remember: You don’t have to actually do all this buying and selling of futures; there are mutual funds and ETFs that will do the heavy lifting for you. Taxes Futures contracts get unusual tax treatment by the IRS. Sixty percent of any gains are taxed as long-term capital gains (with a 15 percent maximum tax rate), while 40 percent are taxed as short-term gains (with tax rates topping out at 35%). That creates a maximum blended tax rate of 23 percent (less if you’re not in the top income bracket). The kicker with futures is that you have to pay each year: holdings are “marked-to-market at year-end.” That means that any gains you accumulate during the year are taxed, and cannot be deferred. Next Up? More About Futures If you think a futures investment will track the price you hear about on the evening news, think again. |
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