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Thursday, October 23, 2014 2:38:40 AM EST

Leveraged, Inverse and Commodity ETF Commentary

Read and review commentaries written by Morningstar experts. These observations and insights are specific to Leveraged, Inverse and Commodity Exchange Traded Funds.

Definitions

What are Leveraged, Inverse and Commodity ETFs?

As the name implies, these ETFs provide leveraged returns based on the performance of an underlying index. It's important to note that these leveraged returns are generated on a daily (occasionally monthly) basis. Due to the impact of what is known as daily compounding, investors should not expect the promised daily leverage of these returns to persist over periods longer than a day. This is especially true if the leveraged fund is tracking a very volatile underlying index. Leveraged funds provide daily returns that are generally 3x, 2x, -2x, or -3x of the underlying index performance. Leveraged ETFs generate their leverage through the use of derivative positions. Because derivatives are taxed differently from equity or fixed-income securities, investors should be aware that these funds may not have the same tax efficiencies that investors have come to expect from many ETF products.
These funds are related to leveraged ETFs in that they provide -1x return on an underlying index. Similar to leveraged ETFs, this inverse return is provided on a daily basis, and investors should not expect the promised daily leverage of these returns to persist over periods longer than a day. Inverse ETFs generate their returns through the use of derivative positions. Because derivatives are taxed differently from equity or fixed-income securities, investors should be aware that these funds may not have the same tax efficiencies that investors have come to expect from many ETF products.
These products provide exposure to commodities through a variety of underlying holdings and fund structures. Several--most notably in the precious-metals space--hold actual physical commodities in a trust. However, that is more the exception than the rule. Most of these products hold or track indexes based on futures and other derivative products. This important distinction means that the promised return of the fund is not actually the spot price of the underlying commodity or basket of commodities, but rather the return from a strategy that holds futures contracts and rolls them as dictated by the rules governing the underlying index. Investors in these products should be familiar with the specifics of how futures curves work, especially in terms of backwardation and contango. The performance of Commodity ETFs tracking commodities whose futures curves are in severe backwardation or contango have a high likelihood of experiencing returns that deviate from the returns of spot price indexes.

Structurally, commodity ETFs come in the form of trusts for precious metals, ETFs that are in reality limited partnerships, and exchange-traded notes (ETNs). The taxation and other risks are unique to each of these funds. Precious-metals trusts, such as SPDR Gold GLD, are taxed similarly to a collectible, so all gains will be taxed at ordinary income rates. Because commodity ETFs actually hold futures and other derivatives, they are subject to the same tax treatment these instruments would face if held individually and will be less tax-efficient than ETFs holding stocks or bonds. ETNs are taxed like bonds, making them more tax-efficient than their commodity ETF counterparts, but there is a trade-off. Because ETNs are essentially promissory notes backed by a bank, holders of these products face credit risk should the backing bank become insolvent.

Core Resources



Bradley Kay(Aug 24, 2009)

Paul Justice, CFA(Aug 24, 2009)

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