Midas touch or fool’s gold?

Okay, let’s give the World Gold Council the benefit of the doubt and assume that gold, in the very long term, does maintain its purchasing power. Maybe Hershey bars are an anomaly. Maybe the years 2000 and 2010 were anomalies. Still, you would hope that your investments would do better than merely keep their purchasing power. If that is all gold can do, why hold it as an investment? (After all, it is an unproductive lump of metal, so what should you really expect?)

Well, if you type “gold” into your favorite search engine, you’ll find 10,000 vendors selling it and 10,000 reasons, according to those vendors, why now is the time to buy. (Um, excuse me, sirs, but if the price of gold “can only go up,” why are you trying so hard to sell it?) Every day I hear one explanation or another as to why gold “must” go up from here on (India’s demand for gold … dentists’ demand for gold … the mines are drying up … gold demand in the tech industry … and so on and so on). These are the very same arguments I’ve been hearing for years. Only now there’s one more: All these ETF investors are demanding gold!

I believe that the best you can expect from gold over the very long term, as the World Gold Council puts it, is that it will maintain its purchasing power. But, hey, that’s not a bad thing when every other investment is tanking. Gold, as it happens, does show little long-term correlation to other assets. And when the going gets really tough — or even seems that way — when people run from most investments, they often turn to gold. Then, as a self-fulfilling prophecy, the price rises. Indeed, that seems like a plausible explanation for gold’s run-up in the years following 9/11, when we’ve seen wars in Iraq and Afghanistan, mounting federal deficits and debt, a financial crisis, and growing doubts about the true value of paper currencies.

In the final analysis, it probably wouldn’t hurt you to hold gold in your portfolio. But please don’t buy the nonsense that gold “must go up.” It will go up. It will go down. It will go up again. Have a ball. Just don’t bank your retirement on it, okay? (Personally, I don’t own shares in a gold ETF, but I haven’t ruled it out.)

If you allot a small percentage of your portfolio to gold — no more than, say, 5 percent please (actually make that 5 percent total precious metals) — and keep that percentage constant, you’ll likely eek out a few dollars over time. Every year, if the price of gold falls, you might buy a bit; if the price rises, perhaps you sell. That strategy is called rebalancing, and I recommend it for all your portfolio allocations. (See my discussion of yearly portfolio rebalancing in Chapter 23.)

And if all goes to hell in a hand basket, your gold may offer you some protection.

A vastly improved way to buy the precious metal

When, in November 2004, State Street Global Advisors introduced the first gold ETF, it was a truly revolutionary moment. You buy a share just as you would buy a share of any other security, and each share gives you an ownership interest in one-tenth of an ounce of gold held by the fund. Yes, the gold is actually held in various bank vaults. You can even see pictures of one such vault filled to near capacity (very cool!) on www.spdrgoldshares.com.

If you are going to buy gold, this is far and away the easiest and most sensible way to do it.

You currently have several ETF options for buying gold. Two that would work just fine include the original from State Street — the SPDR Gold Shares (GLD) — and a second from iShares introduced months later — the iShares Gold Trust (IAU). Both funds are essentially the same. Flip a coin (gold or other), but then go with the iShares fund, simply because it costs less: 0.25 percent versus 0.40 percent.

The tax man cometh

Strange as it seems, the Internal Revenue Service considers gold to be a collectible for tax purposes. A share of a gold ETF is considered the same as, say, a gold Turkish coin from 1923 (don’t ask). So what, you ask? As it happens, the long-term capital gains tax rate on collectibles is 28 percent and not the more favorable 15 percent afforded to capital gains on stocks.

Holding the ETF should be no problem from a tax standpoint (gold certainly won’t pay dividends), but when you sell, you could get hit hard on any gains. Gold ETFs, therefore, are best kept in tax-advantaged accounts, such as your IRA. (Note that this advice won’t serve you well if gold prices tumble and you sell. In that event, you’d rather have held the ETF in a taxable account so that you could write off the capital loss. Life is complicated, isn’t it?)

Quick silver on the move

To say that silver is volatile is a gross understatement. In 1979, the price of an ounce of silver was about $5. It then rose tenfold in less than a year — to as high as $54 an ounce in 1980 — after the infamous Hunt brothers had cornered the silver market (until they were caught, because, y’know, it’s illegal to corner the market in just about anything). The price then fell again. Hard.

Fast forward to April 2011. The price of silver, having risen steadily and sharply since the introduction of the first silver ETF, had topped $48 an ounce and seemed headed back to the highs of 1980. And then … pop! Within a mere several days, the price fell about 30 percent to slightly under $34. Then it rose back up in the following months to $42, and then, in September 2011 … pop! In a mere two days, it fell back down to $30.

If there is any reason to stomach such volatility, it stems from the fact that silver has a very low correlation to other investments. For the three years prior to my writing these words, the price of silver has had very, very little correlation to stocks (except for some modest correlation to the stocks of silver-producing countries, such as Chile); almost no correlation to bonds; and even a decidedly limited correlation (0.75) to the price of gold.

If you must …

If you’re going to take a position in silver, the iShares ETF is the way to go. The expense ratio of 0.50 percent will eat into your profits or magnify your losses, but it will still likely be cheaper than paying a commission to buy silver bars or coins and then paying for a good-sized lockbox.

In the very long run, I don’t think you’re likely to do as well with silver as you would with either stocks or bonds. Note, however, that unlike gold, silver has many industrial uses. Demand for silver can come from diverse sources — not just jewelers and collectors — which can cause the metal’s price to fluctuate with changing expectations for industrial production. Because the uses for silver effectively “consume” the metal, the laws of supply and demand may influence the future prospects of silver prices in a way that doesn’t apply to gold. In the end, silver may prove useful as a hedge, maybe even better than gold. But I would urge you to invest very modestly; no more than 5 percent of your portfolio should be allocated to precious metals. Keep in mind that the same strange tax law pertains to silver as to gold. Any capital gains will be taxed at the “collectibles” rate of 28 percent. You may want to keep your silver shares in a tax-advantaged account.

Oily business

If you buy into USO and the price of oil escalates, you stand to make money. But is there reason to believe that the price of oil will always (or even usually) escalate? It has certainly gone up and down over the years, as have oil futures.

The famed economist John Maynard Keynes in 1930 theorized that commodity futures, over time, will offer compensation above and beyond any rise in the price of a commodity. He speculated that speculators will somehow be rewarded for taking the risk of future price uncertainty. Keynes’s theory was very controversial for very many years, and in the past few years it has come to look as if Keynes was wrong. Of course, he didn’t know that so many investors, largely thanks to ETFs such as USO, were going to pile into the commodity-futures arena. Such piling on has resulted in some ugly discrepancies between commodity-future prices and the price of the actual commodity.

But even if Keynes were right, and even if the futures market more accurately tracked the price of the actual commodity (AKA the “spot price”), why pick a single commodity to invest in? Why not diversify your risks with a variety of commodities? A good number of ETFs attempt to do that, and more are on the way. (I discuss these options next in this chapter.) I equate the arrival of USO with the end of ETFs’ Age of Innocence because as I see things, USO is clearly pandering to people’s disgust over high oil and gas prices.

No experience necessary

The issuer of the USO fund is not a major investment bank. Victoria Bay Asset Management, LLC is “a wholly-owned subsidiary of Wainwright Holdings, Inc., a Delaware Corporation … that also owns an insurance company organized under Bermuda law.” The fund’s prospectus, especially the part about the management of Victoria Bay, makes for very interesting reading.

Two of the top people running the fund also manage a mutual fund called Ameristock, and a third, Malcolm R. Fobes III (no relation to Malcolm Forbes), is the founder of the Berkshire Focus Fund (no relation to the fabulously successful Berkshire Hathaway.) Both Ameristock and Berkshire Focus (both with Morningstar one-star ratings) have track records that would make most people cringe.

But the part of the prospectus that really raises an eyebrow is where it explains that “the managing and directing of day-to-day activities and affairs [of the fund] relies heavily on … Mr. John Love,” who, we later learn, is not only employed by Ameristock but also “holds a BFA in cinema-television from the University of Southern California. Mr. Love does not have any experience running a commodity pool.” His experience: “from December 2000 to February 2001, Mr. Love was employed by Digital Boardwalk, Inc.”

Even if John Maynard Keynes were right, no one running this fund seems nearly as smart as J.M. Keynes — or Jed Clampett. I would not invest in this fund, and neither should you.

The sad saga of contango

As fate would have it, the promise of the United States Oil Fund has turned out to be nothing like the reality. Consider this: The price of an actual barrel of oil rose from about $40 in January 2009 to nearly $100 in June 2011. In the same time period, USO’s share price went from about $35 to $38 — not much of an increase.

That meager return, however, might be considered pure gravy compared to the return suffered by investors in Victoria Bay’s United States Natural Gas Fund (UNG) introduced on April 18, 2007. Through mid-2011, this fund’s share price, which started at about $90 a share, had fallen to — are you ready? — roughly $11 a share. Investors in UNG have had anything but a gas.

The explanation for USO’s stagnant share price and UNG’s sink-like-a-rock share price can be found not only in the lackluster résumés of their managers and the dynamics of supply and demand for natural gas but also in something called contango. That’s a word that nearly all investors in commodity ETFs, at least those that rely on futures contracts, wish to heck they never heard.

Contango refers to a situation where distant futures prices for a particular commodity start to run well ahead of near futures prices. In other words, if you want to maintain a futures position that looks one month out, you buy futures contracts for the next month that expire in 30 days. Then one month later you replace them with contracts that contango has made more expensive. The effect is sort of like holding a fistful of sand and watching the sand sift through your fingers until you are left with nothing but an empty hand.

The actual price of natural gas, for example, dropped precipitously in the several years prior to this writing because new gas drilling technologies and the discovery of new reserves have increased supply beyond demand. But buyers of UNG were not tapping into these falling prices each month. Instead, they were buying future contracts each month that were more expensive than the futures contracts they replaced. Why? The explanation is complicated, but the buying pressure coming from investors themselves helped to fuel the inflated futures’ prices. On top of that, speculators, knowing that funds such as UNG had to buy additional futures contracts as the old ones expired, started to front-run the purchases and drove prices higher yet.

As a result of contango, many commodity investors have lost money, and some have lost lots of money, in recent years — even in cases where, as with oil, the price of the commodity itself rose. The illustrious managers at Victoria Bay led their investors to slaughter. But more experienced managers were also caught with their trousers down.

For you, the ETF investor, I would advise much caution before investing in commodities, especially in funds that use futures and other derivatives.

Taxing your tax advisor

ETFs that use futures typically generate special tax forms called K-1 forms. If you ask anyone who has ever filed a tax return and needed to account for earnings from K-1 investments, he’ll tell you that these forms are a pain in the butt. Not only have investors in UNG been stung by falling share prices, but also they often have found that they were paying their tax advisors considerably more than in previous years, simply to file the dastardly K-1s.

As if that weren’t bad enough, any gains on the sale of funds that use futures are taxed largely at short-term capital gains rates, even if the funds were held for more than a year — just another one of those IRS quirks. (Granted, not many people have had this problem recently because gains are hard to come by with these funds.)

General commodity index funds

In this section, I tell you about three funds that allow you to tap into a broad spectrum of commodities. I begin with a commodity pool offered by PowerShares and then discuss two exchange-traded notes issued by Barclays.

Actively managed, or quasi-actively managed, commodity funds

In Chapter 25, I discuss actively managed funds and whether and how to work non-ETFs into your portfolio. Given all the challenges with investing in commodities by using exchange-traded vehicles, as discussed so far in this chapter, I’m inclined to believe that active management may be just the place to go if you want to invest in commodities. (And, by the way, you don’t need to do so; you can invest indirectly in commodities in ways that may make more sense. More on that topic in just a moment.)

If you want direct commodity exposure, consider that a number of the newest ETFs and ETNs are promising to deal with some of the problems of the first-generation commodity funds. The leader in this brigade is iPath, which in April 2011 introduced a new lineup of ETNs called Pure Beta indexes. I wouldn’t quite call these funds actively managed, but they aren’t quite passively run, either. The Pure Beta ETNs promise to “mitigate the effects of certain distortions in the commodity markets” (this language refers to contango) by rolling over futures contracts in an allegedly more intelligent manner (less mechanically) than the older commodity funds that used futures.

It’s too soon to say whether Barclays’ strategy will prove successful, but I’m keeping my eye on the iPath Pure Beta Broad Commodity ETN (BCM), which uses this newfangled strategy to track a basket of commodities consisting of energy (37 percent), agricultural products (24 percent), precious metals (20 percent), industrial metals (16 percent), and livestock (2.5 percent). The management fee is 0.75 percent. I’m ignoring the rest of the Barclays’ Beta lineup that allows you to speculate on individual commodities, such as lead, nickel, and aluminum. (The ticker for that last fund is FOIL — cute, eh?)

Another ETN worth considering for commodity exposure is the ELEMENTS S&P CTI ETN (LSC). This fund tracks the S&P Commodity Trends Indicator–Total Return index. The fund tracks 16 different commodities, using futures contracts. Unlike Barclays’ funds, LSC uses a momentum strategy, buying “long” those commodities rising in price and selling “short” those commodities falling in price.

Backtesting of the index showed that this strategy, known as a managed futures strategy, has been successful for investing in commodities. (Of course, backtested strategies are notorious for performing less well in real time than their hypothetical numbers suggest.) The fund was born in October 2008, and although I feel that the strategy shows promise, it is far from proven. And just like any other kind of futures investing, but even more so, a managed futures strategy will not necessarily reflect ups and downs in the spot prices of commodities.

Because LSC is an ETN and not an ETF, remember that you get your money back only if the issuer remains solvent. This fund is issued and backed by HSBC Bank USA, which has the very same high credit ratings as Barclays.

Awaiting new developments

Given all the confusion about how best to invest in commodities, I’m certain that other ETF and ETN providers will soon introduce all sorts of new strategies to tap into this asset class. Some will likely be crazy; others may turn out to be golden.

Keep in mind also that many commodity mutual funds exist. If you want to try an actively managed approach, don’t want to have to file pesky K-1 forms, and don’t want the credit risk that comes with ETNs, some of the available funds may be reasonable options. Because this book is not about mutual funds, I won’t go into much depth here, but one mutual fund worth considering is the PIMCO Commodity Real Return Strategy Fund (PCRDX). It’s been around since 2002 and has a rather positive history thus far — better than many of the commodity ETFs. See www.pimco-funds.com.

Tapping into commodity companies

In this section, I introduce you to ETFs that let you invest in the stocks of companies in the oil and gas sector, in mining, and in the broader category of “natural resources” or “materials.”

Tapping into commodity-rich countries

As commodity prices go, so (often) go the stock markets of countries that supply the world with much of its commodities. By and large, these are the emerging market nations. (Yes, developed nations, such as Canada, Australia, and the United States, also bring the world many commodities. But because their economies are larger and more diverse, commodity prices have a much lesser effect on their stock markets.)

Although country funds can be just as volatile as commodities themselves, you can invest, through Barclays iShares, in the stock markets of nations. For example, you can invest in:

• Gold-rich South Africa via iShares MSCI South Africa (EZA)
• Timber giant Brazil through iShares MSCI Brazil (EWZ)
• Multi-mineral-laden Malaysia with iShares MSCI Malaysia (EWM)
• Top silver producers Chile and Peru through iShares MSCI Chile Investable Market (ECH) and iShares MSCI All Peru Capped (EPU)

I would suggest that, instead of needlessly taking on the risks associated with any single country, you diversify any investment in emerging markets through one of several ETFs that allow you to invest in a broad array of emerging market nations. These funds include the iShares MSCI Emerging Markets Index (EEM), the BLDRS Emerging Markets 50 ADR (ADRE), and the Vanguard Emerging Market ETF (VWO). I discuss these funds in some depth in Chapter 9.