ETFs And Onions August 12, 2010March 18, 2017 PAVEMENT II Yesterday I offered this exciting video about paving roads with solar panels. Meanwhile, Rachel Maddow was running her own decidedly less upbeat paved-roads segment. Under the heading, “Unpaved: Out-Of-Cash America Undoing Its Infrastructure,” Dave Johnson blogs: In case you missed Rachel Maddow Monday night, she had a segment on American cities and counties actually undoing their infrastructure because they are out of money. She listed city after city across the country that is shutting off its streetlights, turning paved roads into gravel, shutting down bus systems, shutting down schools, firing police, and other steps to save money. To me, the most striking comment was, “Somewhere in China it is entirely possible that a businessperson sat down for a ride on a 200mph state-of-the-art levitating bullet train, and cracked open the Wall Street Journal, and read about how in American we’ve decided we can’t afford paved roads anymore.” JPMORGAN – WHAT ARE YOU DOING? According to my friend Janet Tavakoli, here, JP Morgan Chase is a giant commodities speculator (losing, most recently, hundreds of millions of dollars on coal). And this is appropriate for a bank . . . how? CHEAP +AND+ GAY? Zac Bissonnette: “OK, so there are two things about this that you wouldn’t normally see: A piece about a gay couple in a magazine for senior citizens; a pair of frugal gay men. It’s written by my friend Jeff Yeager, whose new book The Cheapskate Next Door is quite good.” ☞ Can I just say what a nice thing this is? A long time ago, I wrote about the “hohumization” of the whole gay thing. (Like: who cares?) We’re not there yet, to be sure. But when “the world’s largest-circulation magazine” runs a piece like this (why not? who cares?), it’s one more sign of progress. ETFs Greg Stroud: “I double checked the archives and can’t find a recent ETF article. I thought ETFs would be ideal ways to get into certain areas (like gold) but with the ease of just buying a stock. But recently I heard ETFs can have surprising tax bills based on how they are structured and surprising problems (like contango).” ☞ Two things you definitely need not know about are contango and backwardation, which is why I never remember what they are – and turn in such matters to Less Antman, who knows everything: ETFs are just closed-end mutual funds whose issuers minimize discounts and premiums by the judicious issuance and redemption of large units of the underlying securities: there are no special tax issues related to them. [This much I knew.] However, some ETFs invest in exotic instruments that have special tax issues related to them, and the ETFs have the same treatment as those underlying investments. Plain vanilla ETFs that invest in stocks and bonds are no more complicated than any other mutual fund. For a discussion of the tax complications associated with commodity, leveraged, and inverse ETFs, I recommend this fine article by Paul Justice of Morningstar. Justice, not being a tax professional, does as good a job as can be done in translating the applicable tax rules into English. Contango is a word that many people are learning for the first time from a recent Business Week article trashing commodity funds (unfairly, in my view, but that’s another subject entirely). It refers to the very natural tendency of most commodity futures contracts to trade at values higher than the underlying commodity, because the owner of the futures contract doesn’t have the storage costs associated with holding the commodity itself. I assure you that it is far less expensive and far more pleasant to have a six month pork belly futures contract in your possession than to have the pork bellies themselves for half a year. On the other hand, there is also a reason for commodity futures contracts to sell for less than the underlying commodity, because these contracts are typically sold by the producers of the commodities in order to protect themselves against the devastating consequences of a drop in the price of the product they sell, and the buyers of insurance are willing to pay something for the value of that insurance. If the insurance value to the producer is high enough, the net effect can even be for the futures contract to sell for less than the spot commodity, and this is called backwardation (I have no idea why it isn’t called protango). Complicating all this is the fact that virtually all commodities are expected to fluctuate in value on a seasonal basis, or for other reasons, and the futures contract has no reason whatsoever to sell for the same price as the commodity itself today. Indeed, the very point of futures speculation is to anticipate fluctuations in prices and thereby avoid future surpluses and shortages and reduce price volatility. There is plenty of evidence that speculation does, in fact, reduce volatility: the one commodity on which commodities trading is prohibited, onions, suffers from larger fluctuations and supply/demand imbalances than other commodities. (If you’re wondering why onion futures are banned, it was because of special interest legislation pushed in 1958 by a farm state Congressman named Gerald Ford. The history of the legislation would bring tears to your eyes). The reason to include commodity-based investments in a portfolio is that radical changes in commodity prices have a tendency to destabilize the business environment and hurt stocks; so commodities have tended to do well when stocks have been doing poorly, and vice versa. Indeed, 2008 was the first year in which both the S&P 500 and the Reuters Continuous Commodity Index suffered double-digit losses, and those indexes go back more than a half century. The losses and gains from contango and backwardation are dwarfed by the diversification benefit of commodity futures, in my opinion. The bottom line is that ETFs are nothing special, but some investments held in them are.