Clouds Hang Over Commodities Funds

Funds designed to profit from commodity-price increases have been getting investors' attention. That probably has something to do with the fact that crude oil is trading comfortably above $70 a barrel while other commodities, such as gold and silver, have recently hit new highs as well.

Yet these funds have also been getting attention from other quarters: the IRS. A recent IRS ruling stated that commodity funds could no longer use one of the key investment maneuvers they've used in the past, prompting these offerings to scramble to change the way they do business. While we think commodity funds bear watching as they transition to new investment strategies, we don't think the IRS ruling diminishes these funds' appeal entirely.

The Logistics

Mutual funds have to jump certain hurdles to pass muster as regulated investment companies (RICs) by the IRS. The RIC distinction is important because without it, mutual funds would face corporate taxes much like regular corporations do. To avoid being taxed at the fund level, mutual funds must derive at least 90% of their income from qualified investments. In December, the IRS ruled that the returns produced by so-called "total return swaps" linked to commodities are not considered qualifying income. At the time, several mutual funds were using total return swaps--contracts under which a fund agrees to pay interest plus a small fee in exchange for the total return of a commodity index--to gain exposure to commodities. Financial instruments such as swaps are integral to these funds' approaches because it is not realistic for them to buy barrels of crude oil and bushels of wheat to get exposure.

Six mutual funds and one exchange-traded fund invest directly in the price movements of raw goods. The table below outlines some of their key characteristics including what type of derivatives they were using when the ruling hit in December.

Commodity Fund Overview
Fund	Asset Size (million)	Index	Method Used to Track Index*	Net Exp. Ratio
PIMCO Commodity RealReturn Strategy	$12,265	Dow Jones AIG Comm.	Swaps	1.24%
Oppenheimer Real Asset	$1,772	Goldman Sachs Comm.	Structured Notes	1.32%
Credit Suisse Commodity Return	$184	Dow Jones AIG Comm.	Swaps	0.95%
Merrill Lynch Real Investment	$90	Goldman Sachs Comm.	Structured Notes	1.57%
Potomac Commodity Bull	$9	Actively Managed	Swaps	2.00%
Rydex Commodity Securities	NA	Goldman Sachs Comm.	Swaps	1.20%
Deutsche Bank Commodity ETF	NA	Deutsche Bank Liquid Comm.	ETF not subject to same RIC rules	1.30%
*As of December 2005.

There have been several developments since the IRS' ruling in December. Below, we highlight some of the key factors investors should be focusing on.

No Reason to Panic