Oil ETFs versus ETNs - They are Different, and even Different Amongst Themselves

I just wanted to clarify a few things for those of you who are interested in price oil, whether long or short. First of all, at the top level you have ETFs (exchange traded funds) and ETNs (exchange traded notes). They are both meant to replicate an index, sector, or price of an asset or commodity. In this case, I am talking about the price of oil, a commodity.

The main difference between them is their tax structure. Oil ETNs are taxed like a stock, where the holding period determines short-term or long-term capital gain tax treatment. You, as an investor, can control the holding period for preferential tax treatment if you still think there is upside. But remember, when it is time to sell, it is time to sell, regardless of the taxes, whether you have a gain or loss in that particular trade, etc.. When it is time to sell, it is time to sell, regardless!!

Oil ETFs, on the other hand, are set up as a partnership and issue K-1s. Gains are taxed at 60% long-term and 40% short-term regardless of how long you held the fund. It is based on the gains & losses of the underlying futures contracts. That means you might be liable for taxes even if you have not sold the fund.

Therefore, it would seem that ETNs would be better, right. Well, not necessarily. The other difference is that an ETN is a note, issued and backed by a company. The credit worthiness of the company can and probably will affect the price (and the ability to pay it back). Even though they are traded in the open market, the issuing company's financial strength can be an issue.

Conversely, oil ETFs are backed by the underlying futures contracts (the securities held inside the ETF). They are bought and sold in the open market, or can be "redeemed" by the "Authorized Participant" (like a market maker) of the Issuer. This is meant to keep them in line with their "NAV."

Now down to the investment in the commodity price of oil itself. Because they are based upon monthly futures contracts, your intentions are important and will help determine the vehicle you choose. Namely, the time frame you think you will be investing will determine which ETF or ETN to use.

Hopefully without getting to complicated, futures contracts are rolled forward each month, and due to supply and demand expectations, will either have "contango" or normal "backwardation," technical terms that determine whether expected future prices will go up or down. In the futures markets, you can either buy/long or sell/short a contract 1 month out and keep "rolling" contract forward, or go out months in advance to hopefully pick the most advantageous contract to minimize contango or maximize backwardation. There are proprietary yield indexes to help find the "best" contract.

If you believe the price of oil will go up, then you want to go "long" oil. If you are looking at the short-term or trading, there are two funds available. The first is "OIL," the iPath S&P Crude Oil Total Return Index, which is an ETN backed by Barclays. The second is "USO," United States Oil Fund LP, an ETF. Both are meant to track the spot (current) price of oil closely.

For longer-term investors, "DBO," the Powershares DB Oil ETF is worth looking at, another is "OLO," Powershares DB Crude Oil ETN backed by Deutsche Bank. They both employ the Deutsche Bank Optimum Yield Index to select the best contract. Lastly, "USL," United States Oil Fund LP, an ETF, also employs a monthly roll strategy but it holds all the contracts for the next 12 months. All 3 of these funds will not be quite as correlated to the spot price of oil, and theoretically, will be a little "smoother."

If you think oil is going to go down, then you want to "short' oil. This can be done with "SZO." the Powershares DB Crude Oil Short ETN, or the "DNO," the United States Oil Fund, LP ETF, both attempt to move inversely 1 to 1 with the price of oil.

For a double inverse, you have the "DTO," Powershares DB Crude Oil Double Short ETN or the "SCO," Proshares UltraShort DJ-UBS Crude Oil. DTO resets monthly just like all the Powershares, but SCO resets daily. Therefore, for a very short-term trader, SCO might be more appropriate. Someone wanting to hedge may consider DTO.

Volume is always a consideration for any ETF or ETN you invest in, so always make sure there is enough liquidity for you. I know this was long winded, but to many people think all ETFs (or ETNs) are the same. That is almost like saying all stocks are the same. I think this is enough to think about for today.

I have attached a graph of the iPath S&P GSCI Oil Trust Index ETN. As you can see, it bounce off it lower support level and is currently breaking through the next level of support (which can become resistance). Oil looks very bullish at the moment. Well, those are my thoughts for the day.

Keep studying,
Dan Stewart CFA®