The announcement a few days ago by President Obama to increase fuel consumption by 2016 (see CNBC article) still has some scratching their heads, given the head-winds the automakers already face. Nonetheless, it is what it is, so you might as well start considering investment opportunities. A few days ago, Phil LeBeau, the CNBC Automotive Reporter, posted a nice article at his Behind The Wheel blog outlining a few companies that are poised to take advantage of the lower emission and higher fuel economy standards coming down the pike (see the post). The main idea behind the investment opportunities is that to lower emissions and increase mileage, cars will need to become lighter and/or more efficient. Five companies that could offer help in these areas include the following:

• Alcoa (AA): positioned for the push for lightweight steel and aluminum, while still maintaining strength.

• Borg Warner (BWA): maker of turbochargers that will give engines the desired performance while still providing for fuel efficiency.

• Eaton (ETN): auto parts supplier who makes camshafts and valve trains that help improve combustion engine efficiency for existing non-hybrid/electric designs.

• Honeywell (HON): for the same reasons as Borg Warner.

• Magna International (MGA): leader in hydroforming, which allows parts, including body panels, to be lighter.

These companies have also been pumped on CNBC's Fast Money recently, causing them to run-up a little, although each are still off their 52-week highs (then again, who isn't). A few are also still consolidating somewhat after the October 2008 sell-off, allowing for some opportunity to move. Of course, in this economy and market, anything related to automakers has to be given pause and due diligence, but each is still worth a look.

There is an interesting BusinessWeek article that is worth the read if you invest, or are planning to invest, in a commodity fund. Since most commodity funds invest directly in futures, how those funds are managed can have an effect on returns.

One area of difference is how the fund manages margin. Since the fund is purchasing futures, margin must be set aside, but it is up to the fund to determine how those funds are invested. Some of the more conservative funds will purchase Treasuries, while others will invest in higher yielding bonds. Over the long haul this can have a noticeable effect on overall returns (and risk) for the fund.

Another area of difference which may have an even bigger impact is the effect of "roll yield." Roll yield is the positive or negative return you get when you sell one futures contract and/or roll an expiring contract into a new one. How often this is performed depends on both the duration of the contracts (how often they have to be rolled over), and any strategy employed by the commodity fund to try and manage the duration exposure. Depending on duration and strategy, having prices go into either contango and backwardation can have either a positive or negative effect on the commodity portfolio.

Some funds will only invest in short duration futures, essentially trying to mimic the commodity spot prices as close as possible. Other managers believe the fund is a long-term investment, and should be managed as such. These funds will buy contracts with durations from 3 months to 3 years. Various strategies and back-testing are performed to find the best contract durations based on whether the market is in contango (longer-duration contract prices are higher) or backwardation (longer-duration contract prices are lower).

Initial results are somewhat inconclusive as to which strategy is the best - i.e., managing the duration works sometimes, and sometimes it does not, especially if the dynamics of the market have recently changed. This is especially true of crude oil futures which seem to be affected on a daily basis by new variables in somewhat unpredictable ways.

Nonetheless, when purchasing a commodity fund it is worth thinking about what type of management you are comfortable with. Do you want relatively passive management with a fund that mimics the spot price dynamics - both good and bad? Or do you want a fund that tries to more actively manage the contract durations, allowing the fund to respond better when the market is either in contango or backwardation - even if fundamental and technical changes can put the fund on the wrong side of the market? As usual, it is often a matter of personal preference and current exposure. Unfortunately, while investing in commodity funds is certainly easier than trading futures for most, you still need to do your homework.

I wrote in a recent post how Barclays was getting into the physical trading of crude oil. Now IndexUniverse.com is reporting that Barclays is launching a new iPath Exchange Traded Note (ETN) targeting carbon emissions - the iPath Global Carbon ETN (ticker GRN). As cap-and-trade becomes more prevalent, it is expected that ETN funds tracking carbon emissions will become more popular. Some estimates have the global carbon market being worth more than $50 billion a year. Talk about making money out of thin air.

For the uninitiated, Investopedia (here and here) and Wikipedia give an overview of ETNs. In short, ETNs were first introduced by Barclays in mid-2006 and represents a type of senior, unsecured, unsubordinated debt security that is similar to other forms of debt (since it has a maturity date), but is different in that ETN returns are based on the performance of some other primitive (be it a stock, index, carbon emissions, or anything else). Unlike normal bonds, no periodic coupon payment are made, and your principal is not protected. On the other hand, they can be traded on exchanges and shorted, similar to ETFs. Since they are like bonds, the value of the ETN is affected by the credit rating of the issuer, and is therefore impacted by credit rating changes. This may explain why more ETNs have not been issued in the current environment.

Why use them instead of ETFs? There are a number of advantages (see Wikipedia for an overview), but basically they offer flexibility and tax advantages (see iPath for additional overview of ETN characteristics). Since there is no interest payments and dividend distributions, neither incurs a tax. Capital gains also only occur when the investor buys or sells the ETN - not when gains and losses are taken by the fund, as with a mutual fund, or when securities must be sold due to composition changes in an index, as with ETFs. ETNs are essentially treated as a prepaid contact (like a forward contract), allowing the difference between the sale and purchase to be treated as a capital gain, deferring the tax payment. ETNs also have no tracking error, unlike ETFs which have to buy the underlying assets or futures, thereby producing an inevitable, albeit usually small, tracking error. ETNs do not hold the underlying asset, but simply promise the match the index. This is another area where credit risk potential creeps-in. In a sense, you are trading tracking error risk for credit risk. ETNs also offer the flexibility to gain exposure in areas that are difficult for ETFs to replicate (such as carbon emissions), and allow for the deployment of strategies, such as momentum investing.

Of course, not everything is rosy (see the April USA Today article). In addition to credit risk issues, ETNs also have the disadvantage of being illiquid at times, although as they become more popular, it is hoped that this will be less of a problem for individual investors. Redemption issues do exist for institutional investors. There is also a worry that current tax benefits will be removed/modified by the IRS, which is still considering tax treatment of ETNs (see update) and likes to say "show me the money." There is the potential that the IRS will tax profits as interest, and not capital gains (which long-term are currently only 15%). Single currency ETNs have already been ruled on, and are now being taxed at ordinary income tax rates. Finally, as with all products that offer a specific investment strategy, there are risks with each strategy. Yet, for ETNs this gets magnified since there are now more options available, and as a result, more potential risks for those choosing strategies without understanding the goals, risks, and fit to their current investment portfolio. After all, not everyone wants to worry about whether sub-prime credit problems are going to affect their carbon missions ETN investment, or whether crude oil being in contango is good for their commodity spread ETN.

Note: When researching about ETNs to see if there was any new information to include for this post, I did run across the following on the Investopedia site: "While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions." Given all the negative connotation around the term financial engineering, this is refreshing. Then again, this article may not have been updated for a while. Nonetheless, every now and then you have to take what you can get.