Ask most folks about "TRAKRs" and you might be regaled with a timorous description of a newfangled SUV or an Internet hit counter. In spite of the fact that TRAKRs have been around since 2002, many people are still in the dark about them.

What? You Don't Know What TRAKRs Are?

Well, TRAKRs are futures contracts. Not like the futures contract of yore, mind you; these are radically different. Your first clue to their distinction is their somewhat tortured acronym: Total Return Asset ContRacts.

Developed by Merrill Lynch and traded on the Chicago Mercantile Exchange's electronic Globex platform, TRAKRs offer retail investors the cost-effective equity, currency and commodity exposure for which traditional futures are famed, absent the onus of leveraged loss. One TRAKR, as well, is a hedge fund proxy, an exposure that just can't be found in traditional futures products.

Futures Past And Present

To fully understand what TRAKRs are, it's important to know what they are not. And what they're not are traditional exchange-traded futures.

Conventional exchange-traded futures contracts were developed in the 19th-century as hedging tools for agricultural producers and users. Since then, additions to the futures product set have allowed commercial buyers and sellers of metals, currency and financial instruments to efficiently lay off price risk, too. The efficiency comes from the small margin deposits—and thus, the high degree of leverage—characteristic of futures.

Speculators provide the grease in futures' risk transference machinery. Shouldering hedgers' unwanted risk, speculators hope to profit by correctly forecasting price movements in the underlying commodity.

Speculators in gold futures, for example, put their necks under the double-edged sword of 30-to-1 leverage. Alas, the prospect of "making $30 for each $1 invested" when right can translate with despairing quickness into "losing $30 for each SI invested" when wrong.

Here's where TRAKRs come in. TRAKRs don't expose retail buyers to the overhanging threat of mark-to-market margin calls. Paid in full like regular stock purchases, long TRAKRs are unlevered (though short positions are margined at a Reg T-like 50 percent).[1] The buy-in is small, too: Each TRAKRS contract has a notional value of $25 when launched.

TRAKRs are also long-term contracts, unlike most traditional futures. When TRAKRs debuted in 2002, contract maturities stretched as far as 4-1/2 years, allowing early adopters to eliminate the cost of rolling contracts forward.

Better still, TRAKRs can be traded inside a securities account; no futures account is required. That means no Series 3 exam for the executing brokerage representative, no additional registration for the firm, and no account-opening rigmarole for the client. All that's required to trade TRAKRs through existing securities accounts is 'notice registration' of the executing broker and online training of its representative through the auspices of the National Futures Association, the self-regulatory organization for futures brokers. Brokers must also have access to the CME Globex quotation and trading platform, of course.

The underlying asset for each TRAKR is actually a proprietary index, rather than a physical commodity. Unlike traditional index futures, though, TRAKRs prices represent the total return derived from owning the underlying assets. The index underlying Gold TRAKRs, for example, reflects the current metal price augmented by the imputed income earned through lending gold at the "lease rate." Despite this, TRAKRs do not pass taxable distributions through to holders—any gains are simply reflected in the value of the contract itself.

What's more, TRAKRs aren't taxed like conventional futures. In fact, TRAKRs' tax treatment may be their single greatest attraction. TRAKRs owners, you see, qualify for long-term capital gains treatment after only a six-month holding period. Gains in conventional futures contracts are treated as 60 percent long-term and 40 percent short-term, adding up to a (maximum) blended 23 percent tax rate. TRAKRs' tax treatment also gives them an edge over the recently-introduced gold and euro exchange-traded funds (ETFs), which must be owned for more than twelve months to be considered long-term holds.

Not everything about TRAKRs differs from their conventional cousins. For example, futures-style (same-day) settlement—not T+3—applies to TRAKRs trades.[2] And, as with all futures, SIPC coverage[3] isn't extended to TRAKRs, despite the fact that they may reside within a securities account.