Commodity ETFs: The makings of a perfect partnership?

www.ftseglobalmarkets.com/media/k2/items/cache/3c9e3a3fff3ae99bc1a5094c9e66003d_XL.jpg

Commodity price moves are making headlines again after a relatively quiet period earlier this year. The intensifying crisis in Iraq is fuelling the rise in crude oil prices, the six-month long miners’ strike in South African has pushed platinum and palladium prices higher and gold is also attractive again as a safe-haven buy. By Vanya Dragomanovich.

For many investors exchange-traded products (ETPs) are becoming the financial instrument of choice when it comes to commodities as they are easy to trade, they bypass some of the regulatory restrictions linked to futures and they come with relatively low fees.

At the end of May assets in commodity ETPs stood at $136bn, only 5.3% of the phenomenally high $2.55trn in global exchange-traded funds (ETFs) and ETP assets, but clearly on the rise. According to ETF specialists ETFGI, in 2005 assets in commodity exchange-traded products were only $8bn but they mushroomed to $223bn by 2012. Since then there have been significant outflows during the periods when gold prices fell sharply but the levels this year are back to those last seen at the end of 2009.

Although commodity ETFs in the US hark back to the early 1990s, and were introduced in Europe in 2000, initially institutional investors showed little interest in them. The upward spiral in gold, oil and metal prices which started in 2005 changed all that. “Up until then investors had typically 60% exposure to stocks and 40% to bonds and this was the threshold of their allocation. Investors started to take note only in about 2005 when there was a big run up in oil,” says a commodities trader who preferred to remain anonymous.

European investors are still noticeably more in favour of commodity ETPs than their US peers. In Europe commodity ETPs make up 9.5% of total ETF/ETP assets whereas in the US this percentage is only 4.7%, according to ETFGI data. Precious metals, and gold in particular, are the most popular type of commodities ETFs making up 70.8%, or $96.4bn, of global commodity ETF and ETP assets. Gold products alone have attracted a total of $68.8bn.

The instruments available to investors fall into two main categories: ETFs, which trade on a stock exchange like shares and exchange-traded notes (ETNs), which are more akin to bonds. In the case of Europe, they are frequently UCITS compliant. ETFs frequently track the price of a single commodity, typically a future, or in the case of gold, the spot gold price. This type of financial instrument is used for commodities that are easily stored, such as base and precious metals, and is typically backed by the physical commodity which is deposited in storage and remains there as long as the position is open. Gold and other precious metals are stored in bank vaults, most frequently with HSBC, while base metals like copper and aluminium are held in London Metal Exchange (LME) warehouses.

The largest such ETF product is SPDR Gold Shares managed by State Street Global Advisors, which was for several years the second-largest exchange-traded fund in the world. Among the largest single-commodity ETFs in Europe are ETF Securities Physical Platinum Shares and ETFS Physical Palladium Shares. The other type of commodity ETP investors will come across is a swap-based structure, an exchange-traded note (ETN). “Basically a bank or perhaps an oil company will be tasked in delivering a return of a benchmark such as a commodity index, less the fee they charge for providing a swap,” says Neil Jamieson, Head of UK & Ireland, ETF Securities.

Here, counter-party risk is addressed through the provision of collateral, such as AAA money market funds, T-bills or AA-rated G10 sovereign debt, posted with a collateral manager and marked-to-market on a daily basis. These kinds of structures are more appropriate for commodities which are not practical to store, such as corn or coffee. Apart from the ease of access and a much lower regulatory burden than in the case of futures, what also appeals to investors is that both products have a significantly lower cost than comparable mutual funds. Mutual funds typically have a total expense ratio (TER) of between 1% and 3% while the TER for ETFs and ETPs is normally in the 0.2% to 1% range. For instance, the TER on the db Physical Gold ETC is 29 basis points (bps) per year, on ETF Securities single commodity ETFs it is around 45pbs.

Although both structures are tried and tested there are few pros and cons for each. In the case of ETFs, investors don’t have to carry any credit risk, unlike with ETNs. However, in turn, ETNs fall under a far more favourable tax regime which has motivated investors — particularly in the U.S. — to try out commodity ETNs.

In the United States ETFs investing in commodity futures are subject to the 60/40 rule, that is 60% of the gains and losses from selling this type of assets are taxed at a long-term gain rate of tax which is 23.8% and the remainder at a short-term gain tax rate of 43.3%—the highest in the US. Owning commodity futures requires the investor to pay tax on the gain experienced by those futures regardless of whether the investor has sold the underlying futures or not. “This can be an administrative headache and even if you don’t sell the futures you still have to pay tax on the gain every year. This is almost a full show-stopper for institutional investors in the US who want to have exposure to commodities,” says a London based commodities trader.

In the case of ETNs there is no tax to pay until investors unwind their positions and then when they do sell the product they are subject to the more favourable long-term gains tax. However, what keeps some investors away from ETNs is that buying them involves taking on credit risk —albeit a very short term one. The investor buys a credit note from the bank stating that the bank will deliver the return on a, for example, diversified commodity index, but if the bank goes bankrupt, the investor will become a creditor of the bank.

“Many investors, when they hear that, don’t do the second level of analysis – the taxation and the massively favourable after-tax returns on ETNs versus ETFs – which is a shame. However, this is slowly changing as investors are getting more comfortable with credit risk again,” says the trader.

ETNs can be redeemed every day at their net asset value, which means that effectively, although there is credit risk involved, investors have to carry the risk only for one day unlike in the case of bonds which can be for years.

Investors less familiar with the ins and outs of the commodity markets frequently look to gain exposure by investing in oil or mining companies, or into commodity producing regions such as the Middle East, or Brazil for soft commodities. The choice will depend on the investor’s remit, but it is worth bearing in mind that fundamentally commodity companies, countries and commodities themselves are driven by different factors.

“In the past investors may have taken positions in, say, a metals mining company in order to get indirect exposure to gold, but by using a gold ETC they can get exposure to the commodity itself without the equity correlation,” says Manooj Mistry, London-based head of exchange-traded products and institutional passive, EMEA, at Deutsche Asset & Wealth Management.

For instance, although there will be some correlation between a share of BP or Shell and the oil price, the oil price will move much faster on the back of geopolitical news, such as unrest in the Middle East, while BP shares will react not only to the price of oil but also to company specific news such as large capital expenditure, mergers and acquisitions, or major disruptions like strikes and fires at platforms.

“If you look at commodity returns versus commodity equities returns in the current situation in the Middle East it is pretty clear that things are going awry for companies working there while the oil price might be going up. Similarly if you look at the strike in South Africa, this is bad news for the companies facing the strike but good news for platinum and palladium prices,” says Jamieson.

When it comes to regional exposure there could be reasons other than commodities price performance for why investors might want to invest, such as relatively low valuations compared to other countries.

For instance Russia ETFs will typically have a large exposure to gas producers, oil companies and mining companies but the underlying index will also have exposure to banks and telecoms companies. The price/earnings ratios for companies in Russia ETFs are far lower than for most other emerging market or BRIC countries ETFs and in that respect could be an interesting investment. Here three of the top three products are Market Vectors Russia ETF, the iShares MSCI Russia Capped ETF and the SPDR S&P Russia ETF.

So why opt for ETFs rather than investing in commodity futures directly?

Although investing in commodity futures is a more cost effective way of gaining exposure to commodities—the investor needs to only be able to cover the margins rather than the finance the full value of investment—investors who are not as active managers as for instance hedge funds, who don’t have the relevant expertise, or have to comply with certain regulatory requirements such as UCITS, may not be able to use futures at all. ETFs and ETPs neatly cover this gap.

“Exchange traded products are easy to manage from an operational point of view, they trade and settle like equity and fixed income, and they are UCITS-eligible,” explains Jamieson. Critics of ETFs have frequently cited the rolling-over of contracts as one of the issues that can erode returns of such instruments. For instance, an ETF provider of a Brent crude ETF holds the underlying Brent crude oil futures. This contract is traded on a monthly basis and the provider has to sell the June Brent crude contract by the end of June and buy the July contract to keep his overall exposure to oil. If oil prices are rising, the provider will make a loss on the trade and this will be passed on to the investor, but the same will happen if prices are declining over the time curve. However, this kind of erosion is inherent to having exposure to a futures position and would be incurred by any financial instrument linked to futures.

Investment strategies

At present several commodities present an interesting buy. The situation in Iraq is keeping the oil market on its toes and there is no promise of a quick solution, which means that oil prices could trend higher over the coming months.

In South Africa, which is the biggest global producer of platinum and the second largest palladium producer, miners have been on strike since mid-January. There are now signs that a deal to end the strike is close to being signed but nevertheless, five months of production have been irrevocably lost this year and the short fall will not be easy to make up. The two metals are not only used for jewellery but are also a key component used by the car industry to reduce emissions.

Among base metals, nickel is the most interesting buy and has already rallied almost 50% since the beginning of the year. The metal is widely used to make stainless steel and consequently has applications in construction, car making, airplanes, shipbuilding and infrastructure. The trigger for the rally came from Indonesia after the country introduced an export ban on exports of nickel ore this year. This ore was mainly bought by Chinese steel makers who now have to look for alternative sources of supply, leading analysts to anticipate that prices will continue to rise for the rest of the year.

In addition, the tensions in Ukraine are also spilling into the commodities markets particularly as an escalation of fighting could eventually lead to tougher sanctions against Russia and could potentially disrupt Russia’s sizeable exports of gas, oil, nickel and palladium. Deutsche Bank, UBS, ETF Securities and a number of others provide ETPs with exposure to all of these commodities, either as a single commodity or within a basket.