From Special Report:
Commodity investing the exchange traded way
Investing in commodities through ETPs is now more accessible and cost-effective
With the advent of exchange traded commodities (ETCs) and commodity-linked exchange traded funds (ETFs), commodity investing is now more accessible than it used to be.
Investing in commodities was once the preserve of investors with the expertise to trade futures contracts and closely track their investments to ensure there was no risk of having to take delivery of physical assets. However, in recent years ETCs and ETFs have made it easier for retail investors in particular to invest in the asset class. After all, ETCs and ETFs can be traded through brokers in the same way as other listed securities and are relatively cheap to hold.
According to Deutsche Bank’s global markets research unit, there are roughly 400 ETCs and commodity ETFs listed in Europe, representing some €48bn (£39bn) in assets under management. The bulk of these assets are in gold products (70 per cent), while the next biggest segment is broad commodity indices (9.7 per cent). Institutional investors are the biggest users of the products, although they are gaining the attention of private investors as well.
With such a vast menu of choice open to them, some investors can be confused as to the differing characteristics of ETCs and commodity ETFs (and to add to the confusion there are also exchange traded notes (ETNs) that can provide exposure to commodities), how these different instruments work, how the underlying markets being accessed function and in what way this can impact the performance of the instrument that tracks them.
The first point to make is that ETFs and ETCs both aim to track the performance – provide the risk and reward – of their underlying market as closely as possible. But for an index tracking product to qualify as a fully regulated ETF under European Ucits regulations, the index that it tracks must be sufficiently diversified.
This means that Ucits compliant ETFs cannot reference a single commodity or a highly concentrated index. Also, Ucits compliant ETFs are prohibited from having any physical holdings of commodities, including physical precious metals. For these reasons, European ETFs only offer exposure to broad commodity indices.
As a result, there was a challenge when it came to creating products that would provide investors with the listed, liquid, tradable, cost-effective characteristics of an ETF, but with exposure to a single commodity, such as gold. The answer was the ETC.
ETCs are not funds, but rather are debt securities typically issued by an investment company, with the assets of the company designed to be ring-fenced in the event of bankruptcy of its parent sponsor.
An ETN is typically a debt instrument issued by a bank, and as such usually has full counterparty credit risk to the bank, which means if the bank became insolvent, holders of ETNs would be treated in the same way as other holders of the bank’s debt.
Some ETCs are designed to track the spot price of individual commodities that can be stored physically, such as the various precious metals. In these cases, each ETC will typically have its own physical allocation of the metal, which will be stored in a secure warehouse.
In the case of commodities where it would generally be impractical to buy and store the underlying asset, replication of returns can only be achieved through the purchase of futures contracts. For these types of commodities, oil for example, the ETC will often replicate the price performance of the commodity through a swap agreement with an investment bank, with the bank delivering the performance of the underlying index (and the bank therefore performing the futures investing).
ETCs can therefore be split into two distinct types: precious metals ETCs, which are classed as physical replication, and ETCs designed to track futures prices, which are classed as synthetic replication. There are differences in structure and risk between both, which investors should be aware of.
Although the main risk investors in exchange traded tracking products face is the market risk they are explicitly aiming to be exposed to, many investors will also want to know if there are any counterparty risks they should be aware of.
With ETFs, counterparty risk is strictly managed under the Ucits rules. Although ETCs are not subject to these requirements, similar processes for managing counterparty risk are put in place.
For ETCs that replicate the returns of a market using derivatives, this generally means that physical assets are held by an independent custodian in a segregated account. To summarise, although ETCs are debt securities, their counterparty risks are designed to be more akin to that of an ETF than a debt instrument.
This contrasts with an ETN, which is typically an unsecured debt instrument. ETCs are generally described as secured debt securities as they are usually backed by physical assets.
Contango and backwardation
Taking prolonged exposure to commodities that are difficult to store involves constantly rolling over futures contracts – buying new contracts as the ones currently held expire. A noted downside of doing this relates to the fact that performance can be impacted by positive or negative roll return.
Whether spot prices for the delivery of commodities stretching out into the future are increasing or decreasing through time will impact the investment in different ways. A market where the futures curve – a graphic of futures prices stretching out in time – slopes upwards is said to be in contango, while a market where the futures curve is sloping downwards is said to be in backwardation.
For long-term investors, a market that is in contango will create negative roll yield, with the future price trading at a premium to the spot, thereby creating additional costs that reduce the total return on investment. Conversely, a market that is in backwardation will generate positive roll yield for the continuous buyer of futures contracts.
For an investor wishing to track spot prices, the impact of positive or negative roll yield can come as a surprise. Some investors in oil tracking products, for example, have in the past seen the value of their investment diverge significantly from the spot price of the underlying market.
To manage the impact of roll costs, some index providers have developed automated processes designed to minimise the effects of negative roll yield. The algorithms work in different ways, but one way could be that, rather than constantly rolling futures contracts on a pre-defined schedule, the strategy instead automatically selects the futures contracts that either maximise positive roll yield in situations of backwardation, or minimise negative roll yield in markets that are in contango.
By automatically selecting the optimal part of the pricing curve to invest in, the end result should be lower tracking difference. This could bring the return the investor receives much closer to the spot price of the underlying commodity index when compared to rolling futures contracts on a pre-defined schedule.
Another factor to take into consideration when investing in commodities is exchange rate risk. The vast majority of commodities are denominated in dollars on the international markets. That means a UK investor taking a long position in gold, for example, will generally also be taking implicit sterling/dollar exchange rate risk at the same time.
To alleviate currency risk for those investors not wishing to retain exposure to the dollar, some ETC providers offer currency hedged ETCs. A sterling hedged ETC will let investors gain exposure to the underlying commodity while automatically minimising the impact of the sterling-dollar exchange rate. This can be done in various ways.
For a physical precious metals ETC, the currency hedging may be carried out on a daily rolling basis. For synthetic replication ETCs, currency risk may be hedged at the index level by the swap provider using forward contracts.
Investors generally pay a higher fee for a hedged version of an ETC, but the benefit should be significantly reduced dollar/sterling currency risk, and therefore more accurate exposure to the underlying commodity.
Tracking commodity markets clearly has its intricacies. However, some providers of ETCs and commodity ETFs have created products that make the process relatively simple and cost effective, with some designing products that aim to give the most accurate exposure to the underlying commodity through minimising exchange rate risk and/or minimising the impact of negative roll yield.
Manooj Mistry is UK head at Deutsche Bank’s ETF platform, db x-trackers