Noting this milestone in its August paper: ‘The Commodity Investor – The $300bn question’ – Barclays Capital also confirmed the growth of index swaps as the main driver for this sub-sector, following a large outflow of funds from physically backed gold products. It added that over the past 10 years, commodity AUMs had risen by $290bn, with investment inflows amounting to $245bn, at an annual average rate of about $24bn.
Since ETFs (Exchange-Traded Funds) made their debut in the US 17 years ago the industry has developed to the point where these vehicles are now viewed as everyday investment tools for portfolio planning purposes. In the interim, choice has widened – led by ETCs (Exchange Traded Commodities) − with products becoming ever more sophisticated.
Fund issuer, Black Rock, in its ‘ETF Landscape Industry Review: End of Q2 2010’ reported that as of end-April 2010 the ETF industry globally comprised 2,252 products with 4,637 listings, assets of $1,025.9bn from 130 providers on 42 exchanges.
YTD assets were showing a one percent decline, as opposed to a 10.9 percent fall in the MSCI World Index in dollar terms.
Breaking the numbers down, the US industry comprised 846 ETFs, assets of $693.2bn, from 30 providers on two exchanges.
In Europe, there were 961 ETFs with 2,979 listings, assets of $218bn, from 35 providers on 18 exchanges, while in Asia the corresponding numbers were: 254 ETFs, 360 listings, assets of $74.1bn from 66 providers on 15 exchanges.
Bringing up the rear were Canada (145 ETFs, 170 listings, assets of $30.4bn, from four providers on one exchange) and Latin America (21 ETFs, 257 listings, assets of $8.4bn from three providers on three exchanges).
Whether commodity-based funds of this type are referred to as ETCs or Commodity ETFs, the underlying principle is basically the same, though subject to the laws of the jurisdiction in which they operate, of course.
The key point for ETCs is broad exposure to the commodities markets and, by extension, at a significantly reduced risk to the investor than would ordinarily be the case via more specifically targeted futures and options trading contracts.
ETCs in their simplest form are pooled investments tracking an underlying commodity or basket of commodities. Self evidently, single commodity ETCs will follow the spot price of say gold, while index-tracking ETCs will follow a group of commodities.
They also have the benefit of being open-ended – hence units can be created or redeemed on a continuous basis by market makers, matching the liquidity of the underlying markets. Therefore, supply is theoretically unlimited and price changes will reflect developments in the price of the underlying commodity being tracked.
Life is never that simple of course and for the investor there are myriad ETCs available.
The first and most obvious ones are equity ETCs giving investors exposure to mining companies involved in commodities production.
Alternatively, ETCs based on futures contracts do what they say on the tin – the underlying principle being that contracts are settled or swapped for cash before their expiry date.
Physical ETFs, on the other hand, hold the actual physical commodity with individual investors owning a fractional amount of the commodity concerned. The company rather than the investor takes on the physical delivery of the said commodity.
Finally, there are swaps-based vehicles − a swap in its basic form being an agreement between two parties to swap future cash flows.
Swaps-based ETCs having been gaining in popularity as managers have sought to keep their total expense ratios (TER) down, given that a full replication ETC buying every constituent of a given index is going to incur additional costs for the manager. Swaps-based ETCs also allow for one set of holdings to be used as a substitute for the benchmark the ETC is following.
The downside is that the counterparty could theoretically default on its obligation. Liquidity and transparency can also become issues.
If default is a very real issue for swaps-based ETCs their futures-based counterparts face the possible negative impact of contango.
In a futures context a market is said to be in contango if the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery. While this may be a normal situation for equity markets a fund operating in a market in contango may face the prospect of being forced into buying more expensive futures contracts as nearer contracts expire, in order to avoid having to take delivery of a particular commodity. As a consequence, investors end up paying the penalty in the form of lower returns as profits are impacted. The opposite effect of contango is known as backwardation.
Of course, companies use their own strategies to lessen the impact of contango, not least Invesco PowerShares Capital Management through its stable of US-listed PowerShares DB funds based on Deutsche Bank Indices.
Noting there is a great deal of learning taking place in the ETC space, Bryon Lake, senior product manager at Invesco PowerShares, says PowerShares has a strong focus on educating advisers through its PowerShares Universities (PSUs).
He adds that a great deal of time has been spent discussing the potential benefits of the PowerShares DB lineup such as the Optimum Yield roll process.
“Since the underlying holdings in most ETC products are futures contracts, the way in which those contracts are rolled is of great significance.
“Futures returns are driven by three things, spot return, collateral return, and roll return. There isn’t much you can do about spot, unlike some actively managed commodity offerings, the Index does not collateralise with any security other than 90-day or less Treasury bills. This avoids adding bond risk or duration risk to the commodity fund.
“The Optimum Yield process, which is implemented in all of the PowerShares DB funds, seeks to maximise the positive impact of backwardation and minimise the negative impact of contango in the futures market,” he notes.
“We believe the employment of this strategy unlike some of the more rigid front month rolling strategies may level the playing field for investors wishing to implement strategies that have been utilised by professional investors,” he adds.
The firm’s PowerShares DB Precious Metals Fund (DBP) – tracking the Deutsche Bank Liquid Commodity Index – Optimum Yield Precious Metals (Index) and managed by DB Commodity Services – is based on gold and silver futures contracts.
Through end-June 2010 the fund’s NAV was showing a 33.1 percent return over 12 months, 11.81 percent over two years 19.85 percent over three and 18.60 percent since inception. Corresponding figures for the DB Precious Metals Index were 34.41 percent, 12.61, 20.72 and 19.52 respectively. The Index had a 79.8 percent weighting in gold, 20.20 percent in silver.
PowerShares DB Commodity Index Tracking Fund (DBC) on the other hand, has a wider brief – the fund being based on the Deutsche Bank Liquid Commodity Index — Optimum Yield Diversified Excess Return (Index), and composed of futures contracts on 14 of the most heavily-traded and important physical commodities in the world.
The big beast in the precious metals jungle though is US-listed SPDR Gold Shares marketed by State Street Global Markets.
Noting it’s the second largest ETF in the world ($52bn in assets as of end-August), behind SPDR S&P 500, Tom Anderson, Head of the Strategy and Research Group for the Intermediary Business Group for State Street Global Advisors, says that as investors’ views of gold shift from a safe haven asset to a core allocation, demand for gold will remain strong.
At the end of the second quarter, total identifiable gold demand reached a quarterly record high of 1,050.3 tonnes, according to Anderson – a result of a rise in identifiable investment and industrial demand and a slight decline in jewelry demand.
“Identifiable investment demand was the strongest performing segment, with a 118 percent increase over Q2 2009.
Gold ETF demand played a significant role in this substantial rise, growing to 291.3 tonnes, an increase of 414 percent over Q2 2009. Investors bought 273.8 net tonnes of gold via exchange traded funds, bringing total gold to a new high of 2,041.8 tonnes, worth $81.6bn at the end of the second quarter,” he says.
Designed to track the price of gold with the yellow metal physically held in an allocated account, the fund – YTD to August 31 – was showing a 13.75 percent increase against 13.4 percent uplift for the spot price of gold.
Corresponding figures over 12 months were 30.74 percent and 30.4 percent. Since inception (November 2004) the fund was showing a gain of 18.92 percent against a 19.61 percent rise for spot gold.
In the UK and Europe meanwhile the ETF industry can trace its origins back to April 2000 when Merrill Lynch listed two vehicles tracking the Eurostoxx 50 and Stoxx 50 indices on the Frankfurt Stock Exchange. iShares listed its first ETF in the UK shortly afterwards, with a FTSE 100 linked fund. However, the first ETC wasn’t launched until 2005, after The Committee of European Securities Regulators (Cesr) clarified the definition as to what benchmarks product providers could use under the Ucits III Directive – allowing for the creation of commodity indices.
Ucits III (Undertakings for Collective Investment in Transferable Securities) is the latest version of Europe-wide regulations governing the creation and distribution of pooled investment funds, including mutual funds and exchange-traded funds.
A stamp of EU-wide regulatory approval, a UCITS fund listed on one European exchange may be “passported” to and distributed in all other Member States. Almost all European ETFs are now structured to comply with Ucits III.
Equally important, the implementation of Ucits III from 2002 created the necessary conditions allowing for issuers to create ETFs using swaps and other derivatives.
Philip Knueppel Vice President db ETC Product Management notes the ETC market is heavily dominated by the UK, with gold accounting for roughly 80 percent of AUM. He adds that ETCs have approximately 50 percent of the overall ETF market.
Kneuppel notes that under Ucits III it is only possible to issue ETFs on well diversified indices, so at least seven non-correlated underlyings are needed, which is far too many if you look into the commodity world.
“For ETCs you want to trade sectors like industrial metals or energy or even single commodities like gold or oil. So, an ETF is simply not possible in this market and ETCs are the best alternative,” he says db x-trackers, Deutsche Bank’s Exchange Traded Funds (ETFs) index tracking solution platform (launched in January 2007), is currently the fastest growing ETF provider in Europe, with over £20bn of AUM according to the latest available figures.
The Luxembourg-domiciled firm’s ETFs are listed on six different exchanges across Europe and Asia (Borsa Italiana, Frankfurt Xetra, Paris Euronext, London Stock Exchange, Zurich SIX Swiss Exchange and Singapore Exchange SGX) and are supported by multiple market makers.
On the LSE, over 60 ETFs are covered offering equity, fixed income, credit, money markets and commodities.
With gold recently hitting an all-time high and silver climbing to 30-month high investors could be forgiven for thinking that ETCs represent nothing more than a precious metals investment play.
But as last summer’s heat and drought in the wheat producing areas of Russia – prompting a temporary ban on exports – showed, agriculture, along with the usual suspects such as oil, are set to become even more important.
Indeed, Bryon Lake of Invesco PowerShares says that globally there are a number of macro factors that are impacting commodities. Agriculture has been getting a great deal of attention lately due to the impact on supply from wild fires and poorer harvests.
“The feedback we are seeing from clients is that broad based commodity ETFs such as PowerShares DB Agriculture Fund (DBA) and PowerShares DB Commodity Index Tracking Fund (DBC) offer direct access to some of the permanent shifts that are taking place globally in the commodity space,” he says.
Lake notes, for example, significant shifts in the eating patterns of the emerging markets’ middle classes.
For example Brazil, from 1996 to 2008, witnessed double digit growth in GDP, which in turn had a knock-on effect for meat and dairy product demand.
Indeed, in 2008, red meat and poultry meat consumption was 31 kg above its 1993 level at 89 kilograms per person. Yet meat production takes four times as many resources as producing plant-based foods, which will lead to increasing demand for other staple crops such as corn, soy and grains, says Lake.
Additionally, continued population growth in emerging markets creates further demand for agriculture producers.
“Finally, we are also watching interesting shifts in the base metals complex as producers like Chile watch their production go down and consumers like China are seeing double digit demand for metals like copper.
“We believe, PowerShares DB Base Metals (DBB), which offers exposure to aluminum, zinc and copper (grade A), looks like a good opportunity to invest in the continued emergence of countries, like Brazil, India, and China.”
Looking ahead, Black Rock has found almost 55 percent of institutions currently employing ETFs expect their usage of the product to increase in the next three years − including nearly 20 percent that expect the amount of assets dedicated to ETFs to grow by 5–10 percent in that period. However, around 20 percent of plan sponsors expect to reduce their use of ETFs.
The issuer also found that 30 percent of institutions not using ETFs say they lack familiarity with the product. Self evidently, many investment consultants are either not recommending ETFs to clients or even initiating discussions with them, according to Black Rock.
On a global level many regulators are now looking at rules regarding short selling, the use of commodity futures, the use of derivatives and the transparency of fees. Given many of the documents examining these issues, such as the European Union directive on markets in Financial Instruments (MifID II) and the Retail Distribution Review in the UK, are either in consultation phase or have yet to be implemented, a high degree of uncertainty remains for the industry.
In the market itself meanwhile, it has yet to be determined whether the increasing tendency for investors to buy swaps-based ETCs is part of a definitive trend. What is clear however is that commodities will continue to be a valid investment play given the global macroeconomic uncertainties in the West as the banking system – two years on following the collapse of Lehman Brothers – continues to rebuild itself.
