Asset class popularity shows it’s as easy as etc

It’s not difficult to get people to disagree about the commodities ‘super cycle’. Some are sure that this one will be much longer than previous examples, while others advise that “super cycle” is a misnomer, because the pattern of 15-25 year bull markets has been seen many times before. But pretty much everyone accepts that there are fundamental drivers for price rises for some time to come. One of the easiest access points for private investors has been through mining, energy and agribusiness equities. But the same fundamentals that drive commodity prices up – scarce and lower-grade resources, increasing political risk, spiraling costs, underinvestment during the bear market – are pressurising those companies’ margins. “When you invest in the physical asset, your correlation to the asset is 100 per cent,” says William Rhind, head of UK and Irish sales with ETF Securities, which has been launching a range of ETF-like commodity securities (ETCs), culminating in physical metals products this April. “The more you branch out, the more you increase risk and lower correlation to the underlying asset.” This is the first, clearest advantage of ETCs – equity-like access to real commodities exposure, cutting out the hassles of margins, expiry or delivery associated with futures (which in the case of ETF Securities are held by AIG or Shell.)

Bienkowski: interest from wealth managers

ETCs are open-ended debt securities backed by underlying assets (indices, futures or physical metals), tradable on-exchange by anyone with access to a broker. They are Ucits-eligible; suitable for ISA, PEP and Sipp tax wrappers; and free of stamp duty on the London Stock Exchange (LSE). “A lot of interest is coming from the private wealth managers, which is where we’ve been focusing our marketing activities,” says EFT Securities’ head of research Nick Bienkowski. Russell Chapman of consultant Hymans Robertson agrees that there are many applications for opportunistic investors or those constrained from the usual routes into commodities – particularly in the retail and private-investor space. “ETCs are bound to give more flexibility to the market,” he says. Market leaders A number of providers – including Barclays’ iShares, State Street’s streetTRACKS, Lyxor Asset Management, Deutsche Bank, AXA’s EasyETFs and PowerShares – offer index trackers, sector-index trackers and individual commodity ETCs. ETF Securities is a market leader with its All Commodities DJ-AIGCI tracker, nine DJ-AIGCI sector-index trackers, 21 individual commodity ETCs and five physical precious metals products, all listed on the London Stock Exchange and elsewhere. This diversity is the second advantage of ETCs – because price behaviour between commodities can be hugely divergent. This is not just a case of differentiating hard and soft commodities. Precious metals tend to be uncorrelated with other commodities because they are seen as proxies for currency – but they are often uncorrelated between themselves because the markets are so small. Even within oil – let alone energy as a sector – a significant price gap has developed between Brent and WTI since the end of February, peaking at $6/bbl, thanks to oversupply at an Oklahoma trading point on the back of falling demand and increasing imports from Canada. “It’s a very segregated and heterogeneous market,” says Eugen Weinberg, senior commodity analyst with Commerzbank, “so coming up with the individual ETCs was a good idea.” ETCs can be shorted – so negative directional views can be implemented as well as relative-value trades which could play that Brent-WTI spread, for example. Demand has been strong, with $600m (e447m) heading into ETF Securities’ commodity securities since September last year, $200m into its oil securities since July 2005 and a remarkable $60m into its recently-launched physical metals products (to mid-May). The firm is just starting to pitch to institutions and their consultants. If preliminary interest manifests as trading then these figures are likely to be, in the words of ETF Securities’ founder and chairman, Graham Tuckwell, “the tip of the iceberg.” What effect will this have on markets not used to these volumes – and should private investors see this as a cause for concern or an opportunity? It will probably make no difference in sectors like energy – but the hottest properties appear to be the new precious metals ETCs. In just three weeks the new physical metals products picked up $14.6m worth of gold, $13.2m worth of platinum, $7m of palladium; and $8.6m of silver. “Fifty per cent of our new money has been into precious metals products over recent months,” says Mr Bienkowsi. “But you’ve also got the private banks following themes like corn for ethanol – so we have $50m in our corn product. Two years ago we’d never have guessed we’d be trading that kind of money.” Mr Rhind observes that “recent press” surrounding platinum and palladium has made them “a very popular idea for certain investors at the moment.” But, of course, in these small markets ETF Securities’ new products are the subject of a good deal of that press – not all of it good.

Tuckwell: if it ain’t broke don’t fix it

There have been reports that the world’s biggest platinum producer, AngloPlatinum, opposes ETCs because they will put pressure on supply – even that the firm intends to block supply to ETCs. It is not clear how it could do so, as ETCs simply buy platinum freely from the OTC market. For private investors the danger may be that speculation and profit-taking could lead to a bumpy ride for ETCs in the short term. “Before Barclays launched the first silver ETF the price had been inflated, and with the launch it actually came down,” recalls Mr Weinburg. “Many people just didn’t recognise that platinum and palladium were investable metals before and even a small allocation from these new investors will probably have a huge impact on the price. Hedge funds are already very, very long in platinum and palladium.” Mr Bienkowski concedes that there “can be a little bit of froth and speculation” around ETCs, but insists that things have been “pretty orderly” up until now. Ironically, an onslaught of institutional money is partly to blame for the slow demise of their favoured route into the asset class – commodity indices. Many commodities have been in contango for some time and the negative roll yield is particularly punishing for investors in indices, because rolling contracts at the same time each month allows speculators to run up prices for easy profits. “Because there are so many smart people in the market and so much institutional money we get this contango, and this is really making indices on broad commodities obsolete,” says Mr Weinburg. The third advantage of ETCs is therefore peculiar to those backed by physical commodities, and priced against the OTC spot price. There have been physical gold and silver ETCs on the market for some time, but ETF Securities’ new platform represents world firsts for platinum and palladium and a European first for silver. An individual security represents a fixed metal entitlement -0.10oz if you buy the platinum ETC; 0.10oz of palladium; 1.00oz of silver; or 0.10oz of gold. Alternatively, the ETFS Physical PM Basket security buys exposure to an optimal proprietary weighting (not an index) of 0.01oz of platinum, 0.02oz of palladium, 1.2oz of silver and 0.04oz of gold. Moving metal The metal itself is held in HSBC’s vaults in London and Zurich, all allocated, physically segregated and audited twice yearly. (Insurance and storage costs are included in the management fee). “In the OTC market each dealer receives instructions from their client up until clearing cut-off times, and then accounts are debited and credited,” explains Jeremy Charles, head of precious metals in London at HSBC. “We could demand a delivery of physical metal from another clearer – but that would mean a fleet of trucks driving around London full of gold when the next day we might well owe that gold back again, so instead we all have exchange accounts with one another. However, for the ETCs, all the metal is brought back to our vaults at HSBC. The investor effectively accesses the liquidity of the OTC markets on the same basis as the OTC market participants, and that guarantees a tracking error of virtually zero.” At the moment there are no explicit plans to expand the project beyond precious metals. “The world-recognised market for the other commodities is the futures market,” observes Mr Tuckwell. “We just decided to bring the established markets onto the stock exchanges – if it ain’t broke, don’t fix it.” Mr Weinburg, however, is bullish for more physicals-backed ETCs in theory. “I think it’s a real prospect for oil and gas,” he says. “You would need a huge store, but it’s just a hole in the ground. What is difficult is the agricultural market – which is definitely the next big thing. If someone finds a way to store grain or lean hogs that will be a nice instrument. Consumption of meat in China will grow, so commodities like soya beans and corn for feeding stock are growing quicker than some of the others. There is also the fuel theme: ethanol production has grown fourfold over the last five years; the palm oil price doubled in the last 12 months, the crude oil price didn’t. With acreage and water constrained, if the US devotes more to corn because prices are high, the acreage for wheat, cotton or soya beans will be lower – creating upward pressure there.” Right now playing individual commodity markets is probably beyond most non-specialist investors. But for their wealth managers and private banks ETCs will certainly make investing in commodities - and explaining exposures to clients – that much easier. “I think that when we look back on this in five years’ time we’ll see that we started something really important,” Mr Tuckwell says of the physical metals securities. And in the longer term, who knows how greater access will change the way these markets are perceived?