ETFs: Hot metal

Commodities are seen as a tool for diversification.

Commodities may not suit everyone but can be a good diversification tool – especially precious metals.

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ETFs: Hot metal

Commodities are hot at the moment. After three catastrophic years oil, copper and silver looks cheaper than ever. For a contrarian investor, this weakness could be an opportunity.

One of the purest ways to access commodities is through exchange traded commodities. Before ETCs were launched real assets like nickel, gasoline and wheat were only available to certain institutions. But commodities will not be suitable for all investors and some products are more risky and complex than others.

The investment case

Commodity investing has become increasingly common in the last decade since the first ETC was listed on the London Stock Exchange in 2004. These alternative strategies have crept into the portfolios of some cautious institutional funds, fuelled by the work of academics like Gorton and Rouwenhorst. A small satellite holding of real assets is considered by some as mainstream.

Commodities are seen as a tool for diversification. Different market forces affect supply and demand in commodities markets to those in bond and equity markets. Historically, commodities have shown low correlation with traditional asset classes. The diversification value is disputed – I looked at the correlation between the UK equity market and the S&P GSCI Index, one of the most widely quoted broad indices of commodity derivatives. Correlation rose after the global financial crisis and has yet to drop back to pre-2008 levels.

However, some individual commodities are still holding up. For example, precious metals are a true diversifier for a portfolio.

Gold is an asset which polarises opinion, but its ability to diversify a traditional portfolio remains. In the last two months of 2014, the gold price rose by 5.5 per cent (in sterling terms) whilst equity markets shuddered.

Commodities are a way to profit from global growth. The world is growing and people need to be fed. Developing countries particularly are building infrastructure, demanding more goods and using more energy. At the same time it is becoming harder and more expensive to extract many vital resources. Investing in the materials that make the things we buy gives some inflation protection.

How to invest

Physical metal ETCs are a brilliant financial innovation. They offer a liquid way to invest with low costs and good ongoing liquidity. Physical gold ETCs were one of the best adverts for the ETF industry in the last decade, investors flooded in as the metal rose from $256/ troy oz in 2001 to almost $1,900 in 2011. There was once over 80 million troy ounces of gold held in ETPs globally, a testament to their popularity.

Many commodities cannot be physically held. It is impractical to store millions of cubic litres of gas and agricultural produce would spoil. Therefore synthetic ETCs track commodities through the futures derivative markets. The problem is that the futures price can deviate from the spot price.

Most commodity futures cost more if they have longer till maturity. Every time the ETC rolls its futures position, (selling a short dated future to reinvest in one with a longer maturity) they must bear the difference in prices as a cost – called Roll Yield. This is the reason that synthetic ETC performance tends to drift from the spot price over time. The complexity is compounded because futures market information is difficult for investors to access.

For those investors who want to get access to topical areas, like Crude Oil, ETCs are still one of the most pure ways to invest but I would not recommend these to investors who did not have the knowledge or experience to use these properly.

Of course there are other ways to use ETFs to get exposure. ETFs investing in equity of commodities producing companies have been popular. The largest of these is iShares Gold Producers Ucits ETF, with over $300m in assets. But whilst many individuals find investing in miners or oil producers familiar, many of these firms are highly leveraged, volatile and correlated with equity performance. Counter intuitively, these alternatives to alternatives might be more risky than the real thing.

Key Takeaway:

Commodities ETFs and ETCs can diversify a portfolio, but can add complexity

Adam Laird is head of ETFs at Hargreaves Lansdown

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