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Commodity ETFs grow in stature

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Commodity ETFs only represent a small proportion of all ETFs but are expected to increase both in number and in invested assets, particularly as investors look to commodities to diversify their portfolios.

Nine commodity ETFs are currently listed in Europe, according to Morgan Stanley - a mere drop in the ocean compared to more than 840 ETFs with more than 1,200 listings globally.

A commodity ETF is a regulated and listed product with a fund behind it that offers exposure to a commodity market.

The benefits and liquidity of the underlying commodity in the related futures market take on the form of a share in commodity ETFs. They are similar to other ETFs and can be bought and sold through brokers or on exchanges.

But they differ from equity ETFs in that the underlying exposure is a commodity index and the commodity ETF tracks the return measured by the index.

Liquidity, and the ability to create more shares at the primary market or directly with the fund, help commodity ETFs to be one degree removed from the underlying commodity, which is attractive to investors.

Basket ETFs are more popular with long-term investors than single commodity ETFs, according to Greg Ehret, senior managing director at State Street Global Advisors.

Exchange-traded commodities (ETCs) are also becoming increasingly attractive to investors. In contrast to ETFs though, ETCs are debt products, open-ended listed securities and not funds. They also outweigh the number of ETFs in both Europe and the US.

Dan Draper, head of ETFs for the UK, Ireland and the Nordic region at Lyxor Asset Management, a subsidiary of Société Générale Corporate & Investment Banking, explains that commodity exchange-traded instruments such as the Lyxor Gold Bullion Securities listed on the London Stock Exchange provide investors with direct exposure to the price of one or more commodities. Prior to the emergence of gold ETFs, Draper points out, investors who wanted exposure to the physical price of gold were restricted to either owning gold bullion and incurring the associated storage costs and various trading difficulties, buying gold futures contracts, which have minimum contract sizes, roll-over risks and margin requirements, or buying unit trusts and funds that own shares in companies related to the gold industry, which only provides indirect exposure to the physical price of gold.

Draper adds that a gold ETF, however, allows investors to get direct exposure to the price of physical gold by buying as little as a single share.

The main drivers behind the growing demand for ETFs generally are their tradability, ease of use and ability to short since they can be lent if the investor is long, as well as transparency and cost-efficiency.

ETFs differ from index funds by charging an annual fee, a total-expense ratio that accrues on a daily basis and goes to the asset manager on top of the normal brokerage commission or trading cost, although investors only pay the fee based on the holding period.

David Claus, responsible for business development in Dublin and Luxembourg at the Bank of New York, says another benefit of the ETF is intraday trading, which does not take place on a regular index fund, where investors can only subscribe and redeem according to the fund's valuation cycle.

Investors can buy an ETF at a known price whereas when they buy a regular index fund they subscribe at an unknown price because the calculated net asset value (NAV) will only apply to the subscription after the close.

 

Deborah Fuhr, managing director for investment strategies at Morgan Stanley, says the annual cost of a ETF is 45 basis points, which is considerably greater than the cost of a typical institutional passive mandate, although this can be mitigated through stock lending.

An indirect cost - which ETF fund managers are trying to minimise through efficient trading in the relevant underlying commodity or futures markets - can occur if there is a tracking error against, for example, the price of gold or the GSCI index. But Tony O'Brien, responsible for business development at the Dublin office of the Bank of New York, says a lot of mechanisms are in place to ensure that the fund accurately tracks the index, and where it fails to do so, the differences are explained.

Draper believes that for investors seeking broad-based commodities exposure, it is important to choose an index benchmark that has an established track record such as the Reuters/Jeffries CRB Index that Lyxor uses for its commodities ETFs trading on Euronext. Claus adds that commodity ETFs are tax-efficient. He explains that as most commodities are sold though the derivatives market and every time a futures contract is rolled over, a potential taxable event for the investor is created.

However, there is no need to roll over with a commodity ETF as the investor buys equities and there is hence no need for exposure to that taxable event.

Pension funds and other institutional investors predominantly use ETFs for strategic or tactical asset allocation and risk-budget purposes or for risk-adjusted returns.

Ever since the tech bubble burst in 2000, the investment community has increasingly embraced the diversification benefits of adding broad-based commodity exposure to investment portfolios, Draper says.

The tendency of commodities either to have a negative or a very low positive correlation to traditional asset classes, particularly stocks and bonds, helps investors to achieve similar returns at lower volatility levels.

Many pension funds and other institutional investors are currently reviewing efficient ways of adding commodities to their portfolios. And commodity ETFs and ETCs are playing a key role in this strategic asset allocation evolution, the likes of Draper believe.

Tim West, COO at iShares Europe, says: "There is interest in the underlying, in commodities themselves, due to the recent great run in commodity prices."

West adds that commodity ETFs in the US represent about $10bn (€7.5bn), against the backdrop of an entire US ETF AUM of around $500bn (€372bn). But he says that the growth has been sharp as commodity ETFs have existed in the US only since 2005.

The growth potential for commodity ETFs in Europe looks promising, with not only pension funds but also hedge funds showing interest. Draper thinks the lesson from the US is that there is plenty of room for commodity ETFs and ETCs as well as commodities derivatives markets, such as futures.

O'Brien says that commodity ETFs have grown as part of a broader trend in the US and expects the same to happen in Europe. Sponsors of ETFs are looking for to exploit appropriate niches in the market in order to sell the product to people who need exposure, not only to equity indexes but also to commodities, he adds.

"ETFs in Europe are based on the more widely traded commodities such as gold, silver and oil. In the US, ETFs are also based on agricultural products and we expect to see the same in Europe over the course of the next year or so," continues O'Brien.

"Higher retail penetration is one of the reasons why there are more commodity ETFs on the other side of the Atlantic," he says.

"In Europe, however, people buy ETFs mainly for exposure, which is why a lot more pension funds, hedge funds and asset managers with separate account mandates buy the ETF in order to hold it, and they like the ability to easily get out of ETFs. A lot of hedge fund managers use ETFs as the core of their portfolio with some derivative instruments around it in order to provide some alpha on top of the beta that the ETF brings."

But question marks remain over the UCITS directive, which has been interpreted differently in differing jurisdictions.

iShares only has commodity ETFs in the US, not in Europe due to UCITs, the legal regulations of mutual funds, which, prohibits funds from investing in commodity futures and offering exposure to single commodities. But some commodity ETFs in Europe are UCITS compliant.

O'Brien says: "A commodities ETF would typically only hold a limited number of securities. And so an ETF gold-holding would have to have a non-UCITs structure because the UCITs requirements require a certain amount of diversification. Some commodity ETFs in Europe are not UCITs-based - they are not necessarily pan-European but domestic products."

Ehret does not believe there is a commodity ETF in Europe as such. He says that some commodity ETFs are only ETF-like products or securities that do not have the structure of an ETF or UCITs funds. Instead, he says, they are debt instruments backed by the balance sheet like ETCs.

The advantage of buying an ETF as opposed to other products depends on the investor's domicile, Fuhr says.

She explains: "If the regulations, for example, will not allow investments in OTC or derivatives, the investor cannot buy swaps or futures but can turn to ETFs. On top of that, using an ETF in certain jurisdictions can prove very tax-efficient for investors, for example in Germany."

Fuhr says that ETFs are open-ended under UCITs guidelines. But she adds that only up to 20% of ETFs are a UCITs funds.

So are commodity ETFs a good way forward for institutional investors?

Draper says: "For an institutional client the challenge is finding the most efficient implementation option for their given investment time horizon. And that really depends on the client's needs and requirements.

"Some futures contracts, such as crude oil, are very liquid and can be efficient for short-term trades. But for medium- and long-term portfolio allocations, rolling over futures contracts each quarter can be burdensome and lead to unacceptable levels of tracking error over time. In an ETF, all rebalancing is done for the investor."

And Fuhr says: "People like using an ETF to equitise cash and easily get low-cost beta. Commodity ETFs and ETCs attract a lot of interest. They are both good vehicles as long as investors understand the product they are investing in. It's now a challenge to educate investors about the different products."

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