Capitalise on commodities

By Danny Laidler, ETF Securities

Exchange-traded commodities (ETCs) are simple, secure, low-cost and transparent securities that enable investors to gain direct exposure to commodities without the need to trade futures or take physical delivery of the underlying metal. Management fees on ETCs range from 0.40 per cent to 0.49 per cent per annum.

ETCs provide exposure to the underlying commodity and not a portfolio of commodity shares. They are open-ended and can be created or redeemed on demand by authorised participants. They can be traded and settled just like a share through normal brokerage accounts, and pricing and tracking operate in a similar way to an exchange-traded fund (ETF).

ETF Securities' physically backed ETCs offer investors exposure to the precious metals sector by holding allocated bullion. It tracks the spot price of the metal, less relevant fees and expenses. These ETCs offer investors exposure to the agriculture, energy and industrial metals sectors by ultimately holding fully collateralised swaps (a form of futures contract) with multiple commodity contract counterparties, which track the applicable total return of commodity indices, less relevant fees and expenses.

The ETC story so far

ETCs have had strong investor demand since their introduction in 2003, with assets rising to US$175 billion by the end of June 2012. Growth has been particularly strong since the 2008 financial crisis.

Assets here have more than tripled since the end of 2008 as commodities and other "hard assets" have become an increasingly important part of mainstream investment portfolios. ETCs have facilitated the broadening of the investor base for commodities by providing convenient and liquid exchange-listed access to markets that were previously the preserve of a relatively small group of specialist investors.

The drivers of demand

There are a variety of reasons for the rise in investor interest in gaining direct access to commodity returns. Foremost has been a dramatic shift in the supply-demand dynamics affecting the long-term price outlook for a wide range of commodities. The growth of China and other large emerging markets as major importers, as their economies have gained critical mass over the past few years, has led to a large structural upward shift in global commodities demand.

On top of this, agricultural commodities have enjoyed a large new source of demand from the heavily subsidised and rapidly growing biofuels industry.

On the other side of the equation, the supply of many commodities has been constrained by years of under-investment in exploration, infrastructure and new supporting technology. Although investment is now being increased, in many cases it will be years before it results in substantial new supply. The marginal cost of production of many commodities has also been increasing as firms are forced to dig deeper and move further afield to source new supply.

In addition, the cost of key inputs such as land, labour, transport and machinery has been rising at an extremely rapid pace. This has put a much higher floor under prices than only a few years ago.

ETCs versus buying physical or investing in shares

Investors can gain exposure to precious metals, such as gold or silver, through buying the actual metal. The challenges in this include checking the purity on purchase, transporting, storing and insuring it, and realising its true market value when selling it.

With physically backed ETCs, investors have the benefits of ownership of physical metal sitting in a vault that meets London Bullion Market Association (LBMA) standards for quality and purity, combined with the convenience of being able to buy or sell the securities on an exchange, through ordinary brokerage accounts, as you would a listed equity.

Traditionally, Australian investors have gained access to commodities by investing in resource shares. The issue with using resource shares as a proxy for commodity investment is that, because of management and operational risks, shares only offer indirect exposure to commodities.

Because of these risks, resource shares tend to be more closely correlated to equities (i.e. move more closely in the same direction as the sharemarket) than to the commodity the company is producing. With ETCs, investors can gain direct exposure to the commodity.

Direct commodity investment can bring diversification to a portfolio of Australian equities and bonds, particularly silver and gold, which has helped to buttress portfolio returns in the past during equity market shocks. The chart below shows the improved risk-adjusted return for a portfolio when a direct allocation to physical gold is added.

How exposure to gold can improve the risk adjusted return for your portfolio

STANDARD DEVIATION

Source: ETF Securities, Bloomberg

(Analysis is based on monthly returns in Australian dollars from April 2002 to April 2012. Equities proxied using the All Ordinaries Accumulation Index, and bonds proxied using the Bloomberg EFFAS Australia 7-year+ Bond Index.)

The black line at the bottom of the chart shows the risk-adjusted return for a portfolio of Australian equities and bonds; the yellow line at the top shows the improved risk-adjusted return when a 12 per cent allocation to physical gold is added to the portfolio.

In other words, adding an allocation to physical gold resulted in greater returns during the period. The equity benchmark used in the chart is the All Ordinaries Index, which includes mining shares. Because return from gold shares are more closely correlated to the overall sharemarket, they do not offer the same diversification benefits as physical gold.

By listing a complete platform of ETCs, ETF Securities now provides investors with the building blocks to construct a portfolio for their needs. For example, if an investor is bullish on the outlook for agriculture, they can invest in Wheat (ASX code: ETPWHT), Corn (ETPCRN), Grains (ETPGRN) or Agriculture (ETPAGR) ETCs.

Understanding liquidity

The liquidity of an ETC is not determined by the volume that is traded on the sharemarket or by the ETC's assets under management. It is determined by the liquidity of the underlying precious metal or commodity future to which the ETC is giving exposure.

To illustrate the depth of this liquidity, the average daily volume of physical gold traded on the LBMA, which backs ETF Securities' physically backed ETCs, is in excess of US$33 billion. The average daily volume of physical silver on the LBMA is in excess of US$5 billion. The 20 futures underlying the ETF Securities commodity ETCs trade in excess of US$133 billion every day.

Counterparty risk

ETF Securities' physically backed ETCs are backed by allocated bullion held by an independent custodian (HSBC) and therefore do not have any counterparty exposure (the risk that a third party will fail). Because the ETCs ultimately enter into swaps to gain exposure to the total return of commodity indices they are tracking, there is a counterparty exposure to the relevant swap providers. ETF Securities has taken steps to mitigate this counterparty risk, including:

1. Have multiple swap providers writing swaps for the ETCs.
   The swaps ultimately backing the ETCs are provided by Merrill Lynch Commodities Inc. and UBS AG, which helps spread the risk.
2. Collateralise the exposure to the swap providers on a daily basis.
   Both swap providers are required to post collateral to at least 100 per cent of the value of swaps outstanding on a daily basis.
3. Only accept a good-quality basket of diversified and liquid collateral.
   Cash is not accepted as collateral, because it carries balance-sheet risk against the institution with which it is deposited. The collateral schedule of quality assets has strict diversification and liquidity controls.
4. Appoint an independent manager to the collateralisation process.
   This is the Bank of New York Mellon, the largest collateral manager in the world. It is responsible for collateral on a daily basis and making sure it meets the schedule requirements.
5. Be totally transparent about the collateral held.
   The full list of collateral held on behalf of the commodity ETCs is available on the ETF Securities website and is updated every day.

About the Author

Danny Laidler is head of ETF Securities Australia and New Zealand. ETF Securities is one of the world's leading providers of exchange-traded investment products and a pioneer in ETCs. It listed the world's first exchange-traded gold product on ASX in 2003 (ETFS Physical Gold, ASX code: GOLD). ETF Securities has assets under management in excess of US$25 billion at July 25, 2012. It has 15 ETCs on ASX offering exposure to 22 commodities.