ETCs offer a new exposure to gold

Over the past year there has been a surge of interest in commodities, with flows into global commodity exchange traded commodity securities rising 2.5 times to $56 billion by the end of June 2008. The introduction of exchange traded commodities (ETCs) has permanently changed the nature of commodities investing, opening up a key asset class to a much wider range of investors than in the past.

An ETC is a securitisation process that allows you to trade the price of commodities on the sharemarket with having to actually buy or sell the actual commodities. The first ETC was a gold one listed in 2003 on the Australian Stock Exchange by the founders of ETF Securities. Since then, a full platform of ETCs has been listed on exchanges across Europe, giving a wide spectrum of investors direct access to physically backed gold, silver, platinum and palladium and the ability to take long, short and leveraged positions in commodities ranging from livestock to copper.

Assets in ETF Securities ETCs - including Gold Bullion Securities ETCs - now stand at around $8 billion, giving it about a 75 per cent share of the European and a 15 per cent share of the combined United States and European commodity exchange traded securities markets.

Dramatic shift in commodity supply-demand dynamics

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 emergence of China and other large emerging markets as major importers of commodities, 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 seen an additional 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 this investment translates into substantial new supply. The marginal cost of production of many commodities has been increasing as firms are forced to dig deeper and move further afield to source new supply. Also, 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.

An additional long-term factor that is only now starting to play an important role in the commodities markets is the growing interest of institutional investors in gaining long-term exposure to commodities as an asset class.

A key appeal of commodities is their low to negative correlation with most other major asset classes. This has meant that adding commodities to a portfolio made up of equities and bonds has often improved its long-term risk-reward profile. While some large endowments and pension funds have been doing this for a number of years, the recent creation of sharemarket-listed securities that track physical commodity returns - such as ETCs - has opened this long-recognised method of improving long-term risk adjusted returns to a much broader range of investors.

Precious metals dominate holdings

As illustrated in the pie chart above, the bulk of assets in exchange traded commodity securities is in precious metals, with the largest portion in gold - 53 per cent of the total. Broad diversified commodity baskets make up the second largest holding, accounting for 18 per cent of total assets under management. This is followed by agriculture at 1118 per cent, other precious metals at 10 per cent and energy at 7 per cent. Industrial metals and livestock make up a relatively small share, each accounting for about 1 per cent of total assets under management.

Strong flows into physically-backed ETCs

The extremely rapid growth of flows into the physically-backed precious metals ETCs partly reflects investors' growing demand for safe haven assets as financial sector risk, concerns about the long-term outlook for the US dollar and inflation fears have risen. It also likely reflects long-term strategic investors increasing positions as insurance against future financial shocks and to diversify portfolio risk. The fact that inflows into ETFS Physical Gold continued to increase even during periods when the gold price was falling, is a strong indication that strategic investors are using these ETCs to implement longer-term investment strategies (see chart below).

ETFS Physical Gold: Net Cumulative Creations
Source: ETF Securities

ETCs mark a watershed in commodities investing

The creation of commodity exchange traded securities marks a watershed in commodities investing. By providing an easy, transparent and cost-effective method for investors to access commodities returns, exchange traded commodities have opened a new asset class to a wide range of investors. Innovations now permit investors to implement a variety of investment strategies that previously were accessible only to a relatively small group of specialised investors.

Continued strong inflows into a number of ETCs, even during periods of falling prices, highlight the longer-term strategic nature of a large portion of these flows. More recently, the surge of flows and trading volumes in short and leveraged ETCs indicates that investors are starting to use these products not just for longer-term strategic purposes but also are using them to hedge risk, pair trade and take shorter-term tactical views.

Continuing innovations in the commodities investment arena, together with growing investor knowledge of these markets indicates that commodities investing will continue to rapidly move into the mainstream.

ETFS Precious Metals ETCs

• ETFS Precious Metals DJ-AIGCI ^8M
• ETFS Short Precious Metals DJ-AIGCI ^8M
• ETFS Leveraged Previous Metals DJ-AIGCI ^8M
• ETFS Physical Gold
• ETFS Physical Gold £
• ETFS Physical Palladium
• ETFS Physical Platinum
• ETFS Physical PM Basket
• ETFS Physical PM Basket £
• ETFS Physical Silver
• ETFS Physical Silver £
• ETFS Gold
• ETFS Short Gold
• ETFS Leveraged Gold
• ETFS Gold £
• ETFS Short Platinum
• ETFS Leveraged Platinum
• ETFS Silver
• ETFS Short Silver
• ETFS Leveraged Silver

About the author

Nicholas Brooks is responsible for research and investment strategy for the ETF Securities group of companies

From ASX

• Access a free ASX fact sheet on ETFs (PDF 232KB)
• Recent research on ETFs by the broking firm Tolhurst (PDF 98KB)

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