Structuring ETF definitions

Commodities continue to boom in popularity as an asset class underlying exchange-traded products. Yet fluid definitions of product structures are causing confusion, as Helen Fowler discovers

The market for commodity exchange-traded products (ETPs) more than doubled last year, fuelled by growing demand for oil, gas and other natural resources. 

Commodity ETPs listed in Europe rose in value from €9bn to more than €21bn in 2009, according to Deutsche Bank, a performance which contrasts with sluggish growth elsewhere. Indeed the ETP market overall grew only 4% in the year to March, according to BlackRock. 

Christos Costandinides, ETF strategist at Deutsche Bank, said: “Commodities enjoyed very strong growth in 2009. It was the year that defined them as a major asset class in ETPs.” Three years ago, European commodity-based ETPs had just €5.4bn in assets. By March, this figure had more than quadrupled to €23bn, according to Deutsche. 

As recently as six years ago, there was just a handful of commodity ETPs in Europe. This figure has risen to more than 270. “It wasn’t until 2006 and 2007 that this market came out of the closet,” said Costandinides. “We are experiencing the birth of a new market.”

Last year, Deutsche said commodity ETPs in Europe attracted €9.7bn in fresh inflows and increased their assets by 145%. In contrast, fixed income ETPs brought in only €2.7bn. 

In recent weeks, several issuers have launched commodity ETPs. When Barclays returned to the ETP market in April, following its sale last year of iShares, it led the way with the launch of nine commodity exchange-traded notes (ETNs). 

Uwe Becker, head of investor solutions Europe at Barclays Capital, said: “We are going to expand our range of commodities products. We are very ambitious in that space.” 

The bank is planning to launch around 10 commodity ETPs soon, based on a mixture of market strategies and single commodities. 

On the same day as Barclays, French bank Société Générale launched an ETN platform in London offering investors access to both commodities indices and the spot prices of precious metals such as gold and silver. 

A month earlier, Deutsche Bank set up its new exchange traded commodities (ETC) platform on Frankfurt’s Xetra exchange. Like Barclays, the bank plans to expand its commodities offering. Thorsten Michalik, head of db x-trackers at Deutsche Bank, said: “We expect to launch more than 30 products before June and will continue to add to the product range.”

Fluid definitions 

Despite the significant rise in issuance and uptake of commodity ETPs, the industry faces a number of hurdles. One of the most prominent obstacles is that definitions of ETPs remain fluid. “There is a lot of confusion,” said Costandinides. The description of an ETN, or how one differs from an ETC, remains nebulous. However, a consensus is slowly emerging. 

In general, an ETN is senior, unsecured debt, which is not collateralised, with a maturity date, issued by a highly rated financial institution. Like other ETPs, ETNs generate returns based on the respective underlying or benchmark. Yet the note carries issuer risk, as it is exposed to the credit rating and stability of the underwriting institution. 

In contrast, physically backed ETCs are based on physically allocated, ring-fenced bullion. As a result, there is no credit risk. 

Swap-based ETCs do not rely on the issuer to the same extent as ETNs. “There are a number of structural and legal differences between ETCs and ETNs,” said Costandinides. “Perhaps the most important is that for ETCs, the notes or certificates are issued by a special purpose vehicle.” 

The risk and return of an ETC typically stems from an over-the-counter derivative transaction, entailing counterparty risk, a chilling phrase following the Lehman crisis. 

As such, an ETC is almost always collateralised. “But the degree, form and mechanics of collateralisation can differ greatly from one ETC to the next,” said Costandinides. 

He added: “Investors need to be aware of what type of collateral is held, who holds it, whether it’s in a separate account, or on the provider’s balance sheet.” 

However, there is also a level of confusion regarding returns. Costandinides said investors venturing into the commodities ETP market for the first time can often be surprised to discover these products behave differently to equities. “Their fundamentals are not driven by the fundamentals that drive stocks,” he said. 

The disparity between an ETP and a basket of stocks is most marked in products tracking single commodities. “When you buy a fund that tracks oil, it tracks a specific commodity. That will be more volatile, with a bigger chance of loss and a smaller chance of making more than you would in the FTSE 100.”

Investors may be unrealistic in their expectations. For example, when investors see stories about the rising price of certain commodities, they do not understand that an ETP cannot necessarily replicate the spot price. “It is important to recognise that obtaining exposure to the spot is very often not possible because of storage and perishability issues,” said Costandinides. As a result, ETPs use futures to access many types of commodities, with the exception of precious metals where investors can obtain exposure to the spot price through physically-backed ETCs. Indeed investors must be aware the returns of ETPs using futures will consequently differ to spot returns. 

Even using ETPs to tap commodities as an asset class does not avoid issues of contango and backwardation. These stem from disparities between the current and expected future prices of commodities and can affect valuations. 

Contango is more than just a technicality. It has a profound impact on how well, or not, a commodity ETP performs. Futures contracts can last only a month, meaning the provider must replace them many times during the lifetime of a product. 

When the markets are said to be in contango, as is currently the case, the new futures contract will almost inevitably cost more to providers than the one it is replacing. That incurs a cost to the product known as negative roll yield. 

“Backwardation and contango still apply, because most of these products are constructed using futures,” said Costandinides. Using futures means providers must ‘roll’ them over, which in turn entails costs. Providers have introduced a mechanism, known as a ‘dynamic’ roll, to keep these costs down. “It does reduce the roll cost,” said Deutsche’s Costandinides. “It doesn’t eliminate it.” 

Popular underlyings

Commodity ETPs are dominated by a single product: gold. Although this is starting to diminish, gold still accounted for 68% of the entire market at the end of March, according to Deutsche. As a result, the sector is dependent on whatever fluctuations occur in demand for the precious metal. 

As Greece teetered close to default in early May, with speculation mounting over the finances of Portugal, Spain and Ireland, investors did what they have always done in times of crisis and hoarded gold. “The sovereign crisis in Europe has prompted a flight to quality, so inflows to gold ETPs have picked up,” confirmed one analyst. 

Among the factors driving interest in commodity ETPs is strong performance in the underlying assets. Industrial metals last year returned more than bonds, cash and real estate, according to ETF Securities (ETFS). 

The firm said gold spot prices were up by almost a quarter (24%) over last year. ETFS said: “Commodities were the second best performing major asset class in 2009 after equities.”

The performance of commodities is also strong over the longer term. As a broad asset class, ETFS said commodities have returned more over the past 10 years than most other leading asset classes. 

The low correlation of commodities to equities can be an advantage when there is stock market uncertainty, as is currently the case. “Commodities have historically tended to outperform most other asset classes during equity market downturns,” said Daniel Wills, senior analyst at ETFS. Seven years ago, the firm set a precedent by listing the world’s first gold ETP. 

Commodity ETPs also offer access to an asset class that was previously almost inaccessible. “Historically, investors have used derivatives and purchased shares in companies that operate in the commodities sector to achieve their investment objectives,” said Costandinides. 

ETPs can represent a more practical and cost effective route to gaining commodities exposure. For some investors, buying into an ETP may even be the first time they have been able to invest in commodities. 

“There have been a number of studies on the optimal allocation to gold. The World Gold Council figures suggest that five to 10% of portfolios could be put into gold,” said Wills at ETFS. Current allocations are typically much less than that, suggesting the market retains growth potential. 

Deutsche’s Costandinides expects the market to grow further as mainstream investors switch into commodities. “There is a lot of growth expected from people using these methods to re-allocate. They find it more flexible and it doesn’t require expertise in the futures market.” 

Many of the issues facing the commodities ETP market relate to its rapid growth. “It is very much early days in terms of the industry itself,” said Wills at ETFS. As familiarity grows, misunderstandings should disappear. 

Analysts are convinced the industry’s prospects look bright. “We are continuing to see very strong growth in these products that should mirror the growth of last year,” said Costandinides. 

With so much discussion surrounding the nature of different products, it can only be a question of time before the industry agrees on suitable definitions, or before the regulators step in to ensure that investors, especially retail clients, are not misled.