Sunday 26th June 2016
NEWS and COMMENT ROUNDUP - June 24th – The UK has voted to leave the European Union – Prime Minister David Cameron has resigned, saying he will leave office in October, following an orderly management of the run up to the declaration of Article 50, which will precipitate the UK’s exit from the Union. The question is whether the incoming leader of the Conservatives will be the next prime minister and can take up the post without an electoral mandate – will the country have to vote again before the end of the year? – EU President Donald Tusk says that the remaining 27 members of the EU have recommitted to the European project and that if the UK wants to leave, it should do so quickly; a view reiterated by Martin Schultz, the president of the European Parliament – Nicola Sturgeon says she will begin talks with the EU on possible Scottish membership and that a second referendum on the Union is now likely – Sinn Fein’s Martin McGuinness has called for a border poll on union with a United Ireland, resurrecting potential secession from the Union by part of Northern Ireland as well - Jeremy Leach, Chief Executive Officer at Managing Partners Group, believes Brexit will have little long term impact on the UK financial services industry. He says: “Financial services will continue to be the UK’s biggest export for the same reasons it has been for the last 100 years, which is its pragmatism, innovation and desire to trade. Nor will the UK necessarily be excluded from the European Union’s pass-porting regime for financial products. Most of the EU’s regulatory processes were adapted from those of the UK’s Financial Conduct Authority anyway so negotiating a workable agreement will be more straightforward than for other EEC members that are still evolving on their regulatory framework.” With regards to Sterling, Jeremy Leach believes it will settle down and strengthen in the longer term: “As much as sterling has fallen today, the market will gravitate back to pre-referendum levels within a few days. In the longer term, sterling will strengthen against the Euro because the UK’s economy is in much better shape than many of its European peers.” - Steve Davies, fund manager, Jupiter UK Growth Fund says, “The UK domestic economy held up surprisingly well in the run up to the referendum, aided by the fact that disposable incomes are still rising by some 7% year-on-year (according to ASDA’s income tracker). The uncertainty of ‘Brexit’ clearly poses some threat to this: business investment is likely to be put on hold during the negotiation process and there is also likely to be a hit to consumer confidence, while a weaker pound may lead to higher imported inflation. Some offset may occur if the Bank of England chooses to reduce interest rates from here or introduce a further round of quantitative easing. Commodity prices may well weaken too in response to a stronger dollar – the fund remains zero weighted in the oil and mining sectors … One final thought: a falling pound combined with a hit to the share prices of UK domestic assets is likely to reignite M&A interest in the UK market from overseas players and I would expect Chinese investors to be right at the front of that queue” -- Mark Burgess, CIO EMEA and Global Head of Equities at Columbia Threadneedle says, “Not surprisingly, equity markets are going to be quite weak today, with sterling assets more broadly quite weak. The thing that markets hate most is uncertainty and with the prime minister resigning we’ve got political uncertainty thrown in on top of economic uncertainty and we don’t know what shape the UK economic arrangement with Europe is going to take. That is going to take quite some time to negotiate and we are going to have to negotiate any bilateral trade agreements with the rest of the world as well. The real issue is about what it means for Europe. We’re likely to see calls for referendums in some of the other European countries and members of the Eurozone and the single currency, and I think the market is going to worry about the implications of that. We’re a single trading nation and clearly what the nature of our trading arrangements with rest of the world looks like is going to be uncertain and I think that will naturally slow activity. The uncertainty as well as what this means for Europe will also slow European equities unequivocally so this is a negative event for global GDP.” Richard Colwell, head of UK Equities at Columbia Threadneedle adds: “Certainly in the short term the Leave vote will be a negative for both Sterling and the UK economy. In the longer term the consequences are much less clear. However, given the FTSE 100 is comprised of around 70% overseas earnings, the implications for the UK equity market may not be as great as some people fear. There may be further opportunities in UK domestic stocks that have been sold off aggressively, in particular those stocks that were in the various ‘Brexit Baskets’ created by investment banks as they tried to exploit concerns about leaving the EU. Clearly, any exposure to overseas earnings is positive for investments as they are considered less exposed to the domestic economy and can benefit from a weaker sterling.UK stocks (excluding financials) are also, to a degree, cushioned by the current market yield (at time of writing) of 3.95%, which is three times that of gilts and attractive in a global context. Indeed, gilt yields are already at their lowest level since records began in 1729.” Meanwhile, Jim Cielinski, global head of fixed income at the firm says, “ This outcome was very different to what the markets expected and certainly to that which was priced into the market as recently as yesterday. Consequently, the market reaction has been as immediate as it has been extreme. Core bond markets have rallied sharply – as market yields have plunged to record lows in many developed markets. The benchmark 10-year US Treasury bond, for example, is lower in yield by around 20 basis points. This takes that yield to around 1.5%, the lowest in recent decades. German 10 year bonds have fallen by a similar amount to -0.10%. Peripheral European bond markets are being hit hard (Italian government bonds are wider in spread by around 30 basis points) and this should continue. Within currencies, sterling is around 9% weaker to the US Dollar (1.35), the weakest level since 1985 and the euro is also weaker by around 3% (1.09). Meanwhile, the yen has surged, strengthening to 101.5. Credit markets are weaker. The widely watched Main index opened 26 basis points wider (around 25% wider of actual spread) and is at the widest level this year. Meanwhile, the Crossover index opened wider by 100 basis points (in percentage terms a similar amount). Financials, higher beta and cyclical credit have been harder hit with spreads around 30% wider over the last day. Commodity prices have been marked down with the exception of gold which has rallied. We believe that a number of central banks (Bank of England, European Central Bank and Bank of Japan) will need to ease policy. A weaker UK currency will produce higher inflation in the year ahead but this will ultimately prove to be transitory. Hence, although the decision to ease may be a close call - growth and stability concerns will dominate policy maker’s thinking. Core government bond yields have plunged to record lows and will be supported as long as risk aversion prevails but further declines in yield should be limited. The price of so-called safe havens is now extreme. Corporate issuers have become well-accustomed to operating in a low growth, weak revenue environment and for such companies it will be the extent of economic weakness that matters most. Our central case is for slow growth, no credit improvement but no sharp rise in defaults. Demand for income remains and this will continue to support spread markets as will a policy response (for example, corporate bond purchases) that provides a ‘back stop’ and cushions losses in corporate bonds. As such, we remain modestly constructive of corporate credit” - Howard Cunningham, fixed income portfolio manager, Newton Investment Management says, “The leave result is likely to be supportive of shorter dated gilts as activity slows and the prospect of interest rate increases recedes even further into the future. The gilt curve may steepen as investors demand more compensation for the longer term uncertainties, but overall yields should not necessarily be higher. It is worth bearing in mind that, to the extent investors initially view the leave vote negatively and want to dump sterling assets, we doubt gilts will be top of their sell lists. Sterling corporate bonds face conflicting forces and greater uncertainty may ultimately lead to risk premia, i.e. higher credit spreads (particularly for UK domiciled issuers). It is important to point out that with yields on euro denominated bonds already low, sterling corporate bond yields might look more attractive. Particularly if, as we expect, ECB intervention has unintended negative effects on liquidity in the euro corporate bond market.” -- Paul Hatfield, Chief Investment Officer, Alcentra says, “We think the short-term impact will definitely be negative for the UK economy, with the uncertainty delaying investment decisions and stalling spending all round. Longer term, it is possible the UK can renegotiate a good outcome with the EU but it hasn’t said how, or on what basis. You could see the other EU countries making life difficult for the UK after Brexit, partly out of pique and partly to deter other countries from doing the same.” -- Mark Bogar, European Smaller Companies Manager, The Boston Company Asset Management “Follow-on risk is now a major factor and we have to think about potential knock-on effects; for example, other countries voting on their membership of the EU. If this leads to an unravelling of the EU the hit to economic activity over the immediate term will be significant. I like to think over the longer term countries will figure it out – and will continue to trade with one another – but it could take up to three years to iron out the ‘new order’ and in the meantime economic activity and GDP growth in European countries will feel the impact. In my opinion the Eurozone will go into recession again during that time.”

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A better slew of commodity ETPs? Photograph © Paul Fleet/Dreamstime.com, supplied September 2013.

A better slew of commodity ETPs?

Tuesday, 29 October 2013
A better slew of commodity ETPs? There is still a good investment case for commodity ETFs but in the current environment of declining prices careful selection of the right ETF is imperative, rather than opting for the simplest basket-only approach. Older generation ETFs have lost their shine of late; no wonder then that a new slew of sleeker, more sophisticated ETPs have been launched that claim to be an improvement on previous ETP structures. Are they right for the times? Vanya Dragomanovich reports. http://www.ftseglobalmarkets.com/media/k2/items/cache/34a8b2917baf842126ae02b0152a473f_XL.jpg

There is still a good investment case for commodity ETFs but in the current environment of declining prices careful selection of the right ETF is imperative, rather than opting for the simplest basket-only approach. Older generation ETFs have lost their shine of late; no wonder then that a new slew of sleeker, more sophisticated ETPs have been launched that claim to be an improvement on previous ETP structures. Are they right for the times? Vanya Dragomanovich reports.

Commodity ETFs became very popular with investors during the commodities price boom, attracting everybody from retail buyers to large scale asset allocators. They appeal to investors because of the straightforward route they offer to an asset class which until recently has been dominated by futures trading. Commodity ETFs also offer the benefit of diversification away from equities and bonds and can act as an inflation hedge.


In a strong economic environment, commodity prices are as good as guaranteed to rally. However, as global growth has slowed commodity ETFs gradually began to lose significant ground this year. China, the key driver of demand for a whole host of commodities including gold, metals, oil and iron ore, started showing early signs of slowing growth, with commodities prices sinking into a downward spiral in response. Gold also lost its allure as a safe haven investment for institutional buyers.




In August alone investors pulled $1.08bn from precious metals ETFs and ETPs, and the total net outflow from all commodity ETFs was $911m, according to specialist ETF research firm ETFGI.


“Investors' concern and uncertainty over the impact on markets of a potential military conflict in Syria and when and how the Federal Reserve will begin QE tapering caused investors to net withdraw from (all) ETFs and ETPs in August,” says Deborah Fuhr, managing partner at ETFGI.


August though was a poor month for ETFs full stop, with the largest outflows on record for the segment, though overall ETFs came in with a net $53bn inflow through Q3. The seemingly quixotic flows were down to US equities drawing in investor interest, though bond ETFs fared indifferently. Europe had the fastest growth of any equity category, bringing in $8bn for the quarter, with both Vanguard FTSE Europe ETF and iShares MSCI EMU Index each receiving more than $3bn over the three month period. In particular selling within the precious-metals category pressured the commodities category group, having experienced net redemptions.


When it comes to acting as an ­inflation hedge, “commodities usually underperform in periods of low inflation and outperform when inflation is high, allowing investors to maintain their purchasing power,” explains Abby Woodham, Morningstar analyst. “Generally, commodities shine at the begin­ning of a recession and at the end  of an economic expansion. As for risk, commodities are a high-volatility asset class.”


In the post financial crisis world the high-volatility element of commodities has worked against them as large institutional investors started shunning the assets. In addition many investors have been disappointed by the lower-than-expected returns from commodity ETFs caused by the cost of rolling forward the underlying futures contracts—a practice by which a commodities future close to expiry is sold and a new contract, typically for the next month, is bought. If the forward future is more expensive, which is the case more frequently than not, the performance of the ETF is impaired.  


Both ETF providers and commodity index developers have met with disillusionment among investors and, not surprisingly, have begun to counter with a response involving a host of new generation products designed to address both the volatility and the roll loss issue. In August, for instance, iShares, the world’s largest provider of ETFs launched the iShares Dow Jones-UBS Roll Select Commodity Index Trust (CMDT) on the NYSE Arca, the first ETF based on the Dow Jones-UBS Roll Select Commodity Index.


The main appeal is that the ETF is designed to minimise the costs of closing expiring futures contracts and replace them with new ones. Typically, when the futures contracts come close to their expiry date the index replaces them with the next available contract—either the next month ahead or three months ahead. This works well when forward contracts are cheaper than existing contracts but frequently this is not the case.


Even so, the new generation of indexes allows a more sophisticated way of choosing the forward contract to roll into (as it will not opt necessarily for the immediate next contract but will potentially chose a contract further away in the future); key criteria being that the forward contract is not only cheaper but it also has sufficient liquidity.


Other similar ETFs listed on the London Stock Exchange are the db Commodity Booster ETC based on the S&P GCSI Index but roll-optimised by a proprietary Deutsche Bank process and the Lyxor ETF Broad Commodities Optimix TR which tracks the SGI Commodities Optimix TR Index.


Another new ETF which has addressed both the roll-yield and the volatility issue is the Ossiam Risk Weighted Enhanced Commodity Ex Grains TR UCITS ETF. This is the first risk-weighted commodity ETF and it is based on Risk Weighted Enhanced Commodity Ex Grains index created by Société Générale and published by S&P. The ETF is also UCITS4 compliant. “The feedback from investors has been that they are less keen on volatility so we are using an index in which weigh-allocation in not based on production levels, as was the case in the past, but is inversely proportional to the volatility of a commodity,” says Isabelle Bourcier, Head of Business Development at Ossiam.


This means that while in the traditional commodity indexes such as the S&P GCSI Commodity Index or the DJ-UBS Commodity Index oil is the most prominent component with an allocation of about 65%, in Ossiam’s case the allocation to oil—a volatile commodity—is only 25%. Instead, there is a larger allocation to base metals and some other commodities other than grains.


“The index is looking at the one-year volatility for every commodity and adjusts the weighting accordingly,” Bourcier said. Also, when it comes to rolling contracts forward the index looks 24 months ahead and selects a contract that is a combination of the most liquid and cheapest according to a proprietary process.


The new generations of ETFs and the indexes they are based on have to a large extent only been launched this year so have little track record, making it difficult to assess their performance.


In Ossiam’s case, the SG index the ETF is based on was developed in February this year. However, Bourcier said that Ossiam ran the model with existing commodity prices going back ten years and found that had the ETF been operational that long it would have generated returns of 11.7% while the S&P GSCI Index would have generated returns of 9.6%. Also, the volatility of Ossiam’s ETF would have been 13.9% versus the S&P’s commodity index 23%.


In the meantime in June S&P launched its own roll-adjusted version of its main commodity index, the S&P GSCI Roll Weight Select, which operates in a similar way to the SG index.


In terms of strategies there is some variety among ETFs including long, short and leveraged, but the vast majority of ETFs are positioned long only, a strategy that backfires in a declining market. Some investors may opt for this strategy nevertheless simply to replicate the move of the underlying commodities.


Investors turned to commodities for portfolio diversification and to protect themselves against risk such as inflation and rapidly changing supply and demand dynamics but so far, “long-only commodity indices have not provided a good solution since they have become highly correlated with equities and have experienced sharp drawdowns,” says John Mulvey, chairman of DPT Capital Management.

Mulvey has worked with the FTSE group on creating the FTSE Target Exposure Commodity Index series; a set of rules-based long-short indices which allocates commodities based on quantitative tactics and avoids large concentration in certain commodity sectors.


Unsurprisingly, single commodity ETFs have performed much better than broad-basket ETFs because the baskets follow anywhere between 15 and 24 commodities and those commodities will frequently trade completely irrespective of each other. For instance price moves in coffee or pork belly futures are almost completely unrelated to oil and gold prices, meaning that the average price move across a basket of commodities will be much smaller than its best performing components.


According to Morningstar data all of the top US-based broad basket commodities ETFs have had negative returns so far this year. In contrast, the iPath S&P GSCI Crude Oil Total Return Index ETN is up 12.4% year-to-date and the United States Oil ETF returned 11.5% since January. Gold and silver ETFs have dropped between 20% and 30% with only palladium ETFs holding up.


Although typically ETFs perform less well than the underlying futures, this has not been the case this year for natural gas and corn. ETF UNG has done almost 7% better than futures and corn ETFs had 2% higher returns. Oil was almost on a par, while wheat and coffee ETFs performed worse than their futures equivalents.


Looking ahead, analysts are tipping platinum ETFs as the next big thing. Platinum is used not only in jewellery but is a key component in catalytic converters which reduce car emissions.


Investments in platinum are being driven by the anticipation of a gradual recovery in the global economy, but in particular in the European Union, where there is a large market for diesel-powered cars which use a significant amount of platinum in their converters, says Robin Bhar, analyst at Société Générale.


“The other element working in favour of this precious metal is the shift away from investment in platinum mining companies in South Africa because of their high costs and the undercurrent of difficult labour relations, and the associated migration into platinum ETFs,” adds Bhar. The New Plat fund launched only in April this year is now the largest in the ­platinum ETF space, accounting for nearly a third of all the platinum ETF holdings globally.

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