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.