Question: When should a passive investment be anything but a passive investment? Answer: When it’s a synthetic exchange traded product (ETP) investing in commodities.
The market for commodities exchange traded funds (ETFs) and indeed all ETPs has mushroomed, as commodity prices have broken records. Gold makes up the vast majority of sales.
Investors can be forgiven for wanting part of the action, even at current high prices. With ETPs, buyers gain exposure to an index or individual commodity quickly and cheaply, without having to hold the underlying raw material or security.
However, professionals warn to tread carefully with synthetic investments or risk making less money than you expected.
David Coombs (pictured), head of multi-asset investment at Rathbone Unit Trust Management, says: ‘It’s a minefield, handle with care.’
Mick Gilligan, head of research at Killik & Co, says he does not use synthetic ETPs much to invest in commodities: ‘Unless you keep a constant eye on the shape of the futures curve, it can be very expensive exposure.’
Looking under the bonnet
Michael John Lytle, managing director of product provider Source, says: ‘As an investor you have to do more work before choosing a commodities product.’
Commodity ETPs grew from $7 billion to $172 billion in the five years to 2010, and the number of products increased from 17 to 665 (source: BlackRock data to November 2010). The Thomson Reuters/Jefferies CRB index has hit a two-year high, as other commodities indices climb skyward.
ETPs invest either in physical commodities – normally precious metals – or synthetically, by using swaps based on the commodity futures index. Physical commodity index products are relatively straightforward and do not carry the risk of synthetics.
Funds actually own the asset – for example, buying gold, platinum, palladium – and store it ~in a warehouse. Precious metals are expensive, so storage is cheap.
Physical commodity funds track the metal spot price – the headline market price listed in the newspapers. In other words, you get what it says on the tin. Most commodity ETP money is in precious metals.
To gain exposure to other commodities, however, such as oil, gas, wheat and livestock, you have to use synthetic investment, because storage is either expensive or impossible. For example, wheat goes off after a certain period.
Unlike physical commodity ETPs, futures-based index products mean you cannot track the spot price. The total return from the futures index can be very different (as shown above).
Perhaps you see a commodity spiking, and want a slice of the action. However, the performance may not be reflected in the futures index owned by your target ETP. In 2009 oil ETFs missed out as the oil spot price marched upwards.
David Mooney, co-head of investments at Schroders NewFinance Capital, explains this potential underperformance: ‘The shape of the [futures] price curve is crucial – when there is persistent contango (when distant delivery prices for futures exceed spot prices) then total returns indices will lag the spot returns indices, reflecting the cost of rolling positions.’
At the end of the future, rather than take delivery of so many tonnes of corn, you sell the security and buy another to maintain exposure. If you sell at, say, $100, but have to pay $103 for a replacement contract, the market is said to be in contango. The price difference is known as ‘negative roll yield’.
The futures market may be shaped the other way, though, and investors can be in the money. The opposite of contango is something called backwardation, where the delivery price is less than the spot price, and there is positive roll yield.
Longer-dated futures tend to be less vulnerable to contango markets (although they are sometimes illiquid). Near-dated futures are more profitable in backwardation.
There are ETPs with near and longer-dated futures, and savvy investors sometimes play these, for example, by buying into contango markets, in the expectation of a turnaround into backwardation.
ETF houses are marketing a product to manage roll yield called roll optimisation strategy ETPs.
One example is the Deutsche Bank Liquid Commodities Indices – Optimum Yield Balanced ETF (DBLCI-OY Balanced ETF for short). Vehicles are programmed to optimise returns by varying futures contracts according to whether the markets are in contango or otherwise.
David Norman, joint founder and chief executive of fund of fund provider TCF Investment, notes that DBLCI-OY has tracked the underlying index extremely well (though buyers should understand index mechanics.)
Nicholas Brooks, head of research and investment strategy at ETF Securities, says roll optimisation strategy products are based on extrapolation of historical models, so care is needed. For example, algorithms will not take account of illiquidity and wide bid-offer spreads.
Schroders’ Mooney is critical about the passive approach to commodities as an asset class. He says commodities markets are less efficient than equities – experienced practitioners have more ready access to market-critical information, and close to 100% of active managers outperform the indices (although this is proprietary information and he will not disclose details).
Tracking the index
Mooney says academic work fails to underpin passive commodities investing in the same way as equities. Active managers aim actually to make clients money, where ETPs merely track the index. Take gas fund UNG, for example, which suffered a 46% decline over three years.
Active managers have a broad range of strategies, including shorting and substituting one component for another. Mooney likes commodities funds at Pimco, Schroders and Gresham among others.
Source’s Lytle agrees there is imperfect information, and there may be more opportunities for active commodity managers to outperform than in equities.
However, there are ways to deliver using passive funds. You need different strategies for oil, agricultural commodities, gold and base metals because they are driven by different market characteristics. And, of course, there are physically backed products too.
Further, investors looking for alpha must also be willing to take greater manager risk and pay extra fees. Those looking for beta, to buy market exposure, get passive funds.
TCF’s Norman says: ‘I agree commodities are less efficient than larger developed world equity markets. But for many investors a low-cost, long-term position via a passive fund will be ideal.
‘Do you need to do more due diligence to buy a commodity rather than a straightforward, physically backed equities ETF? Yes. There are more factors to take into account, and more risk of getting the wrong one.’
When sourcing synthetic ETPs for clients, the next thing you should consider is counterparty risk, as recently highlighted by Terry Smith, the founder of Fundsmith.
Synthetic ETP futures exposure is gained through total return swaps provided by banks, which guarantee the return of an underlying index. Swaps are fully collateralised to the value of the investment, and this collateral is regularly topped up to protect the investor from counterparty risk. One type of ETP called exchange traded notes (ETNs) may not have any collateral backing.
Smith says: ‘Anyone who has studied the events of the credit crisis should be able to spot a potential problem here: what if the counterparty supplying the swaps defaults? This risk may once have been considered theoretical, but after the collapse of Lehman and the need to rescue AIG to prevent the contagion from a default, it surely no longer is.
‘True, the ETF should be holding collateral against such a failure, but collateral is an imperfect science, even where it is held, which is not in all cases.’
Smith worries retail investors may not understand what they are buying, especially with more complex products, and this could lead to another misselling scandal. Most commentators Citywire spoke to agree counterparty risk is crucial, as well as the quality of the collateral.
Synthetic commodity ETFs, then, should be hung about with financial health warnings. But they do fulfil important functions. Although imperfect because of problems buying the spot price, the instruments may be the only way into some commodities and indices.