Issue 48
Exchange Traded Commodities
The introduction of Exchange Traded Funds – ETFs – in the early 1990s revolutionised the mutual funds industry. Now Exchange Traded Commodities – ETCs, a part of that revolution – are transforming the way investors think about the commodities markets.
Commodities – along with real estate and hedge funds – have attracted increased interest as investors seek non-correlated assets to improve portfolio diversification. Around 2000, commodity markets went through some fundamental changes. Tight supply, caused by falling capex and record low inventories for some commodities, coupled with increasing demand for raw materials from emerging markets such as China and India, provided the foundations of the current bull market.
ETCs were designed to tap into that pool of increasing demand, and they have experienced spectacular growth. Global ETC assets have grown to over $28 billion since March 2003, and products are now available to suit most commodity investment strategies.
ETFs: Providing Investors with New Asset Classes
ETFs are similar to mutual funds, but trade on an exchange. Since their inception, ETFs have made a huge impact on investment and portfolio management. Currently almost $700 billion of assets is held in 950 ETFs globally across 41 different exchanges – this amount is expected to reach $2 trillion by 2011 (source: Morgan Stanley, ETF Report, August 2007).ETFs cover the traditional asset classes of equities and fixed income as well as the alternative asset classes of real estate and commodities. With these various asset classes covered by a wide variety of ETFs, a diversified portfolio can be constructed in as little as four or five easy transactions.
The primary advantage of ETFs was to provide easy, real-time access to mutual funds, which in turn provide portfolio diversification benefits in a single trade. By trading intra-day and not at day-end prices – as mutual funds do – ETFs could be used to take advantage of daily market movements and for hedging. New ETFs are continually being listed to provide all investor types with access to new investments that were previously barred to many, and certainly were not available through domestic brokerage accounts – for example, emerging markets.
The major common features of ETFs include:
- An exchange listing with the ability to trade continually
- A predetermined, transparent index- linked structure
- The ability to handle cash or physical creation in exchange for ETF units
- Redemptions by market participants, called ‘Authorised Participants’
- Competitive pricing provided by multiple market makers.
A further benefit is that ETFs now provide the ordinary investor cost-effective access to new markets not previously accessible.
Opening Up Commodities Markets
Commodities markets are some of the oldest in the world, yet some of the last to be broadly available to investors. Gold has existed as a currency and an asset for thousands of years, and even though it was the first commodity to be securitised through an ETF structure, it was not available until 13 years after the first equity ETF was created.
Until the advent of ETCs in 2003, commodity markets were the exclusive realm of ‘sophisticated’ institutional investors – through purchasing the physical metal, trading in futures contracts or negotiating bespoke long-term agreements. Although these markets were viewed as less liquid, commodities now trade in the realm ofn$100 billion per day. And whereas originally commodity markets were heterogeneous, opaque and small, today they have become regulated, transparent and liquid. These characteristics have helped make commodities suitable for securitising and investment by a broader group of investors.
Investor appetite increased when commodity markets experienced a surge in interest around 2000. This led to the development of a wide range of structured products on commodities that provided investors with direct exposure to commodities without the need to take on equity market risk through mining companies. The resulting increased demand from a wider investor base in turn led to the development of the ETC, providing investors with a legal structure that was secure, listed and, perhaps most importantly, investable (many institutional investors are prevented from buying physical commodities, or even commodity derivatives). Thus the ETC was the only structure that could allow the broadest range of investor groups to access the commodities market.
Although the ETC market is only four years old, it has experienced tremendous growth. Figure 1 shows the growth of the global ETC market, initiated in 2003 by the first gold product, Gold Bullion Securities.
In the past two years alone, global ETC assets have grown by over 1000%, with the number of products increasing from around 10 to over 80. ETCs have been listed on most of the world’s major stock exchanges and now cover every major commodity group. At current growth rates, global ETC assets are likely to exceed $45 billion by December 2008.
Introducing the First ETC
After the introduction of ETFs in 1990, it took 13 years for the first ETC to be created. Figure 2 shows that approximately 65% of all ETCs are exposed to gold, with the remaining 35% exposed to other commodities. Gold’s dominance is partly due to the fact that it was the first ETC to be created – gold’s characteristics make it one of the easiest commodities to be securitised.
ETFs are generally created by physically delivering a portfolio of shares – e.g. 500 shares in the case of the S&P 500 – and issuing securities from the fund. Gold bullion is easy to purchase, does not decay and can be physically delivered to the fund’s account. Furthermore, unlike most other commodities, it is relatively easy to define a homogeneous type of bar – for example, London Good Delivery bars. Another helping factor was that gold has been considered insurance for a diversified portfolio for many years.
Despite gold’s helpful physical characteristics, securitising gold was not an easy task. Complications inevitably arise when markets originally designed for equities are combined with those for commodities. Each market has its own separate rules, regulations, supervision, jargon and participants. In addition, many equity funds are prevented from buying physical metals and commodities. The solution to the introduction of the gold ETC required a legal structure that would allow investors who had been previously prevented from purchasing bullion to invest in ETFs. Gold Bullion Securities were the result, and from there, a global industry of ETCs was spawned – and whose market acceptance is increasing day by day.
