The release of physically-backed industrial metal ETCs has evoked mixed reactions across the media and financial industry. Paul Burgin explores the pros and cons of these new products
The launch of the first physically-backed industrial metals exchange-traded commodities (ETCs) has caused controversy. Analysts argue their emergence will cause volatility and price spikes in markets that are already overstretched. Yet the exchange-traded product (ETP) industry is keen to play down their fears.
ETF Securities launched the first of a suite of physically-backed industrial metals ETCs in December last year. Copper, nickel and tin were the first to go live on the company’s platform, which uses the London Metal Exchange (LME) as its quality benchmark. Aluminium, lead and zinc, along with a basket of industrial metals product, will follow in the first quarter of this year.
The arrival of these ETCs has sparked much debate. Following the success of physically-backed precious metals products, there are concerns that an influx of new investors will push up demand, volatility and prices for a number of industrial metals that are already trading at high levels. Copper trading volumes grew 25% last year according to the LME, pushing prices to record levels.
Accelerating global economic growth and dwindling stocks could yet drive prices higher. Copper started down in 2011 on fears that demand from China may fall, but many analysts believe new investors trading in ETC products could take up the slack and boost prices.
One analyst thinks physical copper products could spur prices by 20%. Other analysts are also making bold claims for likely demand for the new products and their impact on metals trading. Deutsche Bank believes copper ETPs could hold as much as 400,000 tonnes, an amount larger than that currently stored in LME warehouses worldwide.
So far, analyst concerns have yet to be realised. The first day of trading in the ETF Securities copper, tin and nickel ETPs was described as ‘tentative’. The copper ETP closed down almost 50 cents on turnover of $16.31m. Nickel closed unchanged on turnover of $15.98m, while tin was un-traded.
It is market dynamics rather than ETPs that are causing prices to rise, according to Scott Thompson, co-head of European sales at ETF Securities. He said: “December is a quiet time for investors. Most of ours are long only institutional players who have been taking stock during this time.”
The three new products have attracted around $25m, with demand for the copper product being the strongest. Thompson said the company will be promoting the new physically-backed products throughout early 2011, which should boost inflows. He also said the assets of between $500m and $600m in the company’s futures-based metal products should provide a reasonable benchmark for physically-backed demand.
Research carried out by ETF Securities ahead of the launch of its physical palladium and platinum products in the US showed no evidence they provoked price volatility. But Thompson admits it is difficult to gauge potential demand for the new range of industrial metals ETCs. He said: “We see existing clients with a preference for physicals over futures. The big unknown is marginal investor demand which is almost impossible to quantify.”
The long game
It may be that investors are waiting for the arrival of other players before deciding to allocate to physical metal ETPs. BlackRock and JP Morgan Chase have both filed papers with the Securities and Exchange Commission (SEC) for new copper ETPs but cannot talk about their plans until authorisation is granted.
In its documentation, JP Morgan Chase admits that ‘if the amount of physical copper acquired by the Trust is large enough in relation to global copper supply and demand, further in-kind creations and redemptions of shares could have an impact on the supply and demand of copper unrelated to other factors affecting the global markets for copper.’
Other providers are thought to be considering their options, although shoehorning physical industrial metals into ETF structures is not a straightforward exercise. There are added considerations of cost, storage and insurance to be overcome.
Thompson believes there are both similarities and differences in how gold and other metals are graded, traded and stored. He said: “In gold, you have investment grade gold which is a very specific type of gold bar. There are similar analogies in industrial metals provided by the LME which sets the benchmark.”
LME graded metal trades at a premium over global regional market prices. It also comes with other benefits. The exchange has a global network of approved warehouses and a sound audit structure. Investors are assured their stock of metals exists and is being stored to the highest standard. Thompson said: “That means storage is relatively easy to arrange.”
Yet, industrial metals are far bulkier than precious metals, adding to the scale and complexity of acquisition, storage and disposal. The larger volume increases storage and insurance costs which are reflected in the implicit and underlying cost of the ETPs.
According to the LME, copper finished last year at $9,739 per tonne. Nickel closed at $24,690 and tin at $26,940. The last 2010 published London PM fix for gold was $1,405.50 per troy ounce. Given that there are over 32,000 troy ounces in a metric tonne, industrial metal investors get much more metal for their money.
Costs and the investment characteristics of industrial metals are the main reason why Ben Johnson, ETF strategist at Morningstar, doubts whether physical industrial metal ETFs will be big sellers.
Johnson said there is a big divide in the perceived financial qualities and usage of metals across the spectrum. Both factors will play heavily on demand for physically-backed industrial metal ETC products. He said: “Precious metals such as gold do have practical applications but importantly, they are a big store of value. Copper and aluminium are not big stores. They are not something you would make into jewellery.”
Gold and silver are used as safe havens in times of economic strife or market volatility – as witnessed over recent years. Gold is also considered an inflation hedge. Mid spectrum metals, such as palladium and rhodium used in catalytic converters, occasionally find use in ornaments and jewellery but come with none of the cachet of real gold.
Conversely, pure industrial metals such as copper and tin store no value. Prices fluctuate on supply and demand fundamentals, rather than investor concerns about the outlook for other investment asset classes or inflation. Investors should therefore look at industrial metals in terms of pure trading, rather than as a bolt hole with the additional layer of security that physical gold products may provide.
Johnson said: “There has been a lot of hype about physical industrial metals. But investors need to step back and consider what they are actually doing.”
He is particularly concerned about the additional costs of holding physical metals. A typical metals ETC might cost 69 basis points. Added to that is the cost of insurance at around 12 basis points and storage costs of between 32 cents and 36 cents per tonne a day. Total costs can equate to 2.25% a year, compared with the synthetic forward-based ETFS DJ Copper product that has a total expense ratio (TER) of just 49 basis points.
For futures-based products, investors must consider roll costs – the cost of replacing expiring futures contracts. These can work for or against investors depending on the futures curve. Johnson said: “The futures curve on copper is fairly flat at the moment, so the roll-cost is practically flat too. Investors still get exposure and a very modest roll-gain.”
Ben Seager-Scott, senior analyst at Whitechurch Securities, is no fan of physically-backed ETCs, whether precious metals or not. He believes regulators have been remiss in authorising such products as they will encourage speculation.
He said: “With old style ETCs that use synthetics, authorities were keen to discourage speculation by using margin requirements. Genuine users will be building up the cash to pay for the commodities as their contracts get close to maturity. That makes sense and deters speculators.” But as holders of physical products have no such concerns, he suspects speculative investors will be tempted to opt for physical over synthetic products.
Aside from the speculative aspect, Seager-Scott understands why investors would want to invest in precious and industrial metals. At least with ETPs covering copper and the like, he said fundamentals are more transparent. He said: “They are easier to understand than agricultural products for example. Supply and demand is easier to measure, whereas farmers can be affected by unforeseen events or switch crops from one year to the next. Copper miners cannot do that.”
He also prefers industrial metals over gold. “You cannot value gold on fundamentals only,” he said. “It is purely driven by investors, rather than by usage, supply or demand – like tulips were in Holland.”
As gold is no longer a reserve currency, he says it is simply a bolt-hole. But as investors learned in the 1980s, they can still lose a lot of money in gold – whether physical or derivative-based.
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