If you want a cheap, accessible investment in commodities for the long term, you should consider an exchange-traded fund (ETF). These products track the performance of indices – typically based in the US – and trade on regular stock exchanges. So, you can buy and hold pork bellies or zinc just as you would a share, by logging into your brokerage account.
With an ETF, the provider does all the hard work. There's no need to worry about futures contracts expiring every three months – you can simply buy into a cotton ETF and know that your investment will move in line with cotton prices for as long as you want. And this won't cost you the earth either – ETFs have very low annual management fees. What's more, they don't attract stamp duty when you deal in them.
Commodity investors in the UK are richly served by these products. A wide variety of exchange-traded commodities (ETCs) trade on the London stock market, allowing you to invest in everything from an obscure single material to a basket of many commodities.
To make sense of the growing field of products, you need to ask yourself a few questions to establish what you really want.
What to invest in: spot versus index?
So, you've seen on the news that commodity prices are soaring and you want a piece of the action. However, the price you see quoted – the spot price – is not necessarily the one you'll invest in. Many commodity funds are based on a commodity index, which usually incorporates some form of futures contract. Whereas the spot price is what you'd pay for an ounce of gold or a bushel of wheat to be delivered today, the futures price is the price for delivery at some point in the future.
That said, a small number of funds do track actual spot commodity prices. On the London market, both Close and BNP Paribas provide a small number of investment trusts that offer a long-term investment return (five years or more) based on the total returns from a combination of spot prices. These 'basket funds' usually mix and match energy commodities with metals and some agricultural products. Investors in these structured instruments then receive between 200 per cent and 350 per cent of any gains in the combination of spot prices, as well as some capital protection.
For all their attractions, these products are not representative of the mainstream of commodity investing. The ETCs and ETFs offered by ETF Securities and Lyxor are based on broader indices whose returns are linked to futures contracts. A commodity index return comes from three sources: the interest earned on collateral deposited to secure the positions, the return obtained from holding and trading futures themselves and the roll yield.
Futures contracts typically expire every month or quarter. So, the strategy for a long-term investor is to sell the expiring contract and roll in to the new one. If the new contract costs more than the old one, you lose out; if it costs less, you gain. The result is the 'roll yield' and this is hugely important in long-term returns. It accounts for a larger component of total long-term commodity returns than changes in the spot price.
All in all, how you make your profit – or loss – from investing in commodities varies over time, coming in different proportions from three sources.
Which index do you want to track?
There are a number of indices on offer. The S&P Goldman Sachs Commodity Index is perhaps the most widely used index in the US and is what's called a 'production-weighted benchmark' of two- dozen commodities, adjusted for liquidity. It is heavily weighted towards energy products (40 per cent of the index is made up of crude oil futures). Agricultural and soft commodities, such as wheat and sugar, make up 11 per cent, metals 6 per cent and livestock 2.86 per cent.
Because the GSCI index is based around the notion of 'world production', the constituents' weight can fluctuate widely. The dominant energy sector has varied over time from 44 per cent to 78 per cent of the index, making it very volatile.
The Dow Jones-AIG Commodity Index is an equally popular series of indices and sits behind ETF Securities’ range of funds. It is made up of 19 commodities weighted primarily by trading volume, and thereafter by global production. Volatility is dampened by limits on how much influence any price is allowed to exert.
No single commodity can comprise more than 15 per cent of the index, and no single sector can make up more than a third of the benchmark’s weight. Energy makes up 33 per cent of the Dow Jones-AIG index, followed by industrial metals at 20 per cent, precious metals at 10 per cent, soft commodities at 8.7 per cent and grains at 18 per cent.
The Deutsche Bank Liquid Commodity Index (DBLCI) consists of only six commodities, based around the most actively-traded commodities in each sector. The index provider says that this narrow range of underlying commodities reduces the actual cost of roll and rebalancing in the underlying assets. In practical terms, it means that energy makes up 55 per cent of the index, with agriculturals and metals making up the rest. There is no exposure to livestock or 'softs'.
The designers of this index – and the Powershares range of ETFs that track it – claim to have a unique roll strategy. Rather than simply rolling expiring contracts into the next available month, DBC looks out as far as 13 months ahead for the contract with the highest roll yield. Theoretically, this should improve roll yields whether spot prices are higher than futures prices or vice versa. DBLCI holds only six commodities: heating oil, light crude oil, wheat, aluminum, gold and corn.
Lyxor's products in the UK track the CRB Commodity Index, established by the Commodity Research Bureau in 1981. It consists of 22 futures contracts, with two major subdivisions: raw industrials, and foodstuffs.
Which part of the index do you want to track?
Non-specialist investors often turn to commodities – and to ETCs in particular – as a way to add a bit of spice and diversification to their investment portfolios. They're not that bothered which commodities they track, rather they want a 'composite' return. This idea of a composite return is crucial to most investors – they invest in the composite index that tracks all the main commodities built into the index in a diversified manner.
But some private investors don't like this broad-brush approach, as they know that indices such as the GSCI are heavily biased towards energy products. There's a growing appetite for buying ETFs that exclude energy. It's also possible to buy into one sub-category of commodities, such as metals or agricultural produce. The next level is to invest in single commodities in isolation, such as gold, lead or soybeans.
What kind of return are you looking for?
Until a few months ago, your basic return from commodities was the total return from tracking an underlying index. Now, though, it is possible to pep up the returns you make. While classic ETCs simply go up alongside the underlying index, you can also plump for leveraged upside. Geared ETCs let you double up: if the underlying index goes up by one, your instrument goes up by two.
And if you think a commodity index is headed down rather than up, you can now buy 'inverse' or 'short' ETCs, which go up when the underlying asset falls and vice versa. However, unlike going short via a futures contract, you can't lose more than your original stake, so you know how much you're on the hook for from day one.
An interesting innovation by ETF Securities are 'forward' ETCs. These enable investors to use ETCs to target the underlying price of three-month and 12-month futures contracts on particular commodities. According to ETF Securities, these futures-based ETCs were launched because the new forward ETCs would historically have shown lower volatility. The Forward ETCs provide investors with the opportunity to optimise returns by increasing exposure to differences between spot and futures prices.
Which vehicle to use?
Once you've identified an index you'd like exposure to, you have to choose which instrument to use to track it. While ETFs are a great tool in general, the crucial point to grasp here is that an ETF is only as good as its ability to track its target index faithfully. Tracking risk – the difference between the index's return and the ETF's return – is usually rather small, but is nevertheless borne by investors who are dependent upon fund sponsors to minimise the error.
Some ETF providers, including Lyxor, eliminate tracking error by using underlying derivative instruments, which effectively mean that they don't fully buy a proportion of the underlying index. Instead, the funds invest in a loan note issued by a fellow institution, which guarantees to pay out a sum equivalent to the actual index’s move. This makes for low or non-existent tracking errors, but it does introduce the risk that the institution issuing the note might go bust, taking your investment with it.
Tracking errors will also occur because of the effect of charges, which generally range between 0.2 per cent and 0.9 per cent a year. Although there are no up-front charges, the difference between buying and selling prices can amount to more than 1 per cent.
ETF Securities' ETCs are essentially ETFs by another name. They are almost exactly the same as ETFs in that a big institution buys a basket of futures contracts in the market and then holds them for ETF Securities.
Physical ETCs are yet another variation on the same theme. They track actual physical commodity prices, but instead of buying you access to the index, you buy an allocated bit of a physical precious metal. All of these ETCs are backed by allocated metal, in uniquely identifiable bars, held in trust in London by the custodian, HSBC Bank USA.
Physical allocation is important to some investors because other ETCs come with the risk that the counter-party guaranteeing the payout will go bust. However, physical ETCs have no such counter-party risk. According to ETF Securities, its physical platinum ETC is now the largest platinum ETF in the world, with over $150m (£75m) in assets, while its silver physical product is the fastest-growing silver ETC in the world, having increased 15 times, and now boasts stocks exceeding 10m ounces.
ETF Securities’ physical gold ETC is not far behind, with funds worth $470m, and an increase of over 575,000oz in actual holdings. There's also a physical palladium and a combined ETFS Physical PM Basket.
Which commodities should I buy?
Most commodities and their accompanying composite indices have done extraordinarily well in the past few years, reflected in the strong growth numbers of nearly all the ETCs and Lyxor ETFs.
If you're after the broadest exposure to commodities, your best bet is either the ETF Securities All Commodities ETC (AIGC, total expense ratio of 0.49 per cent), or the equivalent Lyxor CRB ETF (LCTU, total expense ratio of 0.35 per cent). Be aware, though, that these two funds track their differing underlying indices in dollar terms. Both also have sterling versions of the same index (AGCP and LCTY, respectively).
For exclusive exposure to non-energy commodities, try ETFSE Ex-Energy DG-AIG (AIGX, total expense ratio of 0.49 per cent) and Lyxor's LCNU. These are both dollar-denominated, but with separate sterling funds available.
If you want to take short or 'inverse' exposure to these broad indices, then ETF Securities offers the only tracker products in the field. Its short/inverse on All Commodities is called SALL; the equivalent twice-leveraged fund is LALL. There are also mirrors of these funds for commodities excluding energy – short is SNEY and leveraged long is LNEY. All four short and leveraged products have a fairly chunky expense ratio of 0.98 per cent.
A particularly popular product set focuses on gold and precious metals. ETF Securities has a very popular basket of physical precious metals, including gold, which trades as PHPM and has an underlying total expense ratio of 0.43 per cent. More specifically, there are also inverse/short gold ETCs trading as SBUL and an equivalent leveraged upside ETC called LBUL (both with total expense ratios of 0.98 per cent).
