Think before you join the commodity rush

Source Bloomberg Commodity UCITS ETF launched on 16 January and by 6 February had accumulated inflows of over $925m (£738m). The ETF's popularity can partly be ascribed to its relatively low charge of 0.4 per cent a year - 0.19 per cent ongoing charge and swap fee of 0.21 per cent - which undercuts its peers.

Investors are also piling into commodities: ETF Securities reports inflows of $58.5m into broad commodity exchange traded products (ETPs) in January 2017, the highest level in eight months. This follows a turnaround last year.

Between 2011 and 2016 commodities including oil, gold and industrial metals all suffered due to factors including the plummeting oil price and high valuations. The Bloomberg Commodity index fell 12.7 per cent in 2011 and then every year after that, including 20.3 per cent in 2015.

But last year this index rose 33.4 per cent as nervous investors poured money into gold and the oil price recovered significantly. The index is still well below its pre-2011 peak, but is back at levels not seen since 2009.

The rally in commodities could continue. Investors tend to turn to real assets such as gold and other commodities in rising inflationary environments. And reflationary infrastructure spending plans laid out by US President Donald Trump and the UK government could be a boon to industrial metals, while supply deficits and reductions in mining capital expenditure in 2015 and 2016 are still having an impact.

However, commodities are extremely volatile and many cannot be accessed via physically replicating ETFs, meaning most tend to be more complex fund structures, which have tracking issues or extra costs built in.

Like most commodity ETPs, Source Bloomberg Commodity UCITS ETF uses synthetic, swap-based replication. It aims to give investors the return of the Bloomberg Commodity Index, a benchmark of 20 different commodities, without holding those assets itself. Source Bloomberg Commodity holds a basket of Treasury Bills (T-bills) and pays investment bank JPMorgan the return of those securities in exchange for the performance of Bloomberg Commodity Index. This arrangement, known as an unfunded swap, incurs swap fees and adds counterparty risk.

If the counterparty, JPMorgan, was unable to pay the ETF the return of this index, Source could pay back investors by selling the basket of T-bills it holds. However it is important to consider this added layer of complexity.

And not all ETPs are collateralised. For example, ETF Securities WTI Crude Oil (CRUD) is backed by swaps and trades with two counterparties - UBS and Merrill Lynch Commodities - which post collateral held in segregated accounts at the Bank of New York Mellon. That collateral is made up of 3.3 per cent equity, 21.7 per cent bonds and 73.9 per cent G10 government debt.

ETF Securities Brent 1 mth (OILB) also engages in swaps but is not collateralised.

Commodity ETPs involve other costs, too. Due to the impracticality of holding large volumes of commodities such as oil, ETPs get exposure to the future oil price via futures contracts. But when the futures contracts expire, to prevent the ETP taking delivery of an unmanageable quantity of oil, it must purchase a new contract. But if the price of oil is rising, the expiring contract will be worth less than the new one, translating into a cost for the ETP's investors. That means a dent in your returns and less reliable tracking.

James McManus, analyst at wealth manager Nutmeg, says: "A good example is USO - the US listed WTI Crude strategy. When compared to the generic WTI future over the past 12 months, the impact of contango (where the future price is higher than the spot price) is clear to see. USO has seen a total return of 45.18 per cent against the futures return of 96.2 per cent between 10 February 2016 and 10 February 2017. The opposite of this, when markets are in backwardation, can of course increase an investor's return."

Source Bloomberg Commodity UCITS ETF is affected by contango and backwardation as the index it tracks is made up of futures contracts. Over one year ETFS All Commodities (AGCP), which tracks the same index, has returned 33.39 per cent against 34.74 per cent for the index. Over five years the ETP has lost 26.5 per cent and the index has lost 23.03 per cent.

But unlike an oil ETP, the Bloomberg Commodity index is made up of a diversified basket of commodities. Energy accounts for 29.04 per cent, grains account for 23.6 per cent and industrial metals account for 18.2 per cent. This means you get exposure to a basket of commodities rather than betting on one. Because Bloomberg Commodity index remains well off its 2011 highs there is potential for it to rise. And commodities can be a good portfolio diversifier and potential inflation hedge.

However investing in commodities involves extra costs and fees, and over 10 years Bloomberg Commodity index has lost 11.12 per cent. Investors considering commodity exposure should make sure they have the risk appetite for it and ability to tolerate volatility.

Bloomberg Commodity index composition

Source: Source.com