Opportunities in industrial metals ETCs

When it comes to gaining access to the commodity price of metals for the lowest price, an exchange traded commodity (ETC), which deals in the future price of raw metal, is the best option. However, this is by no means a safe bet. It might be cheaper than an actively managed fund that invests in mining equities and metals but ETCs are also high-risk, volatile and structurally complex.

Most industrial metals ETCs are based in US dollars, meaning that they are also a punt on sterling and the dollar. Added to that, the difference between the spot price and futures price of the metal could negatively impact your returns: If the price of the futures contracts underpinning the ETC are repeatedly lower than the metal's spot price, a phenomenon known as contango, your returns will be hit when those contracts are refreshed.

There are cost issues to watch out for too. As well as introducing the risk of contango, underlying futures contracts are based on swaps which add third-party risk and tack on extra fees to products. Swap fees tend to add around 0.45 per cent annualised fees to the product.

"These are products you can really be burned with but for people who know what they're doing these are really interesting areas," says Adam Laird, head of passive investments at Hargreaves Lansdown.

Aluminium

Aluminium's fate appears to be looking up. The metal was the top performer among the 20 key mineral ores and base metals tracked by Bernstein research last year, rising 17 per cent. Despite the fact there remains the equivalent of 20-30 per cent of annual global refined aluminium output sitting in warehouses around the world, demand for the metal is up. That is due to smelter closures and upcoming reforms to warehouse storage prompting nervousness over supply. As a consequence European duty unpaid premiums are at a record high of up to $265 per tonne according to Metal Bulletin against a London Metal Exchange price of $1,700.

There is one ETC on the London Stock Exchange dealing purely in aluminium futures offered by ETF Securities. The ETFS Aluminium ETC (ALUM) is a swaps-backed product which tracks the Bloomberg Aluminum Subindex. Over a four-year period the fund has closely tracked its benchmark: It lost 24.75 per cent over four years compared with a drop of 21.71 per cent for the benchmark, over two years fell by 0.60 per cent compared to 4.32 for the index and in the month to date posted a 6.59 per cent drop in comparison to the benchmark's 6.56 per cent decline.

Nickel

The price of Nickel also soared in 2014 amid a long-running tussle over a ban on exports of unprocessed ore from Indonesia, the world's biggest producer of the mined metal. After the export ban, the price of refined nickel jumped more than 50 per cent and reached $21,625 a tonne in May 2014. The price jumped again later in the year when reports emerged that the Philippines was considering a ban too.

The metal remains popular and many predict it could retain buoyancy this year. According to Morningstar, in the past month the commodity has experienced asset inflows of €8m, in contrast to net outflows from aluminium of €41m €106 from gold.

One option for investing directly in nickel is ETFS Nickel ETC (NICK), which tracks the Bloomberg Nickel Subindex and has demonstrated little tracking error in five years. Over a cumulative three-year period it lost 32.6 per cent compared with the benchmark's 30.61 drop and in the past year fell by 3.59 per cent compared with a 3.57 fall in the index. That compares to Societe Generale's SPGS Nickel ER ETN USD (NCLU), which saw a share price return drop of 25.31 compared to a 30.17 drop in its S&P GSCI Nickel TR USD benchmark.

However, ETF Securities' counterparty agreement means an additional fee of 45 basis points is added to the 0.49 per cent management expenses ratio.

SPGS Nickel ER ETN USD (NCLU) has an annual charge of 0.50 per cent.

Copper

Of all high-profile industrial metals, copper is currently taking the biggest battering, plunging to a five and a half year low this week. However, that discount could make it worth a bet in the long-run. The metal is also one of the few commodities currently in backwardation - the profitable opposite phenomenon to contango, effectively meaning that copper is a seller's market. Rumours of slowing Chinese demand driving down copper prices are balanced out by projects like the National Development and Reform Commission's commitment to spend around $115bn in large building projects at the end of last year.

A different way to invest in the metal could be through copper mining equities. You can do this via the UBS ETF Solactive Global Copper Mining (UC49), which gives exposure to 21 globally listed companies active in exploration, mining and/or refining copper with the highest correlation to the spot price of copper amongst their peers.

UBS ETF Solactive Global Copper Mining (UC49)

Index 10 largest equity positions

Source: UBS as at 21 January 2015

Index Country exposure

Source: UBS as at 30 November 2014

Playing the field

There is no doubt that investing in commodities is one of the riskiest places to put your money and when it comes to income, potentially the least rewarding.

"The problem with commodities is there is no yield, you are completely betting on price," says Michael John Lytle, chief development officer at Source.

"Plus the real challenge for the individual is matching the time and energy that it takes to understand the dynamics of that specific commodity versus the potential returns to them for investing. That is particularly true if you are only allocating a small part of your portfolio," he adds.

If you don't have a clear hunch about a commodity or a real desire to take a bet on share prices, your money would be safer channelled into a broader commodity ETF such as db X-trackers DBLCI OY Balanced ETF (XBCU). Not only is the risk spread by exposure to a wider variety of commodities but the fund actively monitors the futures curve in order to minimise the risk of contango.

db x-trackers DBLCI – OY Balanced UCITS ETF (XBCU)

Index composition

Source: Deutsche Asset & Wealth Management at at 31 December 2014

Alternatively, the Lyxor UCITS ETF Commodities Thomson Reuters/Corecommodity CRB TR C-USD (GBP) (CRBL) invests in a multitude of commodities including crude oil, gold, live cattle, coffee and sugar and over a five-year period has posted a tracking difference of -3.44 per cent.

Lyxor UCITS ETF Commmodities Thomson Reuters/Corecommodiety CRB TR (CRBL)

Index composition

Source: Lyxor ETF as at 31 December 2014

Performance of recommended ETPs vs relevant indices

Source: Investors Chronicle, using data from ETP providers, Trustnet and Morningstar

Notes: *as at 19 January 2015

The end of physical metal ETFs?

Among the dizzying variety of things which can make your ETF selection seem more complicated, the choice between a physical and synthetic one is one of the biggest. Synthetic funds dealing in the derivatives market can have distorting impacts on your returns and introduce more elements of uncertainty into the mix. However, over the past two years the market in physical metals ETFs appears to have fallen away, with huge storage costs and concerns over the impact of mass-metal buying on supply taking its toll. Both the db-ETC Physical Copper ETC (XCO1) and ETFS Physical Copper (PCHU) were delisted between 2012 and 2014. ETFS shut down its range of physically-backed industrial metals after deciding that the storage costs had too negative an impact on product performance.