Article: Keep track of commodities

Financial advisers and discretionary wealth managers in the UK are nearly as likely to buy exchange-traded funds (ETFs) and exchange-traded products (ETPs) for their clients as they are traditional mutual funds over the next 12 months. This is according to a recent survey by Source ETF.

Around one fifth (22%) of respondents say they are planning to purchase more traditional funds in future while 17% said more ETFs or ETPs.

In terms of future purchasing plans, the most commonly cited ETPs were simple equity trackers (20%) – the vanilla products tracking the likes of the FTSE 100 or S&P 500 – along with commodity (20%) and equity sector (16%) vehicles.

Commodity focus

The interest in commodities reflects the rebound in this asset class since it bottomed out earlier in 2016. It also tallies with data from IG on the most popular ETFs with its clients in the first four months of 2016.

Oil has been central to the commodities comeback. Macquarie analyst Colin Hamilton comments: ‘Oil remains crucial for the wider commodity cycle, as it does two things for other commodities – drives industry cost structures and also attracts (or dissuades) commodity investment.’ Of IG’s top 10 most traded ISA-eligible ETPs, six offered short, long or leveraged exposure to oil prices.

Leveraged products are unsuitable for novice investors due to their heightened risks. Losses can quickly build up if the trade doesn’t move in your favour.

The popularity of commodity-based ETPs is understandable as these markets are otherwise very difficult to reach for retail investors.

It is important to remember commodities can be extremely volatile. The volatility in the underlying commodity markets which the tracking product seeks to replicate can be exacerbated by the impact of the futures market phenomena ‘contango’ and ‘backwardation’. These particularly apply to ETPs linked to crude oil but can also affect those linked to other assets.

(Click on table to enlarge)

ETFs tabel

Futures shock

Most commodities are traded in futures contracts. The purchase or sale of a commodity is agreed at a fixed price for delivery on a specified date – typically either one month, three months or six months out. This facilitates the buying and selling of the said commodity without anyone having to take physical delivery of a barrel of oil or bushel of corn. Only a tiny fraction of these contracts are settled through deliveries which are instead ‘rolled over’ to the next month.

Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above the spot price. The resulting futures ‘curve’ would be upward-sloping with prices for dates further in the future trading at ever higher levels.

Backwardation describes the reverse – where futures are trading below the spot price – often because of short-term tightness in the underlying market. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance.

What does this mean for an ETP investor? Well, when the product rolls contracts in order to avoid taking delivery of the physical asset contango sees returns diminished, also known as ‘negative roll yield’. Meanwhile, backwardation sees returns enhanced due to the ‘positive roll yield’.

The impact of contango is more acute for investors in ETPs because, unlike other passive investors, the providers of these products do not pay a premium every month to cover the cost of the roll and maintain the same position. In effect the instrument is giving up a proportion of its position to cover the cost of the roll.

This can make commodity-based ETPs more appropriate for short-term rather than long-term positions.