Are Physically-Backed Metal ETFs A Good Idea?

by on October 15, 2010 | ETFs Mentioned:

As optimism over a quick return to growth in the U.S. has waned, many investors have begun to turn their attention to rising superpowers in the developing world. This trend, combined with ongoing speculation over further easing measures, have sent the U.S. dollar tumbling in recent sessions, as several rival currencies have touched new record highs against the greenback. The slide in the dollar has helped to fuel impressive rallies in nearly every corner of the commodity market, as precious metals and industrial metals, grains, and softs have all soared higher.

Most don’t think of industrial metals as an investable asset, but those who have established exposure have been handsomely rewarded this year. One of the widely used industrial metals, copper, has seen its price soar in recent months up to $3.80/lb.–a level within striking distance of pre-crash prices that briefly climbed above the $4 mark. Meanwhile, less well known but equally important metals have also joined in on this trend; the GMFS Base Betal Index is now up 22.8% over the past year, and has posted a 13% gain in just the past 60 days alone [also see Three Reasons Why The Copper ETF Is Soaring].

This boost has led to renewed interest in industrial/base metal investing, including the products in the Metals ETFdb Category. Currently, there are nine products in this group, all of which allow investors to obtain exposure to metals through futures contracts. Included are five broad funds, which invest in a basket of metals futures contracts, as well as four more specialized ETNs from iPath that each track a single industrial metal: copper (JJC), nickel (JJN), aluminum (JJU), and lead (LD).

Rumor has it that British firm ETF Securities–best known in the U.S. for its suite of physically-backed precious metal ETFs–could make a foray into this space with a line of products that take a different approach to industrial metal exposure. According to numerous sources, the company is planning on launching funds that physically hold copper, aluminum, zinc, nickel, lead and tin, as well as a basket of all six major base metals.

While the launch date remains a mystery, Graham Tuckwell, the CEO of ETF Securities, hopes that the products can come out in the “reasonably near future.” The products would likely debut overseas on the LSE, but could eventually make their way to the U.S. market. “This new platform is intended to provide investors with exposure to physical industrial metal without the need to purchase and store such metal directly,” said Tuckwell. “These products will complement our existing offerings which are priced off futures prices rather than cash market prices.”

Possible Roadblock

In addition to the traditional minefields these products will have to wade through, the funds will likely meet scrutiny from regulatory agencies that are growing increasingly concerned about the impact of exchange-traded securities on volatility of commodity prices. While the rise of physically-backed commodity funds has likely contributed to the rise in gold prices, that metal has virtually no use in industrial applications. But if physically-backed ETFs began to accumulate significant quantities of copper or tin–or any other metal widely used in manufacturing operations–rising prices could ripple throughout the global economy. Should these concerns be at the forefront of regulators’ minds, it could end up further delaying the passage of the products through the regulatory system [see The Controversy Over Palladium and Platinum ETFs].

Furthermore, there are some hurdles at the London Metal Exchange that must be cleared. The LME has strict rules for accounts that  hold 50% or more of the warrants and/or cash today/cash positions in relation to stocks of a metal. “For markets like copper and lead, where LME stocks are relatively tight, the chances are much higher that an ETF product would attract enough investment to push it into the category of dominant long,” writes Andrea Hotter. Once an entity becomes the dominant long holder in a commodity, it is generally required to reduce positions to a level that no longer exceeds this 50% threshold. As such, some worry that the fund would not be fully backed by the physical metal, especially in low inventory markets. However, it appears as if ETF Securities has already considered this and has a plan in place to soothe investor fears, although it remains to be seen how exactly the company will mitigate these concerns. “We’ve structured the product to ensure that these regulations and requirements are complied with… We’ve found a way to work with [these rules] that works for both the exchange and the investors,” Tuckwell told Dow Jones Newswires.

Good Idea / Bad Idea

Should ETF Securities be able to pass the hurdles and secure enough physical inventory for its products, the funds could prove to be another huge success for the firm. The four ETFs listed in the U.S. are all physically-backed products and each has at least $290 million in assets under management, including the billion dollar Swiss Gold ETF (SGOL). ETFS is one of the largest players in the European market.

Physically-backed commodity products are appealing to investors because they move in unison with spot prices and won’t be impacted by the nuances of futures-based investment strategies. Some investors have been frustrated with the performance of exchange-traded commodity products that lag behind a hypothetical return on the spot price of the underlying commodity. When futures markets are contangoed–meaning that longer-dated contracts are more expensive than contracts closer to expiration–the “roll yield” incurred each month creates some stiff headwinds for investors in the funds.

While physically-backed products eliminate the potentially adverse impacts of contangoed futures markets, this structure introduces its issues. Exposure to precious metals–including gold, silver, platinum, and palladium–works well within a physically-backed ETF because of the high value-to-weight ratio of the metals. An ounce of gold is currently worth close to $1,400, meaning that a relatively small storage space can accommodate gold worth a tremendous amount of money. An ounce of copper, on the other hand, is worth about 25 cents, meaning that storage costs could be considerable. The industrial metal backing each proposed ETFS product, which Deutsche Bank will be responsible for sourcing, will be stored in LME-approved warehouses. The big question is just how hefty the storage fee will be.

Storing aluminum, which currently is worth about $2,400 per tonne, costs about 7% of its value per annum for carmakers in Detroit. Even if the proposed physically-backed products were able to slash those fees, the effective expense ratio of these proposed products could set new records for the ETF industry. It’s important to keep in mind that storage costs are often a primary reason for contango in futures markets, as longer-dated prices include additional months of storage. Physically-backed metals ETFs may do away with the costs incurred in a futures-based strategy, but investors would likely run into these fees elsewhere [see Why The Aluminum ETF Is A Terrible Idea].

It appears that the next wave of innovation in the commodity ETF space is upon us. In all likelihood, the physically-backed metals ETFs on the horizon will be a big hit, and may eventually make their way to the U.S. And while more options for investors is always a positive development, it remains to be seen whether the next generation of products will be a major improvement over what is already available [also read Inside The Third Generation Commodity ETF].

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Disclosure: No positions at time of writing.