Commodities have been having their day in the sun with a noticeable run of commodity-linked launches in ETF form in the UK.
Net flows into broad commodity ETPs globally stand at USD11.1 billion year to date and gaining exposure to commodities has become an increasingly important feature in the investment landscape, as investors become more aware of the importance of raw materials in supporting global economic growth, particularly in terms of a more sustainable future.
WisdomTree and LGIM, both with a shared distinguished commodity ETP provider heritage, have produced new products in recent months. Nitesh Shah, Director of Research, Europe, WisdomTree, says: “Broad based commodities demand is definitely on the up with individual segments in commodities presenting more of a mixed picture than last year.”
Meanwhile, LGIM’s Howie Li says: “We have always encouraged investors to understand the commodities markets.”
From the investor side, Mark Northway, investment manager, Sparrows Capital, reveals that as a firm they have seen increased interest in commodities as a by-product of inflation concerns which, he says, have been front and centre over the past 12 months.
“Our clients are expressing interest in the likely performance of their portfolios in an inflationary scenario, and the commodities discussion naturally arises, as does a focus in inflation-linked bonds, duration management, selective equity exposure, real estate, infrastructure, gold and even cryptocurrencies.”
Laith Khalaf, financial analyst at AJ Bell agrees that with the arrival of inflationary concerns in the markets, it’s no surprise to see new commodity ETCs launching on the market, however he strikes a cautionary note.
“However generally speaking these products are mainly aimed professional investors looking to get exposure within a diversified portfolio. The costs, complexity and focused nature of these products means they aren’t likely to hit the mainstream with retail investors any time soon, although undoubtedly some more experienced investors do make use of them at the margins,” Khalaf says.
“The one exception is gold ETCs, which have found more commonplace acceptance in investor portfolios, because they offer diversification from equities, and are available in physically backed form which precludes the need for more complex derivatives to be used in their construction.”
Both WisdomTree and LGIM offer products that are designed to produce an enhanced commodity return. LGIM’s L&G Multi-Strategy Enhanced Commodities UCITS ETF, is designed to give investors diversified exposure to the commodities futures market, tracking the performance of the Barclays Backwardation Tilt Multi-Strategy Capped Total Return Index.
“This latest product has techniques that are deployed by active commodities managers,” Li says. “The idea is to give investors the exposure to multi-strategy or multi-technique enhanced commodity returns.”
The ETF is designed with the aim of smoothing out natural market volatility in commodities caused by external forces such as seasonality in energy, for instance.
The WisdomTree launch, the WisdomTree Enhanced Commodity ex-Agriculture UCITS ETF – EUR Hedged (EXAG), is designed to give investors broad enhanced commodities exposure through an ETF. Shah explains that the product has a degree of optimisation that positions each commodity on the futures curve.
Li says: “There is lots of attention on the commodities market because of the energy rally which has piqued people’s attention and also the pandemic has caused dislocations in certain commodities. The inflation discussion has started to creep up a lot this year and commodities are always seen as an inflation hedge.”
Sparrows Capital’s Northway says: “The problem with inflation is that it is insidious. By the time the investor community is aware of inflation risks, the markets have already priced in an unattractive hurdle rate. Our message is invariably that reacting to market concerns is likely to harm portfolio performance, and that it is better to design a portfolio ab initio to perform across the cycle, and to harvest the returns from that portfolio without subjective intervention.”
WisdomTree’s Shah also believes that people are worried about inflation, which in the US is at 5 per cent, the higher end of a scale over recent years.
For Shah, we now have a well-functioning banking system so inflation shouldn’t be the concern it used to be back in 2008, with banks efficiently stress-tested.
“Inflation is driving a big demand for commodities and people wanting to engage in this cyclical upturn and a growing sense that it’s not just a business cycle phenomenon – it’s more than that, more like a supercycle,” he says. A supercycle is an elongated bull cycle and for Shah, in commodities, that is partly driven by the new focus on infrastructure, a sector that needs commodities.
“For decades we have seen very little investment in infrastructure but with the pandemic all this fiscal firepower is almost looking for a home, so they are throwing it into infrastructure with a USD1.2 trillion program in infrastructure in the US,” Shah says, quoting the Biden infrastructure plan.
Infrastructure developments are commodity intensive. NTree’s head of research, Hamad Ebrahim, has commented on the Biden initiative, saying: “President Biden’s signature USD579 billion infrastructure initiative is now one step closer to being rolled out, and its staggering size and ambition will have a profound impact on commodity markets and supply chains, in particular metals like copper, nickel, and silver.”
NTree lists the key elements of the physical infrastructure plan, including modernising 20,000 miles of highways, roads, and main streets, fixing the 10 most economically significant bridges and repairing the worst 10,000 small bridges. Replacing or repairing 24,000 buses, 5,000 rail cars, 200 stations and thousands of miles of track, signals, and power systems. In addition, developing and rolling-out electric vehicles and corresponding charging network, including building 500,000 EV chargers by 2040, replacing 50,000 diesel transit vehicles and electrifying at least 20 per cent of yellow school bus fleet. Replacing of all lead pipes and service lines; investing in the electric grid network and rolling-out affordable reliable high-speed broadband across the country.
For all of this copper, nickel and silver are the most likely to become beneficiaries, NTree says.
And underlying of all this is the move to create greener and cleaner energy. Shah says: “A further aspect is the energy transition that is taking place. With the pandemic people are unsure if it would put the brakes on the green transition but actually it has accelerated and all the materials used in the renewables world are typically based on commodities.”
More cautious on investing in commodities is Ben Seager-Scott from Tilney who agrees that there has been a lot of activity in commodities, both with direct ETCs (especially physical industrial metals) and the more diversified ETFs (incorporating both a selection of direct commodities and indirect exposure through commodity equities).
“Most of my involvement is through our own discretionary services, and so from that perspective, whilst it’s noteworthy, we’re not increasing our commodity exposure for now and I see these launches as useful tools in the toolbox for the future,” Seager-Scott says.
“Commodities can be fickle investments, and may find a use if we believe that inflation is starting to accelerate beyond the control of existing policies, which is currently a bit of a tail-risk but I wouldn’t consider it to be our base case. As a result, I’d rather use the risk budget for equities which have some ability to deal with inflation thanks to pass-through effects, as well as the ability to grow earnings over time.”
Northway essentially agrees that while commodities are useful in the construction of long-term portfolios for diversification, their use by investors requires a degree of caution.
“A thorough understanding of the index methodology is required (whether for a basket of commodities or a single commodity) and of the practicalities of trading physicals where deliverable matters,” Northway says.
“An example in the oil sector is WTI vs Brent, where WTI is physically delivered. Gold ETFs saw price discrepancies between currency share class unrelated to FX movements, due largely to Covid disrupting the physical supply chain. Most ETFs track futures or swaps baskets, so involve synthetic replication; investors need a good understanding of derivatives futures and forwards markets and underlying physical markets and the notion of contract expiry, roll and backwardation/contango.
“Commodity ETFs demonstrate high levels of volatility and drawdown, and are correlated to equities in sharp market corrections. We continue to regard Commodity ETFs as a specialist instrument, notwithstanding the current market focus on the commodities “super cycle”.