May 2011

COMMODITIES ETPs: Hold a steady course

CompassVeering off track when trying to keep an eye on commodity prices with exchange-traded products should not deter investors, finds Angele Spiteri Paris Increased tracking error of exchange-traded products (ETPs) based on commodities indices is nothing new, but what should investors do? They could simply stay away from these instruments altogether. But if they see the opportunity to invest in commodities as too good to miss, they could buy and sell them as the shape of the commodity curve changes, or buy into one of the newfangled optimised strategies that promises to minimise what is known as the contango effect. Two words any commodity investor needs to get acquainted with are “backwardation” and “contango”. These determine the shape of the commodities curve. When investing in commodities, an investor does not buy the actual barrels of oil or the sacks of sugar. Exposure to commodities markets is usually obtained through futures – financial contracts where speculators bet on the future price of commodities. It is the price of these contracts that lead to the creation of the commodities curve. When a market is in backwardation, it means that the price of a futures contract is lower than the present spot price, leading to a curve that is sloping downwards. On the other hand, if markets are in contango it means that the futures contract is more expensive than the current spot price, creating a steep upwards curve. The shape of the curve has a huge impact on the performance of commodities markets and also the performance of an ETP. For a number of reasons, most commodities markets are usually in contango. The main reason touted by experts is that the world assumes commodities prices will increase in the future as demand increases. But contango is not great news for ETPs. Jeremy Charlesworth, chief executive officer at Moonraker Fund Management, an independent fund of funds manager, says: “The deeper the contango, the larger the tracking error of an ETP versus the spot price.” In 2009 and 2010, the underperformance of the United States Oil Fund ETF and the United States Natural Gas Fund ETF was well-documented as spot prices rebounded from their post-crisis lows and these products lagged significantly. The exchange-traded funds (ETF) research team at data provider BarChart says: “That ETP poor performance was a direct result of the steep contango in the crude oil and natural gas markets over that time frame… However, the poor performance [of those two ETPs] was
completely predictable if those investors had understood the negative effect from the steep contango that existed in the futures markets over that time frame.” What has been called the “contango effect” in commodities ETPs is something that investors have to come to terms with; it is a mechanism of the markets. When ETPs don’t keep up with increases in the spot price, providers are often berated. Talking about ETFs, Mike Weston, head of investment at DMGT Pensions, says: “We’ve all seen the performance numbers from some commodity ETFs where the spot commodity prices have gone up significantly, but the ETF is struggling to make a positive return simply
because of the way the product is constructed.” So when the spot price soars, for example, when oil reached US$145 [€102] a barrel in July 2008, capturing that increase is extremely difficult, if not impossible. Neil Jamieson, head of UK sales at ETF Securities, says: “There’s a misconception that spot returns are investable and, really, they’re not. In the cases where they are investable, they come with costs attached.” And these costs would obviously chip away at any return. Jamieson says: “To buy something on spot means you’re taking delivery of it [the physical commodity] now or at the expiry of the next futures contract. So the 40%profit [the spot price] is not actually a real return because there are costs associated with buying a commodity and storing it for a period of time.” He says the contango issue is something investors in this part of the ETP world need to get used to. “Investors need to get comfortable with the fact that there is structural contango in certain commodities markets and so the product may deliver returns that deviate, in some cases significantly, from the spot price performance,” says Jamieson. Nizam Hamid, head of ETF strategy at Lyxor Asset Management, an ETP provider, says: “The reality is that because of supply and demand and because of transport and storage costs, different commodities go through a cycle of contango and backwardation.” Optimisation
One market development that looks to minimise the “contango effect” hangs on the idea of optimisation. When the futures contracts expire, managers may need to buy new ones otherwise they could have to accept the delivery of the physical commodity (some are settled in cash, some are not). When the markets are in contango, those new contracts are more expensive than the old ones. This is known as the roll-cost and with markets in contango, investors end up paying more for the same amount of exposure. Charlesworth of Moonraker gives an example. “An investor places $100 into an ETF when the futures contract on oil is priced at $50 per barrel, which means you’re effectively holding two barrels worth of exposure to oil.When that contract expires they then have to roll it forward and buy the next contract for $52 this time. So now you effectively hold less than two barrels worth of exposure but you’ve paid more for it. This is called the negative yield.” And this is the reason commodity ETPs cannot accurately track a commodity’s spot price and therefore underperform – it is because of the cost of rolling the futures contracts. Although it is a characteristic of the futures market, this is not ideal and, therefore, providers have been looking to minimise the contango effect through “optimised” products. Jamieson of ETF Securities says: “To help address structural contango, there are products available that position investors further out on the futures curve. “Such products can help reduce impact of contango because they position investors on the futures curve where it is less steep than in the front months [that is they have exposure to longer-dated futures contracts]. In addition to reducing the impact of negative roll, products positioned further out are likely to expose investors to less volatility than they would experience in a product with front month exposure.” Lyxor’s Hamid says: “We are seeing the creation of a range of indices and ETPs where people try to optimise how that roll exposure is managed. This can be done either by trying to maintain some form of constant maturity and minimise the roll costs, or by trying to have an optimised strategy that will switch between the near and the far months and create an efficient roll mechanism.” The question is, could or should, investors try and time the market and buy commodities ETPs when the underlying indices are in backwardation, and sell when they switch to contango? According to some, this strategy would not be beneficial to investors looking for exposure to broad commodities performance. Hamid says: “Going in and out of commodities ETPs according to whether the markets are in backwardation or contango doesn’t make a whole lot of sense. By focusing on that single technical aspect investors would miss the benefit of the asset allocation exposure
to commodities trading.” Christopher Aldous, chief executive at Evercore Pan-Asset, an asset allocation manager that uses ETPs for its exposure to commodities, agrees. “I suppose one could move out of commodities ETPs when markets go into contango – but then you wouldn’t continue to benefit from the upside movement in the spot price either.” So essentially, getting out before the ETP’s tracking error increases is the equivalent of throwing the baby out with the bathwater – you eliminate the contango issue but do not make the most of what can ultimately be a good thing. Blog ranting
The issues around tracking error spawned a number of financial blog rants against commodities ETPs. But for some investors the fact that the tracking error of these instruments increases significantly when markets are in contango is not such a concern. “Yes, with the futures-based ETPs you have the contango issue, but at the end of the day, they’re offering cheap and very liquid access to commodity markets,” says Aldous. “So although there are more efficient ways of trading commodities, doing it through ETPs is
probably the most convenient.” Jamieson says: “An ETP is just an access vehicle to the asset class, opening the door to investors who would otherwise not be able to obtain exposure to commodities. Also, operationally, it’s easier to hold an ETP than to buy, sell and roll futures so it has a lot of operational convenience.” Charlesworth says: “It is highly risky for Joe Public to go out and buy commodities futures. There are many mechanics involved that make the whole process very complex. An ETP takes all those worries out of the equation.” Aldous adds: “Commodities ETPs don’t not work, they just don’t work as well as the physical commodities markets.” Which he suggests is to be expected considering the other benefits they offer investors. ©2011 funds europe

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