Supplements » ETF Report Sep 2021

Commodities ETFs and the net-zero transition

Ship_containersDemand for commodities ETFs has soared this year, but where does the asset class fit within a broader ESG agenda? Alex Rolandi reports.

In July, Legal & General Investment Management (LGIM) launched a multi-strategy exchange-traded fund investing in commodities futures, designed as a tool to manage inflation and generate alpha across market cycles.

According to Howie Li, LGIM’s head of ETFs, the fund is a continuation of the firm’s pre-existing efforts in the commodities sector. The idea was to make an ETF as active as possible within an index framework offering exposure to the commodities futures market.

“This is about taking a rules-based approach of well-known alpha-generating areas that really helps us enhance the main commodities range, and that’s why we’ve launched it. It’s probably the most active you can get without having a discretionary manager sitting on top of it,” says Li.

The strategy takes into account risks and opportunities associated with the seasonality of certain commodities, as well as roll yield enhancements in managing futures and the momentum of certain agricultural commodities. 

Investor demand for commodities has been on the rise as pandemic-related restrictions are lifted. After a turbulent 2020, commodities were among the best performers across asset classes on a par with bitcoin in the first half of 2021. Broad commodities rallied by 21% in the first six months of the year, Forbes reported, citing data from JP Morgan, Factset, and US Global Investors.

At LGIM, assets under management (AuM) across its commodities ETF range was circa US$650 million (€555 million) at the start of the year. As of the week commencing July 9, the figure stood at around $1.25 billion.

Meanwhile, data from Morningstar shows that broad basket commodities ETFs in Europe attracted inflows of more than €3 billion year-to-date by the end of June. In 2020, however, as the pandemic rattled markets, broad commodities suffered estimated outflows exceeding €460 million.

Industrial and broad metals have also seen a rise in demand, drawing in nearly €418 million in the first half of this year, already surpassing the €114 million of net flows seen in 2020.

Reflationary reactions
In the current reflationary environment, commodities have become a topic of interest, says Vincent Denoiseux, head of ETF research and solutions at Lyxor. 

European ETFs are witnessing a record year in terms of growth. The strong flows into commodities need to be put into this context, he says, adding: “We are already exceeding the level we have observed in 2019 with regard to inflows into Europe-domiciled ETFs.”

By the end of July, assets under management in the European ETF industry hit a new all-time high of €1,197.5 billion, according to Refinitiv.

Another reason behind the soaring investor demand for commodities ETFs, according to Rumi Mahmood, senior associate, ESG research at MSCI, is because they offer exposure to commodities without the need to learn how to buy futures or other derivatives products. 

But where do commodities ETFs – which often have heavy weightings towards polluting sectors such as oil and agriculture – fit within a wider ESG framework, especially within the context of the transition to net-zero emissions? 

“Clearly we can’t just cut off oil usage today, so it is indeed a transition,” says LGIM’s Howie Li. 

Equities take care of the new technologies and approaches, he explains. Commodities act as a “counter” for how much product is available, while the equities element, handpicking companies, is where fund managers identify firms responsible for reducing carbon footprint. “It’s all connected,” says Li.

If a company were able to generate a commodity such as corn or wheat more efficiently with a low carbon footprint, what the futures market cares about is the commodity itself, he adds. 

“If you’re taking a forward-looking view as to what kind of investments you can make to help promote clean energy whilst you’re transitioning out of traditional energy like natural gas, then let’s really look at a clean energy proposition.”

Investors withdrew €1.2 billion from energy commodities ETFs in the first six months of this year, according to Morningstar. This was in sharp contrast to the net €593 million inflows seen in 2020. 

Nitesh Shah, director of research at WisdomTree, notes that oil went through a sharp slump last year, which drove “bargain-hunting” inflows.

“This year there has been a rapid rebound in price, which has driven profit-taking. When the dust settles, we should be able to see whether the energy transition is having any meaningful impact on oil ETPs’ demand,” he adds.

The ESG hierarchy
There is a chronological hierarchy to ESG, says MSCI’s Mahmood. The first step was ESG integration, followed by the “darker shades of green” such as socially responsible investment (SRI) and then climate and net-zero considerations.

“Whereas the transition has fed well into asset classes such as equities and fixed income, commodities ETFs are still different in the sense that they still haven’t applied that first stage of ESG,” he tells Funds Europe. 

This is no criticism of commodities ETFs, he adds, as there are good reasons why ESG criteria has not been applied to the asset class. “When it comes to applying ESG principles, the challenges are twofold.”

One is the issue of supply chain transparency, while the other concerns how ESG is applied to different commodity types. “For derivative-based products, [implementing ESG] remains impractical and there’s a lot of work to be done. The industry isn’t ready yet,” says Mahmood.

At the same time, as countries ramp up their decarbonisation efforts, it is increasingly clear that this will boost demand for other commodities, says WisdomTree’s Shah:

“While the demand for traditional hydrocarbon commodities such as oil may start to weaken in that decarbonisation path, the demand for metals such as copper, nickel, aluminium, tin and silver will rise as electrification intensifies.” 

The impact of climate change
Meanwhile, according to a European Environment Agency report, climate change is likely to affect agriculture by altering regional crop-growing conditions and the incidence of pests.

Although global aggregate agricultural production is not projected to decline before 2050, the report stated, annual yields will become more variable as suitable production zones shift, leading to an increase in agricultural commodities’ price volatility.

When it comes to the number of commodities in indices, the situation remains stable for the time being – but that could change in the future. It will be up to index providers to add any new significant commodities.

“Of course, with changing markets and industries, there might be changes over time,” says Lyxor’s Denoiseux. “But let’s bear in mind that commodities are used by investors sometimes to diversify, sometimes to hedge – in this context, it’s reflationary trade – and they are quite volatile. We’ve seen energy reaching very low valuations last year and bouncing back very sharply.”

In the mining industry, greenhouse gas emissions abated through the use of renewable energy, while battery technology outweighs the extra emissions from increased mining activity, notes WisdomTree’s Shah.

“Over time, cleaner mining processes and more responsible sourcing will indeed improve the carbon footprint of the mining industry. Already several mines are piloting the use of solar, hydrogen fuel cells and other new energy sources to operate their mines,” he says. 

As the transition to net zero gathers pace, certain commodities producers will obviously be more impacted than others. It is too early to say just how big climate change and decarbonisation’s impact will be on the asset class, however. 

As Denoiseux notes, it’s a long-term issue. “For any transformation, for any needs for new infrastructure, we still require energy and all these raw materials anyway.”

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