Long On Promise, Short On Detail

The firm revealed that its new ETCs will include copper, aluminum, zinc, nickel, lead, tin and a basket of all six metals, based on the London Metal Exchange’s pricing and warehousing network.  The ETC launch is still  “subject to approval from relevant regulators and the London Stock Exchange”, ETF Securities says, making it sound some months away.  Critically, no information is on offer about the cost of storage of the relevant metals.

If a long-heard complaint from investors is that the contango typically priced into futures-based commodity trackers eats into their returns, then offering physically backed commodity products seems like a way around this.  Everything, however, comes down to the pricing.  According to John Hyland, CEO of the US Oil Fund, quoted by Bloomberg, investors in an aluminium-backed ETC would “get eaten alive on the storage costs.”  Hyland mentions a possible 10% per annum, while another market observer estimates 6-8%.  Investors will then have to weigh up the relative certainty of these costs against the vagaries of the commodity futures curve shape when deciding whether to choose a futures-based or physically backed product: not an easy decision for most people, I imagine.

The record contango in equity volatility trackers that we reported yesterday is a reminder of how important such considerations are: with the VIX futures curve so sharply positive, investors in ETFs and ETNs that roll mechanically from the first to the second month futures would lose over 85% of their money over a year if the same curve shape prevailed.  Although commodity contango hasn’t been quite so extreme as this, the principle is the same.

It would be ironic if futures contango in metals, the prime driving force behind the creation of physically backed ETPs, were to lead to the opposite occurring.  After all, if ETPs started to control a significant proportion of metal stocks, then it’s easy to imagine that pricing might suddenly shift to backwardation, removing the rationale for buying the physical product in the first place and making futures-based trackers attractive again.

As Chris Flood of the FT pointed out yesterday, it’s also unclear how ETF Securities will handle the LME’s metal lending guidelines, which oblige market participants to lend out some of their stock if a “dominant position” in the supply of any particular commodity is reached (with thresholds set at 50%, 80% and 90% of live LME warrants, the bearer certificates that serve as evidence of physical possession of a metal).

Flood notes that if an ETC were subject to these enforced lending rules, as seems quite likely from time to time, this would remove the 100% physical backing, although it’s unclear whether this would also create any significant counterparty exposure (in other words, whether and how such loans might be collateralised).

If ETF Securities has gone further than other rumoured sponsors of physically backed metals trackers in at least sketching out the structure of its planned products (Credit Suisse, Glencore and Rusal, all long reported to be involved in the launch of an aluminium ETC, have so far declined to offer any detail), it’s still difficult to assess whether these vehicles will make sense for investors.  Nevertheless, if they can enjoy a mere fraction of the success enjoyed by precious metals trackers, base metal ETPs’ sponsors will be happy.

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