Metal Bearings

The recent push to deliver ETCs which offer underlying physical exposure,  rather than via an investment in futures contracts, has been driven by price contango in many raw materials. With longer-dated futures contracts trading at a price premium to those for near-term or “spot” delivery, investors have suffered a steady erosion of their money over time when an ETC simply rolls forward the futures contracts it owns.

In the worst cases, as last year with oil tracker products (see “Contango Blues”), investors earned only a fraction of the price return in the underlying raw material, as measured by the spot price. To make things worse, there is abundant evidence that those who were investing in passive, futures-based products were also being gamed by other traders (see “Rolling into Trouble”).

For these reasons alone it makes a lot of sense to have commodities trackers which actually own their underlying raw material rather than investing in a derivative contract that gives at best second-order exposure to the commodity.

It isn’t a one-way bet, of course: if you owned physical metal ETCs rather than the futures-based equivalent you would be exempt from contango but you would also lose the ability to gain from backwardation if spot prices rose to exceed those for forward settlement. Paradoxically, putting a lot of metal in storage to meet demand for physically backed ETFs and ETCs might actually help to bring about such a backwardation.

A lot of issuers, lawyers, exchanges and traders have jumped through a lot of hoops in creating physically backed ETCs. ETF Securities’ industrial metals ETCs have been on the drawing board for some years, said one market insider, while we’ve witnessed rumours of similar products from other providers – Credit Suisse, Glencore, Rusal – for well over a year, without their end-product yet appearing.

Why? Because actually creating the link to physical storage is both complex and costly.

ETF Securities’ initial estimates of storage fees are 6.54% per year for aluminium, 1.56% for copper, 5.67% for lead, 0.75% for nickel, 0.61% for tin and 6.13% for zinc. Add that to a 0.69% annual management fee and 0.12% insurance cost and for aluminium you’re losing nearly 7.5% of your invested money a year in charges, for example. The issuer hopes that charges will reduce over time, but there’s no guarantee that they will. In theory, storage fees might even go up if demand to own metals exceeds warehousing to hand.

ETF Securities has got around the thorny problem of the London Metal Exchange (LME) lending guidelines- which force an owner of metal to lend it back to the market in the case of a supply squeeze- by permitting its ETCs to own metals ‘off-warrant’.

‘On-warrant’ metal is owned in specified lots, meets the relevant LME Standards and is stored in a specific approved warehouse. Off-warrant metal may be stored at half the cost or less of its on-warrant equivalent, according to John Kemp of Reuters, but is potentially less liquid due to its lack of standardisation.

According to the ETF Securities Industrial Metals ETC prospectus: “The issuer intends initially to hold only LME Physical Metal, which can be used for the settlement of LME futures contracts, but may elect to hold some (but not all) of its metal as warehouse physical metal to reduce warehouse fees or ensure compliance with LME Lending Guidance.”

This wording leaves ETF Securities the option to store metal where it likes (beyond a promise to keep within the LME as much as it feels it needs to meet redemptions). As a result, investors will undoubtedly want to know in detail how storage costs are calculated and whether any cost savings resulting from holding metal off-warrant are being passed on to them, particularly in those metals with higher percentage storage fees: lead, zinc and aluminium.

As competing metal products from other issuers appear on the market, evaluating these details will become easier.

For the first time, investors now have the ability to choose between futures-based and physically backed industrial metals trackers. Ultimately, there’s no free lunch – the contango in futures-based ETCs reflects an implied cost of storage for holding the metal directly in a warehouse. Arguably, though, having both types of tracker product should ensure more efficient overall market pricing.

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