London, 12 October 2010

Retail and institutional investors are about to be offered an opportunity to participate in industrial metal markets through a range of physically backed exchange-traded products. But they should tread carefully.

Launching physically backed funds will tighten the supply/demand balance and push up prices in the short term. In the longer term, however, the cost of finance and storage will bite deeply into risk-adjusted returns, especially in metals like aluminium characterised by structural oversupply.

ETF Securities yesterday confirmed reports that it was preparing to launch a range of exchange-traded commodities (ETCs) backed by actual metal stored in LME warehouses. The firm already offers ETCs backed by holdings of futures on the London Metal Exchange. Physical ETCs have been billed by analysts as a natural evolution. In reality, they represent something of a step-change.

In the past, analysts argued investment flows do not drive the price of base metals and other commodities because investors gain exposure to commodity prices through futures rather than owning physical metal, and do not take actual delivery.

This distinction between futures and physical positions was never convincing. But it will be swept away if investors take delivery of substantial amounts of metal and tie it up in exchange warehouses in physically backed ETCs. Physical funds will compete directly with end-users for base metals such as copper and aluminium. Investment in physical ETCs will represent a form of hoarding and directly affect the physical supply-demand balance. The more metal that is owned by investors the less will be available to end users.

This is why physically backed ETCs are so attractive to their biggest supporters. They provide an alternative source of demand for metals such as aluminium that have been in structural over-supply in recent years.

Pressure to launch physical ETCs has been most intense from aluminium smelters and merchants; it provides a way to place the huge overhang of surplus inventory accumulated over the past two years with a retail investor base.

At present, stocks are financed by investors through commodity indices and hedge funds via the contango in futures prices. Once the ETC is launched, the costs of finance and storage will be borne directly by a wider range of retail and institutional investors through the upfront costs of buying units and in ongoing warehousing charges. Physical ETCs have the merit of considerably widening the marketing base.

DRAWBACKS WITH PHYSICAL

But as promoters of futures-based products and commodity indices pointed out in the past, physical investment is very much a second-best alternative to investing via futures markets:

(1) Investors in a physical fund will not have to pay contango to maintain a long position. But nor will they benefit from any backwardations.

(2) Futures investors pay for warehousing via the contango. Investors in a physically backed fund will have to pay fees directly, and cannot hope to have them offset by a scarcity premium during a backwardation.

(3) Physical funds provide less opportunity to benefit from the gearing inherent in futures contracts. Investors in futures can earn returns on the whole of their notional investment in the commodity futures -- plus a collateral return on the 90 percent or so of the funds that do not have to be put up as initial and variation margin, which can be invested in interest-earning assets such as Treasury securities. In contrast, investors in a physical ETC pay the full face value of their investment up front and will not earn collateral yield.

(4) Much of the case for investing in broad-based commodity indices has been based on the claim that investors can capture a "risk premium" built into futures prices -- paid by producers to transfer price risks to investors.

Participants in physical funds will not be able to reap this premium, if it still exists. Instead they will be dependent on timing the market right to capture spot price appreciation. From an investor perspective, physically backed ETCs have all the drawbacks of futures and none of the benefits.

PICK YOUR METAL CAREFULLY

Not all base metal ETCs are created equal. Physical ETCs based on copper, nickel and tin are likely to perform better than ETCs based on aluminium and zinc, because of their higher value-to-volume ratios.

Copper, nickel and tin are high-value metals which take up relatively little storage space. Warehouse rents will be only a small fraction of the sum invested, so the total return on investments should track the spot market quite closely. Their performance should be more like gold and other precious metals, which are easy to store.

In contrast, aluminium, zinc and lead are bulky products that take up lots of room and are expensive to store on a per-tonne and per-dollar basis. ETCs based on these metals are likely to behave more like oil and wheat, where storage charges have driven a big wedge between the appreciation in spot prices and the actual return achieved by investors.

Moreover, because base metal ETCs will be based on metals stored on LME warrant, rather than private off-warrant storage, charges are likely to be exceptionally expensive.

Storage on warrant is far more expensive than private rents (in some cases twice as expensive or more). Part of the differential reflects costs of assurance and compliance. Part reflects high entry barriers into the business. Either way, investors in physical ETCs will be paying for some of the most expensive storage around.

It might be worth paying premium rates to own physical copper, nickel and tin via ETCs, provided investors time the market correctly and enter at a relatively low base price. But it is probably not worth owning physical aluminium and zinc, except in the short term, when spot price movements dominate storage costs.

Like commodity indices based on futures contracts, physically backed ETCs should be considered a short-to-medium term investment for investors with a clear view on nearterm price movements.

For the bulkier metals, they are not really suitable for expressing a long-term view (3 years or more) since storage and the opportunity cost of financing will bite deeply into expected returns.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.