We could have called today “Base Metal ETF day, as all three posts will cover various aspects of ETFs and their role in metals markets. This first post examines the types of base metal ETFs available in the market today along with the pros and cons of ETF’s as an investment vehicle. Our second post will examine our hypothesis that ETF’s have played a large role in the run-up of base metals prices this year. Our third piece will examine whether or not ETF’s can be used as a hedging mechanism for industrial metals buyers.
Wikipedia offers a fairly comprehensive overview of ETF’s if not a confusing one. What is an ETN (Exchange Traded Note) vs. an ETC (Exchange Traded Commodity) vs. an EFT (Exchange Traded Fund). For our purposes, we’ll focus on ETF’s and ETN’s that make up the bulk of base metals activities.
To keep the explanations short and simple, we would suggest that base metal ETF’s (sometimes referred to as ETN’s) fall primarily into two buckets. The first bucket, index ETF’s, allow investors to buy “units in a fund (the ETF) which follows a rules-based index, which may for example dictate the mix of metals to be held, with the fund investing in the underlying futures contracts for those metals on a rolling monthly basis. Unit values increase or decrease as the underlying futures markets for those metals increase and decrease. The second type of metal-based ETF involves physicals in which as before, an investor buys units (think of units as shares) of a fund while the fund manager invests in actual physical spot purchases of the underlying metal. Our final post today will cover these types of ETF’s in greater detail.
Here is a list of metals-based ETF’s in which we calculate 32 in total, plus the two new ones Stuart will discuss later for 34 in total.
The argument for investing in ETF’s essentially rests on a few arguments. The first, diversification represents the classic “don’t put all of your eggs in one basket. As some asset classes look less attractive these days, others look more attractive. Commodities provide a means to diversify. A second plus of ETF’s relate to their ability to act as a hedge to inflation. The theory behind that suggests that as the dollar drops and inflation rises, so too will commodities, protecting one’s investments. ETF’s can also aid in creating a hedging instrument. Finally, one might argue ETFs provide more accurate price identification as the more liquidity, the greater the opportunity of achieving true price discovery. Of course that argument has a flip side in that after some point, more market participants hardly help a market become more efficient and can have the opposite effect of pulling up the price for the underlying metal.
The arguments against ETF’s also loom large. The herd effect inevitably pushes prices up as money pours in and could have the opposite effect if the herd leaves the market. We believe ETF’s have created price distortion at best.
In terms of their individual make-up, typically speaking, even though we have not gone through the analysis of each and every base metal ETF, most contain a blend of several base metals in a specified proportion (part of the rule-based index). For example, the PowerShares DB Base Metals Fund contains aluminum, zinc and copper in specified percentages. One would have to look at the iPathÃ‚Â® Dow-Jones UBS Copper Subindex Total Return (SM) ETN to invest in say “just copper.
This last point has significance for hedging strategies.