A year or two back, physical metal ETFs were all the buzz. Talk was they were the vanguard for retail investor access to the commodities markets, providing low-cost entry into speculating on the metals markets and even opening the possibility of hedging for smaller users.
Since then the OTC swaps market has created much better hedging instruments, but precious metal ETFs in particular have proved very popular on both sides of the Atlantic. Apparently an ETF cannot be created overnight; considerable regulatory hurdles must be overcome and JPMorgan Chase & Co’s physically backed copper fund, formally known as JPM XF Physical Copper Trust, has been two years in the making.
Although slated to start in June, it has already hit weighty opposition in the form of major US copper consumers and traders objections to the damage such a fund could do to accurate price discovery.
According to Reuters, lawyers representing Southwire, one of the largest copper users in the United States, and Red Kite, a major metals hedge fund and physical trader, argued in a letter to the US Securities and Exchange Commission (SEC) this month that such a fund would inflate prices and squeeze supply by removing as much as a third of the London Metal Exchange’s copper stocks.
The FT quotes sections of the letter saying the product (JPM XF PCT) would “grossly and artificially inflate prices” and “wreak havoc on the US and global economy.” Its regulatory filings suggest the ETF could hold 61,800 metric tons, out of a global annual output of some 18 million tons.
So let’s examine the evidence.
On the one hand, similar physically backed ETFs launched by ETF Securities and Deutsche Bank in Europe have had negligible impact on the market. ETF Securities launched their fund in October 2010, but it had only amassed investments representing just over 6,000 tons as of March, worth about $50 million at today’s prices. Part of the reason for that, however, may be that ETFs do not pay commission to financial advisers, unlike mutual funds.
According to an FT article, in the US, half of all ETFs are held by institutions while 45 percent are held by financial advisers and 5 percent are held directly by retail investors. In contrast, UK and continental European ETF markets remain dominated by institutional investors who hold 90 percent and 85 percent, respectively, of outstanding ETFs. So uptake in the US, where fee-based advice dominates, may be more rapid and widespread.
Consumers’ objections center around a fear that large physical purchases of copper stocks, particularly in the US (which is a net importer of copper and therefore more exposed to sudden physical shortfalls) would drive up premiums and deprive consumers of access to metal. Similarities could be drawn with the millions of tons of aluminum held in storage as banks, hedge funds and traders play the financial stock-and-carry trade which has locked physical aluminum away from access by consumers.
This has artificially supported prices, particularly prompt or spot premiums. JPM may argue the proposed 60,000+ tons is a drop in the 18-million-ton ocean of copper produced annually, but the firm expressly states it would only hold LME-approved metal, so if not purchased from the LME, it is metal that could otherwise be destined for the LME. 60,000 tons is equivalent to 27 percent of the copper held in the London Metal Exchange’s global network of warehouses and an even larger proportion of the copper held in US exchange warehouses. Nor is JPM alone: BlackRock iShares has also filed for a copper-backed ETF said to target 121,200 tons of metal.
In the current market, uptake of a new copper fund is likely to be lackluster at best. The price has been falling in recent months and spot prices are higher than forward prices, so even in a flat market investors would currently stand to lose money. But consumers’ fears are not confined to this week or this month; rather, an established fund removing tens of thousands of tons of metal from the market could have an impact in a more buoyant market months or years down the line.
Once approval is given, the genie is out of the lamp — and who knows what mischief it could get itself into.