ETF Securities (ETFS) recently released their Global Commodity ETP Quarterly Report. The Q3 news appears mixed particularly amongst three base metals – copper, aluminum, and zinc.
Industrial metals saw another quarter of net outflows ($195 million USD). For that, we can blame copper, which contributed $196m in outflows. The movement out likely comes down to the expected increase in supply of copper, keeping investors away. On the other hand, aluminum and zinc compensated with inflows of $59m and $24m, respectively.
So how do ETF inflows and outflows impact underlying metal prices?
For those of you less familiar with how ETFs function, we will cover this in a moment. However, whether one likes it or not, the investing and metal buying worlds do indeed work together.
Here’s my very simple explanation of ETFs:
- An institutional investor or Authorized Participant (AP) (he almost acts like a broker) puts up capital to buy the metal or group of metals that the ETF will track.
- Then, the AP delivers the metals to the ETF, which will physically hold them.
- In exchange, the ETF will create an equal value of ETF shares and give them to the AP.
- Finally, the AP will sell the shares in the open market and investors will buy them the same way they buy stocks.
Throughout the life of the ETF, the AP can create new shares by repeating the process when it senses an increase in investor demand. This process is called creation and it translates to inflows.
ETF Creation Process
In the same manner, the AP can also can deliver shares to the ETF and get the underlying metals in exchange. Then, the AP can sell these metals into the public market. This process is called redemption and it translates to outflows. These two processes are what make the ETF share price move together with its underlying metal or basket of metals.
In essence, flows indicate investor sentiment. We can interpret net outflows for copper in Q3 to mean that more investors expect copper prices to decline. However, that doesn’t mean that it will happen. Indeed, we have not seen proof of correlation between investment flows into metal-backed ETFs and the price of those metals.
As for the impact of these ETFs on the prices of metal, the opinions appear mixed. Some people would argue that the expansion of ETFs makes prices rise since it lowers LME stock volumes. However, we have seen very little statistical correlation between LME stocks of copper and its price.
The Case For ETFs
ETFs actually have some arguments going for them. First, they make it easier for individuals to invest in metals. This translates into a new source of demand buoyed by more supply, giving the market more liquidity. More liquidity reduces the power of investment banks when tying up metals in financial deals.
Greater liquidity reduces the buying power of the largest players – and the positions that they take. Think Goldman Sachs and the big volumes they hold, which lead to more control and often more volatility.
A more dispersed buying base has a lot going for it. And industrial buyers in particular ought to like that.