Commodity ETFs

Capitalising on the success of ETFs as a diversification tool

Originally published in the July/August 2008 issue

Exchange traded funds (ETFs) have been one of the fastest growing products in both the US and European markets over the past three to five years with almost US$1 trillion of AUM. ETFs are characterised by having high levels of underlying liquidity, ease of trading and settlement whilst offering exposure to a wide range of asset classes. Whilst daily trading volumes and assets under management have been dominated by equity-related products, such as the S&P 500 in the US and EURO STOXX 50 and country ETFs in Europe, there has been explosive growth in other asset classes covered by ETFs.

Commodity ETFs: fulfilling a need

Commodities have been one of the most interesting and dynamic asset classes for investors due to both the high recent returns and the lack of correlation to other assets. The latter has helped highlight the diversification benefits from a portfolio perspective. However, trading in this area and the ability to gain access to efficiently priced trading tools has been a challenge. Commodity ETFs have been able to address these issues and have become increasingly popular. In addition, they have also achieved a relatively high level of market awareness. This is due to the fact that listed products, such as ETFs, notes and exchange traded certificates, provide an unparalleled ease of access and have managed to build on the recognition already enjoyed by the original equity-based ETFs. The recent product innovation in the commodity area has allowed a wider range of investors to consider adding this as an asset class to broad portfolio strategies.

Product issuance in both Europe and the US in the commodity area initially focused on precious metals such as gold, followed by oil and then broad commodity indices. Whilst single asset ETFs and products remain the core areas for asset growth and turnover, there has been a general trend towards following diversified and relative broad indices. In addition to this, investors have been keen to gain exposure to indices that can effectively manage the vagaries of the returns and structural issues that can arise from trading the underlying assets or futures on the underlying commodities. This has led to a series of enhanced total return and optimal yield related indices that offer both transparency and ease of use.

Turnover in the US commodity space has jumped substantially over the past year, rising from less than US$400 million to a peak of close to US$3 billion in the first quarter of this year. Currently, average daily volume has fallen back to over US$2.5 billion per day with a decline in turnover in precious metals being compensated for by rising interest in energy-related products. Turnover in the US is now dominated by energy ETFs which account for close to 57% of trading activity, whilst precious metals now account for only 37% of trading. The jump in energy-related turnover has been particularly strong in recent months, reflecting both greater interest in the sector and the launch of some successful new ETFs such as the United States Oil Fund (USO).

We expect trading volumes to remain heavily focused on energy-related products especially as the market evolves with the creation of short-related ETNs and products with higher levels of leverage. These offer investors more accessible trading opportunities than energy-related futures contracts whilst the direction of energy prices remains an important factor to commodity and equity returns.

US and European preferences

In contrast to the relatively high turnover in the US market, European products have seen lower interest from a trading perspective. Part of this may be due to the fact that the majority of European exposure can only be gained through exchange traded certificates (ETCs) rather than ETFs. This is likely to lead to a longer development process as European investors understand ETCs and how to accommodate these into their portfolio strategies.

In the US market, the majority of current turnover in commodity products, close to 97%, is done in ETFs. In Europe, 84% of all turnover is in ETCs. We believe that this development of a different market structure reflects the evolution of the listed products rather than a particular preference of ETFs over exchange traded certificates. As the markets and trading instruments evolve we expect that investors will focus more closely on the process of gaining asset class exposure than the finer details of the individual products.

In the context of the total European ETF market, commodities, at €112 million per day, are close to 11% of total ETF activity in an area that is likely to remain important to a wide range of investors. Around 70% of European trading is in long ETCs, with traditional ETFs representing around 15% of the market. Other ETCs that cover short, leveraged and forward constitute the rest of the market and are relatively new innovations.

European turnover remains dominated by trading in precious metals which account for over 47% of recent volumes. In terms of other sub sectors in the commodity space, agriculture has seen good growth in interest with recent turnover of €19 million. Unusually, given the prominence accorded to movements in the oil price, energy related products only trade €24.4 million which is just less than 22% of total turnover.

Assets in the European commodity space are firmly concentrated in precious metals and these account for close to 55% of all assets and this is broadly in line with the proportion of turnover. The next largest area is with assets related to diversified broad indices and these are close to 21% of total exposure. Over the past year the growth in assets has been led by precious metals which have added close to €3 billion in assets representing growth of 150% whilst agriculture has added over €1.16 billion of assets for growth of over 300%.

Asset growth in the US over the past year has been around 110%, with strong growth in traditional ETFs and above average increases in exchange traded notes (ETNs). It is likely that ETNs will continue to show higher growth rates as the structure can be more flexible for providing exposure to a wide range of non-traditional underlying indices and instruments. Overall ETF-related commodity assets have reached US$37.2 billion, and are currently showing significantly faster growth rates than equity ETFs.

ETFs and ETNs offer investors ease of access to commodities at a time when the asset class has achieved considerable prominence as a diversification tool with interesting return and risk profiles. We expect that these trends are likely to help commodity-related ETFs and related securities maintain their recent healthy growth rates.

Whilst precious metals such as gold and silver were amongst the first wave of commodity-related ETFs, recent trends have focused on energy and agriculture.

Perhaps showing the emphasis on commodities as an asset class, recent trends have tended to favour ETFs based on broad diversified indices and in the US these now represent over 21% of total assets, whilst in Europe they are also close to 21%.

As investors continue to focus on commodities as a relatively new investment opportunity, especially with respect to easy-to-trade exchange listed delta one products, we expect further growth in broad index-related products.



Nizam Hamid is Managing Director of Portfolio & Index Strategy at Deutsche Bank and has been at Deutsche Bank since 1998. The Portfolio & Index Strategy team works closely with the derivatives, prime brokerage, structured products and trading function in a research/advisorycapacity producing objective and quantitative research on indices, ETFs, futures and portfolio strategies