ETFs
A more optimistic scenario for commodity ETFs
Kiruna is a small town in northern Sweden. Here, one of the richest iron deposits in the world (80% of European iron), the ground is sinking due to intensive mining. It is home to just over 20,000 people who will soon be relocated elsewhere.
It is also the symbol of the thirst for natural resources that the world, and in particular the West, needs to fuel its economic development. Kiruna is an example of the growing conflict between development and preservation of the planet.
It is also a harbinger of a new, overly complex geopolitical landscape, in which new countries will emerge as leaders in the supply and processing of natural resources – a dynamic that is not lost on financial markets.
Even though the Bloomberg Commodities Index is up 100% since the pandemic crash in March 2020, it is still far from its 2008 highs (-54%). This asset class therefore seems to be entering a new Goldilocks scenario, or even a secular bull market.
It is therefore not excluded to look at this asset class in terms of rediscovery or rebalancing of investment portfolios.
But from an ETF buyer’s perspective, which commodities will look best? The CRB index consists of six groups and 24 commodities. Beyond this taxonomy, it is more useful to adopt a different approach to select the most attractive raw materials in terms of financial performance.
This approach distinguishes traditional products from innovative products. For example, H2 Moves Berlin is “a two-year pilot project led by Toyota Germany, Anglo American and the SafeDriver Group with ENNOO to promote sustainable hydrogen transport.” However, hydrogen is not part of the CRB index. The same goes for rare earths.
Last December, the European Commission defined 34 raw materials as essential to the energy transition. Of these, only copper and nickel are included in the CRB. However, the interactions between ancient and modern natural resources are much closer than we think. The defense industry needs iron from Kiruna, but also rare earths from Beijing, which has a monopoly not on their extraction but on their transformation, which is much more polluting for the environment.
The renewable energy industry consumes many raw materials that are not considered very environmentally friendly. For the pig skyscraper in Enzhou, China (26 floors each housing 20,000 pigs), a massive use of traditional raw materials was necessary. The soy consumed by these pigs has a devastating environmental impact.
Regardless, analysts agree that both categories of natural resources present very favorable prospects. It is also worth noting that they generally have low correlation to traditional asset classes.
They also benefit from falling interest rates and the stabilization of the exchange rate. Without forgetting of course their ability to defend against inflation. There is no doubt that the demand for copper, nickel, silver and platinum will increase as the production of new technologies increasingly requires their use. However, the use of innovative raw materials will also increase thanks to these technologies.
The wide range of ETNs available today allows ETF buyers to build an incredibly detailed commodity portfolio, but unfortunately just within the space of the monumental CRB’s basic composition, which could eventually be rewritten to add those who are not part of it today.
All of this is made possible by the excellent interaction between the futures market (which actually allows commodities to be traded instead of the much more logistically problematic physical exchanges) and the ETN industry.
Where there is a future (or an index), there is an ETN, and therefore access to the asset class that the derivative represents.
Where they do not exist, it is possible – as a stopgap – to invest in the producers of these resources via ETFs (as in the case of HANetf with its Sprott Junior Uranium Miners UCITS ETF, VanEck Rare Earth UCITS ETF or the L&G ETF UCITS on the hydrogen economy, to name a few). However, these ETFs are not technically the same.
They invest in companies operating in these sectors, and not directly in the raw materials they process. However, if the ETF buyer invests in synthetic ETNs (and not physically replicating ETNs), he should be aware of the refinancing, contango and backwardation mechanisms inherent in underlying commodity futures contracts. underlying.
Synthetic replication ETNs – based on the purchase of futures contracts – are used in markets where it is difficult to purchase the underlying directly (e.g. oil, natural gas or agricultural commodities). When the expiration date of the future approaches, the ETN issuer must sell the current contract and buy a new one with a later expiration date (rollover).
This involves incurring various costs that affect the performance of the ETN. An ETN will underperform the benchmark the longer the futures curve is in contango (contracts with rising prices for later expirations) and vice versa if the curve is in backwardation (contracts with falling prices for later expirations). subsequent expirations).
The mathematical relationship between the performance of the ETN and the performance of the underlying asset is not linear, precisely because of the continuous misalignment that the rollover causes with each expiration.
This effect increases over time. The more reversals, the greater the misalignment. Unfortunately, in the world of commodity futures, contango is the norm for futures curves because purchasing a commodity incurs a number of carry costs (opportunity cost of not investing in an asset without risk, storage, insurance, etc.).
These technical details, if managed, do not rule out the idea of adding or strengthening commodities in an investment portfolio. Ultimately, therefore, they must be closely monitored to avoid a vicious cycle of unintended consequences.
Edoardo Mezza is a director and Filippo Arena is a private banker at Banca Patrimoni Sella & C.