Resource Investing with Exchange Traded Funds Part 2

- September 8th, 2010

The considerable appetite for commodity exchange traded funds (ETFs) is relatively easy to explain, as prior to the launch of these products many investors did not have an efficient and comparatively reasonable means of exposure into the asset class.

By Dave Brown – Exclusive to Gold Investing News

The considerable appetite for commodity exchange traded funds (ETFs) is relatively easy to explain, as prior to the launch of these products many investors did not have an efficient and comparatively reasonable means of exposure into the asset class.

This is supported by the obvious barriers to establishing exposure to the price appreciation of a bar of gold or silver and commodities exposure through futures contracts is a complicated proposition that requires both a considerable skill set and time to monitor and roll holdings.

The emergence of commodity ETFs effectively made commodity exposure as simple as buying a stock;  one ticker enabled investors to obtain efficient resources exposure from base metals to food stuffs, or even a diversified basket of a dozen plus commodities.

Some commodity ETFs have not been accepted as rapidly by investors, potentially raising questions about the specific product or more generally about the value of that asset class.  In the increasingly competitive world of ETFs, being new certainly does not guarantee being successful.  The success in marketing an ETF provides a larger capitalization of the security, realizing greater trading volumes and potentially adding to the liquidity; however investors will generally be most interested in the return on investment of the product.

Relative Outperformance

Gold Investing News and Fred Jheon, Managing Director of Product Development at ETF Securities recently discussed the relatively strong performance since the beginning of the year of ETFS Physical Palladium Shares (NYSE:PALL) and ETFS Silver Trust (NYSE: SIVR) compared to returns for ETFS Gold Trust (NYSE: SGOL).  Mr. Jheon explained the primary driver for demand in the underlying asset was the principle reason for the relatively strong returns.

Specific demand for palladium can be largely attributed to Asian and emerging market automobile demand, and the industrial utility of palladium (as well as platinum) in catalytic converters.  Additional demand is also created through the market for jewelry and investment demand.   Reinforcing the timely significance of exposure for investors, Mr. Jheon remarked, “We are heading into the jewelry season when the precious metals and the jewelry market is expanding, and the investors that were traditionally going into gold and silver are now branching into platinum and palladium.”

Mr. Jheon also noted the industrial cycle as a critical success factor underpinning demand for silver, “Silver is also a key ingredient for manufacturing solar panels.”  This is relevant to the current political context, especially given the administration’s predisposition for alternative energy.  The US Department of Energy has demonstrated this commitment with the American Recovery and Reinvestment Act including more than $80 billion in the generation of renewable energy sources, expanding manufacturing capacity for clean energy technology, advancing vehicle and fuel technologies, and building a more efficient electric grid.

Portfolio Diversification

Commodities have been embraced in the ETF structure because the asset class is perceived to offer very real benefits for investors when included in a traditional stock-and-bond portfolio.

A negative correlation between commodity prices and the other asset classes has traditionally been due to different behavior over the business cycle. Commodity prices have also been positively correlated with inflation, unexpected inflation, and changes in expected inflation, although these elements have been changing over the last 2 years.

The inverse relationship between commodities and equities has been in a transitional state as demand for raw materials has fluctuated along with the health of the overall global economy. Reports and forecasts of strong industrial activity in China and India underscored the outlook for global equity markets, but also stood as indications of increased demand for energy resources and industrial metals. Conversely, when equity markets experienced short term declines, commodity prices weakened with stock markets, as investors expect that slowing industrial and manufacturing activity will correspond with slower demand for natural resources.

Future Outlook

Recently John Stephenson, senior vice president and portfolio manager with First Asset Investment Management Inc., shared his thoughts on the marketplace rapid structural changes around the world “setting the stage for a massive bull market in commodities as smart investors know that after a decade of decline, stocks aren’t where the big money will be made.”

Selecting one particular asset class, Mr. Stephenson was bullish on oil, “If it’s just one, then you would have to pick oil. It’s a miracle fuel, costs less than orange juice on a volume-weighted basis, we’ve reached peak oil and China has just become the largest car market on the planet.”

As global equity markets return to a more stable environment, a correlation between stocks and commodities will likely retreat towards the historical mean, perhaps even returning to negative territory.  With over 40 percent of volume U.S. stock exchanges involving ETFs on some days, and hundreds of billions of dollars of ETF funds invested in contracts that were once dominated by producers and consumers who sought to hedge against petroleum market volatility, the regulators appear to be closing in.

A financial reform bill was signed by President Barack Obama towards the end of July that included provisions permitting new rules to limit the amount of investments in commodities by large institutions speculating on their direction purely for financial gain, enhancing the Commodity Futures Trading Commission’s (CFTC) ability to prosecute trading abuses.

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