Commodity ETF : how does it work?

racing_blue

Some time ago, I invested in a commodities ETF: Lyxor International Asset Management Lyxor ETF Commodities TR/Jefferies CRB (CRBL)

The stated aim is to track an index, the Thomson Reuters/ Jeffries CRB total return index. Historical charts show that the ETF has tracked this index very closely.

The index itself comprises of a basket of 19 commodities, with 39% allocated to energy contracts, 41% to agriculture, 7% to precious metals and 13% to industrial metals. "The Index acts as a representative indicator of today's global commodity markets."

Well, fine.

But in an idle moment today I was reading the funds prospectus, and came across this statement:

Investment Strategy: indirect replication. The fund will enter in to one or more OTC swap contracts. These will serve to exchange the value of the funds assets, for the value of the securities which underly the benchmark index. The securities in which the fund invests include those which make up the benchmark index, and also international equities from all market sectors listed on all exchanges including small -cap exchanges.

The fund's holdings are listed in full and include shares in Banco Santander (9%), Facebook (5%) among more industrial companies like Siemens (9%) and Daimler (9%).

So my question is: how does that work? How does Society General peg the value of a diverse basket of equities, to a global commodity index? What is in it for the counterparties behind the OTC contracts?

kidmugsy

I think Lyxor do all their ETFs with swaps. I prefer ETFs that own physical commodities: as long as they really do own them, then there should be no counterparty risk.

If you look, for instance, at gold ETFs, you'll see that some refer in their title to "physical gold". This means that they claim to hold bullion in safe storage vaults somewhere: they usually tell you who the custodian is, and which firm is responsible for checking that the gold is actually there.

masonic

racing_blue wrote: »

Some time ago, I invested in a commodities ETF: Lyxor International Asset Management Lyxor ETF Commodities TR/Jefferies CRB
<snip>
But in an idle moment today I was reading the funds prospectus...

I've heard the "Invest First, Research Later" strategy has tended to be less successful than doing the research before deciding what to invest in.

So my question is: how does that work? How does Society General peg the value of a diverse basket of equities, to a global commodity index? What is in it for the counterparties behind the OTC contracts?

Essentially, the counterparty takes the money and promises to deliver a return that is equivalent to the benchmark. The counterparty is then under no obligation to invest in the underlying securities that make up the benchmark, but can instead find opportunities that will deliver a higher return from which it can profit. If it generates a higher return than the benchmark, it is only obligated to pay the benchmark return back to the investor and keeps the excess returns as profit; if it makes the wrong call and delivers a lower return than the benchmark, then it has to pay out of its own pocket or default on the debt (the investor would then suffer a loss of returns/capital).

Malthusian

kidmugsy wrote: »

I think Lyxor do all their ETFs with swaps. I prefer ETFs that own physical commodities: as long as they really do own them, then there should be no counterparty risk.

Which is fine for assets like gold and other precious metals that can be easily stored in a vault.

The OP's ETF however tracks a basket of commodities which will include oil, gas, wheat and livestock. It would be possible to have a TR/Jefferies CRB All Physical Commodities ETF but you would need a massive facility containing huge sheds full of barrels of oil, great big gas tanks, granaries and pig pens. And of course the vaults for the gold, silver and industrial metals underneath.

ETF managers tend to prefer working with computers to mucking out pig crap so they instead use the "indirect replication" strategy which in this case seems to mean swap contracts (which work as Masonic said). The other way is using rolling futures contracts, which means they buy e.g. contracts to receive a barrel of oil in one month's time, and then just before someone turns up at their office with a million barrels of oil, they sell the contract (to someone who actually does want barrels of oil) and buy another 1-month future. This should largely, though not exactly, follow the oil price.

If you want to track commodities in general (not just metals) and don't want to run a farm then some form of counterparty risk is unavoidable.

Pincher

If you are good with numbers, you can combine a witches brew of several things, which in the right proportions, behave like the commodity you want to track. Well, historically, on a spreadsheet.

For example, if Royal Dutch Shell goes up and down in step with crude oil price, you could just buy RDSB, and get some dividend as well.

If you want to keep a position in company X, you can buy 1,000 shares at £10, or you can buy a call option, for say £400, which gives you the right to buy 1,000 shares in September 2016. You can use the £9,600 elsewhere, but you don't get any dividend until you actually own the shares. Because you can use the money else where, you are likely to make more money.

They can combine anything they feel like, futures, options, long term OTC contracts, provided they declare what they intend to do.

I doubt people actually read or understand these declarations.
An interesting experiment would be to say: "We WILL NOT DEAL in drugs. We will concentrate on co-operative groups that deal in humanitarian efforts by transporting poor people into rich western countries using rubber dinghies."

grey_gym_sock

the tracked index is not a basket of the values of various commodities, but a basket of what value you'd gain/lose by buying futures contracts in various commodities, and every so often rolling them over into longer futures contracts (to avoid actually taking delivery of hogs & orange juice & so on). (see the calculation supplement: http://financial.thomsonreuters.com/content/dam/openweb/documents/pdf/financial/cc-crb-index-methodology.pdf )

so perfectly tracking this index won't necessarily give you the same result as the change in the prices of the underlying commodities. the result could be better or worse. however, i suspect the current situation is that a lot of people have piled into commodities futures for speculative reasons (or, if you prefer, in order to diversify their portfolios - that sounds better, but it means the same thing), pushing many commodity futures into contango, which reduces the odds of doing well from owning these futures.

given an index based on commodity futures, the (relatively) straightforward way to track it would be to buy the relevant futures, rolling them as appropriate, while keeping the balance of your (or the ETF's) capital in government bonds. (i expect there are ETFs that do something like that, but not CRBL.) buying futures involves counter-party risk, with the other parties to the futures contracts.

CRBL's method involves a different kind of counter-party risk - the risk that societe general won't be able to honour its obligation to pay a return equivalent to what you would have get if you'd actually bought the futures contracts (and they'd been honoured). is that a better or worse kind of risk to take on? i don't know, but it seems like a very complicated way to do it, and i would assume that the ETF is being run in this way because it suits the issuer, not because it's in the best interests of investors.

racing_blue

Thanks very much for those answers which have helped me understand. It tastes bad that SG takes money, invests in Facebook, then looks to swap those shares for a guarantee of the value of a commodities futures index. There's one step too many in there for my liking, and it involves investing in tech and bank shares.

I think I need to look to exit from various commodity ETF investments in a sensible way. Generally they have not performed as I hoped, due to the reasons given by GGS I suspect. I understood that these ETFs might have an attenuated upside and a steeper downside risk, and so it seems. Thinking of setting sell target based on a mid 10 year range price for the underlying commodities, rather than the value of the ETF. Despite the gains made by commodities in the last few months, I will probably lose money overall on this little venture, who would have guessed.

Incidentally I notice the factsheets for some commodities ETFs contain conflicting warnings: they are volatile and not suitable for short term investors; and that their value may erode over time and so they are not suitable for long term investors. Part of me thinks they could have saved ink & said "unsuitable for investors"...

rant over... and breathe ... you live and learn!

Malthusian

racing_blue wrote: »

It tastes bad that SG takes money, invests in Facebook, then looks to swap those shares for a guarantee of the value of a commodities futures index. There's one step too many in there for my liking, and it involves investing in tech and bank shares.

I think it's weird as well. But to play devil's advocate, I suppose it's not much different from me giving my money to RBS who then invest in mortgages and personal loans and god knows what else - none of it really matters to me as long as the bank account does what it says on the tin and pays me the agreed rate of interest. What SG do with the money shouldn't concern you as long as they are able to meet their obligation to pay you a return commensurate with the relevant commodity index. If their investments go badly they are still obligated to pay you from another pocket, so the question becomes purely about whether you think SG have a good enough capital base - enough other pockets - to be trusted in this regard.

I think this question is unanswerable for the average investor so I tend to avoid counterparty risk as much as possible.

Incidentally I notice the factsheets for some commodities ETFs contain conflicting warnings: they are volatile and not suitable for short term investors; and that their value may erode over time and so they are not suitable for long term investors. Part of me thinks they could have saved ink & said "unsuitable for investors"...

Lol, funny. But I think that's not unique to commodities investments - I've seen warnings about inflation risk on equity fund factsheets as well. (And obviously they'd have the one about volatility.) Technically all investments are subject to inflation risk - even an investment that returns 1,000% pa will still have its net return reduced to 998%pa by inflation. The attitude of compliance departments is that no-one ever got fired for including too many risk warnings.

But it is true in a way because commodities unlike equities have no intrinsic engine for growth to help them beat inflation. A gold bar will always be a gold bar, it won't ever expand into 1.1 gold bars.