Before the advent of exchange-traded products (ETPs) that allowed investors access to commodities, private investors were unable to enjoy the diversification benefits of holding physical assets in their investment portfolios.
However, the proliferation of exchange-traded funds (ETFs) and exchange-traded commodities (ETCs) in the past decade has opened up the market by introducing a cost-effective, relatively straightforward way to invest in commodities, with intraday trading that negates the illiquidity argument associated with real assets.
Seven Investment Management’s marketing director Justin Urquhart Stewart says: “Before we [had ETCs] investors had no real way to access the asset class. Their only option was through the mining companies, which had no real correlation to the products they were producing.”
Fully regulated ETFs, under Ucits regulations, are required to have a greater diversification than investing in a single commodity or a heavily concentrated index, so when people talk about ‘gold ETFs’, they’re probably not particularly accurate. While ‘ETPs’ can be used as a blanket banner, ETC is more appropriate when discussing those exposed to precious metals.
ETCs tend to be split into two types – physically backed – where the provider buys the gold (or any other metal) in the form of bars held in a vault, or synthetically backed – where they use derivatives, or swaps, to replicate the underlying asset.
Synthetics tend to be used more where storage and transportation of the asset presents an issue. The storage and release conditions of bullion can have an impact on the price, or may require futures contracts to be taken out.
These futures contracts may expire before the sell date. To retain continuous exposure you have to buy another contract, which could be either lower or higher than the previous price. This potential price differential is just one of the risks associated with synthetics, according to Nitesh Shah, analyst at ETF Securities, as well as degrees of collateralisation and counterparty risk.
But Gordon Rose, analyst at Morningstar, said the typical risk/reward argument that investors tend to think of when looking at other asset classes doesn’t really apply in this sector.
He says: “I think there is a lot more theoretical risk with synthetics, but this doesn’t necessarily result in higher potential returns. If you held physical gold for a month or a one-month future, it shouldn’t really make any difference in theory.
“In terms of the risk, the majority of money is held in physically backed ETPs. The swaps in most cases are over-collateralised.”
Viktor Nossek, head of research at Boost, says: “There are operational and fundamental risks that exist regardless of whether you are looking at a synthetic or a physically backed product. If gold crashes, then even with a physical product you are still exposed to the commodity falling.”
Sam Shaw is a freelance journalist
