ETFs as a Resource Investment

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If you’re tired of us banging on about the risks of falling commodity and resource stock prices, you’ll like today’s Daily Reckoning. That’s because we’re going to acknowledge that there are other people out there who aren’t worried one jot or one tittle. In fact, if anything, the demand for resource-linked investments is rising.

In America, you’ll find two new exchange traded funds (ETF) linked to commodities. Global X Funds has launched an ETF for tracking sliver miners (NYSE:SIL) and an ETF for tracking global copper miners (NYSE:COPX). From our very cursory examination of the prospectuses, the main rationale for both funds is higher demand for industrial metals, which more or less implies a recovery in the global economy.

This is Wall Street’s way – or at least one firm’s way – of telling us that it expects demand for commodity-related investments to increase. After all, Wall Street is essentially in the business of selling investment products. And like any business, it tries to gauge what the public wants and then produce it.

But as an investment idea, the important question is whether the ETF – any ETF really – does what it’s designed to do. In this case, the two new metals ETFs are designed to track an index of metals producing stocks. But the components of an index have to be selected by someone, and that someone is normally a human being.

This doesn’t mean a semi-actively managed ETF isn’t a good proxy for a commodities market. But it does mean that when you own a structured product (these metals indices were compiled by a German firm called Structured Solutions), you essentially own a derivative. You’re not really an equity owner in a going concern, with all the rights and responsibilities that entails.

In fact, that’s what Global X Funds CEO Bruno del Alma essentially said when announcing the funds. He said you get “focused exposure” to certain mining equities, which is not the same as ownership. He said, “Our new ETFs provide investors with efficient and focused exposure to silver and copper mining companies respectively. Both metals are essential for the global economy and may see growing demand as the economic recovery continues.”

The designer of the index which the ETFs track elaborated. Sebastian Seifried, who is the head of Indexing at Structured Solutions says, “Indirect access to commodities via the stock market is an interesting topic for many investors. Thus we have developed these two new mining indices to serve as diversified benchmarks for companies active in silver and copper mining, respectively.”

You can see that “indirect access” is not at all the same thing as actual ownerships. That’s the first important point. The second is whether getting the benchmark performance of a commodity index made up of metals stocks is the best you can do for your money. Is it good value for money?

We’ve been working on just these issues with Diggers and Drillers editor Alex Cowie (see his comments on China and the markets below). Alex is working on the next issue of his newsletter right now and in it he’s articulated a simple idea: if you’re going to bother being a resource investor in Australia, you should be looking for companies that can smash the index.

Alex hasn’t published the newsletter yet (he’s still writing it). But we’d feel safe saying that the idea of investing in an index that tracks a commodity doesn’t give you exposure to big gains in that commodity. Nominally it does. But the idea is essentially to securitise a commodity and make it “safe” to buy.

No equity is really safe, of course. They all have risk. But if you’re going to buy a commodity related equity, the shares of real companies (explorers or producers) at least give you leverage to higher prices. These companies can and do go up (and down) a lot more relative to movements in underlying commodity prices.

You get paid for your risk, in other words, if you’re willing to take it. Of course to get paid you have to pick the right securities (which is something Alex has been doing pretty well lately). But Seifried is right that having access to commodities through the equity market is an “interesting” idea for investors. The addition of investment demand to the gold market through the gold ETFs has made gold a legitimate alternative asset class to institutional and retail investors alike.

But the question is what do you want to own and why? If the silver and copper ETFs take off, Global X is thinking about more funds in lithium, platinum, and gold. And that’s in an increasingly crowded marketplace. If you’re an ETF buyer, you’ll want to take a close look at how the underlying indices are structured and what stocks they own.

And if you’re an Australian resource investor, you may be better off with the leverage that comes from resource equities more directly. Alex has recommended stocks with lithium, platinum and gold exposure as well. And all of them are, or plan to be, actual producers of those commodities.

True, those stocks might be riskier (or more volatile) than an ETF linked to the underlying commodity. But inherently, the idea of the ETF is to take the risk out of investing but still have the benefit of correlated price gains. Is that too good to be true?

Who knows? It depends on the quality of the structured index. You might get a modest, index related benefit. But we reckon if you want the big 3-1, 5-1, and 10-1 gains, you’re probably going to have to take more risk and select single stocks.

Finally, you may have noticed the International Monetary Fund has indirectly waded into the debate over whether Australia has a house price bubble. In its Global Financial Stability Report published last night Australia time, the IMF wrote that, “The dramatic rise in residential property prices in recent years, especially in Australia, Ireland, the Netherlands, Spain and the United Kingdom has heightened concerns of an asset price bubble and thus the likelihood of a sharp price correction.”

That correction, it elaborated, could come from deteriorating underlying fundamentals in the economy like rising interest rates. And the bigger problem is that expectations for rising prices (and not underlying fundamentals) are driving price gains. Or, in the IMFs words, “Metrics of affordability are mixed, but on balance suggest that valuations risk becoming stretched…As typically happens in housing bubbles, many purchasers may have been buying in the expectation of price appreciation, rather than simply for dwelling purposes.”

Yes, we all have to live somewhere. But we also have to be able to afford it.

Until tomorrow,

Dan Denning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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