Innovation has always been a hallmark of the ETF industry, as recent years have seen issuers get creative in efforts to expand the universe of assets available and refine the mechanisms through which such exposure is offered. Some of the latest initiatives have focused in on the commodity space, where issuers are scrambling to come up with product offerings that address the often undesirable impact of contangoed futures markets on fund returns.
The recent debut of the United States Commodity Index Fund (NYSEARCA:USCI), hailed as a “third generation” commodity ETF, represented one attempt to address this issue. In compiling a diversified basked of futures contracts, the index underlying USCI first seeks out those commodities that are exhibiting the steepest backwardation or most moderate contango, before considering momentum scores as well. USCI is relatively new, but has come flying out of the gates by whipping other diversified commodity products in terms of performance.
Further down the pipeline is another type of product that could spur a major shakeup in the commodity ETF space. Both iShares and JPMorgan have filed for SEC approval on physically-backed copper ETFs that would offer investors a new way to bet on prices of the important industrial metal. Physically-backed commodity funds are appealing to investors because the underlying NAV is likely to move in unison with spot prices of the resource. The majority of commodity products achieve exposure through a futures-based strategy that expands the number of factors that can potentially impact bottom-line returns–most notably the “roll yield” incurred when selling contracts close to expiration and picking up longer-dated futures. Though the nuances of a futures-based strategy can work both for and against investors, a physically-backed structure is attractive because it simplifies the risk profile and removes the potential for the “return erosion” phenomenon that has created some frustration with commodity products.
Currently, the only physical commodity ETFs consist of precious metals, which are able to offer cost-efficient exposure through the physically-backed structure thanks to extremely high value-to-weight ratios. One of the great unknowns surrounding the proposed copper products is just how expensive the exposure will be. Copper is very cheap compared to gold and even silver, meaning that a physical copper fund would require significantly more storage space than a precious metals fund of similar value. That could translate into higher fees for the funds, and it wouldn’t be surprising if new copper ETFs are among the most expensive in the industry.
Case For Copper
Copper is one of the most widely-used metals in the world, and is a critical element of a variety of pipes and wires, electronic components, ships, and countless other products. Copper is the best non-precious metals conductor of electricity, making it a common component of cable, wire, and and electrical products for both the electrical and building industries. Chile has historically been the world’s largest producer of copper, accounting for nearly one third of total mining input. Other major producers include Peru, the U.S., Indonesia, and China. Mine production of copper has stayed relatively stable, growing about 19% between 2000 and 2009. Between 2000 and 2008, global consumption of copper had increased by about 20%, before plummeting in 2009 amidst a steep decline in manufacturing and industrial activity.
In recent years, emerging markets have emerged as a major driver of copper demand. Over the last decade, aggregate copper consumption by the U.S., European Union, and Japan has declined by about 35%. Over that same period, China’s consumption has more than doubled, including massive increases in both 2008 and 2009 as much of the developed world was mired in a deep recession. As emerging markets continue to race ahead and urbanization leads to massive construction initiatives, some investors expect demand for copper to climb higher–even if the U.S. and other advanced economies continue to struggle.
Investors would likely flock to a physical copper ETF–assuming that either of the proposed products make it through the regulatory minefield they now face (by some estimates, the launch of a physically-backed copper ETF could give a boost of as much as 20% to current market prices–a development that could squeeze profitability in a number of global industries). And while filings to date have only focused on copper funds, it is likely that additional physically-backed ETFs holding other industrial metals could follow if demand exists. Over in London, ETF Securities is on the verge of debuting a handful of ETFs that hold copper, tin, and other metals.
For investors interested in copper exposure, there is no need to wait for the launch of a physical fund–which may never actually come to market. There are already plenty of interesting ETF options for betting on the metal, whether it be through futures contracts or the stocks of the companies engaged in the extraction of the metal:
iPath Dow Jones-UBS Copper ETN (NYSEARCA:JJC)
This exchange-traded note is the closest thing to a pure play on copper available through the exchange-traded structure. JJC is linked to an index comprised of a single futures contract on copper–meaning that its return depends not only on the change in the metal’s spot price but also on the slope of the futures curve. Some investors have been scared away from commodity products that utilize futures contracts, having been led to believe that these funds will always lag behind the hypothetical return on spot prices. But that isn’t always the case, and a closer look at the the futures curve indicates that investors in JJC may soon have the wind at their back.
Recently, the market for copper futures sloped upwards until May 2011, though contracts maturing then were trading at a premium of less than 0.5% to next-to-expire contracts. After that, the curve inverts and heads downward: contracts for copper to be delivered in late 2011 are cheaper than spot prices, and those as far out as September 2015 are going for about 15% less than the next to expire futures.
Emerging Markets Metals & Mining ETF (NYSEARCA:EMT)
The underlying holdings of this fund aren’t futures contracts, but rather stocks of emerging markets equities engaged in the mining and extraction of both precious and industrial metals. Components of the index include both diversified mining firms, as well as companies that concentrate on specific resources, including platinum, gold, nickel, and copper.
Though EMT doesn’t offer direct exposure to copper prices and the indirect exposure offered through commodity-intensive equities includes a variety of metals, the drivers of this fund may be similar to the factors that influence copper prices. Both stand to benefit as emerging markets continue to exhibit an insatiable appetite for raw materials, and EMT’s price will likely be sensitive to changes in the market price of industrial metals, as these shifts impact the profitability of the companies that make up the underlying index.
First Trust ISE Global Copper Index Fund (NASDAQ:CU)
This fund offers another option for playing copper through stocks; CU seeks to replicate the ISE Global Copper Index, a benchmark designed to track public companies that are active in the copper mining industry. The methodology behind this index is somewhat unique; component securities must be engaged in some aspect of the copper mining industry, and weightings are determined based on a modified linear weighted methodology adjusted by revenue exposure to copper production. As a result, the underlying holdings of CU include both pure play copper miners as well as broad-based mining stocks and companies that focus on other metals, with weights adjusted based on the percentage of total revenue derived from copper. For example, MMC Norilsk Nickel, which generates about half of its revenue from nickel, is included in CU. So is New Gold Inc., a firm whose primary operations focus on the mining of precious metals.
Global X Copper Miners ETF (NYSEARCA:COPX)
COPX is an intriguing way to establish exposure to copper prices–once again through stocks of companies engaged in the extraction of the metal. This ETF seeks to replicate the Solactive Global Copper Miners Index, a benchmark that includes about 35 companies whose primary operations focus around copper mining. Unlike CU, this ETF doesn’t maintain material allocations to more general mining firms, focusing instead on pure play copper miners: the largest holdings include Xstrata, Freeport Copper, and Jiangxi Copper Company. Not surprisingly, COPX has a heavy tilt towards Canadian equities, with Australia and the U.K. also making up big chunks of assets.
Disclosure: No positions at time of writing.
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