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Commodity ETFs: Why greater risks equal bigger returns

on May 02, 2011 at 00:01

Commodity ETFs: Why greater risks equal bigger returns

Question: When should a passive investment be anything but a passive investment? Answer: When it’s a synthetic exchange traded product (ETP) investing in commodities.

The market for commodities exchange traded funds (ETFs) and indeed all ETPs has mushroomed, as commodity prices have broken records. Gold makes up the vast majority of sales.

Investors can be forgiven for wanting part of the action, even at current high prices. With ETPs, buyers gain exposure to an index or individual commodity quickly and cheaply, without having to hold the underlying raw material or security.

However, professionals warn to tread carefully with synthetic investments or risk making less money than you expected.

David Coombs (pictured), head of multi-asset investment at Rathbone Unit Trust Management, says: ‘It’s a minefield, handle with care.’ 

Mick Gilligan, head of research at Killik & Co, says he does not use synthetic ETPs much to invest in commodities: ‘Unless you keep a constant eye on the shape of the futures curve, it can be very expensive exposure.’

Looking under the bonnet

Michael John Lytle, managing director of product provider Source, says: ‘As an investor you have to do more work before choosing a commodities product.’

Commodity ETPs grew from $7 billion to $172 billion in the five years to 2010, and the number of products increased from 17 to 665 (source: BlackRock data to November 2010). The Thomson Reuters/Jefferies CRB index has hit a two-year high, as other commodities indices climb skyward.

ETPs invest either in physical commodities – normally precious metals – or synthetically, by using swaps based on the commodity futures index. Physical commodity index products are relatively straightforward and do not carry the risk of synthetics.

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