GPF Physical Copper Exchange Traded Commodities (ETC) and Physical Nickel ETC have been designed to provide investors direct exposure to physical metal and spot prices. The ETC’s securities are physically backed by bundles of copper and nickel, which are securely held as investors’ entitlements. On sale of the securities, investors receive cash which is funded from the sale proceeds of the metal.1
These physical copper and nickel ETCs are available to investors through the sponsorship of the Global Palladium Fund (GPF), which was founded by Norilsk Nickel in 2016 to increase the accessibility of the world’s base, rare and precious metals. Norilsk Nickel is the world’s largest producer of palladium and high-grade nickel, and a major producer of platinum and copper.2 The two new ETCs follow Gold, Silver, Platinum and Palladium product launches in the first quarter of 2021; all ETCs are structured to provide investors the benefits of physical metal ownership.3
This article explains how these physical ETCs provide simple, low cost and transparent exposure providing new options for long term commodity investors, contrasting with synthetic ETCs that tend to be complex, attract higher costs and more volatile exposures.
Exchange Traded Products (ETPs) can employ derivatives for two purposes; through swaps that acquire economic exposure from a third party and by tracking futures. For example, COPA, a copper ETC traded on London and continental European exchanges, gets its exposure through swaps tracking a futures index.4
ETPs use swaps where investment strategies are costly, complex or difficult to deploy, such as with certain commodities, global emerging markets or small company indices, or to achieve other objectives such as to mitigate dividend taxes.
Swap based ETPs enter into derivative contracts with one or more financial institution, typically an investment bank, receiving the return on specific assets in exchange for cash payments. The purpose is to provide ETP investors with the required economic exposure without the inconvenience associated with holding and managing the assets.
These arrangements are effective in eliminating disadvantages from asset ownership, however they create other issues including dependencies between the parties and structural complexities.
Swap based ETPs have counterparty exposure to the swap provider who receives the investors’ capital and in return provides exposure to performance of the underlying asset and must return investors’ capital upon redemption. Collateral is held against this counterparty risk, which in the funded model is held in a segregated account with an independent custodian or in the case of the unfunded model collateral is purchased from the swap provider through a repurchase agreement.
Collateral is intended to mitigate this counterparty risk, however in practice residual risks remain. Collateral normally includes government and corporate bonds as well as equities. Although collateral is revalued and adjusted daily and over collateralisation can provide a buffer, the risk profile of the collateral can differ materially from the investment exposure of the ETP meaning that intraday volatility can result in under collateralisation.
In the event of the default of a swap counterparty, normally a major financial institution, bond and equity markets are likely to experience abnormal volatility, reducing collateral protection when most needed. In the event of a swap provider failing, as seen following the collapse of Lehman Brothers, significant costs, uncertainties and delays would be experienced in taking possession of collateral preventing active management.
Commodity ETPs effectively track futures-based indices through swaps to avoid the practical difficulties associated with owning physical stock. Investment returns for ETPs structured in this way are based upon futures prices. Futures prices are based off spot prices, however are influenced by additional factors such as future price expectations, inflation, interest rates and carry costs.
To maintain asset exposure investors must roll futures contracts prior to expiry and acquire longer dated contracts. Futures prices that trend higher over longer settlement periods are referred to as in contango, while futures prices trending lower are termed backwardation. Futures returns will therefore be different from returns from physical commodities due to additional costs in the case of a market in contango, or earn a yield in the case of backwardation.
Futures markets differ from physical markets as they lend themselves for use by speculators attracted by factors such as high volatility. Market participants speculating on short term price changes tend to be more tolerant to the higher costs of synthetic exposures.
For investors who attribute high importance to environmental and sustainable standards, futures based exposure to metals can be problematic as it is not possible to trace investment exposure to actual metal or sources of supply.
Swap providers’ fees may be included in the ETP’s total expense ratio, disclosed as a separate item or rolled up within the swap return, making charges difficult for investors to get comfortable with from a governance perspective. Typically swap costs tend to be in the region of 50bps per annum.
The cost of commodity storage, insurance and financing mean that long term returns from futures tend to be lower than for physical investments.
Due to these complexities investors assessing swap based ETPs have numerous factors to assess and get comfortable with, including counterparty risk, collateral risk and total cost of ownership. Futures exposure provides additional complexities to consider in the differences between futures and spot returns. A potential investor performing due diligence would need to assess all these factors prior to investing; for example COPA, a copper ETC traded on London and European exchanges gets its exposure through collateralised swaps tracking a futures index.5
In contrast GPF Physical Copper and Nickel ETCs provide investors with the benefits of simplicity and transparency. These ETCs are physically backed by bundles of copper and nickel which are securely held to cover investors’ entitlements, mitigating credit risk and collateral considerations.
The value of each ETC security is transparent, based upon the LME quoted spot price of the actual metal, the quantity of metal held, the numbers of securities outstanding and the metal entitlement. Costs of ownership are built into the fixed total expense ratio, which incorporates costs relating to storage, security, movement and insurance.
The availability of superior physical based ETPs combined with heighted awareness of structural risks following the Global Financial Crisis helps explain the declining use of synthetic products. According to one provider in 2010 almost half of all European ETFs were synthetic, by 2019 this had fallen to less than a fifth.6
Institutional and private client investment portfolios include allocations to commodities to benefit from real assets’ low correlation with financial assets and higher sensitivity to inflation.
Long term investors tend to favour physically backed commodity ETPs, as seen with physical gold ETPs that have long been preferred over derivative based products. Exposure to spot prices directly reflect supply and demand dynamics, an important consideration for copper and nickel metals which are vital inputs for components in the ongoing green energy revolution, including electric vehicles and batteries, electricity generation and transmission infrastructure.
An alternative strategy with futures in contango is to hold both physical and futures, in order to mitigate roll costs and thereby reduce the overall cost of ownership. Another strategy is for holders of the physical metal expecting strong price movements to use futures to obtain short term leveraged or short price exposure.
GPF Physical Copper and Nickel ETCs provide investors with new alternatives to synthetic based exposure. Physical ETCs provide investors with the benefits of metal ownership combining simplicity, transparency and low costs, together with the ability to transact at spot prices that directly reflect the metal’s supply and demand dynamics, all attributes attractive to long term investors. These characteristics contrast with synthetic ETCs that are more complex, have higher costs and provide exposure to greater volatility.