ETFs back in the spotlight

7th September 2012

Unlike other products that trade in commodities markets using futures contracts, physically-backed ETFs are backed by purchases of the underlying commodity that is then held by a custodian. Critics have accused these products of causing price swings in markets by buy up large quantities of available stock at certain points and dumping them at others.

In a filing to the Securities and Exchange Commission (SEC) the investment bank said that the copper ETF "will track, and not drive, copper prices, which are largely a function of global forces of supply and demand". Yet given the additional demand ETFs add to the market, is this defence credible?

Do as I say, not as I do

As Jack Farchy points out over at the Financial Times, the holes in the defence are twofold: first, prices have risen substantially since the advent of ETFs; and secondly, the banks themselves have attributed some of this rise to these types of products.

The first of these is obviously open to the charge of being a causal fallacy. Simply because one event proceeded another does not necessarily mean that the two are connected.

Unfortunately for JPMorgan, however, they appear to have limited their ability to use this line of attack. In their report they acknowledge the importance of "demand expectations" in setting the price for a commodity – in this case copper – but claim that ETF purchases do not have a direct influence on these.

Yet, as Farchy demonstrates, they have been saying something quite different in the recent past. He cites three separate reports on silver, platinum and palladium markets in which they cite ETF demand as a key price driver. It seems in this case that the left hand may not have known what the right hand was up to.

Is this a problem for investors?

It may be. If ETF demand does push up prices then commodity intensive industries may find that the price they have to pay for raw materials increases. This either means lower profits or higher costs for end consumers – so either investors or consumers take a hit.

Of course, it could equally have an inverse effect. The structure of the product could also be used as a cheap means of financing the stockpiling of these goods for the ETF providers – e.g. banks. In fact Goldman Sachs has addressed this issue:

"If a potential physical fund had a structure that both bought and sold metal with flows into and out of the product, we believe that the fund would be just another financing vehicle for inventory accumulation."

That is to say, investors could simply be providing crowdsourced financing for product providers. Whether they profit from the deals themselves is less apparent as, the Goldman note continues, "the buyer of the ETF would have to believe that there is sufficient shortage in the future at the entry price as to earn a return great enough to overcome the opportunity cost of forgoing a dividend or yield on that capital, on top of paying the fees for storage".

Furthermore, there is also a social utility argument to be made. How does a financial product buying commodities with no intention of using them help to ensure the efficient running of markets? Indeed if they continue to grow at their current rate they could have a distorting effect simply because they have to invest new capital into the underlying assets irrespective of market conditions.

Buyers beware.


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