An Overview Of European Commodity ETFs And ETCs [Corrected]

[Correction: Due to an editorial error, ETCs were incorrectly compared to U.S. ETNs. ETCs are notes but they are backed by commodity contracts purchased from Shell Oil (in the case of the oil contracts) or AIG (in the case of the other commodity products.)]

Commodities have attracted a great deal of investor interest so far this decade, as prices have risen steadily from multiyear lows around the turn of the millennium. Commodity exchange-traded funds and other forms of exchange-traded security (notably ETC—exchange-traded commodities) have been an area of huge asset growth and very active product development, in many cases opening up the sector to retail investor flows for the first time, or at least making market access a great deal easier.

As I've done in previous articles on European equity and fixed-income ETFs for www.indexuniverse.com, let's start with a list of the top 15 European commodity ETFs/ETCs by assets under management.

It is important to point out that while there is a difference between ETFs and ETCs—the main difference being that ETCs use a secured, undated, zero-coupon note structure, whereas ETFs are funds—they are otherwise similar in that both are open-ended, continuously traded and have multiple market makers.

In terms of an investor's counterparty exposure, there are subtle differences, which are worth being aware of. The precious-metal ETCs are backed by allocated bullion in vaults. In the case of ETF Securities' energy and nonenergy ETCs, there is the counterparty exposure to Shell and AIG, respectively. For broader commodity index ETFs offered by the other main players, there may be exposure to multiple counterparties, as the funds invest in futures or swaps rather than the physical commodities, so in each case it's worth checking the relevant prospectus to find out where the exposure lies.

As we can see from the table, 7 of the top 15 and 4 of the top 5 European ETFs/ETCs by assets under management represent precious metals exposure. Gold, silver and other precious metal ETFs have been one of the major success stories of the decade, and the European market is no different from the US, where we have seen the phenomenal growth rate of the streetTRACKS Gold Trust (AMEX: GLD) and similar funds. Having had personal experience of investing in gold earlier in the decade via the inefficient and costly route of bullion coins, it is clear that gold/silver/platinum ETFs/ETCs have offered a quantum leap in ease of use to investors. With governments and central banks continuing their bailouts of the financial sector and devaluing their (fiat) currencies, it is hard to see what will prevent these vehicles from attracting ever-greater inflows.

Here a note on fund/note structure and the European regulatory environment is appropriate. The preferred structure for European ETFs is one that complies with the UCITS III rules—regulations needed to allow for Europe-wide distribution. The UCITS III rules, however, set certain minimum diversification requirements, notably an absolute maximum exposure of 35% of any UCITS fund to a single constituent, which in the case of commodities, is viewed by European regulators as a single commodity or group of closely related commodities. Also, commodities are not a permissible asset under UCITS, so a UCITS ETF has to invest in commodity-related derivatives rather than the underlying asset.

By implication, all the European tracking vehicles offering exposure to a single commodity or group of related commodities have tended to be set up as note structures (i.e., ETCs)—such as Lyxor Gold Bullion Securities and all the single-commodity products from ETF Securities.

Confusingly, the successful ZKB precious metals funds, even though tracking single commodities, are all classified as ETFs. They are regulated under Swiss law as "Sondervermoegen", a specific category of open-ended fund, and are not UCITS funds.

When it comes to more-diversified commodity ETFs, it is noticeable how varied the European product providers' offerings are. We have had a proliferation of commodity index launches over recent years, and it seems a case of "take your pick":

Quite how varied these indexes are is shown, for example, by the energy sector weighting, which is 70% in the S&P GSCI, 55% in the DBLCI, 39% in the RJ/CRB and 33% in the Dow Jones-AIG**.

Of course the divergence in the performance between the different versions of commodity index is not only a function of different component weightings, but also reflects the rules adopted for rolling individual commodity futures contracts, since the roll return (positive in the case of a commodity term structure in backwardation, negative in the case of contango) has historically formed a major part of the investor's total income, and the prevalence of contango in recent years has meant a strong headwind for commodity index investors.

While the intricacies of contango and backwardation are beyond the scope of this article (an excellent explanation is given in Deutsche Bank's guide to commodity indexes), two differing approaches amongst European product providers to dealing with the roll return conundrum are worthy of mention.

First, ETF Securities, by launching a whole range of 3-month-forward commodity ETCs last year to complement the existing spot products, has enabled investors to do it themselves and choose which part of the term structure they wish to be exposed to. While this is undoubtedly the realm of the sophisticated investor, they have attracted over 100 million euros into the forward funds since launch.

Second, DB x-trackers has chosen as its sole (to date) European commodity offering an ETF using a methodology that aims to maximize roll yield by choosing from any of the next 13 months' futures contracts when conducting the roll, according to a predetermined formula. On a backtested basis, this methodology has handsomely outperformed the S&P GSCI and Dow Jones AIG indexes. The recent launch of a forward version of the S&P GSCI index shows that others are thinking along the same lines, although to date there is no ETF in Europe based on this.

All in all, this is a complex area for investors to grapple with, and explaining the pros and cons of their differing versions of the commodity indexes presents a major challenge to the ETF houses.

I noted in my second article for Index Universe the exponential growth in assets of ETF Securities during 2007, a trend that has continued into 2008. From the table above, it is involved in five funds, including four of the top five (three in its own name and the fourth via Gold Bullion Securities Ltd., in which ETF Securities has a 33% share), and the firm has established itself very rapidly as the market leader in the commodity tracker sector.

Its chosen route of entry to the market—decomposing the commodities market into its constituent parts and allowing investors to pick and choose among them—seems very sensible, and the recent addition of inverse funds offers the firm extra tools to attract investors, should the commodity bull run go into reverse.

If the firm has an Achilles' heel, it is the counterparty risk inherent in the note structure it uses—with the exception of its precious metals ETCs, which are backed by allocated metal, investors in its products take the counterparty risk of Shell for energy ETCs and AIG for the others. Although both firms currently carry AA ratings, AIG's recent losses and the announcement of accounting problems have raised fears of a downgrade, and any concerns over the firm's financial strength might inhibit flows into the ETCs concerned.

Amongst the other ETF providers—and all the major European names are represented in the diversified commodity index ETF tables—none has really taken a lead, with most houses running funds in the euros 100-200 million range. Will anyone follow ETF Securities down the single-commodity route? Or will they all continue to search for the perfect index? Expect another busy year for commodity ETF product developers!

Paul Amery is the European correspondent for IndexUniverse.com. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .