Investing in Physical Commodities: The Case for Copper

Investing in Physical Commodities

By Valerio Matriciani and Philipp E. Dettwiler

A comparison between physical copper and synthetic futures-based copper investments

Executive summary and conclusions

Commodities offer an interesting investment opportunity due to their hedge characteristics against unexpected inflation. Commodity-related financial instruments have become increasingly popular with investors, particularly today with rising inflation expectations. Commodity investments are often structured as products which passively and synthetically replicate a futures-based commodity index.

More recently, new forms of investment products have emerged. Digital tokens have started to become popular among investors. The tokens create an exposure to the spot value of the commodity and are efficient alternatives to the synthetic, futures-based commodity ETCs as the latter instruments usually contain significant rollover costs.

In general, investors can optimise roll-over costs by investing in spot-based commodity products. As an example, a pro-forma spot-based copper product including an annual total expense ratio (TER) of 100 bps outperforms a generic futures-based product by 131 bps per annum over a 14-year-period ending December 2022. The robustness of the above conclusion is confirmed by the annual performance distribution as well as by both the distribution of the 3 and the 5 years rolling returns. The variability of the cumulated outperformance strongly decreases with an increasing performance time frame considered.

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Similar conclusions may hold for other base metals, e.g. nickel, and for precious metals, a.o. platinum and palladium, and may be the subject for further research in this area.

Commodities as an alternative asset class

Generally, commodities are classified as an alternative form of investment. Concerning more traditional asset classes, the main advantage of investing in commodities stems from their hedge characteristics against unexpected inflation. When inflation rises and equity markets suffer, commodities typically provide promising investment opportunities. Although over the last decade we have experienced a prolonged period of low inflation, post-pandemic programs accompanied by central banks and government supports as well as global manufacturing activities are supportive factors for higher inflation expectations. The current transition to a low-carbon economy provides solid ground for a prolonged mega-trend where commodities, especially base metals, trade above their long-term price trends over a prolonged period, usually tied to an economic transformational period.

In recent years, price movements in the commodity markets and their relative performance compared to other asset classes, such as equities and fixed income, have reinforced the interest of investors in commodities products.

Financial institutions have increased their offering and found ways to provide their clientele exposure to commodities. For instance, copper and nickel traditionally being less accessible to standard investors. These two base metals are currently enjoying high visibility due to their usage in electronic vehicles. In this article, we will focus on base metals and, in particular, on copper.

Chart 1: Performance in USD (Jan 2009 – December 2022, daily data)

chart 1

How to invest in commodities (traditional forms)

Commodity markets include the spot market where physical commodities are sold, and buyers become owners and store the acquired materials. In addition to the physical market, derivative exchanges as well as over-the-counter (OTC) derivative transactions, facilitate the trading and hedging needs of industrial and financial institutions. On derivatives exchanges, mainly futures and options are traded while OTC-transactions are typically implemented through forwards and swaps.

In the last decade, structured financial instruments issued by banks, investment management, and other financial service companies have become increasingly popular with investors. For both institutional as well as retail investors these types of instruments are easy to trade and to account for. Generally, commodity-related financial instruments issued by financial providers are linked to a reference index (or its subindices) like the well-known and largely utilised Bloomberg Commodity Total Return Index (BCOMTR Index) established on Sep 30, 1990. The indices used as a reference by investible financial products normally track the performance of highly liquid commodity futures contracts. The products synthetically achieve the replication of the index return stream by entering a total-return swap (TRS) with an investment bank: the product receives the return stream of the commodity index while paying a cost, often a fixed price. The duration of the swap contract generally varies between 3 and 5 years. Subsequently, the contract needs to be renegotiated.

Traditionally, investible financial products can take different forms, among others

  • Exchange traded commodities (ETC)
  • Mutual funds
  • Actively managed certificates (AMC)

From a management perspective, some products are actively managed while others simply passively replicate an index. Actively managed products have an in place dedicated team or an investment management agreement with a specialised firm that implements the investment strategy. Consequently, this type of setup originates additional management fees for the investors. Passively managed products instead use reference indices and therefore do not need investment managers. Passive products are normally cheaper for the investor.

The performance of commodity indices used in passive products is often derived based on a hypothetical investment strategy in commodity futures. Typically, the index implements its strategy by investing systematically into the nearest-to-deliver futures contract. When the contract expires, the tracking is rolled into the new nearest-to-deliver future contract to avoid a hypothetical delivery of the commodity. This approach generates an implicit rollover cost which is negative for the investor every time the commodity curve shape is in contango. In a contango situation, which is the natural state of a commodity future front-end curve, the prices are lower in nearer delivery months than in more distant delivery months. Conversely, backwardation is the opposite state, and the rollover cost becomes a benefit. These rollover effects are reflected in the performance of the index. In an index, to avoid sudden jumps in the track record at maturity dates of the futures contracts, the rollover cost is often spread across the month using sophisticated quantitative methodologies.

New forms of investing in commodities: digital assets

More recently, in the wake of the ongoing process of digitization within the financial services industry, new forms of investment products have emerged. Digital tokens have started to become popular among investors for a variety of asset classes and valuables, including commodities.

The tokens can be structured in several forms including those which provide ownership of, or claims versus an underlying asset. The tokens create an exposure to the spot value of the asset, rather than to a derivative and are, like most physically-backed products, efficient alternatives to the synthetic, futures-based commodity ETCs currently out in the financial markets.

In addition, tokens and other spot-based products (e.g. spot-based ETCs) may have an embedded option of physical delivery of the commodity. For industrial companies, this represents an interesting feature for managing potential supply chain shortages. Moreover, the spot-based products also avoid counterparty credit risk inherent in the total return swap transactions of futures-based ETCs.

Performance comparison of spot-based vs futures-based copper investments

The different forms of investment products have various advantages and disadvantages in the areas of standardization, liquidity, and costs. The Total Expense Ratio (TER) of a product represents the overall cost for an investor for owning the financial product. The traditional management fees of a product are just one element of the TER.

While sometimes simple management fees-based tables are available when comparing a specific investment strategy universe, the TER provides a much more comprehensive cost-related comparison among products as it captures all effective costs faced by the investment vehicle. Next to the management fees, the TER also contains costs for the implementation of the replication strategy via total-return swaps. In addition to the swap fees, index-related royalty fees may be charged to the product as well and reflected in the TER.

However, when it comes to the comparison of investment opportunities from an overall investor’s net performance perspective, the TER does not always contain the full picture. One key aspect in the TER analyses is often overlooked: the passive, synthetic future-based commodity products, like most of the base metal ETCs, replicate the performance of an index that tracks commodity futures prices. And the performance of the futures prices differs, sometimes very significantly, from the performance of the spot value of the physical commodity. This difference can be captured by comparing the net performance of spot and of futures-based products.

Analysis spot vs index

We have compared the cumulated performance over an extended period (Jan 2009 – December 2022) for

  • Copper spot price (LOCADY; in USD)
  • Bloomberg Commodity Copper Total Return Subindex (BCOMHGTR; in USD)

Table 1: Performance comparison (Jan 2009 – December 2022, daily data)

graph 6

In addition to the overall performance for the considered period, we have also analysed the distribution of the

  • Annual out/underperformance between the two time-series
  • Rolling cumulated 3 years out/underperformance (annualised)
  • Rolling cumulated 5 years out/underperformance (annualised)

Chart 2: Distribution of outperformance over different investment horizons (Jan 2009 – December 2022, daily data)

graph 7

The results show that over the analysed period of 14 years ending December 2022, the cumulated systematic rollover cost embedded in the futures-based index is 58%. This corresponds to a 173 bps annualised extra-return per annum for the physical asset (spot) considering compound effect over the same period. The robustness of the outcome is confirmed with some outliers, and by the distribution of the results from the yearly analysis as well as by the results from both the 3 and the 5 years rolling analysis with strongly decreasing variability of the cumulated outperformance over those time frames.

Analysis including pro-forma product costs

The track records of both the spot and the futures-based total-return index do ignore costs and fees typically related to an investible financial product. Therefore, we have constructed a pro-forma track record of a hypothetical spot-based copper product including fees. For that purpose, we have assumed a 100 bps annual TER for the spot-based product. The 100 bps TER contains, next to the traditional fees embedded in financial products, also the cost for storing the material. We then compared it with a generic investible synthetic future-based copper ETC available in the market.

Chart 3: Cumulated copper performance in USD (Jan 2009 – December 2022, daily data)

chart 3

Table 2: Performance comparison (Jan 2009 – December 2022, daily data)

graph 2

Despite the additional cost of storage embedded in spot-based copper investments and included in the 100 bps TER (which also contain the normal management fees), the results show a significant outperformance over an extended period of 14 years ending December 2022. Considering compounding effects over the same period, this corresponds to a 131 bps extra return per annum. We can conclude that the negative rollover costs embedded in synthetic future-based ETCs materially negatively outweigh the 100 bps annual TER assumed for pro-forma spot-based investment alternative.

Chart 4: Annualised performance (Jan 2009 – December 2022)

graph 2

Chart 5: Return and cost drivers of annualised performance (Jan 2009 – December 2022)

chart 5

As for the spot vs index analysis, the robustness of the above conclusion is confirmed also by the annual performance distribution as well as by both the 3 and the 5 years rolling analysis with strongly decreasing variability of the cumulated outperformance over those time frames.

Chart 6: Distribution of outperformance over different investment horizons (Jan 2009 – December 2022, daily data)

graph

This article was originally published on 18 January 2023.

About the Authors

Valerio MatricianiValerio Matriciani is the Chief Risk Officer at Eternyze AG. Valerio has 20+ years of experience in risk management and quantitative analysis within the financial industry, especially in the areas of asset management, banking, and insurance.

Philipp E. DettwilerPhilipp E. Dettwiler is the Chief Operating Officer of Eternyze AG. Phil is a seasoned finance and DLT executive with 15+ years of financial industry experience gained across Europe and Asia, covering the entire banking value chain.

About Eternyze AG

Eternyze AG is a Swiss-based company dedicated to digitizing the global commodities industry and physical assets in general. Eternyze provides unique access to precious and base metals at competitive spot pricing from leading producers, backed with safe custody and an innovative digital data storage solution. The metals can be purchased or sold on the Eternyze platform, an in-house developed technological infrastructure, which allows to transact in a simple, cost-efficient, and secure way. Eternyze AG was established in Zug, Switzerland in December 2018 and is led by Marco Grossi, the Chief Executive Officer of the company.

Disclaimer: This article contains forward-looking statements, which involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements. The authors do not accept any liability for any loss or damage arising from any consequence, decision, action or non-action based on or in reliance upon this article. This article is not intended to be, nor should it be construed to be, any recommendation or advice with respect to any products or any services.

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