South Africa’s largest exchange traded fund (ETF), NewGold, has been the top-performing collective investment scheme available to the retail investment public over the past three and five years and the second-best performer over the past two years. In late October 2012, it held gold bars worth R21.5 billion, outstripping the underlying value of any other single ETF that invests in other assets, such as shares, bonds or property.
But, as Takura Mahwehwe, portfolio construction analyst at Cannon Asset Managers, says, gold is a speculative, volatile investment that under-performs other assets for extended periods. Gold will keep rising only if the bad news continues, he says.
Investors with a strong appetite for gold should consider other precious metals, such as platinum, Mahwehwe says. The white metal offers all the positive attributes of gold if the bad news continues, but if the bad news ends and the global economy recovers, he says, “the industrial use of platinum in car manufacturing will support the price. Given that, which precious metal would you rather own?”
The problem is that there is no platinum ETF available on the JSE. And none that invests in any other precious metal, such as silver, copper or palladium, or commodity, such as oil. In fact, if you want to track the performance of commodities via an exchange traded product (ETP), you have to do so by buying exchange traded notes (ETNs), which are similar to ETFs but have important differences.
Both ETFs and ETNs are securities listed on the JSE and both allow you to track an index or commodity prices, such as the gold price or the platinum price.
As Justin Roffey, head of investment product development at Liberty Corporate, puts it, “in passive investing, the goal is to provide investors with the return of a given index or commodity, while keeping costs low. One can view an ETF as simply a vehicle that allows retail investors to invest passively without having to replicate an index on their own, or, in the case of a commodity, without having to purchase a stockpile of precious metals.”
The difference between ETFs and ETNs is that an ETF typically invests in the assets it tracks. The assets are ring-fenced, Roffey says, so that if the ETF issuer goes bankrupt, the assets still belong to the ETF holders. In the case of NewGold, almost 40 metric tons of gold is stored in the United Kingdom for NewGold investors. Each NewGold debenture costs one percent of the rand gold price in ounces and is backed by physical gold approximately equal to 1/100 of an ounce of gold bullion.
By contrast, an ETN may track the spot price (or cash price) or gain exposure to the commodity it tracks through futures or forward contracts (which are both agreements on a price to be paid at some point in future, but with different degrees of risk attached). An ETN is an “unsecured, unsubordinated debenture issued by an underwriting bank”, which is “listed on a registered and regulated stock exchange”, according to the JSE’s definition. In other words, the issuer undertakes to pay the investor a return linked to the specific commodity or index. So investing in an ETN involves accepting the issuer’s credit risk, as well as the risk of the investment itself.
Since there are no issues associated with storing and transporting the underlying commodities, ETNs are simpler to issue and manage than ETFs, according to Vladimir Nedeljkovic, head of investment at Absa Capital, the entity that sponsors NewGold. This explains why there are a number of locally available commodity ETNs and only one ETF. There are platinum and silver ETFs elsewhere in the world, however, Nedeljkovic says.
When NewGold listed in Johannesburg in 2003, it was the only commodity ETP available in South Africa. But in a little more than 24 months, 14 commodity ETNs have been listed, Mike Brown, managing director of etfSA (www.etfsa.co.za), says.
Standard Bank got the ball rolling in August 2010 by listing its answer to NewGold, the Gold-Linker ETN and, as part of the same Commodity-Linker range, silver, palladium and platinum products. About a year later, it added a copper ETN.
In March 2012, Absa Capital listed two precious metal ETNs: NewWave Silver and NewWave Platinum. They track the spot price of the underlying metals, whereas Standard Bank’s Commodity-Linker products cover their liabilities to investors through futures contracts.
Precious metals are not the only commodity ETPs available on the JSE. Rand Merchant Bank offers two ETNs that track the prices of oil and coal, and Standard Bank has ETNs in wheat, maize and oil, plus a “commodity basket’’ ETN. Absa Capital also tracks the performance of a basket of commodities with its NewWave Commodity Index Pure Beta ETN.
The newest entrant to the market is a gold ETN issued by Investec, which listed in late October last year. “It differs from the other two gold ETPs in that the Investec gold ETN provides direct exposure and measures its performance against the US dollar gold price and not the rand gold price,” Brown says. It avoids currency exposure by hedging the rand-dollar exchange rate and offers investors a direct investment in the US dollar gold price.
Brown says ETNs can be more attractive to issuers than ETFs for a number of reasons, including:
* Futures markets are more liquid than spot markets; and
* Futures contracts can be held on margin. This means the issuer can take a position without having to invest all the capital, and then earn interest on the rest.
The issuer of an ETN is obliged to provide the total return performance of the asset being tracked, which tends to eliminate tracking errors, Brown says. And although an ETF and an ETN may be tracking the performance of the same commodity, there may still be a significant difference in returns.
The table “Performance of commodity ETPs to January 2013” (link at the end of this article) shows how the NewGold ETF has provided a consistently better return over the past two years than the Gold-Linker ETN. Nedeljkovic explains that this is because NewGold and the Gold-Linker ETN do not track the same thing. NewGold tracks the spot gold price, whereas the Gold-Linker tracks the gold futures index, based on short-term gold futures, which are rolled over on expiry. The futures price of a commodity is usually higher than the spot price, because interest can be earned on the capital not tied up in the margin calls – a situation known as “contango”.
“However,” Brown says, “with global interest rates currently at historically low levels, the contango effect is minimised and the costs of rolling over current contracts into the next-dated futures contracts can produce a negative yield that more than offsets the contango effect.”
In current circumstances, therefore, spot commodity contracts look more attractive than futures contracts for investors in ETPs, Brown says. However, performance should not be the only consideration for investors. The difference in the level of risk between ETFs and ETNs is a material consideration, too.
According to Nedeljkovic, “the demand for physically backed products is driven by the fact that investors want to eliminate any issuer risk or credit risk associated with the on-balance-sheet notes such as ETNs. This is particularly the case with gold.”
Warren Ingram, director at Galileo Capital and the Financial Planning Institute’s Financial Planner of the Year in 2011, points out that when private investors select a commodity-based investment, they are choosing a safe-haven investment.
“In essence, they are so worried about investment markets that they would prefer to invest in a ‘dead asset’ that generates no income, rather than normal shares or bonds.
“To me, it makes no sense to invest in an ETN, where you still run the risk that the issuer of the ETN could collapse. This might seem unlikely, but the financial crisis has taught us that no institution is too big to fail.
“Private investors should also invest in products they understand, and very few people properly understand the complex structure of ETNs.
“I believe that one should always strive to keep things simple, which is why I prefer ETFs, which are identical in structure to unit trusts. Investors understand them and know that they will not be surprised by some technicality that could cost them money,” Ingram says.
Nedeljkovic highlights another dynamic in the establishment of ETPs that reference commodities other than gold: “There are some regulatory challenges. In particular, South African authorities treat products tracking commodity prices as offshore assets, so institutional investors have to utilise their offshore allocation to invest in such products.”
NewGold is structured to use only South African gold, and Brown says all three gold ETPs available locally are “inward investments” in terms of foreign exchange control regulations. “This means that individual investors and corporations can invest without requiring foreign exchange control approval or tax clearance,” he says.
With more than 1 000 unit trusts and ETPs now available for the investment public to choose from, the superior performance of commodity-based funds is not yet generally recognised, Brown says. This, he says, is because the Association for Savings & Investment SA’s quarterly survey of the collective investments industry ignores commodity ETF and ETN products in its performance assessments. In doing so, Brown believes the investment industry is doing the savings public a disservice, because commodities can boost the overall performance of portfolios and play a key role in the hedging of investment risk through diversification.
Ingram agrees that investors can derive some performance benefit from investing in a commodity such as gold or platinum, but he adds the caveat that “these are massively risky investments that should form only a small part of your overall portfolio”.
“As soon as global investors feel that the world is a slightly safer place for investments again, the price of gold is likely to drop quickly. When you are holding your gold investment, there is no interest or dividend income, as there is with a normal share or bond,” Ingram says.