How to harvest wheat and mine gold using ETCs

I wrote recently about how you can improve your diversification with Exchange Traded Funds tracking government and corporate bonds.For some investors, further tweaks to their asset allocation can come courtesy of the new generation of Exchange Traded Commodities, which enable you to follow everything from the price of iron to the rising (or falling) price of a basket of agricultural goods.

My usual disclaimer about your own investments applies here as elsewhere. Arguably, you need to do even more research before you track commodities, as they’re a much more esoteric investment than a FTSE 100 tracker, say.

Why would you want exposure to commodities?

Commodities are an asset class that rise and fall over time, and are subject to bull and bear markets. In this, they’re not dissimilar to other assets – but they’re not closely correlated either. The price of, say, corn isn’t particularly related to the performance of the stock market, for example.

By buying commodities you can therefore diversify your portfolio over the long-term so it’s less dependent on the returns from shares. You might also hope to trade commodities, if you think you can buy when they’re priced low and sell when they’re high. (Far easier said then done, and plenty of boys in braces will hire you if you manage it regularly).

Commodities also offer a hedge against inflation. If the price of everything is going up, it usually starts or ends with commodities rising in value, too. Therefore, devoting a portion of your funds to commodities can help offset inflation-risk.

If the stock market doesn’t affect the price of a commodity, what does?

Lots of things. The price of corn might go up because of bad weather reducing yields, increasing demand from the emerging markets, diversion into biofuels, or environmental restrictions on farming fertilizer. On the other hand, corn might fall in price because of improved agricultural techniques, say, or a lucky bumper crop worldwide.

What’s more, corn is a ‘soft’ commodity, which behaves different to ‘hard’ commodities like copper or gold (the latter is normally classed as a ‘precious metal’ in commodity-speak, you won’t be surprised to hear). The big difference with hard commodities is many of them are finite in supply, at least in practical terms. (There may be gold at the bottom of the Pacific, but it will likely cost far too much to extract it).

You might then expect the price of hard commodities to naturally rise over time as they run out, but hold your horses. Many, such as oil, have, but equally gold has only in recent years come out of a 25-year bear market. Hard commodities tend to fluctuate in broad cycles linked to both economic demand and their own internal markets. (Companies delay investing in new mines, say, until they are sure the market is firm enough to pay for their expenditure, then in contrast tend to go crazy at the end of the cycle believing the good times will last forever).

Equally, new technologies come along to make commodities cheaper. Who cares now what the price of whale blubber is? We light our homes with electricity instead. Or just ask an old farmer what industrial techniques have done to the money he gets for a chicken or a pig.

How to get exposure to commodities via ETFs

The above is just a taster of how specialist commodity investing can be. I’m not going to pretend to be an expert on the price of coffee or the future direction of silver. Instead, I’m building up a 5% or so allocation of my portfolio to commodities via ETFs, for diversification. I’ll be a ‘passive’ investor, in that I won’t do much more than top up the commodity slice of the pie if it drops much below 5%, and equally sell down my holding if it grows out of line. I won’t track commodities in the news, or guess where soya beans are going.

How to achieve that? From my research, there seem to be two main passive options for UK investors who want to stick with UK securities: ETF Securities’ Exchange Traded Commodities (ETCs), and a couple of funds, including some run by Close Brothers, and some tangentially related trackers from iShares. Other countries have their own ETCs (particularly the United States).

But what are ETCs? I know about ETFs…

ETCs are a particular kind of ETF (exchange traed fund) that tracks the performance of an underlying commodity, or basket of commodities, in such a way as to give you exposure to the forward (future) or spot price.

You can get the latest prices and see all the ETCs available on this London Stock Exchange Commodities page.

The way ETCs work looks complicated but as a passive investor is pretty simple (and essentially irrelevant in my view). ETCs outsource the business of buying forward contracts for different commodities to the issuer (here EFT Securities), in exchange for a management fee. As passive investments, this fee is fairly low – e.g. the broad-based Agricultural commodities ETF (ticker: AIGA) that I hold charges under 0.49% a year.

The London Stock Exchange explains how Exchange Traded Commodities work for those who want to know more. I’ve never traded futures, and I don’t know how closely ETCs track their markets. (I’m presuming more sophisticated investment funds buying many millions of pounds worth are keeping an eye on that!)

Some commentators have suggested that investors could automatically lose some money with ETCs due to the underlying trading mechanism (specifically, the ‘rollover’). Although as I understand it any such loss would be much less significant than the rise or fall of the price you’re tracking, you may want to check that out if you’re capable of following such small print (please do explain for us all in the comments if you do so.)

All I want is exposure to the underlying soft commodity price for diversification, as I expect a basket of prices to go up over time, independently of shares. I believe appropriate ETCs do that for me.

What about shares in commodity producers?

An alternative to buying ETCs is to hold shares directly in commodity producers. This would be analogous to holding small cap oil companies, say.

For investors (like me) who aren’t quite sure they want to track half a dozen tiny UK-listed commodity companies, an investment trust or failing that a fund would be handy, but there doesn’t seem to be anything suitable aimed at UK investors, despite the increasing popularity of the commodity asset class. If you want to pursue this option smaller, look at companies on the UK market such as MP Evans (which grows palm plantations) and Landkom (it’s buying wheat acreage in Eastern Europe).

If you’re prepared to look abroad for your investments, you might consider companies that build tractors, or make other agricultural products (such as bio-engineer Monsanto). This play on the commodity story is similar to the old saw that you get richest selling shovels to gold miners. Be aware though that such companies will be more closely correlated to the general stock market, so you won’t get the same degree of diversification as from holding commodities via an ETC.

Water, water everywhere, and not a drop to drink

A final alternative play on the ‘big picture’ soft commodity story (that is, the story that says there’s only so much land/growing stuff to go around, and we’re eating and drinking more and more of it) are a couple of iShares commodity related ETFs.

The iShares ETFs work like normal Exchange Traded Funds, investing in a wide range of internationally quoted companies.

One is very relevant for us here – the Global Timber and Forestry Fund (ticker: WOOD), which holds listed forestry companies from around the world. It looks well-diversified and charges are low. You can find more info on the iShares WOOD page.

To me, WOOD seems a as a long-term diversifier, as well as a short term play on the commodity story. You can stop cutting down trees if the price of wood slumps (it did for a decade, until around 2003/2004) and wait for better times, while only the very patient plant acorns. In the long-term then, these companies, which own huge tracts of forestry, should do well (and timber has indeed historically matched the stock market). Having said that, the WOOD shares have fallen since I started investing. Ho hum!

Some folk have suggested that, thinking laterally, water could be a good take on the soft commodity theme. On that note, an iShare that might be worth looking at is the Global Water Fund (IH2O). With IH20 you’re investing in utilities and others operating in the field of water supply, rather than in water barrels or lakes; I suppose the analogy would be an oil service company like WellStream. There’s more info on the IH2O iShare’s page.

Remember though that whatever their attractions as an investment, iShares’ collections of companies are likely to be more closely correlated with the stock market than ‘pure’ commodity plays such as ETCs.

Why no soft commodity company tracking ETF in the UK?

Just as an aside, it seems to me iShares are missing a trick in not providing a commodity-company ETF to track some of the commodity shares I mentioned earlier – e.g. Asian Citrus (ACHL), MP Evans (MPE), Laxey (LAX), as well as their larger international brethren in the US.

On the other hand, nearly all commodity investing involves exposure to the US Dollar, as well as the commodity itself, as they’re typically priced in dollars. You might therefore argue that it’d be more sensible for investors to simply look for US-listed commodity ETFs/Investment Trusts, and get the same commodity exposure / dollar exposure that way. I haven’t yet explored that route yet.

My own approach with commodities: a bit on the side

As I said at the start, I’m looking to take soft commodities, industrial metals and energy products like oil to around 5% or so of my portfolio, with an upper 10% figure if I invest more in commodity producing companies, either directly on the market, or through ETFs such as WOOD. I like the (assumed!) diversification benefits of the commodity ETCs, but I think bigger bets on soft commodity prices could well end in tears over the short and perhaps even long-term.

In particular, the price of soft commodities seem to oscillate wildly, due to the weather, short-term demand, supply shifts and Mexican cooking. At least it makes The Archers more interesting…