Sucheta Dalal :Commodities markets ETFs and emerging economies
Sucheta Dalal

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Commodities markets, ETFs and emerging economies  

April 1, 2010

 Diversification is one of the main tenets of safe investing.

Since different asset classes are not supposed to correspond, diversifying your portfolio should allow you to hedge against losses in one category or profit from another.


According to two American finance professors, commodities over the period between 1959-2004 were not correlated with the stock market.


Commodities did well when stocks did not and commodities did poorly when stock markets were rising. Of course, during the recent market collapse, diversification didn’t help, because all asset classes including commodities and stock markets collapsed together. What happened? Two things: exchange traded funds (ETFs) and emerging markets.


Commodities markets all have a central problem, inflexibility of supply. In rising stock markets when demand is high, companies do not seem to have problems fulfilling the demand by issuing debt or stock. Governments can issue mountains of debt and investment banks can issue derivatives with a few key strokes.


This is not true of commodities. It can take years to drill a new well, develop a new mine or plant new fields. So with supply being inelastic, even small changes in demand can send the price soaring and detach it from underlying economic projections.


One of the most recent changes to the commodities markets has been ETFs. ETFs solve some major problems with commodities investing. Before ETFs you had two choices: options and commodities companies like an oil or mining company.


Each had problems. ETFs are not perfect, but they do offer good solutions to these problems. So the money flowed in. Global commodity assets under management increased to about $235 billion by late 2009 compared with a mere $6 billion-$10 billion in 2000.


Commodities markets used to be the province of a few professional players. These included commodities producers and consumers trying to hedge and a few sophisticated speculators. Now it is a huge casino made up of every type of investor.


The ETFs went from tracking the market to being the market. Gold ETFs own more of the metal than China. Two ETFs have accumulated more than 100,000 ounces each of platinum and palladium.


In a market of only about 6 million ounces, a 100,000-ounce swing is big enough to result in large price swings. So speculative frenzies driven by cognitive biases can easily overwhelm economic realities.


The other change in the commodities sector has been emerging markets. It is not news that many of the major commodities producers have been emerging markets. Now many of the commodities consumers are also emerging markets. In time, commodities markets could probably adjust to this change in supply and demand except for one thing. Both sides are heavily dominated by State-owned companies.


State-owned companies are creatures of the state. Regardless of the country, they all function for political reasons, not for profit. They are not, nor do they have to be, transparent. They are usually powerful enough to write their own laws. The result is a lack of timely, complete, or accurate information. Often there is simply no information at all and they can change the rules at any time.


China represents a particularly good example. Buying by Sinopec and PetroChina, and China National Petroleum Corp, massive consumers, most likely caused the oil price spike in the spring of 2008.


Massive stockpiling of copper by Chinese companies pushed up the price of copper in 2009.


ExxonMobil is the largest private oil company in the world, but it only ranks 14th among global oil companies. The rest of the producers, many of which are also consumers, are State-owned. Chile’s State-owned copper company might be required to sell more to pay for earthquake reconstruction.


So not only are commodities markets being changed by ETFs and emerging countries, now there is the combination of the two, which could potentially lead to some real trouble.


Often, emerging market countries have sovereign wealth funds (SWFs). Like many other investors, they have come to realise that ETFs are a good and cheap way to invest and diversify.


For example, China's SWF, China Investment Corporation (CIC), is the fourth-largest investor in the US Oil ETF and it recently also took a 0.4% stake in the SPDR Gold Trust, the largest physically backed ETF.


CIC is worth an estimated $300 billion and its mere size could distort the markets, but that is not the only problem. It is the connections between the government as an investor and the government as a consumer and producer. Through their control of large businesses, governments could and do create bubbles that would also be very profitable for their investments in ETFs.


The general assumption of most investors is that commodities and the ETFs, which are supposed to represent them, move according to general economic trends.


Both the reality and information about the real reason for price movements in this asset class could be quite different. This does not mean that commodities are not a good investment.


Money can be made by taking advantage of the volatility. It does mean that assumptions about economics and safe diversification may simply be untrue.


(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])

-- Sucheta Dalal