Credit Crunch filter - Help me understand Electronic Traded Funds

October 19, 2008 9:01 AM

I want to diversify my asset portfolio to include Noble/Precious metals commodities (primarily Palladium). I've heard an effective method is via ETCs. Can someone explain to me what a Exchange Traded Commodity actualy is.

I know a ETC/ETF is an investment vehicle that tracks the performance of the underlying commodity, rather than an actual investment in the commodity.

I understand the benefits are increased Liquidity, Tax exceptions, no costs for storage of the commodity.

But what I don't understand is what are the disadvantages?

Im looking at the ETFS Physical Palladium sold by ETF securities. Which says its 'backed by a Holding of physical palladium
metal' Thus surely removing all the advantages given above, is this holding only a 'token' amount?

http://www.etfsecurities.com/en/updates/document_pdfs/ETFS_Physical_Palladium_Fact_sheet.pdf

posted by complience to work & money (7 comments total)

Im looking for disadvantages over a traditional commodity investment methods.
posted by complience at 9:03 AM on October 19, 2008

The main disadvantage of an ETF is that you don't have an actual brick of palladium with your name next to it in a vault somewhere. Whether this is a significant problem or not probably depends on how paranoid you are about the total collapse of the financial system, etc etc etc.

The other problem is tracking error. The ETF will have its own liquidity, and its own management costs, which will mean it won't always exactly track the price of palladium. It might be higher or lower, but it's not guaranteed to track it exactly.

A couple of other points, as well:

In general, these metal ETFs buy the physical metal (although it's still held in a vault somewhere - in this fund's case, the HSBC vaults in NYC). Some of them are allowed to buy the metal synthetically, via swaps or options - I can't say whether or not this one is allowed to do that. Barring that point, it won't be holding a 'token' amount - it'll be holding something close to one-tenth of an ounce of palladium per share on issue.

Re the costs for storage of the commodity - you still have to pay these with the ETF, they're just embedded in the management fee. There's no way of getting around it, unfortunately.
posted by The Shiny Thing at 10:12 AM on October 19, 2008

Note that in the current environment, if you invest in an ETF which tracks a commodity via swaps or options, you're exposing yourself to counterparty risk. Investors in some ETFs backed by AIG nearly lost everything before the US gov bailed them out.

Googling for 'ETF disadvantages' throws up a bunch of pages, including this one here from about.com which looks informative. The bottom line is DYOR of course: not all ETFs are alike & not all are appropriate for some investment styles.
posted by pharm at 10:46 AM on October 19, 2008

Ah great answers, think I understand it better now.

The main advantage of EFTs is liquidity: but you pay a price for this so;

The main disadvantage is the palladium you buy is more expensive, because you have to pay a management fee in addition.

so $100 invested in a EFT gets you less Palladium than $100 invested just directly in physical palladium stock

= 0.10oz of Palladium x Palladium spot price
less Management Fee


Correct?
posted by complience at 11:12 AM on October 19, 2008

No, you missed pharm's most important point: you don't hold the palladium in your hand. That's the main disadvantage. If you hold the palladium in your hand the risk of losing your investment is limited to robbery. The risk of holding a share in a palladium ETF is higher than that because of the things that pharm mentioned. How much higher? No one knows, that's why it's risky. Counterparty risk isn't a joke, it can wipe out your entire investment with no recourse. A physical ounce of palladium in your hand, on the other hand, has never been known to disappear.

The management fee is also a downside, but to my mind it is a less important one because it's generally quite predictable - it's in the prospectus - and all you have to do is read what it is and then you know what to expect.
posted by ikkyu2 at 7:31 PM on October 19, 2008

That wasn't quite my point ikkyu2: funds that hold the actual metal have very little counterparty risk. Some funds however, track the indices by buying swaps in the open market. Those do.

Personally, in almost every environment short of TEOTWAWKI scenarios, I'd say that the risk of robbery probably outweighs that of your ETF physical metals fund disappearing with all your money. Letting on that you have a pile of platinum or gold in your house is probably a really bad idea :)
posted by pharm at 11:49 PM on October 19, 2008

Prices for platinum and palladium have been falling far faster than gold price. I suspect this may be due to decreased demand from industry. The more traditional gold holds more value due to it's decorative uses, as well as traditional use as money. You can buy gold in coins with known weight/purity that will be more useful if the fit really hits the shan, and paper money becomes worthless.
posted by Goofyy at 10:59 AM on October 20, 2008