The concept of investing in commodities is oft-viewed as easier to understand than other assets: we all know what commodities are and many of us want them in some guise or other, particularly when it comes to gold, silver and precious metals. But ease of understanding doesn’t mean less risk or lower volatility. How often do we see news headlines such as 'Gold Price Reaches Record High' and then an almost-inevitable 'Gold Price Sees Sharp Drop' at a later date? Given such swings, does a specialist commodities closed-end fund bring more volatility with it than other fund structures?
In our meetings with fund managers, it’s not unusual to hear them talk about how we’re in the middle of a 20-year commodities boom (although opinions vary on where exactly in that 20-year timescale we are at any given time). It comes as little surprise, therefore, that we’ve seen the number of specialist funds--and their assets--grow over the last decade.
The commodities sector for closed-end funds is one of the larger specialist sectors, currently comprising 12 funds with gross assets of nearly £2.4 billion. This compares with £18.9 billion under management in open-end funds that are available for sale in the UK. A direct comparison with ETFs is harder as there are a plethora of commodity ETFs, from those replicating an index to individual types of commodities, from synthetic to physical, and those based on future commodity prices. One thing’s for sure, though--the number and type of funds is rising and for sure they’re gaining interest.
The first commodity CEF to be launched was El Oro & Exploration Company, way back in 1899; this is now known simply as El Oro (ELX) after a restructure in 2009.
El Oro is a great example of how the closed-end fund structure has been used by families for decades to preserve and increase their wealth. The company was originally set up by Major Michael Woodbine Parish and since 1994 it has been run by his son, Robin, who currently holds the position of both chairman and managing director of the company.
However, the lion’s share of the assets in this sector are held in BlackRock World Mining Trust (BRWM), which has been run by Evy Hambro since September 2000. This fund shares many similarities with its sister fund, BGF World Mining, both in terms of its holdings and investment process. These funds both dominate their respective Morningstar categories--47% of assets in the open-end category and 63% in the closed-end category.
If we look at both funds on a statistical basis, over one year to August 31, the standard deviation of both funds differs by just 0.27 percentage points. If we broaden this out to five and then 10 years, the difference is a little greater--1.87 and 1.92 respectively, with the closed-end fund carrying the higher numbers. So, yes, at first glance, one could argue they bring more volatility.
But before we judge too harshly, let’s take a look at the funds’ returns, on an NAV basis. Over one year, the CEF has outstripped its sister fund by 12.05 percentage points; over five years annualised by 2.88 and over 10 years by 3.51 percentage points. That’s some difference in returns for the investor.
So why do we think the CEF structure might bring higher volatility? Well, the last few weeks have seen significant volatility in the market, initially following the U.S. Treasury downgrade and then more recently on fears of a Greek default. Commodity CEFs have also seen a marked reaction, but generally they have been hit harder on price than NAV: a common feature of CEFs as, being traded equities, they’re susceptible to market sentiment. Broadly speaking, their NAVs have moved in line with the market. Conversely, on better days in the market, so the share prices of the CEFs have performed better too.
The fact CEFs are listed equities that are traded on an exchange makes them more susceptible to volatility than their open-end counterparts. Their share price can and does react more quickly in times of market frenzy. They can also be victims of liquidity squeezes, when commodity prices drop and the sector falls temporarily out of favour.
But volatility doesn’t always have to be bad. Investing in commodities isn’t for the feint-hearted from the outset, so taking our earlier example of BlackRock World Mining Trust, a little extra risk goes a long way in returns and for many, that bit of extra risk is worth taking.
