Could Commodity ETFs Really Kill the Economy?

Few things have expanded the investing toolbox of the average investor more than exchange-traded funds. Over the past 20 years, ETFs have gone from being simple index-fund clones of popular stock market benchmarks to encompass just about any asset class imaginable, from international bonds to stocks of every flavor, location, and size.

Yet with nearly 1,500 ETFs available that hold a total of roughly $1.2 trillion in assets, the ones that have drawn some controversy lately are a seemingly innocuous pair of new commodity-oriented funds, as Barron's reported last week. Building on a concept that existing ETFs already use, the proposed funds have nevertheless raised dire concerns that they could destabilize the underlying market for the physical commodity they own and potentially have devastating consequences on the world economy.

All that glitters is not gold
The ETFs in question are funds designed to track the price of copper. Rather than using futures contracts, however, the ETFs would hold physical copper, paying storage costs but ensuring that the funds are backed with the actual commodity rather than just paper exposure. That may not sound all that complicated or sinister, but as the SEC considered whether to approve the funds, a comment from a law firm representing copper merchants and end users spawned significant controversy.

The problem that the firm foresees is that with the planned size of the ETFs, they would need to buy up as much as 21% of the reserves of immediately available copper from current warehouse stockpiles on British and U.S. commodities exchanges. The resulting drain of physical copper for immediate delivery from the market would by itself raise the price of copper and make its price movements more volatile. That in turn would have ramifications for the entire economy and also make it easier for traders to use the remaining physical supplies for purposes of price manipulation. Sen. Carl Levin added to the calls against the SEC, warning that copper supply disruptions would necessarily follow, and the price movements could create both a bubble and a subsequent bursting of that bubble.

Down this road before
If the idea behind these copper funds sounds familiar, it's because investors have had access to similar physically backed ETFs for years. For a while, the SPDR Gold (NYS: GLD) ETF had the most assets under management of any ETF. Moreover, the success of SPDR Gold spawned a bunch of other precious-metals-tracking ETFs, including iShares Silver Trust (NYS: SLV) and a host of other funds covering gold, silver, platinum, and palladium.

The funds' opponents argue that precious metals are traditionally held for investment, while copper is not. Yet that argument ignores what would be perfectly rational behavior from copper producers in response to physical copper becoming an investment commodity. If spot prices for immediate delivery become extremely high compared to those available in futures markets, then you could expect Freeport-McMoRan Copper & Gold (NYS: FCX) , Southern Copper (NYS: SCCO) , and other major copper producers to respond by directing more of their copper production toward the spot market. That in turn would alleviate the immediate-delivery shortage and avoid the crisis that opponents fear.

More cynically, another logical question to ask is that if the physical copper market were so easy to disrupt, why wouldn't traders have sought to capitalize on its fragility by now? Reminiscent of the Hunt Brothers trying to corner the silver market more than 30 years ago, laws and regulations are in place to prevent manipulative movements. But even without direct collaboration or conspiracy, traders and other market participants tend to gravitate toward positions that take advantage of weak players in any market.

Don't blame the ETF
It's interesting that copper ETFs were where the SEC and opponents decided to draw the line against ETF innovation. Admittedly, many markets haven't functioned as well as people would have expected in recent years. But denying investors a simpler way to make an investment that they could make by other means won't really solve any structural problems in the copper market. In fact, it may bring on the very problem it sought to avoid by pointing the finger so squarely at the market's vulnerable spot.

As big as some of them have become, commodity ETFs aren't likely to hurt the economy. Yet until the SEC figures that out, investors will have to get their copper exposure from Global X Copper Miners (NYS: COPX) and other stock-ETFs aimed at the companies that mine copper.

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Fool contributor Dan Caplinger likes shiny things of all types. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is as good as gold.

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