In a recent article we examined the relative merits of investing in an ETF tracking a commodity futures index versus investing in an ETF that tracks the performance of commodity producers’ shares. Here, we take a closer look at one of the investable benchmarks tracking the share price performance of commodity producers—the STOXX 600 Basic Resources Index—the fundamental drivers of its components financial performance, and the ETFs that track it.
Fundamental View
The shares of basic resources firms are often most attractively priced at the very bottom of the macroeconomic cycle. At this point, commodity prices tend to be low as supplies are ample and the demand outlook still uncertain.
Commodity prices tend to be the primary driver of these firms’ financial performance. The market prices of these firms’ products are obviously a factor outside their control, moving in response to global supply and demand fundamentals.
Moving into the realm of control, production costs and output levels are two critical valuation drivers for basic resources firms. Production costs can be managed to a certain extent through investments in more efficient equipment and smart planning. However, the nature of a firm’s resource base is ultimately the most crucial determinant of production costs. Varying ore grades, different levels of technical difficulty, and advantaged access to energy and other inputs can all lead to substantially different production economics amongst producers of the same resource. Finally, firms can also manage output levels by managing existing assets, building new ones, or shuttering uncompetitive ones in response to market signals.
Company- and country-specific risks are also important to keep an eye on when investing in basic resources firms. Company specific risks include firms’ capital allocation decisions. The wave of merger mania that swept the mining sector in the late 'noughties' left many mining firms’ management teams with a big black eye. Many companies overreached during this period, paying lofty valuations based on a continuation of frothy commodity prices. In the wake of the subsequent collapse in commodity prices, many acquirers were left feeling buyers’ remorse and taking massive writedowns.
Country-specific risks take a number of forms. Most notable is perhaps the potential for changes in resource tax regimes—such as those currently being proposed in Australia. Unfavourable changes to existing tax laws can greatly diminish the value of these companies’ precious resources. Asset seizure is another potential threat. While most of these companies’ assets lie in jurisdictions where they do not face the risk of seizure, there have been precedents (in fact many recent ones in Venezuela) that highlight the risk of confiscation.
Portfolio
The STOXX 600 Basic Resources Index is highly concentrated, with the top five constituents comprising 75% of its total market capitalisation. Rio Tinto and BHP Billiton alone comprise over 41% of the index.
Valuation
Morningstar’s equity analysts currently cover 81% of the STOXX 600 Basic Resources Index as measured by market capitalisation. As of the end of May, the fund had a price/fair value ratio of 0.87, based on our analysts’ fair value estimates—implying that the sector is modestly undervalued.
A Look at the ETF Menu
Currently there are seven different ETFs available on European exchanges that track the STOXX 600 Basic Resources Index. The award for lowest total expense ratio amongst the bunch goes to ComStage ETF’s STOXX 600 Basic Resource fund—which levies a TER of 0.25%. The most liquid of the offerings is iShares STOXX 600 Basic Resources fund, which has seen about EUR 2.5 million in average daily turnover on the Xetra exchange over the past year. Source’s Optimised fund is designed with liquidity in mind. The fund tracks an optimised version of its benchmark that removes less liquid components in an effort to improve the overall liquidity of the ETF. In combination with the fact that the firm’s funds are only listed on the Xetra platform, this has made for substantial growth in the on-exchange liquidity of Source’s funds over a fairly brief period—largely thanks to their immediate popularity with the high-turnover hedge fund crowd. The db x-trackers fund also has ample liquidity on the Xetra platform and the Lyxor fund is fairly liquid on the Paris market. Liquidity for the db x-trackers and ETFX funds on the LSE is minimal at present, and we would advise using limit orders in navigating into and out of these (for more on using limit orders and a more in depth discussion of liquidity click here). Finally, the ETFX fund is also extremely illiquid on the Euronext Amsterdam exchange.
