The best way to play the commodities boom

I was flicking through the papers this morning when something caught my eye.

A newly-launched exchange-traded fund (ETF) has just become the fastest-selling ever on the European market.

The ETF, launched by Source, has pulled in just under a billion dollars worth of assets in roughly three weeks.

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What sector is it investing in?

Commodities.

Are investors getting over-excited about commodities?

They are passive' investments, as opposed to active' investments, in that they just aim to follow the price of a market, rather than beat it.

We're big fans of ETFs here at MoneyWeek. They have opened up many new markets to private investors, and they have made investing cheaper. They're an excellent addition to the investors' toolkit.

But of course, like everything in the investment world, they are also subject to fads and bursts of over-exuberance. That's why it can be interesting to watch "flows" the amount of money going in and out of ETFs and also new launches.

Financial companies are like any other company they only produce services or products where they can see demand for them.And that's the tricky thing about financial markets in general.

In financial markets, when demand is greatest, that's usually a sign that profits for the end consumer of the product are likely to be low, or non-existent. In financial markets, the big profits for the consumer of the product (though not the supplier) tend to lurk in the least popular areas, where no one is looking.

So when you see an ETF being launched that tracks the price of 3D printing stocks, for example, or one that follows some other obscure sector, then it can be a sign that perhaps things are getting a bit overheated.

Or if you see a flood of money going in one direction, you might prick up your ears and re-evaluate the sector.

So it's interesting that a new ETF from Source (Europe's seventh-largest ETF-provider manager) has become the fastest-growing ever.The Source Bloomberg Commodity UCITS ETF (LSE: BCOM) has raised $925m in just three weeks.

So is this a sign that the commodities boom is already overheated?

Why buying an index fund isn't the best way to play commodities

And here's the slightly longer version. Firstly, I'd say the commodity boom has further to go. The rebound only started in 2016. If governments really do start spending on infrastructure then demand is likely to keep growing at a time when various commodity producers have cut back on supply. So I'd be surprised if it all fizzles out.

There are wildcards of course there are always wildcards, and in this case, Donald Trump and China are the most obvious. But I don't think Trump would be keen to see a recession in the US this year (although strategically, it would be a good idea to get it over with before he has to start electioneering all over again in a couple of years). And China is showing signs of life again (we'll talk about that more later this week).

Also, I don't think there's too much of a "contrarian" signal going on here. One attraction of this particular ETF is that it's very cheap.It tracks the Bloomberg Commodity Index for just 0.4% a year that's a good bit lower than the 0.75% typically seen for this type of ETF, according to Source.

However, despite my optimism, I wouldn't buy this ETF to play the theme. That's not a criticism of this particular ETF at the end of the day, if you want to invest in an undifferentiated basket of raw materials, then this is probably a decent way to do it. It's just that there are better ways to invest in the commodity upturn.

If you look at the Bloomberg Commodities index, about a fifth of its value depends on crude oil, another tenth on natural gas, and another tenth on heating oil and gasoline. So you've got roughly 40% invested in energy.

Gold then accounts for another 10%. Grains plus other agricultural commodities account for around 30%. And industrial metals makes up the rest.

All of those categories of commodity have different driving forces. Energy is a tricky one right now. You've got shale in the US and you've got oil cartel Opec and you've got the rise of the electric car there are a lot of disruptive forces playing tug-of-war with one another and it's not clear which will win.

Gold, meanwhile, is very different to other commodities. It's not a supply and demand story, or an economic growth story. It's more of a play on how far behind central banks get on trying to tackle inflation. The more negative real' interest rates get (ie the further behind inflation they fall), the better it is for gold. If you want to hold gold (and you should own some), don't do it in a general ETF just buy a gold ETF.

Agricultural resources all have their own little cycles based on the weather, farm efficiency and other esoteric factors.Industrial metals are probably the purest play on infrastructure spending and growth, but they only account for less than 20% of this particular ETF.

So in all, I'd rather get my commodity exposure via commodity producers. I'll own miners for the industrial metals exposure. I'll own gold and also some precious metals miners for that particular exposure.

For agricultural commodities and the general theme of growing populations eating more and better food, I'd rather look at companies that supply farmers with all the tools they need, including tractors and nutrients. As for oil, I'd probably now be looking carefully at which producers have the best individual stories.

On that point, we have some specific suggestions about how to play the sector in the latest issue of MoneyWeek, our investment trusts special. If you're not already a subscriber, sign up now.