Is there really such a thing as a risk-reward “ratio”?
Sounds neat, doesn’t it?
A clever ratio that you can hang your investment decisions on.
But who’s ever seen one? Or at least one that works?
The truth is that setting risk and reward up as factors in an investment decision involves a web of calculation, and depending on what variables you put in, you will get different results out.
So you want exposure to battery metals, given that every man and his dog says that electric vehicles are the future, and the future of electric vehicles depends on batteries.
And that future in turn depends on the metals that go into the batteries, namely copper, nickel, lithium, cobalt, vanadium, and a few others.
With all that said and done, we’ve now reached a starting point, albeit predicated on an unprovable assumption about electric vehicles, but a starting point nonetheless.
Now, which way from here?
Typically, there are three options.
Number one, equities.
Number two, hard commodities.
Number three, ETFs.
This choice tends to apply across the board to any commodity-based investment decision, from the battery metals mentioned above, through the precious metals like gold and silver, down to the softer of the commodities like pork bellies and juice.
Some of the choices available appear obvious.
For example, only a certain type of large-scale investor would be likely ever to take delivery of physical lithium or cobalt. Yes, LME warehouses exist to allow such transactions to take place. But speaking generally, base and battery metals in their physical form are more usually traded for industrial end-use than for investment purposes.
It is possible, though, to invest in equities that produce base and battery metals. And to invest in ETFs that do likewise. So, for most investors, as far as these metals are concerned, numbers one and three on our list are the way forward: equities and ETFs. Number two is out.
For precious metals, though, owning physical is a much more popular and viable option, so number two remains in.
What then are the pros and cons of each investment class?
To return to our original theme for a moment, equities in the commodities space carry with them more risk, and they often offer more reward. Thus, on the standard way of thinking if commodities prices go up, the companies that produce those commodities, operating as they will do – at least for a time – on a sunk cost base – will enjoy greater margins. Correspondingly, if the price goes down, margins will drop away rapidly, and losses will go deep quickly. The mining industry in a bear market is a miserable place indeed. But the physical miners of commodities also carry with them other risks too, like operational risk and country risk.
It’s the piling on of those several risks one on top of the other that often lead commodity-focussed investors towards options two and three. We’ve already mentioned how buying physical battery and base metals is impractical for most investors, and that with the precious metals it’s a bit easier.
You can go on the internet right now – to Sharp Pixley in the UK, or any number of online bullion dealers – and place an order for gold, silver or platinum to be delivered to your house forty-eight hours later. Simple.
But there are a couple of hidden catches. The first is: what do you then do with it? Do you really just want to have gold bullion lying around your house? And if you’re going to put it in a bank, doesn’t that bring you back to the question of whether or not you trust the banks? Why are you buying gold in the first place.
Perhaps a more significant issue than storage is the other hidden cost: tax. If, as a UK customer, you buy silver or platinum, you are subject to 20% VAT. Not, though, if you buy gold. Some metals, it seems, are more precious than others. Or to put it in stark terms, you have to believe that silver will outperform gold by more than 20% before buying physical makes any real sense from the point of view of returns.
But then we get back to the question of webs of risk. After all, the UK economy isn’t doing so well at the moment, and if you buy your gold in sterling it may be far more likely to hold its value against the world’s other currencies than sterling itself. And the same may be true of silver. So you have to ask yourself: what, really, are you hedging against? Is it a half-point rate rise at the next Federal Open Markets Committee or Bank of England meeting, or is it the detonation of a tactical nuclear warhead in a European city.
If the latter, then your 20% VAT cost on silver may not be so important.
But there is a third way too, the way of the ETFs.
In one way, this is the simplest of all.
Yes, you pay dealing costs, and depending on precisely which ETF you end up with, you can pay a small annual fee too, often less than half a percent. But with an ETF you get an investment product that can be administered electronically, and which can be used to trade into and out of almost any commodity in real time.
Yes, almost any commodity.
There was a time, not so many years ago, when ETFs were thin on the ground, an innovation and somewhat racy for that. Now, they are ten-a-penny, and you can find an ETF for anything that’s not outlandishly exotic.
And by anything, we mean anything. Only two of the ten most popular ETFs traded by Hargreaves Lansdown relate to a specific metal: Wisdom Tree Gold and iShares Gold. There’s also something called the iShares II Global Clean Energy Fund, although the definition of clean energy used here seems to be a bit broad.
The rest of the most popular ETFs relate to bundles of indices, and look to have lots in common with tracker funds.
Cast your eye slightly further down the list, however, and you will find more than thirty ETFs on offer through the Hargreaves Lansdown platform alone. The picture is similar elsewhere on other platforms in the UK, and in other jurisdictions around the world.
There are also about half as many silver ETFs, and four related to battery metals.
You draw a blank if you try and get too specific, though, searching say for a cobalt or a vanadium ETF. There is a cobalt future on the LME, but in general the more speciality metals tend to get lumped together in the likes of the Van Eck Rare Earths and Strategic Metals (TSX-V:SMD) ETF.
“Track the enablers of energy transformation and decarbonization,” says the marketing blurb for Van Eck’s ETF – and you could do that, or you could just buy Tesla. It all depends on the way you approach your web of risk.
The thing about risk and reward is that it isn’t really a “ratio”, as the standard presentation has it, but more of a web.
Thus one risk doesn’t ever really tend to balance against one reward, or to put it another way, if you take a bigger risk, do you always reap a bigger reward? Sometimes the reward bears no relation to the risk whatsoever, and sometimes the risks and rewards that have to be factored into a single investment decision are multiple.
Take the commodities markets, for example.
There are many ways to gain exposure to metals or other types of commodities. Big time investors can head on over to COMEX or the ICE and invest directly in everything from pork bellies to frozen oranges to low sulphur gasoil.
Equities offer greater rewards, and greater risks.