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Commodity funds the next bubble?

business Updated: Feb 01, 2010 23:28 IST

A growing number of funds that invest in commodities such as coffee, gold or even pigs, are coming under the scrutiny of regulators who fear they could be the next financial bubble to burst.

Industry insiders have warned the Bank of England that some funds may not have enough collateral to return investors’ money and some of the smaller operators might be committing a form of fraud.

More than 300 Exchange Traded Funds (ETFs) and Exchange Traded Commodities (ETCs) are listed on the London Stock Exchange, with their shares owned by hundreds of retail and institutional investors.

“We can be certain ETF frauds are developing now,” said Jonathan Compton, managing director at London-based Bedlam Asset Management.

“Even worse, the structure of the market makes the fraud easier. Often, for tax and stamp duty reasons, as well as cost and finding the right legal framework, many ETFs are listed in one country, the management resides in a second and the commodity or securities are held in a third.”

Bedlam said it found an ETF where the manager, trustee, custodian and listing were in the Indian sub-continent, the Gulf, Africa and Europe, and where “the verifiers are junior people from small firms with a limited track record.”

The Bank of England and the Financial Services Authority declined to comment, although the central bank has been briefed about the funds, which track a product through a financial index, or invest directly in a commodity.

Investors also fear that during a panic sale, derivatives contracts fall more than the commodity that they track, exacerbating their losses.

“When that happens, run, including from related equities.”

Global ETF assets surpassed a record $1 trillion at the end of last year. ETFs were mostly created by investment banks to offer retail and other investors access to commodities markets for a fee.

But the products have become more complex, with some, such as index trackers, backed by swap contracts with other financial institutions, not investing in the commodity directly. To some, they now offer an uncomfortable reminder of the toxic mortgages that led to the credit crunch, when investors had little idea of what they actually owned.

“Some have started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity,” Compton said.

Low regulation has led to an explosion in the number of funds and their use of such complex financial structures.