The JP Morgan XF Physical Copper Trust —a fund that is currently in registration at the Securities and Exchange Commission—would be the first ETF to be backed by physical copper, much like the SPDR Gold Fund (GLD - News) holds gold bullion. But that’s if the fund ever makes it to market, especially now that a New York law firm filed a complaint with U.S. regulators on behalf of a copper merchant and copper fabricators, arguing that the copper trust would do more harm than good to the overall copper market by making crucial supply unavailable. U.S. Commodity Funds’ Chief Investment Officer John Hyland visited with IndexUniverse.com’s Cinthia Murphy to offer his perspective on what he says is a letter that shows how little the opposition understands ETFs and prospectus language instead of being able to actually identify real threats. Hyland is the brains behind the U.S. Copper Index Fund (CPER - News) , the first futures-based copper portfolio, which his firm made available to U.S. investors in November.
Murphy: The complaint in the letter was that the JP Morgan XF Physical Copper Trust would remove from the market as much as 30 percent of the copper available for immediate delivery worldwide, which would push prices up and “disrupt” the normal flow of copper trading by causing an artificial squeeze. Is that a fair assessment?
Hyland: That part of the SEC comment letter is just a scare tactic. You and I both know that how many shares an ETF registers for in their prospectus has zero to do with how many shares the fund and assets under management the fund will have when it launches. JP Morgan's most recent prospectus shows them registering 6.18 million shares. So what?
When I register funds, I often register anywhere between 50 million and 1 billion shares. The number really reflects how many shares the fund might issue over its lifetime, or at least over the first few years, and not the size on day one or the maximum number of shares outstanding at its peak. When, or if, this fund launches, it will start with no fewer than 100,000 shares worth $7 million [100,000 shares is the NYSE minimum to list], and maybe a maximum of 500,000 shares, worth maybe $35 million.
Note that if an ETF that is a 1933 Act fund registers 50 million shares, and then has an initial wave of creations of 4 million, it now has 46 million unissued left. But if it redeems 2 million shares each month over each of the next 12 months, and creates 2 million more later in the same month, it will end the year still with 4 million shares outstanding, but now with only 22 million unissued shares remaining. So an ETF always needs to register a lot more shares than it ever has outstanding at any one time.
Murphy: Will this fund receive massive amounts of inflows that will cause physical holdings of copper to shoot upward?
Hyland: I doubt it. Copper is not gold, and few, if any, investors feel a compulsion to own it in the physical form unless a compelling financial opportunity arises.
Since this fund will earn you the spot movement of copper minus fund costs and minus what are likely to be hefty storage costs—maybe 3 percent annual combined expense—it is not clear that people will flock to this fund unless copper futures are in steep contango. I think it will have a certain user base, but I doubt it becomes a big fund. Copper futures are most of the time easier and cheaper to use to invest.
Murphy: Will a physical copper fund have a predictable impact on the spot price of copper? Could it cause it to automatically go higher?
Hyland: Anybody who tells you that has no real evidence for their opinion. I can give you reasons why it could cause prices to trend a bit higher, if the fund was large, but I can also give you reasons why it could cause copper prices to go lower.
A lot of it will depend on not only the size of the fund, but on how its exact creation/redemption procedures will work in practice. Remember, at any given time there are hundreds of thousands of tons in LME warehouses anyway. There are millions of tons worldwide in non-LME inventory.
It is not clear that the copper owned by this fund, that must "sell it" to anybody who wants to do a redemption on any given day, will automatically push the price up—as opposed to if the exact same copper was owned by Glencore or General Electric, kept in the exact same warehouse, but only sold when Glencore or GE felt like it.
My best guess is that most likely it will have little or no effect on spot copper prices.
Murphy: Notwithstanding the fact that the NYSE has filed a 19b-4 on this fund, is it actually anywhere near being close to launch?
Hyland: I don't think so. The most recent updated draft prospectus for this fund was filed on July 12, 2011. That draft did not include minor details like the ticker symbol, the CUSIP number, or any disclosure at all about the levels of fees and expenses. Until J.P. Morgan files a draft that does include that info, assume this thing is months and months away from launching.
Murphy: Why do you think the firms who filed this comment letter have done so?
Hyland: Do not automatically assume that they are concerned about the integrity of the copper market. That could be true. It could be that they just do not know how to read a prospectus or do not understand how ETFs work.
However, putting on my cynical hat, it could also be the case that they just do not want a transparent, public player that’s always willing to buy copper every day, at the market price via the creation process, and always willing to sell physical copper every day, at the market price via the redemption process, shining any light on their little corner of the world.
The first rule of big players in any nonpublic market, like physical copper, is to keep everybody else in the dark for your own benefit.
At its heart, GLD—the physical gold ETF—is not really a fund. It is a highly public gold-bullion-trading platform.
The same would be true of a large physical copper ETF. That may be good for the copper market in general, while at the same time being bad for certain large players who like being able to dominate a market. Their motives may be much less pure than their comment letter would suggest.
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