Is now the time for commodity fans to use leveraged products?

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Increasing numbers of investors are being tempted to dip their toe into the energy markets – and oil specifically – following the dramatic decline in commodity prices over the past 18 months.

Crude oil and natural gas prices more than halved as fears over slowing global growth, climbing inventories and a lack of intervention from oil cartel Opec have combined to push energy down to multi-year lows.

With prices now at levels not seen since the early 2000s, investors have been increasing their exposure, in particular to oil which is one of the most accessible commodities.

In 2015, net flows into delta one (long-only) oil ETFs globally were $6.4bn (£4.5bn), with positive flows every month in the final quarter. This compares with flows of $1.7bn in 2014.

While the majority of the inflows are into mainstream oil ETFs, leveraged products have also seen a huge uptick in demand. In Q4 flows into leveraged products totalled almost $2bn, with $1.1bn of inflows into 3x leveraged products, versus $876m into 2x products.

Meanwhile short positions saw outflows of $200m as investors decided that the commodity had fallen far enough in value.

The benefits of leverage for investors are clear.

If they have a solid view on an asset being undervalued, then being able to access two – or even three – times the standard return can have a material impact on returns.

However, there are some key points to consider before using leverage.

First and foremost, these products are for professional investors only. Such is the scale of the volatility they provide exposure to – especially in the commodities space – only the most qualified investors should use them.

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For example, if you invest in WTI crude oil through a standard ETF, there is a one in five chance of making – or losing – 8 per cent in a single week.

If you then include leverage into the equation, that figure jumps to either 15 per cent or 22.5 per cent in a single week, dep-ending on whether investors buy two or three times leverage.

Natural gas has even more extreme pricing. The second most popular commodity within the short and leveraged market (its total assets climbed to $739m by the end of 2015), there is a one in five chance of making, or losing, 14 per cent every week, before any leverage is applied.

So how should wealth managers and advisers approach leveraged ETFs when it comes to portfolios? The answer is to keep any trades very short term.

If investors want to take a longer-term view on oil, then a traditional delta one ETF will suffice.

Opportunistic investors with a very specific, short-term view can make use of the leveraged products, but given the market remains very volatile and there is no discernible upward trend for either oil or natural gas at present, they should only be used for tactical purposes, not as core holdings.

As to whether oil will actually stage a significant rally this year, the outlook currently remains clouded.

While money flowed out of short oil ETPs in the final quarter of 2015, the commodity has struggled – along with natural gas – to turn performance around in 2016, with further price falls in January before a semi-recovery in the first half of February.

Speculation that Opec may tell members to cut production managed to prop up the market in January and the cartel remains the key area of focus for now, but until it pushes through a production cut oil prices will remain subdued.

Viktor Nossek is director of research at WisdomTree Europe.