The RBC Principal Protected Commodity-Linked Note is a straightforward proposition in a confusing market place for principal protected notes. Simon Carling, a director within Global Financial Products, and his team working on cross-asset investment products at RBC Capital Markets have launched a new series of note that aims to provide a simple and relatively cheap means of gaining exposure to the bull market in commodities, a still relatively unknown asset class that has historically complemented equity and bond portfolios in terms of diversification.

The case for a long-term bull market in commodities, beginning just before the turn of the century, has strongly resonated in financial circles in the past few years. Moreover, a rise in commodity prices has historically been associated with rising inflation and, consequently, with sagging equity and bond valuations.

So, the promise of an investment in commodities is the potential for above-average returns—hedged against inflation—and thus crucial diversification, because commodities as the “third” asset-class are uncorrelated with stocks and bonds.

“Institutional investors have broad-spectrum ways of investing in commodities,” notes Carling, “but for individual Canadian investors, there’s an absolute vacuum as it relates to products.” He continues, “Individual investors can invest in futures [directly], but there are [poorly understood] risks associated with them.”

Managed futures funds, in which commodity trading advisors take long or short positions contrast with the long-only approach taken with the RBC Principal Protected Commodity-Linked Note. As Carling emphasizes, “As soon as you put traders’ discretion into the equation, then that inflationary/market-correlation argument [for commodity investments] will fall down very quickly.”

More transparently, the note represents long-only positions in a basket of seven commodities: aluminum, copper, nickel, lead, platinum, crude oil and natural gas. These “hot” commodities are the major inputs to industrial production, and reflect burgeoning Sino-Indian demand.

It is important to note at the outset that this note does not provide exposure to the broadest commodities market; such exposure is already provided by their Principal Protected Dow Jones—AIG Commodity Index™ Notes (the DJ-AIGCI tracks futures contracts on 19 different commodities).

“Studies have shown that the cheapest and most sensible way for most people to invest [in commodities] is in index funds, which have historically outperformed more than two-thirds of managed funds,” according to hedge-fund manager and widely-read author Jim Rogers in his most recent book Hot Commodities. And yet, Carling adds, “Virtually no [individual] investors have [direct] exposure to commodities right now.”

RBC is responding to investors’ requests and wrapping an index-type approach in a principal-protected structure. They are providing 125-percent exposure to the commodity basket and 100-percent principal protection over five-years (if held to maturity).

This RBC note is designed to take the industry-minimum in fees. There is no MER, since no funds are actively managed. There’s no investment-management fee, and no hidden costs in callability or return-capping features. The notes are Canadian-dollar denominated, so there is no currency risk. There is only the front-end sales commission of 3 per cent, amortized over two years. This note effectively raises—or rather lowers—the bar on fees and expenses.

The shorter than usual term to maturity of the note (five years versus an industry average of nine years currently) and the lower fees are both, at least partially, attributable to the nature of the underlying investment. Commodity investments are highly leveraged, requiring only 5 to 10 per cent margin, and thus allowing for earned interest on the majority of invested capital. The leverage allows for less active capital in the commodity market and consequently a lower cost for the principal guarantee, while the interest covers expenses on the note.

Principal protection and index exposure is achieved by RBC through a plain-vanilla option strategy. “In terms of complexity, this is extremely straightforward,” says Carling; “This is a very, very simple structure.” The historically lower volatility of commodities options also contributes to cheaper options: “The relative costs of options for equities and other asset-classes can be and is … quite a bit higher.” Further, as Carling explains, the highly correlated basket of seven commodities was selected in part to reduce volatility and therefore lessen further the cost of options. It’s these aspects of the commodities market that also provides the 125-percent exposure to the commodity basket throughout the note’s term.

Ideally, direct exposure to commodities, by as much as 5-10 per cent of assets, will achieve meaningful portfolio diversification. Better still, commodities and commodity futures indexes have been shown to demonstrate positive returns in periods of heavy equity market losses. Given the rising clamour for exposure to this “asset class of the decade,” driven by the China story, portfolio insurance has never looked this compelling.