What it means
Commodities are raw materials such as gold, silver, oil, natural gas, copper and agricultural products. Buying them directly is awkward: gold has to be stored and insured, and oil cannot be kept in a spare room.
An ETC solves this by issuing a security whose price is designed to follow the commodity's price. There are two broad types.
A physically backed ETC holds the actual metal, usually in secure vaults, so each unit is linked to a quantity of the metal. A synthetic or futures-based ETC tracks the price by holding futures contracts (agreements to buy or sell at a set price on a future date) or by using a swap arrangement with a bank.
Because many ETCs are structured as debt securities, the investor relies on the issuer and, in some cases, on the counterparty bank. Physically backed products usually have assets set aside to protect investors, while synthetic ones may carry additional credit risk.
The documents explain how the security is collateralised, and investors should read them before buying. ETCs charge an annual fee, often expressed as a percentage of the amount invested.
Futures-based products can also suffer from roll costs, which arise when the manager replaces an expiring futures contract with a later one at a higher price. Over long periods, this can make the ETC return different from the spot price (the current market price) of the commodity.
Businesses use ETCs less often than investors do, but they can serve as a simple hedge. A jeweller worried about rising gold prices, or an airline thinking about fuel costs, could use a commodity security to offset the risk.
Care is needed, because a mismatch between the ETC and the real exposure can leave some risk uncovered.
In practice
Real-world examples.
Example
An individual wants some protection against inflation and buys a gold ETC through her pension account. She does not need to store the metal. The product holds bars in a vault and charges a small annual fee.
Example
A small airline treasurer thinks that fuel prices may rise next year. She buys an oil-linked ETC to offset part of the extra cost of fuel. The airline reviews the position every month because futures-based products do not match the spot price perfectly.
Example
A wealth manager adds a basket of agricultural commodities to a client's portfolio to reduce reliance on shares. The ETC is traded on the stock exchange and can be sold within seconds. The manager explains that returns can be volatile and that the product is not a guaranteed hedge.
Formula
Calculation
Annual fee = Amount invested x Fee percentage
Value after one year = Amount invested x (1 + Commodity return) - Annual fee
Suppose an investor puts $50,000 into a gold ETC with an annual fee of 0.50%. During the year, the gold price rises by 12%, and the ETC tracks it exactly before fees.
Value before fee = $50,000 x 1.12 = $56,000.
Annual fee = $56,000 x 0.50% = $280, so the value after fees is $56,000 - $280 = $55,720. The net return is ($55,720 - $50,000) / $50,000 = 11.44%.Case study
Seen in the real world.
Brightwater Capital is a fictional family office with a growing interest in precious metals. The investment committee wanted to hold gold but worried about the cost and security of buying physical bars.
The committee compared a physically backed ETC with a futures-based product and with direct ownership. It chose the physically backed ETC, partly because the documents showed that the metal was held in an audited vault and partly because the fee was low.
In this illustrative case, the family office invested $2 million, equal to 8% of its portfolio. When gold prices rose, the position added to returns and when they fell, it lowered them. The committee reviewed fees and tracking every year and kept the position small because commodities can be volatile.
Watch out
Common mistakes.
- Assuming an ETC is the same as an exchange-traded fund, when many ETCs are debt securities with different legal protections.
- Believing the price will always match the spot commodity price, when fees and roll costs can cause differences.
- Ignoring the issuer's credit risk, when it can matter if the structure is synthetic.
Questions
People also ask.
What is the difference between an ETC and an ETF?
An ETF is a fund that holds a portfolio of assets, while an ETC is usually a debt security linked to a commodity. The legal structure affects how investors are protected.
Are ETCs risky?
They can be, because commodity prices swing widely and leveraged or inverse products can lose value quickly. Investors should check the product type and the fees.
How do I buy one?
Through a normal brokerage account, in the same way as shares, provided the product is available in your country and for your type of investor.
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