Understand Commodity ETCs Before You Invest

With crude oil prices declining and expected to hit around $55 per barrel by the end of 2015, and with many other commodities facing a price slump due to surplus stock, this could be a good time to have some exposure to commodity exchange traded funds (ETFs) or exchange traded commodities (ETCs).

Bernhard Wenger, executive director and head of European distribution at ETF Securities, explained that commodity products also have the benefit of low correlation to other asset classes.

“Commodity exchange traded products can be used by investors as a potential source of diversification within portfolios,” he said. “Research has demonstrated that price movements in commodities, particularly precious metals, have little relation to price movements in traditional asset classes such as equities and fixed income.”

For anybody considering the commodity market, we explore the difference between ETFs and ETCs and what to look for before investing.

ETFs Versus ETCs

ETFs are traded on the stock exchange and are UCITS-compliant, ensuring they are diversified.

ETCs are also listed and traded on the stock exchange. ETCs, however, can track either the performance of a single commodity or a commodities index, which can be anything from agriculture and livestock to gold and crude oil.

The majority of ETCs use derivatives to track commodity prices. Derivatives are based on contracts or agreements and their value is based on the underlying asset or index. ETCs also trade like shares and can be traded intraday.

Between the two structures, investors can access an individual commodity, sector baskets and/or broad-based all-commodity indexes.

Which Price Do They Track?

Wenger said the products provide investors with access to both physically-replicated funds, which track spot prices, and synthetic funds, which track the movement in future commodity returns.

Lamont explained: “The spot price is the price you see, this could be $50 per barrel. But the ETC is tracking futures on the spot price.”

Whereas non-physical commodity ETPs track indexes which provide exposure to price movements in commodity futures contracts.

Kenneth Lamont, Morningstar fund analyst, added: “Technically the [ETC] fund enters into a swap to get a return on a basket of futures. The first thing to say about commodities is that all of them [ETCs] track futures indices and not the spot price.”

Another important point to make about the futures market is that an investor cannot just buy one future and hold it forever because it has an expiration date.

If a retail investor or adviser were to end up physically storing the commodities or the goods due to the future expiring and the investor not renewing his contract, that would involve a logistical nightmare.

The Roll Cost / Yield

Another area to understand when considering ETCs is the “roll cost” or the “roll yield”. It is not possible to hold a futures contract forever, as explained earlier.  But every time the fund rolls over to the next future contract, there is a cost.

The basic commodity futures-based strategy is simply to buy a “front-month roll” – an ETF will hold the futures contract that is closest to expiration—the front month—before selling its position and buying the second-month contract sometime before the front-month contract expires. To read up more on this point, read our educational article here.

Backwardation / Contango

Investors should also be aware of the futures curve in commodities markets. Is the market you want to access in backwardation or contango? Remember the futures market changes all the time.

When investing in futures people must understand the various sources of return when investing. Read more here.

Contango is when the future price of a commodity is above the expected future spot price. If a commodity is in contango, the roll cost may add up. In contango markets the ETF loses money each time it rolls contracts to a more expensive, later-dated contract.

In contrast, a market in backwardation is when the futures price is below the expected spot price for a commodity. Backwardation may also supplement investors’ returns, for example the futures-based commodity ETF investor could benefit if the underlying commodity is trading in backwardation.

Fees And Trading Costs

There are the fees to consider when looking at ETFs and ETCs. The total expense ratio (TER) is usually the main cost of ETF and ETC ownership. The charge covers costs incurred by the fund from trading expenses and custodial fees to index licensing costs.

Lamont explained that synthetically replicated ETCs have a swap cost, which should be considered alongside the management fee.

It is important to check the literature concerning individual ETFs and ETCs for additional index licensing costs, these may vary.

Consider All The Risks

There are many risks involved with investing in ETFs and ETCs. For instance, when using derivatives or futures to replicate underlying assets or an index investors will have to weigh up counterparty risk.

Many ETCs were suspended from trading in 2008 because the counterparty was AIG, which went bankrupt. Although there have been many regulatory safeguards put in place since then, it is important to look at the structure and prospectus of the ETC before investing.