How do ETCs work?Exchange-traded commodities, in short ETCs, offer the possibility to invest in single commodities and precious metals with ease.
The performance of an ETC is based either on the spot price (price for the immediate supply) or the future price (price for the supply in the future) of a single commodity or a basket of commodities.
Why there are no ETFs for single commoditiesInvestors can invest in a broad range of commodity indices cost-effectively with commodity ETFs. However, there is no ETF, which represents only the performance of a commodity since an index must always be diversified. ETFs must ensure a minimum level of diversification and may not hold any physical commodities as per the UCITS guidelines. Thus, it is not possible for statutory reasons, for example, to issue a Gold ETF.
The difference between an ETF and an ETCIf you want to invest only in a commodity, you must buy an ETC. There are ETCs (exchange-traded commodities) for precious metals, industrial metals, oil, natural gas, soft commodities and livestock. ETCs are traded on the stock exchange just like ETFs and offer the same advantages. But there is an important difference: the capital invested in an ETC is not a fund asset that is protected in case of insolvency of the issuer. ETC concerns a debenture of the ETC provider. The investor has an issuer risk in case of an ETC as compared to ETF. Issuers rely on different methods of collaterisation for minimization of this risk.
Exchange-traded fund (ETF) vs. exchange-traded commodity (ETC)
Experts differentiate between physically backed ETCs, completely collaterised ETCs and ETCs with third-party cover.
Physically backed ETCsMost of the precious metal ETCs (Gold, Silver, Platinum, Palladium) generally indicate the spot price and are physically secured. So physical gold bars are stored in the treasury of a trustee as security in case of physically secured gold-ETC. The issuer risk is thereby eliminated in case of physical ETCs.
Completely collaterised ETCs are also backed with collateral, which is basically checked on a daily basis. However, the collateral here is not in the form of precious metal bars, but in form of cash investments or securities with top credit standing.
Completely collaterised ETCs (Swap based)
ETCs collaterised with third-party cover (Swap based)Furthermore, there are ETCs, which are collaterised with third-party cover. However, these ETCs are exposed to the credit risk of the third-party. An example for this is oil ETCs from ETF Securities. Their products are collaterised by Royal Dutch Shell.
Commodity ETCs on futures: rolling profits and losses possibleCommodity ETCs for oil, natural gas or soft commodities basically represent the performance of the underlying futures market. Since the futures have only a limited life, the ETC issuer must sell these regularly before maturity and buy new futures. This process is called “rolling the futures” in the stock exchange jargon. Depending on whether the acquired futures are more cost-effective or more expensive, rolling profits or losses are realized. This means that you should consider the situation in the futures market in addition to the general market trend for commodity-ETCs, since the rolling profits and losses can have a severe effect on the performance of ETCs.
What is contango and backwardation?The situation in the futures market is designated as “contango”, if the forward price (price for supply in the future) is higher than the spot price (price for spot supply). Thus, contango leads to rolling losses.
In a “backwardation”, the forward price is cheaper than the current spot price. Thus, rolling profits can be realized with backwardation for commodities.