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A Guide to Exchange Traded Commodities

05 Oct 2023

Introduction

Have you ever wondered how to invest in commodities like gold, silver, oil, or wheat without actually buying and storing them physically? Or how can you diversify your portfolio with exposure to different sectors and regions of the world? If yes, you might be interested in learning about exchange-traded commodities (ETCs).

ETCs are financial instruments that mirror the performance of individual commodities or a collection of commodities. These instruments are actively traded on stock exchanges, similar to shares, providing a practical and economical means to engage with the commodity markets

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What are the types of ETCs?

There are two main types of ETCs: physical ETCs and synthetic ETCs.

  • Physical ETCs: They track the actual commodity they are backed by. For instance, a physical gold ETC stores gold bars in a secure vault, and its price mirrors the spot price of gold. They are also referred to as exchange-traded notes (ETNs).
  • Synthetic ETCs: They rely on derivatives contracts like futures or swaps instead of being backed by the physical commodity. For instance, a synthetic oil ETC doesn't possess any oil barrels; rather, it engages in a contract with a counterparty to settle the difference between the current and future oil prices. They are also called exchange-traded commodities (ETCs) or exchange-traded certificates (ETCs).

Benefits of Exchange Traded Commodities

ETCs offer several benefits to investors who want to gain exposure to the commodity markets. Some of these benefits are:

  • Diversification: They allow you to diversify your portfolio across different asset classes, sectors, and regions. Commodities usually have a low or negative correlation with other securities, such as stocks and bonds, which means they can reduce the overall risk and volatility of the portfolio.
  • Liquidity: They are tradable on the D-street like stocks. You can invest and redeem them easily and quickly during market hours. You do not have to worry about finding buyers or sellers for your commodities or paying high commissions or fees.
  • Transparency: They have clear and simple structures, and supply and demand market forces determine their prices. You can easily access information about the underlying commodity, the ETC provider, the fees, and the performance of the ETC.
  • Cost-effectiveness: ETCs eliminate the need for you to buy and store physical commodities, which can be expensive and cumbersome. You also do not have to deal with issues such as the commodities' quality, delivery, transportation, insurance, or taxation. Also, compared to other forms of commodity investment, ETCs have low management fees and transaction costs.

What are the risks of ETCs?

ETCs also have some risks that you, as an investor, must be aware of before investing in them. Some of these risks are:

  • Market risk: They are subject to fluctuations in the prices of the underlying commodities, which can be influenced by diverse factors such as supply and demand, weather, geopolitics, and economic conditions. You may lose money if the prices of the commodities fall below their purchase price.
  • Tracking error: ETCs may not perfectly replicate the performance of the underlying commodities due to various reasons, such as fees, expenses, rebalancing, and liquidity. You may experience a difference between the ETC returns and the commodity's actual returns.
  • Counterparty risk: Synthetic ETCs rely on derivatives contracts with counterparties to track the performance of the commodities. If the counterparty fails to honour its obligations or goes bankrupt, you may lose part or all of your investment.
  • Regulatory risk: They are subject to the rules and regulations of the stock exchanges and the jurisdictions where they are listed and traded. These rules and regulations may change occasionally, affecting the availability, liquidity, taxation, or performance of the ETCs.

Conclusion

ETCs are an attractive option for investors who want to gain exposure to the commodity markets. They offer several benefits, such as diversification, liquidity, transparency, and cost-effectiveness. However, they also have some risks, such as market risk, tracking error, counterparty risk, and regulatory risk. Therefore, you should do your research and analysis before investing in them. Also, understand your objectives, risk appetite, and time horizon. 

ETCs can be a valuable addition to a well-balanced portfolio if used wisely and prudently.

 

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