Commodity investing the exchange traded way

With the advent of exchange traded commodities (ETCs) and commodity-linked exchange traded funds (ETFs), commodity investing is now more accessible than it used to be.

Investing in commodities was once the preserve of investors with the expertise to trade futures contracts and closely track their investments to ensure there was no risk of having to take delivery of physical assets. However, in recent years ETCs and ETFs have made it easier for retail investors in particular to invest in the asset class. After all, ETCs and ETFs can be traded through brokers in the same way as other listed securities and are relatively cheap to hold.

According to Deutsche Bank’s global markets research unit, there are roughly 400 ETCs and commodity ETFs listed in Europe, representing some €48bn (£39bn) in assets under management. The bulk of these assets are in gold products (70 per cent), while the next biggest segment is broad commodity indices (9.7 per cent). Institutional investors are the biggest users of the products, although they are gaining the attention of private investors as well.

With such a vast menu of choice open to them, some investors can be confused as to the differing characteristics of ETCs and commodity ETFs (and to add to the confusion there are also exchange traded notes (ETNs) that can provide exposure to commodities), how these different instruments work, how the underlying markets being accessed function and in what way this can impact the performance of the instrument that tracks them.

The first point to make is that ETFs and ETCs both aim to track the performance – provide the risk and reward – of their underlying market as closely as possible. But for an index tracking product to qualify as a fully regulated ETF under European Ucits regulations, the index that it tracks must be sufficiently diversified.

This means that Ucits compliant ETFs cannot reference a single commodity or a highly concentrated index. Also, Ucits compliant ETFs are prohibited from having any physical holdings of commodities, including physical precious metals. For these reasons, European ETFs only offer exposure to broad commodity indices.

As a result, there was a challenge when it came to creating products that would provide investors with the listed, liquid, tradable, cost-effective characteristics of an ETF, but with exposure to a single commodity, such as gold. The answer was the ETC.

ETCs are not funds, but rather are debt securities typically issued by an investment company, with the assets of the company designed to be ring-fenced in the event of bankruptcy of its parent sponsor.

An ETN is typically a debt instrument issued by a bank, and as such usually has full counterparty credit risk to the bank, which means if the bank became insolvent, holders of ETNs would be treated in the same way as other holders of the bank’s debt.