What are ETCs and how to use them for investing

Exchange Traded Commodities (ETCs) are financial instruments designed to enable indirect investment and trading in commodities, without having to take direct ownership of them.

They act like debt notes, i.e. bonds, issued by special purpose vehicles that use the money raised to invest in one or more physical commodities or derivatives on commodities.

In essence, ETCs track the performance of a single commodity or a basket of commodities, making them a popular choice for investors seeking precise exposure to specific commodities. They offer a wide variety of options, ranging from hard commodities, such as metals and oil, to soft commodities, such as grains and coffee.

Because they are designed to track the price of the underlying physical asset, the value of the ETC will depend on factors that affect the price of the commodity itself. For example, when trading wheat, elements such as weather patterns and crop yields can affect its price.

Institutional or private investors looking to diversify their portfolios and gain exposure to commodities without having to trade futures and options often turn to ETCs. Below is a guide to understanding what they are and how to use them to invest.

What are ETCs

ETCs are financial instruments that allow you to invest in commodities such as oil, gas, gold, silver and wheat without having to physically purchase the underlying assets.

They are non-UCIT instruments with no expiration date and are listed on the Italian Stock Exchange. By purchasing units of an ETC, the investor gains financial exposure to the underlying commodity without having to physically purchase it. Furthermore, unlike ETFs (Exchange Traded Funds), funds with a certain degree of diversification, ETCs allow investors to bet on a single commodity.

ETCs also invest in indices, sub-indices and forwards linked to commodities to replicate their performance. They are very liquid instruments, with low transaction costs and transparent as the assets and liabilities of the ETCs are known daily.

How ETCs work

ETCs are issued by special purpose vehicles (SVPs) that physically invest in the underlying commodities, for example gold, oil or wheat. The management companies purchase the raw material and store it so as to have as collateral an equal certified quantity of the same raw material of which they represent the market price. They then issue securities representing these stocks - debt notes - which are listed on the stock exchange.

When an investor buys an ETC, he or she obtains a security that indirectly replicates the value of the underlying commodity. If the price of the commodity rises, the value of the ETC also increases. Conversely, if the price of the commodity falls, the ETC also loses value.

The performance of an ETC is linked to one of two factors: the spot price of the commodity or the futures price. The spot price of the commodity is the current price for delivery while the futures price is for delivery on a future date.

There are two markets to invest in ETCs: the primary market and the secondary market. The first guarantees access only to authorized intermediaries and allows the subscription or redemption of securities on a daily basis at the official value of the ETC.

The secondary market, on the other hand, is accessible to all investors, who can thus trade securities at the price that is determined by the best purchase and sale proposals detected.

It should be noted that investments in ETCs are influenced by the euro-dollar exchange rate, since many commodities are traded in US dollars, exposing investors to exchange rate fluctuations.

Differences between ETCs and ETFs

ETCs (Exchange Traded Commodities) differ from ETFs (Exchange Traded Funds) in several respects:

1. Structure: ETCs are issued as debt securities, while ETFs are mutual funds. ETCs are backed by physical assets such as gold or oil, but may also have commodity derivatives as underlying assets, while ETFs invest in futures contracts or other derivatives from stocks, bonds, interest rates or money market products;
2. Counterparty risk: Since ETCs are issued as debt securities, they carry the risk of default by the issuer. Furthermore, ETCs are not OICRs, therefore they escape the UCITS EU directives. ETFs, on the other hand, being mutual funds, do not present this risk and being OICRs must comply with the UCITS EU directives;
3. Costs: ETCs generally have higher costs than ETFs, due to physical coverage and storage costs. Transaction costs, on the other hand, are similar;
4. Replication of the underlying: ETCs replicate the performance of the underlying raw materials by holding the physical assets, while ETFs use derivative instruments. Physical replication of ETCs is therefore more precise, but also more expensive;
5. Taxation: ETCs do not present the distinction between Capital Income and Other Income envisaged for ETFs and therefore the capital gains produced by operations with ETCs are fully offsettable with any capital losses derived from the same negative operations with ETCs. This means that ETCs have a more favorable tax treatment than ETFs. The taxation of ETCs is therefore similar to that of other financial instruments such as shares, certificates and derivatives and provides for the application of a 26% rate on capital gains.

In summary, ETCs are more suitable for investors seeking direct and precise exposure to raw materials, while ETFs may be preferable for greater diversification and lower costs, albeit with indirect exposure. The choice between the two instruments therefore depends on the needs and risk profile of the investor.

Advantages and risks of ETCs

ETCs are very versatile financial instruments that allow you to invest in raw materials in a simple and efficient way. However, despite many advantages, there are some risks that investors should consider before investing.

Advantages
Exchange Traded Commodities have many advantages, including:

• Easy accessibility and tradability: ETCs can be easily bought and sold in a similar way to stocks, thanks to their tradability on an exchange. This feature offers investors greater flexibility in managing their portfolio.
• Faithful replication of the performance of raw materials: ETCs are designed to precisely follow the performance of the underlying raw materials, offering direct exposure to these assets without having to physically purchase them;
• Security in the physical holding of the raw material: some ETCs are guaranteed by raw materials physically held by the issuer, providing greater security than other financial instruments based only on futures contracts;
• Low costs: ETCs have relatively low trading and management costs compared to other forms of investment, allowing investors to keep a greater share of the gain;
• Portfolio diversification: ETCs offer an opportunity to diversify your portfolio by including exposure to different commodities or commodity-related indices, helping to reduce your overall investment risk;
• Wide range of choice: ETCs are not limited to single commodities, but allow you to invest in baskets of commodities, global commodity indices and forward indices;
• Investment flexibility: ETCs allow you to invest both upward and downward in prices, offering the possibility to buy or short sell the instrument. This flexibility allows investors to adapt to various market conditions;
• Liquidity: ETCs have a high degree of liquidity, allowing investors to execute short-term trades, including intraday, or invest long-term to capture commodity market trends over time.

ETC Risks

• Underlying Volatility Risk: Commodities can be subject to strong price fluctuations, making ETCs susceptible to significant changes in their value. Investors should carefully consider the volatility of the underlying before deciding to invest in ETCs;
• Contango Risk (if the underlying is a futures): Contango occurs when subsequent futures contracts have higher prices than the current ones. This can cause the value of the ETC to decline over time, as more expensive futures must be purchased to maintain its exposure to the commodities;
• Currency Risk: Since many commodities are denominated in US dollars, investors may be exposed to currency risk if the reference currency fluctuates unfavorably against their local currency. This may negatively impact the performance of the ETC;
• Tracking Error Risk: ETCs may not be able to perfectly replicate the underlying commodities due to a variety of reasons such as fees, expenses and liquidity. This may cause the performance of the ETC to deviate from that of the underlying asset. This discrepancy is known as tracking error and may reduce returns to investors;
• Concentration Risk: Investors should be aware of the possibility of concentrating their portfolio too much in specific ETCs or commodities. Excessive concentration can increase the overall risk of the investment.

In summary, investors should carefully consider the risks associated with ETCs before investing. A full understanding of these risks will enable investors to make informed decisions and better manage their portfolio risk.

How to invest in raw materials with ETCs

Let’s now see how to use ETCs to invest in raw materials.

The great advantage of this type of investment is that it offers many possibilities of choice. In addition, ETCs allow investors to gain exposure to raw materials without having to purchase, store and insure the physical asset. In addition, these instruments can be used both for short-term investments (short) to take advantage of the movements of a single stock market session, and for long-term investments (long).

Here is a list of the different types of ETCs available:

• Commodities: Gold, Silver, Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Gasoline, Fuel Oil, Brent Crude Oil, WTI Crude Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Soybean Oil, Soybeans, Sugar, Platinum, Palladium, Wheat, Zinc, Lead, and Tin. This includes agricultural products, precious metals, and hydrocarbons;
• Homogeneous Baskets of Goods: Agricultural Products, Energy, Cereals, Industrial Metals, Livestock, Oil, Precious Metals, etc.;
• Global Commodity Indices
• Commodity Forward Indices

Why Invest in Commodities with ETCs
Commodities offer diversification to your portfolio as they perform differently than stocks and bonds.

ETCs are a simple, cheap and safe way to invest in commodities. Compared to buying them physically, ETCs do not involve storage, insurance and transportation costs. In addition, they are tradable on the stock exchange like stocks, so it is easy to buy and sell them.

ETCs are suitable for both retail and institutional investors and allow you to take advantage of the diversification and return opportunities offered by the commodities market. However, like all investments, ETCs are subject to capital loss risks, so it is important to understand their characteristics before investing.

In conclusion, ETCs represent an innovative and flexible way to access the commodities markets. Their tradability and transparency make them suitable for both short-term and long-term investment strategies.

How to choose an ETC

When choosing an ETC, there are several factors to consider before deciding which option is best for your portfolio:

• Exposure to underlying commodities: The main factor is the specific exposure to the commodity that an ETC provides, such as gold, silver, oil or agricultural products. Investors should evaluate their investment objectives and risk tolerance to determine which commodities are best for them. ETCs on precious metals such as gold and silver can provide a hedge against inflation and market volatility. In contrast, ETCs on energy or agriculture are riskier, but can produce higher returns if the underlying commodities rally;

• Concentration and diversification: Investors should consider how concentrated or diversified an ETC’s exposure is to the underlying commodity. Some ETCs focus on a single commodity, such as gold bullion. More diversified ETCs, on the other hand, offer exposure to a basket of commodities, mining companies, or futures contracts. A concentrated ETC offers more direct exposure, but comes with higher risk. Diversified ETCs may produce lower but more stable returns over the long term;

• Physical Backing vs. Futures Contracts: ETCs gain exposure to commodities through physical assets or derivatives such as commodity futures contracts. Physically backed ETCs purchase and store the actual commodity. They track the spot price, but incur higher storage and insurance costs. Futures-based ETCs provide exposure through commodity futures contracts. They often track the futures price and must periodically roll over the contracts, which can have a positive or negative impact on returns. Investors should determine which method best suits their objectives;

• Fees and Expenses: Investors should compare fees across ETCs, as high fees reduce total returns over time. Management fees typically range from 0.5% to 1% per year. Physically backed ETCs typically have higher fees due to higher storage and insurance costs. Futures-based ETCs have lower fees, but may incur brokerage fees to roll over futures contracts. Fees are an important factor, especially for long-term investors

In summary, investors should carefully consider these key factors based on their financial goals and risk tolerance before selecting a commodity ETC for their portfolio.

Choosing the right ETC can provide valuable diversification and an inflation hedge, but the wrong choice can lead to underperformance or excessive risk. With careful consideration, ETCs offer investors an affordable way to gain exposure to commodities.

Original article published on Money.it Italy. Original title: Cosa sono gli ETC e come usarli per investire