ETCs

It often happens that ETCs are mistaken for ETFs; I too made this mistake initially. In reality, they have very different characteristics. ETCs, which stand for Exchange Traded Commodities, are characterised by not having an expiry date and, like ETFs, they passively replicate a benchmark whilst being listed on a regulated market.

But compared to ETFs, they are characterised by a greater choice of benchmarks and the absence of a tracking error since it is the issuer itself that guarantees the perfect performance of the reference benchmark.

ETCs differ from ETFs in that they are a debt instrument and therefore do not always provide for segregation of assets, which means that the investor, in the event of default of the issuer, is exposed to the risk of insolvency and therefore to the loss of the amount invested. This difference means that ETCs carry a higher degree of risk than ETFs. For this reason, the investor should periodically check the rating, i.e., the assessment of the issuer’s solvency.

However, some issuers deposit a monetary amount or securities in a separate account as collateral for investors.

Another critical issue with ETCs is that the return is not only a function of the reference benchmark (and other factors that you will see later) but also depends on the issuer’s rating. Simply put, if the issuer’s strength declines, the price of the ETC will also tend to decline.

When choosing an ETC, you should consider two aspects:

• replication of the reference benchmark
• the variables that influence the price

Trying to be as clear and simple as possible, I will explain these two aspects.

The replication of the benchmark can be:

• Physical. The money is used to buy the reference commodity directly (e.g., a precious metal such as gold, silver or platinum). ETCs belonging to this category usually contain the word “physical” in their name (for example Xtrackers Physical Gold ETC).
• Synthetic. When, due to storage problems, it is not possible to buy the reference raw material (think of cotton, cattle or oil), the replication takes place through the purchase of futures contracts. A futures contract is a forward contract whereby the parties undertake to exchange a given asset (financial or real) at a fixed price, with settlement deferred to a future date. In practice, by purchasing a futures contract, I undertake to buy the benchmark at maturity at a price set in advance.

In an ETC, the difference between the two methods is important, as it affects the price and efficiency of the ETC itself.

The variables that may influence the price of an ETC differ and depend on the type of replication of the reference benchmark.

If the replication is physical, there are two variables that affect the price: the price of the reference commodity and, possibly, the exchange rate. Since commodities are quoted in dollars, anyone who buys an ETC and is not a resident of the United States needs to watch the exchange rate between their country’s currency and the US dollar (for example, Eur-Usd if a person lives in Germany, Aud-Usd if they live in Australia, Usd-Cad if they live in Canada, etc.).

If the replication is synthetic, in addition to the two variables seen above, you must also take into account another aspect. Futures, being derivatives, have an expiration date. As the expiration approaches, the futures contract is replaced with the next one; in jargon, this is called a rollover. Generally, on this occasion, there is a misalignment between the price of the ETC and the price of the commodity, which can work to the advantage or disadvantage of the ETC (I’m not going to explain this process, as it is too technical and complicated).

In conclusion, ETCs are a great way to further diversify your portfolio and, in the case of gold, to help protect it in the event of a downturn. However, you need to be careful about what you buy. ETCs with synthetic replication are inefficient and you need some experience to use them properly, otherwise you risk heavy losses. Therefore, they are unsuitable for those who want to invest their savings in the long term (they are more suitable for experienced traders than for quiet investors).

Personally, as an experienced trader in commodities, I only use ETCs that physically replicate a commodity in my investments. This is for several reasons that would be too complicated to explain. I do, from time to time, add ETCs that replicate a basket of commodities but only for hedging purposes (which are however unsuitable for inexperienced investors) and then only for short periods.

Just for the record, and to complete this topic, in the ETP landscape there are also some ETNs that replicate certain currency pairs (such as Eur-Usd). They allow you to take a long position on one currency (for example the US dollar) and a short position on another (the euro).

In theory, these would be ideal as hedges for instruments denominated in foreign currencies, but in practice they are not very liquid and are not traded much, so they are not ideal to include in a portfolio.