What is a Commodity ETF (or Exchange Traded
Generally, investing in commodities is considered to be relatively risky. However, a commodity investment as a custody admixture to the portfolio diversification can be quite useful. This is mainly due to the historically negative correlation to Equities.
Investing in the price development of commodities is usually done through so-called futures markets. By futures contracts - in the jargon also futures called investing in the commodity index.
If you want to invest in commodities with the help of commodity funds, there are several indices available, which are usually widely spread. Using ETF to integrate resources into your portfolio is therefore not difficult.
In this article, we will give you a comprehensive overview on the topic of Commodity ETF, which will certainly provide you with valuable services in your choice of the correct commodity ETF for your individual investment needs.
What is a Commodity ETF?
ETFs (Exchange Traded Funds) invested in Agriculture, Precious Metals, Natural Resources, etc. are known as Commodity ETF. Investing in commodities for price development is usually done through the so-called futures market.
How does a Commodity ETF work?
ETCs (Exchange Traded Commodities) give investors a chance to invest in precious metals and commodities in a straightforward way.
The performance of an ETC is determined either by the spot price or the futures price of a single commodity or a whole resource basket.
Are there any ETCs funds on individual commodities?
While it is possible to use commodity ETFs on widely spread commodity indices, but not on a single commodity, there is no ETF on cobalt. This is because an index must always be diversified. This is ensured by the UCITS directive. Thus, ETFs must guarantee a minimum diversification and must not hold any physical commodities.
This means, it is impossible for legal reasons in the EU to offer a pure gold ETF. An ETF can include only commodities of certain kind, so in, so-called soft commodities ETF only commodities from the agricultural sector are included.
A typical commodity ETF, for example, iShares Diversified Commodity Swap UCITS ETF (WKN: A0H072), replicates the Bloomberg Commodity (Total Return Index) benchmark. It is based on a total return swap in companies in the energy, precious metals, industrial metals, livestock and agriculture sector.
What is the difference between an ETF and an ETC?
If a market participant or a financial institution wants to invest in a single commodity, they cannot do so with an ETF, but instead will have to buy an ETC. Because ETC funds (Exchange Traded Commodities Funds) are spot price and the futures price oriented.
ETCs can be found on precious metals, industrial metals, oil, natural gas, agricultural commodities, livestock, rare metals, bitcoin and basically everything that is tradable. Just like ETFs (Exchange-Traded Funds), ETCs are traded on the stock exchange. In principle, the ETCs offer the same benefits as of ETFs, but there is also an important difference.
The capital invested in an ETC is not special capital. As a result, the capital is not protected in the event of the originator’s insolvency.
Rather, the ETC is a bond between the provider and the investor, thus has an issuer risk. Of course, there are various methods to protect against this issuer risk, or at least can be reduced.
In essence, there are three different variants that are differentiated by the financial advisors or professionals:
Let’s discuss these three in detail:
Physically deposited ETCs: Gold, Silver, Platinum, Palladium and precious metal ETCs typically track the spot price and are physically secured. In other words, this means, that gold bars are physically stored in the vault of a trustee. By doing so, the issuer risk is completely eliminated in case of physical ETC.
Fully secured ETCs (SWAP based): Collateral is also deposited for the so-called fully-collateralized ETCs and normally checked daily. However, there are no gold bars, which are physically deposited, but rather kept collateral, for example, from an insurer. Also, cash deposits or securities with very good credit rating can be served as collateral.
ETCs secured with third-party cover (SWAP-based): The third variant is covered by the so-called third-party cover. However, they also have the credit risk of the third party. An illustrative example of this type of third-party collateral is ETF Securities, Oil ETCs. These ETCs are backed by Royal Dutch Shell.
Commodity ETCs on Futures
While precious metal ETCs account for spot prices as explained above, commodity ETCs on oil, natural gas or agricultural commodities are based solely on the performance of a futures contract, which is referred to as futures in English and Japanese language.
Logically, these futures have a limited maturity. Therefore, the issuer of this type of ETCs must regularly sell it before the contract period expires. He then immediately buys new futures contracts.
This constant forward movement is also called "rolling". Rolling losses are said to have occurred when the new futures contract was more expensive than the previous one, and vice versa, of course, from capital gains.
If the new futures contract was more favourable than the previous one.
In this case, one not only has to observe and analyse the general price development, but also the developments in the futures markets.
Logically, the roll and roll losses can have a very strong and significant impact on the performance of the ETC.
What is Contango and Backwardation?
If the future price is above the spot price, this is referred to as "contango" or “market is in contango”. As a reminder, the spot price is the price for immediate delivery, which is also called spot price. The future price refers to the price of delivery in the future. The Contango thus leads to rolling losses.
The reverse situation is referred to by those skilled in the art as "backwardation" of the commodity ETF. Here, the future price is lower than the current spot price. That is why rollover can be made for raw materials with backwardation.
Difference between ETC’s and ETN’s
ETC’s track the performance of the commodity market through physical replication or futures contracts, because for some commodities, the physical mapping is not practical. For example, agricultural products cannot be stored for a long time, due to storage constraints and perishability (unlike gold bars).
If the storage is possible, the cost of storage should be considered against these costs carry the roll-over of the futures contract. ETCs are fully hedged through deposits, which allows the expense ratios to be balanced.
Exchange Traded Notes or ETNs are exchange-traded securities in the form of a bond issued by a bank. These are also traded on the stock exchange. The subscribing bank pays out the return of the index when it matures, of course charging a fee, which can be called, its profit. Anyone who invests in this product thus enters into credit risk for the bank.
Also at ETN, there are two models, more specifically secured and unsecured ETNs. ETNs are owned by special purpose entities. This includes the commodity and the investor also gets a share of the company that owns the commodity.
Secured ETNs are either partially or completely hedged against the counterparty risk. In contrast, unsecured ETNs are exposed to counterparty risk unprotected.
One should, therefore, be really sure before investing to have an understanding of the potential risk.
An example of an ETN is Coba ETN -2x VIXF Daily Short Index (WKN: ETN072), while a good example of ETC is the Coba ETC -4x Natural Gas Daily Short Index (WKN: ETC042).
Commodity = Futures?
The broad basket of Commodities includes agricultural products, metals, currencies and other products, but today the short term trading is equated with futures and used identically.
Commodity categories are usually:
Metals (such as gold, silver, copper, platinum, palladium, iron ore, aluminium and others)
Softs (agricultural products or farm animals such as corn, wheat, coffee, sugar, rice, soybeans, soybean meal, cattle, milk, butter, potatoes, pork and others)
Energy (such as natural gas, crude oil, electricity, fuel oil, fuel)
Interest Rate Contracts (all types of bonds such as T-Bill, Eurobonds, Gilts, ...)
Forex (currencies like Euro or USD against a basket of currencies)
Indexes (like DAX, DowJones, S&P 500, Powershares DB Commodity and others)
Special categories such as volatility futures or even issue or weather futures.
The fact that both the terms are used equivalently is because commodity ETFs are used only by futures to track performance rather than the spot price, as in this case with precious metal ETCs.
Otherwise, the commodity ETCs are usually based on futures.
Bloomberg Commodity Index
Of course, there are many commodity indices, but let's take a look at the Bloomberg Commodity Index (formerly the Dow Jones UBS Commodity Index). This is based on the economic importance of the individual raw materials. For example, index weighting uses diversification, continuity and market liquidity.
Today, the Bloomberg Commodity Index provides access to 20 commodities like energy, precious metals, industrial metals, livestock and agriculture.
The Bloomberg Commodity at a glance
A broad range of 20 raw materials
Raw material selection is based on economic relevance i.e., production, diversification, continuity and market liquidity
Index adjustment and rebalancing are performed annually
Monthly roll period of futures contracts
A single commodity has a maximum weight of 15%
A commodity sector has a maximum weight of 33%
The index was first launched on 14 July 1998. An example of an ETF that represents the Bloomberg Commodity Index is the ETFs All Commodities (WKN: A0KRKC). The Dow Jones-UBS Commodity Index is a broadly diversified index that reflects the price movement of various commodity futures.
These raw materials are Zinc, Crude Oil, Wheat, Sugar, Soybeans, Soybean Oil, Silver, Nickel, Natural Gas, Live Cattle, Lean Pigs, Fuel Oil, Gold, Cotton, Corn, Copper, Coffee And Aluminium.