Exchange-traded products have become some of the most popular assets on the stock market. You’ve probably heard of exchange-traded funds, which allow you to invest in a diversified portfolio of equities like stocks, but they’re not your only option.
Investors often look to commodities in their diversification efforts to protect their portfolios from inflation pressures. Commodities are the raw materials or agricultural products companies use to make goods, such as gold, wheat, and oil.
Exchange-traded commodities give investors an easy way to gain exposure to commodities without going through a commodities exchange. But there are key differences between investing in commodities directly and buying a stake through ETCs.
What Are Exchange-Traded Commodities (ETCs)?
Exchange-traded commodities are tradable financial assets that track the value of a single commodity or a commodity index — the measure of a group of commodities — similar to a mutual fund.
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They’re called “exchange-traded” because you exchange them on the same stock exchanges where you trade publicly traded companies, such as Nasdaq or the New York Stock Exchange. Stock exchanges are likely more familiar options for the average investor than a commodities exchange where you’d usually trade them.
How ETCs Work
ETCs are debt instruments, which are like IOUs. The company (issuer) markets the ETC to investors with a prospectus, a document that explains the underlying commodity or commodities the fund tracks, its method for tracking those assets, and the expense ratio (cost of ownership) associated with the fund.
The issuer of the ETC purchases either physical commodities or futures contracts — contracts for the future delivery of commodities at a predetermined price — as outlined in the prospectus as collateral for the loans investors make when they purchase the fund.
The value of the ETC ebbs and flows with the value of the underlying commodity, whether it be based on the spot price (the price you pay for immediate delivery of the commodity) or the futures price (the price you pay for the future delivery of the commodity).
If at any point the ETC can’t pay investors as agreed, it must liquidate the collateral to produce at least some return of value for investors.
But that doesn’t mean these are risk-free investments. The two biggest risks of investing in ETCs include:
- Commodity Price Volatility. ETCs get their value from the underlying commodities or futures contracts they hold. If the underlying commodity price falls, the value of the fund falls too.
- Insolvency. Liquidation doesn’t mean you get all of your principal investment back. You only get your share of the cash value of the assets once the issuer has paid all fees, which could be pennies on the dollar compared to your original investment.
Types of Exchange-Traded Commodities
Although several investments fall under the ETC category, they’re not all exactly the same. In fact, there are four different types of ETCs, and the biggest difference between them is the collateral the fund holds.
Physically Backed ETCs
Physically backed exchange-traded commodities are the traditional type of ETC. These funds purchase and store physical commodities as collateral. For example, a physical precious metals ETC may purchase and store large quantities of precious metals like physical gold, silver, and platinum to hold as collateral.
These types of ETCs have a strong correlation with or spot commodity prices (current prices) because their portfolios are made up of physical goods. They’re also the most secure type of ETC because they’re backed by real goods.
Commodity ETCs on Futures
Commodity ETCs on futures work just like physically backed ETCs — with one major difference.
Instead of purchasing and storing physical commodities, these ETCs invest in commodity futures contracts, contracts to take delivery of physical commodities at a later date for a set price. That brings additional risk because you never know what the future price of the commodity might be. So, the ETC’s set price may be lower (or higher) than the goods are really worth later.
Completely Collateralized ETCs
Completely collateralized ETCs aren’t usually backed by commodities or commodity futures. Instead, the issuer backs the investment with cash investments and investments in securities with top credit ratings.
Though there are traditionally no commodities used as collateral in these ETCs, their issuers agree to pay returns equal to that of an underlying commodity-focused market index.
Leveraged ETCs
Leveraged ETCs use complex investment strategies, typically investing on margins (borrowed money), to produce multiples of the returns generated by their underlying commodity indexes. For example, a 3x leveraged gold ETC is designed to produce three times the returns of gold calculated daily.
This is the riskiest form of ETCs because increasing returns by borrowing money and accepting increased risk comes with a high investment cost. At the same time, there’s no guarantee prices will go up and keep going up. So while the funds will be great to have on good days, bad days result in painful declines.
However, leveraged ETCs aren’t designed to be long-term investment vehicles. Instead, these funds are often used for short-term trading.
Pros & Cons of ETCs
There’s no financial product without its fair share of pros and cons, and ETCs are no exception. These funds provide perks like easy access to commodity markets, but they also come with other disadvantages.
Pros
ETCs have become a popular option for investors who want to add commodities to their portfolio but aren’t interested in futures trading or physically storing those commodities. Some of the biggest advantages to these investments include:
- Easy Access to Commodity Markets. Investors often see the commodities market as more complex than the stock market, acting as a turnoff to some. ETCs are essentially commodities that trade on the traditional stock market like stocks, making the investments more accessible to all.
- Liquidity. Liquidity is often a concern when you invest in commodities. You can usually convert ETCs to cash more quickly than traditional commodities investments. So when it’s time to exit your investment, you won’t have to sell at a discount or wait too long.
- Inflation Hedge. Commodities investments are investments in goods, and inflation is the rising cost of those goods. As a result, these investments act as an effective hedge against inflation because the value of your investment increases as inflation does.
- Added Diversification. Spreading your risk over various investment types can protect you if one suddenly loses a lot of value. Many investors have a portfolio made up of stocks and bonds as a way to diversify and protect their investments. Adding commodities to the mix adds a new level of diversification that can result in stronger protection against portfolio drawdowns.
Cons
ETCs are an attractive asset with plenty of benefits, but there are also a few drawbacks. Those include.
- Varying Expense Ratios. Like most investment-grade funds, ETCs come with expense ratios representing the annual cost versus the amount you have invested. Though there are some low-cost funds, expense ratios vary wildly among these assets, so pay close attention to the fees you pay.
- Liquidity. Though ETCs are often more liquid than their underlying commodities, they aren’t nearly as liquid as stocks. So it’s crucial to invest in popular funds to ensure you can exit the investment when the time comes.
- Volatility. Commodities are highly volatile assets, especially in times of uncertainty. One geopolitical event, heat wave, or even jobs report can send prices rising or falling dramatically, so it’s crucial to pay close attention to geopolitical conditions and macroeconomic events at all times.
- False Notion of Safety. The collateral that backs ETCs makes investors feel even more at ease. However, they’re not a 100% safe investment. Every investment vehicle has the potential to drive you into a wall. Never blindly invest in ETCs under the false notion that they’re safe investments that can’t lose.
Should You Invest in Exchange-Traded Commodities?
Exchange-traded commodities can find a comfortable place in just about any investment portfolio. The key is determining what percentage of your portfolio you should invest in these assets at any given time.
ETCs track the commodities markets, so pay close attention to geopolitical and macroeconomic news and consider how the current news is likely to affect the market.
For example, just before writing this article, I read a news piece about record-high inflation rates. There’s also a war between Russia and Ukraine, leading to a squeeze on the global supply of oil and sending oil prices through the roof. With high inflation rates, it’s time to allocate more to commodities. Moreover, with oil prices soaring, a strong allocation to oil and energy-centric ETCs isn’t a bad idea.
Then when inflation starts to dwindle and geopolitical tensions cool, it will be time to reduce the percentage of these assets in your portfolio and bank on the likely stock market recovery ahead.
How to Invest in ETCs
Exchange-traded commodities are traded on major stock exchanges the same way stocks trade, so you invest in them the same way you invest in stocks. Follow these steps to get started:
- Research. Research macroeconomic and geopolitical conditions and how those conditions are likely to affect commodity prices. As you research, think about the types of commodities that are going to benefit the most in the current landscape. For example, if you’re considering an oil investment, think about the current supply and demand and how geopolitical conditions may impact those metrics in the future.
- Create a List. Use your favorite search engine to find ETCs representing the types of commodities you want to invest in and make a list of at least five.
- Consider Underlying Benchmarks. There are several benchmarks, or market indexes, ETCs attempt to follow. Look into these benchmarks and their historical performance and note the results on your list. You can compare the performance of each fund to its underlying benchmark to get an idea of how good the fund’s management team is at tracking the assets they designed the fund to track.
- Compare Your Options. Compare net asset value (the fund’s total assets minus liabilities) to determine which funds are most popular. Also, look into their expense ratios and whether they track spot or future prices.
- Buy Shares. Once you decide which ETCs to buy, go to your favorite online broker and buy shares the same way you would if you were interested in adding a few new shares of stock to your portfolio.
Exchange-Trade Commodities FAQs
I don’t think I’ve ever been able to learn something without asking questions. I’m sure I had a million of them when my parents taught me how to tie my shoes. Exchange-traded commodities are far more complex than tying shoes, so it’s natural to have a few questions of your own.
What’s the Difference Between ETCs & Exchange-Traded Funds (ETFs)?
There are a couple of crucial differences between exchange-traded funds and exchange-traded commodities:
- Structure. ETFs are structured as equities. That means that when you buy shares of an ETF, you’re buying a small percentage of every stock owned by the fund. Their commodity counterparts are notes, which are debts. Those debts are secured by collateral, but you don’t own any equity in that collateral.
- Diversification. The vast majority of ETFs are made up of a highly diversified portfolio of equities. ETCs are generally far less diverse, and many only focus on a single commodity.
What’s the Difference Between ETCs & Exchange-Traded Notes (ETNs)?
ETNs and exchange-traded commodities are both debt instruments underwritten by banks, so they may seem very similar. However, ETNs aren’t backed by collateral, so if the issuer suddenly goes under, the ETN becomes worthless, whereas if the same happens to an ETC issuer, investors receive something back after it sells the collateral.
What Exchanges Are Commodities Traded On?
Exchange-traded commodities are traded on major stock exchanges just like stocks. That includes Nasdaq and the New York Stock Exchange.
Final Word
ETCs are an exciting investment opportunity because they allow you to diversify your portfolio with commodities without having to jump through the hoops of storing physical commodities or understand the complexities of the futures market.
But increased volatility and exposure to geopolitical and macroeconomic risks could be a turnoff for some investors.
Nonetheless, they’re compelling assets to consider in times of high inflation or geopolitical uncertainty and can generally fit into any investment portfolio, even if in only small qualities. As with any investment, the key to success is doing investment research before diving in.