Commodity ETCs and broad commodity indices: structure and costs

What you will learn

• How ETCs, ETNs and commodity index ETFs differ legally
• How broad commodity indices decide their weights
• How to break down the full cost of a product, including currency
• How to compare two commodity products before buying

Explanation

Lesson 7 explained the return of a futures-based product: spot change, roll yield and collateral interest. This lesson looks at the wrapper around that return and the index inside it.

Three wrappers

An exchange-traded product (ETP) is any exchange-traded security that tracks an underlying value. For commodities in Europe there are three main types:

• ETC (exchange-traded commodity): a debt security (Schuldverschreibung) issued by a special-purpose company, tracking one commodity or an index. It is not a fund and lacks a fund's special-asset protection.
• ETN (exchange-traded note): a debt security that may be unsecured; if the issuer fails, you are an ordinary creditor.
• Commodity index ETF: a UCITS fund (UCITS = Undertakings for Collective Investment in Transferable Securities, the EU fund rules). UCITS funds must be diversified, so they can track a broad commodity index but not a single commodity. Single-commodity exposure in Europe therefore usually comes as an ETC.

How ETCs are secured

A physically backed ETC holds the metal in a vault, with a trustee holding security for investors; this is common for precious metals. Oil, gas or grains cannot be stored cheaply, so ETCs on them are synthetic: the issuer enters a swap (a contract in which a bank pays the index return) and holds collateral (cash or high-quality bonds), valued daily. Collateral reduces, but does not remove, the risk that the issuer or swap bank fails. The prospectus shows what the collateral is.

How broad indices are weighted

Rule of thumb: read the current weights, not the name. A production-weighted "broad" index can behave much like an oil investment.

Index versions and costs

An excess return (ER) index contains spot and roll return only. A total return (TR) index adds collateral interest, usually on short-term US Treasury bills. Costs include:

• TER (total expense ratio): the annual product fee.
• Swap costs: often outside the TER but visible in the tracking difference (product return minus index return).
• Bid-ask spread and order fees.
• Currency: commodity indices are priced in US dollars (USD); a euro investor loses when the dollar falls. A euro-hedged share class removes most of this effect at a cost or gain roughly equal to the USD–euro short-term interest-rate difference.

Tax orientation for Germany

ETCs are generally not investment funds, so the fund partial exemption (Teilfreistellung) does not apply, and gains are usually subject to the flat withholding tax (Abgeltungsteuer). For certain gold ETCs with a claim to delivery of gold, the Federal Fiscal Court (Bundesfinanzhof) has ruled that gains can be tax-free after more than one year. Treatment depends on the product terms and can change: check with a Steuerberater.

Worked example

Hypothetical example: €10,000 in a USD total return commodity index product for one year. Assumptions: spot +5%, roll yield −4%, collateral interest +3%, product costs 0.30%; EUR/USD (US dollars per euro) moves from 1.10 to 1.15. Order fees, spreads and taxes are excluded; adding components is an approximation.

1. Index return in USD: 5% − 4% + 3% = +4.0%.
2. Product return in USD: 4.0% − 0.30% = +3.7%.
3. Start value in USD: €10,000 × 1.10 = $11,000.
4. End value in USD: $11,000 × 1.037 = $11,407.
5. End value in euros: $11,407 ÷ 1.15 = €9,919.
6. Return in euros: €9,919 ÷ €10,000 − 1 = −0.8%.

The weaker dollar turned a gain into a small loss. A euro-hedged class with a hypothetical hedging cost of 1.5% would return about +2.2% (€10,220). Hedging removes one risk at a cost.

Common mistake

Practice activity

You compare two products for €8,000 held five years.

• Product A: swap-based copper ETC, historic tracking difference −0.60% a year.
• Product B: UCITS ETF on a broad index, historic tracking difference −0.30% a year. Current index weights: crude oil 16%, natural gas 8%, heating oil and gasoline 6%, metals 35%, agriculture and livestock 35%.

Tasks: (1) Estimate A's extra cost over five years, ignoring compounding. (2) What is B's energy weight? (3) Which carries single-commodity risk, and which has fund protection?

Limitations: Past tracking difference is not a guarantee of future cost, and roll yield can differ far more between products than fees do.

Key takeaways

• An ETC is a debt security; a commodity index ETF is a UCITS fund. Single commodities in Europe usually come as ETCs.
• Index weighting decides exposure: BCOM uses caps and liquidity plus production; the S&P GSCI is mainly production-weighted and energy-heavy.
• Total cost = fees + tracking difference + trading costs; the currency move can dominate.
• German tax treatment depends on the product structure; check with a Steuerberater.

Next step

In lesson 9 you compare an alternative route to commodity exposure: shares of the companies that produce the commodity.