Synthetically Backed Commodity ETPs
How do synthetically backed commodity exchange traded products (ETPs) work?
All ETPs, commodity or otherwise, allow investors to gain exposure to an underlying asset or benchmark. To do this, ETPs need to be underpinned by the assets they’re designed to track, either physically or synthetically.
Synthetic replication is sometimes necessary, as purchasing the underlying assets may not always be a feasible way for ETP issuers to track performance, particularly for benchmarks with a large number of constituents, or for commodities, where storage can be expensive or goods can be perishable.
Therefore, ETP issuers typically use derivatives to gain synthetic exposure to commodity underlyings.
Synthetic commodity ETPs work by tracking total return indices underpinned by commodity futures.
A commodity futures contract is an agreement to buy a specified amount of a commodity on a future date at a set price.
And an ETP price reflects what is known as a total return exposure to the underlying commodity futures investment after fees and costs are deducted.
Total Return Components
The total return has three components:
- Price return reflects price movements in the underlying commodity futures contract.
- Roll yield is the reduction or increase in return caused by reinvesting or rolling a futures contract that’s nearing expiry to a longer dated one.
Rolling is necessary for a synthetic ETP to maintain constant price exposure to an underlying commodity, and
It’s important to recognize that roll yield can be negative or positive.
For an investor who is long in a commodity, rolling into a longer dated futures contract that is priced higher, known as contango, causes the investor to incur a reduction in their total returns.
And if the longer dated contract is priced lower, known as backwardation, investors enjoy an increase in total returns.
- Collateral yield, which comprises the final component of total return, is the interest earned on the cash value of the investment.
That is why the returns from an ETP can be different from those implied by the spots or front month futures price.
In summary, synthetic replication allows investors a cost-effective way to access a range of commodity ETP products in an efficient, liquid and accurate manner.
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