Duration: 2:56
Level: Beginner

This lesson offers insights into synthetic ETPs and what investors should be aware of when deciding to invest in these products – for example, spot versus futures exposure.

Contributed By: WisdomTree Europe

Study Notes:

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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This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.

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Disclosure: Complex or Leveraged Exchange-Traded Products

Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products.  Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155

Disclosure: Forex

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.