An introduction to ETCs and ETNs

What are ETCs and ETNs?

ETCs (Exchange Traded Commodities) and ETNs (Exchange Traded Notes) are exchange-traded products that derive their value from underlying assets such as stocks, bonds, commodities or indices. 

ETCs are a type of security that can offer traders and investors exposure to commodities such as metals, , and livestock, while ETNs are a structured product providing returns to investors based on the performance of an underlying reference.

Leveraged and Inverse ETCs and ETNs?

Leverage refers to amplifying returns (or losses) by using borrowed funds or derivatives. ETCs and ETNs can be leveraged products, meaning that they aim to provide amplified returns based on the performance of the underlying asset. For example, a 2x leveraged ETC may seek to deliver twice the daily return of the underlying asset. It’s important to understand, however, that trading with leverage also increases your potential risk and can result in larger losses. For example, if you invested in a short 2x ETC/ETN and the price of the underlying increases by 5%, the value of your investment will decrease by approximately 10%.

Inverse ETCs and ETNs track the reverse performance of an index. An inverse S&P 500 ETN, for instance, will have a positive return on days when the S&P index falls.

A number of factors can drive ETC and ETN price movements, including market demand, supply and demand dynamics of the underlying assets, economic factors and market sentiment. For example, if the price of the underlying commodity or index increases, the value of the ETC or ETN may also increase, and vice versa. There may be instances where this correlation is not seen and, in extreme scenarios, the prices may move in opposite directions.

What affects ETC and ETN prices?

ETC and ETN prices can be influenced by several factors, including:

1. Performance of the underlying securities: The prices of underlying assets held by an ETC and ETN, such as stocks or bonds, directly impact its value. Positive or negative performance in those assets generally leads to corresponding price movements in the ETC and ETN.
2. Supply and demand: Like any tradable security, an ETCs and ETN's price is affected by supply and demand dynamics in the market. Increased demand leads to price appreciation, while higher supply can result in price depreciation.
3. Market news and indicators: Economic indicators, company news, geopolitical events or changes in market sentiment can all affect the prices of an ETCs and ETN's underlying securities and, consequently, the price of the ETC and ETN that tracks them.

What are the risks of trading ETCs and ETNs?

When trading ETCs and ETNs, it’s important to be aware of the potential risks. These include:

1. Market risk: ETCs and ETNs are subject to market volatility risk, which means their value can fluctuate and be affected by changes in the overall performance of the underlying asset or market. There can be differences in the volatility of an ETC/ETN and that of its underlying assets. Economic conditions, supply and demand dynamics and government policies can all potentially impact the value of ETCs and ETNs.
2. Liquidity risk: Liquidity risk refers to the possibility that a financial asset may not be easily tradable in the market without impacting its price. ETCs and ETNs may experience reduced liquidity, for the investor to trade the ETC or ETN, but also for the ETC or ETN to trade the underlying securities. An ETC or ETN that invests in illiquid assets invests in securities that are traded less frequently which may have greater price fluctuations. This can result in wider bid/ask spreads and difficulty in executing trades at the desired price, thereby increasing the indirect cost for the investor. Infrequently traded securities may have greater price fluctuations. 
3. Counterparty risk: Counterparty risk arises from the possibility that the issuer or other parties involved in the ETC or ETN transaction may fail to fulfill their contractual obligations. If the issuer becomes insolvent or defaults, it can negatively affect the value of ETC or ETN. These products typically use derivatives as a substitute for a given security such as a stock. This is typically referred to as synthetic replication as opposed to physical replication (actual stocks and bonds).
4. Tracking error risk: refers to the possibility that an ETF’s performance may deviate from its underlying index due to factors like fees, transaction costs or imperfect replication.
5. Other risks of trading ETCs and ETNs can include volatility risk, where price fluctuations of the underlying assets can impact the ETC or ETN value; credit risk, which arises from the creditworthiness of the issuer; and leverage risk, which magnifies both the potential gains and losses.
6. Psychological risks: Emotional decision-making and lack of discipline can lead to poor trading outcomes.

How much can you lose when trading ETCs and ETNs?

The maximum loss you can face when trading ETCs and ETNs depends on the specific product and its structure, there is the risk of losing your full investment.

When trading leveraged ETCs and ETNs, however, it’s essential to understand that this type of ETCs and ETNs magnify both gains and losses. While they aim to provide amplified returns, adverse market movements can result in significant losses. Due to the compounding effect of daily rebalancing, leveraged ETCs and ETNs may deviate from the performance of the underlying index over longer periods. You should carefully assess the risks and closely monitor leveraged ETCs and ETNs positions to avoid potential losses.

Potential additional costs and charges with ETFs

When trading ETCs and ETNs, there may be additional costs and charges to consider. These can include brokerage fees, transaction fees, exchange fees, management fees and spread costs. It’s essential to understand and evaluate these costs before trading in order to assess their impact on your overall return on investment.

Investors may also incur brokerage commissions when buying or selling ETF shares. These are fees charged by brokers for executing trades.

The difference between the bid and ask prices of an ETF represents a transaction cost. A wider spread can result in higher costs when trading ETFs.