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Duration: 2:56

Level: Beginner

Contributed By: WisdomTree Europe

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.

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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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Disclosure: Wisdom Tree

WisdomTree is not affiliated with Interactive Brokers LLC

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Wisdom Tree and is being posted with permission from Wisdom Tree. The views expressed in this material are solely those of the author and/or Wisdom Tree and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

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.

Disclosure: Leverage ETFs

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:

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