ETC vs. ETF: What's the Difference?

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Reviewed by Charlene Rhinehart
Fact checked by Suzanne Kvilhaug

ETCs vs. Commodity ETFs—Not What You Think

In the U.S., investors commonly use the phrase "commodity exchange-traded fund" (ETF) to refer to investment vehicles that track a single commodity. But the vast majority of those investment vehicles aren't really ETFs. They are more like exchange-traded commodities (ETCs), except that ETCs, while common in Europe, don't actually exist as a formal investment category in the U.S.

Confused? It's OK. What you really need to know is that exchange-traded investment vehicles that track the price of individual commodities aren't ETFs, they're exchange-traded products (ETPs), and therefore are structured and managed in fundamentally different ways. We'll explain below.

Key Takeaways

• The phrase commodity-focused ETF is often used to describe investment vehicles that track individual commodities, but that's usually not accurate.
• In contrast to ETFs, which typically contain a basket of stocks or bonds, a vehicle that tracks a single commodity, or less frequently a basket of commodities, is usually an exchange-traded product (ETP) or exchange-traded note (ETN), which is a type of ETP.
• Unlike ETFs, most commodity ETPs aren't registered under the Investment Company Act of 1940.
• ETPs (and ETNs) are used primarily to invest in physical commodities such as gold, hard currencies such as the euro, and crypto assets. Many commodity ETPs are classified as grantor trusts for tax purposes.

Understanding Commodity ETPs

Commodity-focused ETPs are designed to provide investors with exposure to individual commodities such as gold, oil, and agricultural products without the need to directly own physical commodities. They trade on stock exchanges, similar to equities and ETFs, and their value is linked to the performance of an individual commodity or a basket of commodities.

The primary function of commodity ETPs is to offer an efficient, low-cost way for investors to access commodity markets. Historically, investing in commodities required an active futures trading account or direct ownership, which involved logistical challenges like storage and transportation. Commodity-focused ETPs also enable retail investors to access the commodity markets while avoiding the technical aspects of futures trading.

Many investors use commodity ETPs to diversify their portfolios and hedge inflation. Many commodities have a low correlation with traditional asset classes like stocks and bonds, making commodity ETPs valuable for reducing overall portfolio risk.

One example of a prominent commodity-focused ETP is the SPDR Gold Trust (GLD). Though it is commonly called an ETF, including by State Street Global Advisors, its marketing agent, it is technically not an ETF, and as such it is not regulated under the Investment Company Act of 1940, which regulates all ETFs in the U.S. GLD is, as its name indicates, an investment trust. It is designed to give investors exposure to the price of gold, and holds physical gold.

Commodity ETNs

Not all commodity ETPs that offer exposure to a single commodity actually hold physical commodities like GLD. Those that don't are technically called exchange-traded notes (ETNs), and while their returns are linked to an individual commodity, they do not own physical commodities. For that and other reasons, they carry additional risks for investors. Fundamentally, they are unsecured debt obligations, similar to bonds, and are typically issued by a bank or other financial institution, with the promise to pay a return linked to a commodity price or a commodity futures index. That means ETNs carry a risk similar to bonds—including the risk of default and bankruptcy by the issuer.

Understanding Exchange-Traded Funds (ETFs)

ETFs are "investment companies" designed to track the performance of specific indices, sectors, or asset classes, offering investors a convenient way to gain diversified exposure to markets. ETFs can include a mix of equities, bonds, commodities, or even alternative assets, depending on their investment objective. Their primary purpose is to provide cost-effective access to broad market segments, enabling both retail and institutional investors to build diversified portfolios with ease.

Management styles for ETFs are predominantly passive, meaning they aim to match the performance of an index rather than beat it. For example, an ETF tracking the S&P 500 will hold all 500 stocks in the index in proportion to their weighting. However, actively managed ETFs have grown in popularity in recent years, with fund managers selecting assets based on market opportunities.

Key Differences: ETFs, ETPs, and ETNs

While most investors will rarely notice any difference between ETPs such as SPDR Gold Shares and equity index ETFs such as the SPDR S&P 500 ETF (SPY), ETPs and ETFs are structured, managed, and regulated differently, and therefore offer different levels of protection for investors.

ETFs as Investment Companies

Most ETFs are legally "investment companies," meaning they must register under the Investment Company Act of 1940 and follow an extra set of rules under SEC Rule 6c-11. Basically, the rules require them to maintain liquid holdings, limit how much they can borrow, maintain a certain level of diversification, establish an independent board to watch fees and conflicts, and publish detailed financial reports. They follow the same rules as mutual funds, and so investors get the same protections and regulatory oversight.

Commodity ETPs: Not Investment Companies

Commodity ETPs are more lightly regulated than ETFs. Though they trade like ETFs, their prospectuses explicitly say they are not investment companies under the 1940 Act, which means they are not required to provide investors with the same level of transparency, and investors are not afforded the same level of protection under the law. Commodity ETPs are still governed by general securities laws, but prospective investors should conduct thorough due diligence.

Commodity-Linked IOUs: ETNs AND ETFs

Among the three types of vehicle, ETNs offer the least protection to investors. They hold no physical assets, and any returns to investors depend on the issuer's ability (and willingness) to pay. Because ETNs are unsecured debt, they carry credit risk, with repayment subject to the creditworthiness of the issuer.

• Tracking Errors: While ETFs aim to replicate an index's performance, discrepancies can arise due to fees, market conditions, or imperfect replication methods.
• Market Volatility: Like any traded security, ETF prices can fluctuate during the trading day based on supply and demand.
• Liquidity Risks: While most ETFs are highly liquid, niche or specialized ETFs may have lower trading volumes, making them harder to buy or sell quickly.

Important

The benefits of investing in commodities include acting as an inflation hedge and having a low correlation to equities and bonds.

Considering Expense Ratios

Expense ratios represent the annual fees charged by the fund or issuer to cover management, administration, and operational costs. For ETFs, expense ratios are generally lower, averaging around 0.15% for index equity ETFs in 2023, according to the Investment Company Institute (ICI). In contrast, commodity ETPs that purchase physical assets tend to have higher expense ratios, reflecting the additional costs associated with commodity storage, insurance, and futures contract management.

For example:

• An ETF with a 0.15% expense ratio on a $10,000 investment would cost $15 annually.
• An ETC with a 0.55% expense ratio on the same investment would cost $55 annually.
  These costs directly reduce the net asset value (NAV) of the investment, impacting long-term returns. Over time, even small differences in expense ratios can compound significantly, particularly for long-term investors

Bottom Line

Although often lumped together, ETFs and commodity-focused ETPs (including ETNs) are structured, managed, and regulated differently. ETFs are registered investment companies that offer diversified exposure to broad markets with strong investor protections under the Investment Company Act of 1940. In contrast, commodity ETPs track individual commodities like gold or oil, operate as grantor trusts or debt instruments, and carry less regulatory oversight and more risk.

Commodity ETPs can be useful for short-term commodity exposure or inflation hedging, but require more due diligence. Understanding the structural and regulatory differences before investing is crucial.

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