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ETP Guide: How Exchange Traded Products Work

ETP Guide: How Exchange Traded Products Work

DFX Research,

WHAT IS AN ETP?

Exchange traded products (ETPs) are exchange-listed investment vehicles that typically track the movements of an underlying index, sector, commodity or financial instrument. The value of each ETP security is tied to both the value of its underlying and its market demand. This means that prices can appreciate or depreciate – like stocks and other securities – over time.

To restate this, ETPs are securities that can be bought and sold on public exchanges in the same way as normal stocks. Whereas a stock’s price is highly dependent on the value of the company it represents, the value of an ETP is largely based on the value of the securities or assets it tracks.

New to the stock market? Read up on stock market basics.

These products cover a range of securities and assets including indices (both stock market and sector indices), a single commodity or collection of commodities, bonds and currencies. ETPs are often divided into two subcategories: exchange traded funds (ETFs) and exchange traded notes (ETNs).

An ETF is a pooled fund that issues shares to investors in exchange for investment capital. This capital is combined and used for investments by the fund manager, and the issued shares can be traded on an exchange (the secondary market). As ETFs are passively managed, their operating expenses – and their fees – are often considerably lower than most actively managed mutual funds. More on that below.

An ETN is an unsecured debt instrument, typically issued by a bank, that acts in a similar way to a bond. However, whereas a bond may make payments before maturity, an ETN will not. The value of the ETN principal repayment is dependent on the value of an underlying asset and can vary with movements in the underlying.

ADVANTAGES OF AN ETP

The ever-growing popularity of ETPs is based on the several advantages they confer, including lower costs and the deferral of capital gains taxes. Two of the most attractive benefits, however, relate to increasing investor access to markets through a single point of entry and the opportunity for portfolio diversification.

An index tracking ETF will, for example, use its pooled funds to buy the individual shares appearing within an index. To mimic the index’s performance as closely as possible, the ETF would purchase each share in proportion to its weighting in the index. In theory, an S&P 500 ETF would trade all the stocks appearing in the S&P 500, and likewise for the FTSE 100 or NASDAQ 100.

Here’s where market access comes to the fore: an individual investor would, to achieve the same result, need enough capital to not only buy each stock, but enough of each to build proportions that mirror the index weightings. An impossible task, both logistically and monetarily, for most.

With an index ETF, by comparison, each share held by an investor represents a part ownership of a fund large enough to replicate an entire stock index. In simple terms, the index ETF gives the investor exposure to the entire stock market aggregate via a single point of entry – that is, a share in the fund.

This automatically leads on to the second advantage of an ETP: diversification. A well-diversified portfolio is a collection of investments that mitigates risk by including as many uncorrelated assets as it can.

In terms of share portfolios, the only portion of risk that can’t be diversified away is known as systematic risk. This is the risk faced by each company incurred by virtue of it being a part of a wider economic system. In a weak economy, for example, the demand for goods and services declines, no matter how well managed a company may be.

When investors only buy a small selection of stocks, the risk profile on the portfolio is higher than it would be if it contained a wide selection of shares from several sectors. Exposure to an index is one of the most effective ways to diversify, and thereby can lessen the risk of holdings concentrated into few underlying assets. The choice between individual stocks and an ETF is up to the investor and their objectives and risk tolerance.

Diversification isn’t the sole domain of index ETFs and index ETNs, however: ETPs that focus on commodities can also diversify a portfolio by enabling investors to gain access to assets that may, under other circumstances, be too problematic and expensive to purchase.

TYPES OF ETPs

Because ETPs can track a wide variety of underlying securities or assets, they can be divided into several types.

  • Index ETFs: these ETPs attempt to track the performance an entire stock market by buying, in their correct magnitudes, the collection of stocks used by a particular index like the S&P 500, FTSE 100 or DJIA. Index ETFs give an investor exposure to the market, which, through diversification, lowers risk. However, index ETFs are subject to some degree of tracking error: due to the size of the index, and trading frictions, they might not track the underlying exactly.
  • Sector ETFs: like index ETFs, stock sector ETFs purchase a basket of stocks, but unlike an index ETF, will attempt to track a sector rather than the market. To do this, they may track a sector index like the NYSE Arca Biotechnology Index (BTK) – an equal dollar weighted index designed to measure the performance of publicly traded companies in the biotechnology industry.
  • Commodity ETFs: commodities have traditionally been very difficult to access for retail investors. The physical assets are expensive, impractical to store and manage, and futures and options are complex instruments that require specialist knowledge to trade. By pooling funds, however, a commodity ETF exposes investors to the commodities markets. Commodity ETFs are also known as exchange traded commodities (ETCs). As an addition to a portfolio, commodity ETFs can be used as a diversification element and as a hedge against inflation (commodities often move in an opposite direction to inflation).
  • Bond ETFs: these ETPs focus on fixed-income securities like corporate bonds, convertible bonds, floating rate bonds and government bonds (like US Treasuries). In keeping with the lower costs of ETPs, they are comparatively inexpensive and give investors passive exposure to the bond markets. However, because bonds incur interest rate risk, investors should research the relationship between interest rates and bonds. Bond ETFs can be used to diversify an existing portfolio.
  • Currency ETFs: these ETFs give investors exposure to the forex markets via one or more currency pairs. As they allow for forex speculation through a managed fund, currency ETFs are useful for portfolio diversification and hedging against exchange rate risk (for example, an investor’s overseas investments may depreciate owing to an appreciation in the local currency). Risks are incurred both at home and in the foreign market, meaning that foreign interest rate hikes or political instability are additional risks that need to be managed.

Learn more about how interest rates affect forex.

  • Leveraged and inverse ETFs: both are innovations on the traditional ETF. A leveraged ETF makes use of derivatives to amplify the movements of a chosen underlying. The benefit and risk is that any movements in the underlying are amplified many times over in the fund’s capital. At a leverage ratio of 5:1, for instance, a 1% change in the underlying will produce a 5% change in the fund. Inverse ETFs use derivatives to short the market – that is, to profit from a falling market – enabling an investor to hedge against downward trends without having to short any stocks themselves. It should be noted that derivatives are complex instruments and come with significant amounts of additional risk. A further phenomenon is that there is no theoretical limit to gains in many underlying assets, but downside potential is capped at zero.
  • Exchange traded notes (ETNs): ETNs can be seen as a hybrid of a traditional bond and an ETF. They are like ETFs in that they are based on an underlying security or asset and can be traded in a secondary market. They are similar to bonds in that they make a future payment in exchange for current funds. In contrast to ETFs, however, the issuer of the ETN need not purchase any of the underlying securities or assets: the promise is strictly that a payment based on a specified underlying will be made at a future date. Although ETNs are often issued by large, reliable financial institutions, they are subject to counter-party risk. That is, the issuer may default and not make the promised payment, in which case all monies paid for the ETN will be lost. Popular ETNs are issued on indices and commodities.

HOW DO ETPS COMPARE TO OTHER SECURITIES?

Mutual Funds

A comparison is often drawn between mutual funds and ETFs as both employ the pooled-fund model and both are open to public investors (unlike certain other pooled-fund investments such as hedge funds and private equity). But, there are four significant differences to highlight.

  1. Mutual funds are, typically, actively managed. This means that a fund manager looks to outperform the market by selecting stocks that are undervalued or stocks of companies that will appreciate in the future due to increased market demand. For their services, the manager will charge a management fee that could be between 1% to 2% of the fund’s assets under management (AUM). This fee applies no matter the actual performance of the fund and could be in addition to other entry and exit fees. By comparison, ETFs are passively managed. This means that fund managers simply manage the fund in accordance with a benchmark like an index. The lower participation of management and the lower operating expenses of the ETF result in fees that could be as low as 0.5% of AUM. There is much debate about whether active management is a worthwhile investment expense as research indicates that all but a few actively managed funds actually outperform an index over the long run.
  2. ETF shares can be traded on an exchange. In open-end mutual funds, investors interact directly with the fund, which issues or redeems shares after calculating the fund’s net asset value per share (NAV) at the end of each trading day. The NAV is essentially the total value of the fund divided by the number of shares – this is the amount which the fund charges new investors per share, and the amount at which it redeems existing shares. To take a profit or limit a loss, shares can only be redeemed from the fund itself at the end of the day. They can’t be traded on exchange. ETF shares can be traded on an exchange throughout the day.
  3. ETF shares trade at NAV. This difference relates to closed-end mutual funds. Closed-end mutual funds issue shares that can be traded on exchange, but these can be sold or bought at an amount higher or lower than their NAV. Should market demand for the fund’s shares decrease, investors will have to sell the shares at a discount to the NAV. Similarly, because closed-end mutual funds don’t issue new shares after their creation, new investors can only join the fund by buying existing shares on an exchange. If demand is high, they will pay more for the share than its NAV. For ETFs, however, because large institutional investors known as authorized agents or authorized participants can redeem shares with the fund itself, if the share is selling for less than the NAV, they can simply arbitrage by buying shares and redeeming them at their NAV to earn a profit. If the market price is higher than NAV, they can short shares and again make a profit. This means that ETF share prices on an exchange will always equal their NAV.
  4. ETFs defer capital gains tax. When a mutual fund closes positions by selling the stocks and bonds in which it has invested in order to pay out its own investors wanting to redeem shares, it must pay capital gains taxes if the securities have appreciated. Owing to the way ETFs are created and operated, investors are often only required to pay capital gains taxes if their shares have appreciated at the time of selling. The capital gains tax is unavoidable, but with ETFs, investors are given some leeway in choosing when to lock the gains in.

Real Estate Investment Trusts (REITs)

Another common comparison is drawn between ETFs and real estate investment trusts (REITs). REITs, like ETFs and mutual funds, make use of the collective power of pooled funds to invest in assets that may be off-limits to smaller investors due to large minimum capital outlays.

Whereas a mutual fund invests in securities like stocks and bonds, a REIT buys income-producing real estate assets. This financial vehicle was established in the US in the 1960s, but are a recent addition to the UK. There are two types of REIT: equity REITS and mortgage REITS (mREITS).

Equity REITs buy income-earning properties, which generate income for the fund. The income is distributed to shareholders in the form of dividends. Equity REITs are generally listed on an exchange, and shares can be bought and sold by investors at will. This means that share prices are determined by the market and can fluctuate – offering the opportunity to earn a potential profit should market demand increase.

Mortgage REITs are available in the US. They don’t invest in physical assets directly, and instead collect payments from mortgages. In this way, they generate an income from mortgage-backed securities.

  1. Like equity and mortgage REITs, ETFs can be traded on exchange. But the ETF price is always determined by its NAV (discussed above).
  2. REITs are required to pay up to 90% of their income as dividends. This is attractive to investors wanting to own income-generating stocks. ETFs may choose, depending on the ETF, to either pay dividends in the form of distributions or to re-invest dividends and issue more shares.
  3. REITs add diversity. Real estate is generally seen as a major investment category and by some measures provides similar returns to stock markets, but with less volatility in prices and with less dependence on business cycles. When creating or developing a portfolio, shares in a REIT can add diversity and hedge against inflation. In fact, REITs are so in demand that REIT-tracking ETFs have been introduced, offering yet another way to gain exposure to the benefits of real estate. Some popular REIT ETFs include the Vanguard REIT ETF, the Schwab US REIT ETF and the iShares Global REIT ETF.

HOW TO INVEST IN AN ETF

As an exchange traded product, investing in an ETF is a straightforward process. As an investor, you just need to follow these three steps:

  1. Open a brokerage account. Traded like individual stocks, brokers should give investors access to a variety of ETFs. Some brokers allow for the commission-free trading of their own, proprietary ETFs, while others will have partnerships with third-party providers. In addition to brokerage commissions when entering or exiting a position, investors should research the annual expense ratio of the available ETFs to assess the total costs of holding the stock.
  2. Plan the portfolio. A primary aim of any portfolio should be the diversification of assets to minimize risk. Put another way, a solid portfolio will include assets that are as uncorrelated with each other as possible. Many ETFs contain similar holdings, so investors should ensure that their portfolio covers different asset classes. It’s important to research the historical performance of an ETF and its constituent stocks – but, please note, past performance is never a guarantee of future results.
  3. Place the order. As with all stocks, proceed by identifying the correct ticker symbol, noting the price, number of shares and order type. To help manage your risk and lock-in any profits, decide whether to use stops and limits where available.

ETP SUMMARY

  • ETPs track an underlying security or asset and can be traded like normal stocks on an exchange. There are two subcategories of ETPs: exchange traded funds (ETFs) and exchange traded notes (ETNs).
  • ETFs are pooled-fund investments that issue shares in exchange for investor capital. They are passively managed and give investors exposure to assets that may otherwise be unaffordable.
  • ETNs are hybrids of ETFs and bonds. Similar to ETFs, they track an underlying like an index or commodity, and can be traded on exchange. Similar to bonds, they offer the promise of a future payment in exchange for current funds. They, too, give investors access to a wide range of markets.
  • ETPs can help lessen a portfolio’s risk by increasing the portfolio’s diversification.
  • ETPs can be contrasted with other pooled-fund investments like mutual funds and Real Estate Investment Trusts (REITs). ETPs are seen as less expensive than actively managed mutual funds and have a share price that always closely reflects the value of the fund.
  • As ETPs are comparable to stocks and are exchange traded, investment is a relatively easy and straightforward process, although each investor should do due diligence to check that the ETF aligns with their own investment goals.

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