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Exchange - Traded Products (ETPs), How They Work, Its Inherent Risk and How They Differ From Mutual Funds

 



Exchange – Traded Product (ETP)

Exchange- traded products (ETPs) are instruments that track underlying securities, an index, or other financial products. ETPs trade on the exchanges similar to stocks, meaning shares can be purchased, and prices can fluctuate through a trading day. ETPs share price are derived from the underlying investments that they track.

Exchange-traded products can be benchmarked to myriad investment, including commodities, currencies, stock and bonds. ETPs may contain a few or hundreds of underlying investments. Here are the types of ETPs trading on the market.

Exchange-Traded Fund (ETF)

An exchange -traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.  ETFs can be designed to track specific investment strategies. Various types of ETFs are available to investors for income generation, speculation, and price increase, and to hedge or partly offset risk in an investor’s portfolio.  Th first ETF was SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index.

An ETF must be registered with the Securities and Exchange Commission. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940. Open-end funds do not limit the number of investors involved in the product.

ETFs are passively managed, resulting in a significantly lower expense ratios compared to actively managed mutual funds. The costs driving up mutual fund expense ratios – such as management fees, fund accounting, trading expenses and load fees – are minimized in ETFs

ETFs come in various types:

-       Passive ETFs aim to replicate the performance of a broader index (e.g. S&P 500)

-       Actively managed ETFs have portfolio managers making decisions about which securities to include

-       Bond ETFs provide regular income based on the performance of underlying bonds (government, corporate, municipal bonds)

 

In Summary

1.     ETFs are a type of ETP

2.     They track an underlying index, such as the S&P 500, and aim to replicate its performance

3.     They can be bought and sold through the trading day at market prices

4.     ETFs offer diversification because they hold a variety of assets, like stocks, bonds, or commodities

5.     They are known for their cost efficiency and lower fees compared to other investment products like mutual funds

Exchange – Traded Notes (ETNs)

Exchange – traded notes, like ETFs, generally track an underlying index and trade on major exchanges, however they track unsecured debt securities and are issued as bonds. ETNs are issued as bonds, which pay the return of their original invested amount -the principal- at maturity and any returns generated.  ETNs do not pay periodic interest payments (coupon payments).  As a result, the likelihood that investors will be paid back the principal and the returns from the underlying index depends on the issuer’s creditworthiness.[1]

Exchange -Traded Commodities (ETCs)

Exchange – traded commodities are financial instruments designed to offer investors exposure to commodity prices. ETCs are traded on stock exchanges, allowing to easily access and trade them just like they were individual stocks. The underlying assets of ETCs typically include a range of commodities such as precious metals, agricultural products, energy resources, or a combination thereof. ETCs let investors buy and sell commodities without holding or owning any of the underlying commodities.

Associated Risks when Investing in Exchange-Traded Products (ETPs)

Market Risk

The single biggest risk in ETPs is market risk. Like mutual funds or closed-end funds, ETPs are merely a wrapper for their underlying investments. Investing in an ETP that tracks an index (e.g. an S&P 500 ETF) and the index experiences a significant decline, the ETPs’ value will also decrease, regardless of its other features like tax efficiency or transparency.

“Judge a Book by its Cover” Risk

With over 3,200 U.S.-listed ETFs available, investors face numerous choices. Different ETPs within the same category (e.g. biotech ETFs) can have vastly different holdings. Understanding these nuances is crucial.

Tax Risk

Tax implications can be tricky. For example, the SPDR Gold Shares ETF (GLD) holds gold bars and is taxed as a “collectible,” resulting in a 28% tax rate regardless of holding duration. Currencies are treated even worse. As one more beyond stocks and bonds.

Liquidity Risk

ETPs with low trading volume may have a wider bid-ask spreads and difficulty executing trades at desirable prices.

Tracking Error

ETPs aim to replicate the performance of their underlying index, but there can be slight deviations due to tracking errors. It is important to understand how closely an ETP tracks benchmark.

ETPs vs. Mutual Funds: Unwrapping the Differences

Mutual Funds

Mutual Funds pool money from multiple investors to create a diversified portfolio of stocks, bonds, or other securities. They are bought and sold at the end of each trading day based on the net asset value (NAV). Fund managers actively manage mutual funds, making decisions about asset allocation, stock selection, and timing. The objective is to outperform the market or a specific benchmark. However, these funds tend to have higher fees and expense ratios due to research, analysis, and trading costs. Additionally, they often require higher minimum investments.

ETFs

On the other hand, ETFs (Exchange-Traded Funds) also pool investors' money, but they trade on stock exchanges throughout the trading day. ETFs can be bought and sold like individual stocks, with prices fluctuating based on market demand. Unlike mutual funds, ETFs are usually passively managed. They track market indices or specific sector indexes, aiming to replicate their performance rather than outperform it. As a result, ETFs generally have lower expense ratios due to their passive management style. Additionally, they allow investors to buy any dollar amount, making them accessible even with small investments. 

In summary, both ETPs and mutual funds have their merits. Mutual funds offer professional management and a wide range of investment options, while ETFs provide flexibility, lower costs, and intraday trading.  From an investor’s perspective, the choice depends on his investment goals, risk tolerance, and preferences.

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[1] James Chen (February 2024). Exchange-Traded Product (ETP): Definition Types and Examples. Investopedia


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