Financial literature is flooded with acronyms many investors struggle to keep up with. It almost seems that every new financial product comes with at least two new acronyms. The ETF world is no exception. In fact, already at this point is where we find the first misconception, for ETFs or Exchange Traded Funds are not an umbrella term but rather a specific product-type within a wider range.
In part I of this guide, I shall give a broad definition of the different Exchange Traded Products (ETPs) available. Future chapters of the guide, due in coming weeks, will provide more detailed analysis into key aspects of these financial products, with a view to help our readers make well-informed investment choices.
ETPs are best defined as open-ended investments listed on the exchange and traded and settled like shares. They are passive investments aiming to replicate the performance of a given market, generally by tracking an underlying benchmark index. Being generally open-ended investments, they usually trade at or close to net asset value (NAV). In some instances, ETPs may also be referred to as Exchange Traded Vehicles (ETV).
While each ETP provider favours a slightly different definition, the general tendency both in the marketplace and the media is to use ETF and ETP as perfectly interchangeable terms. It is therefore important that investors make sure they understand what the provider is referring to when looking at these products.
Exchange Traded Funds
ETFs are UCITS III compliant and usually track equity or fixed income market indices. In order to achieve their investment objectives, ETF providers can either use physical or synthetic replication.
Physical replication can be achieved either through full replication or optimised sampling. The optimised sampling approach is more common for indices with a large number of components, in which case the provider would only buy a basket of selected component stocks reflecting the same risk-return characteristics of the underlying index.
When using synthetic replication, ETF providers enter into a swap agreement with single or multiple counterparties. The provider agrees to pay the return of a pre-defined basket of securities to the swap provider in exchange for the index return. Synthetic replication generally reduces costs and tracking error, but increases counterparty risk. For markets not easily accessible, swap structures do have an advantage over physical replication.
Exchange Traded Commodities/Currencies
ETCs are similar to ETFs; however they track the performance of commodities markets, either using a physical/spot approach or futures contracts in order to achieve their objectives and are not UCITS III compliant. A physical approach is not feasible for every commodity (e.g. agricultural products cannot be stored for years). More so, in some cases where storage is possible, its costs have to be weighed against the roll-over costs of futures contracts.
ETCs are fully collateralised, meaning that counterparty risk is hedged out. The main difference between ETFs and ETCs is that the latter are debt securites instead of funds.
Like exchange traded commodities, exchange traded currencies are secured debt securities. They give exposure to foreign exchange rates and are not UCITS III compliant.
Exchange Traded Notes
ETNs are generally senior, unsecured, unsubordinated debt issued by a single bank and listed on the exchange. They are not asset-backed. The underwriting bank agrees to pay an index return, minus fees upon maturity. Therefore by buying this product, investors get direct exposure to the credit risk of the underwriting party.
There are two types of ETNs; namely collateralised and uncollateralised notes. Collateralised ETNs are hedged partly or fully against counterparty risk whereas uncollateralised ETNs are fully exposed to counterparty risk. Investors should therefore make sure they fully understand the underlying risk of the ETN before investing.
Part II of this guide will look into ETFs in greater detail, focusing on how they are structured – in particular synthetic ETFs – and what investors should watch out for in terms of counterparty risk and collateral.
