Exchange Traded Products – what are they and what are your options?

Exchange Traded Products (ETPs) is a collective term for describing investments that normally track an index of securities or assets. However, they can also be actively managed, where they try to beat an index.

There are three types of ETP: Exchange Traded Funds (ETFs), Exchange Traded Commodities/Currencies (ETCs) and Exchange Traded Notes (ETNs). They’re all priced and traded throughout the day on exchanges, just like shares.

The price of an ETP will vary depending on the value of the underlying investment. They’re typically used by investors as low-cost alternatives to active funds, but that doesn’t mean they’re right for all investors.

Below, we take a closer look at the three types of ETP, the differences between them and what they can offer investors.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest.

ETFs

An ETF is a basket of investments that usually includes shares or bonds. Their price can rise and fall in line with their underlying holdings. If they track an index like the FTSE 100 or S&P 500, they’re known as passive.

ETFs tend to be associated with passive investing and lower fees, though that’s not always the case. They can be run in a number of ways, including:

• Physically replicated ETFs, which buy a basket of investments matching the index.
• Synthetically replicated ETFs, which use derivative contracts to replicate the index. Synthetic replication generally reduces costs and tracking error, but comes with counterparty risk. This is the probability that the other party in a transaction might not fulfil its part of the deal and default on their obligations of the contract.
• Smart Beta ETFs, which follow alternative strategies as opposed to market capitalised weighted indices, where larger companies make up a bigger proportion of the index. They’re often seen as a blend of passive and active management.
• Active ETFs, where managers try to beat the performance of a benchmark index by buying specific investments.

ETCs

Exchange Traded Commodities/Currencies (ETCs) offer a way to track the performance of a commodity or currency, including certain indices for markets like oil, precious metals, natural gas, and livestock.

Commodities appeal to investors as they can often move in the opposite direction to shares and bonds. While this won’t always be the case, they can offer investors some shelter if share or bond prices do fall.

An ETC can use either a physical approach of buying the underlying investments, or futures contracts. Futures contracts entitle the holder to receive the underlying investment, like a barrel of oil, at a set price, location, and a set date in the future. By using an ETC, it means investors don’t have to hold physical stock themselves like gold bars or a barrel of oil.

ETCs that track commodities differ from ETFs as they use the commodity as collateral for the investment, which is purchased using the inflows of money into the ETC. This offers an extra layer of security for investors in case anything happens to the issuer of the investment.

Physically backed ETCs are physically secured. For example, gold bars are stored in a bank or the treasury as security. This helps eliminate the issuer risk of the ETC. However, storing the asset can also add costs and weigh on the returns to investors.

ETNs

ETNs use debt securities issued by banks or investment companies to track the performance of an index. ETNs are like bonds in that investors receive the return of their original invested amount at maturity.

However, unlike bonds, ETNs don’t pay interim interest payments. Investors of ETNs also don’t own the securities they track. This means the likelihood of being paid back the principal payment and returns from the investment relies on the creditworthiness of the ETN issuer (the bank or investment company).

Assuming there are no issues with the issuer, investors can expect the principal payment and the return received from the index they track at the maturity date. This will be after any fees or commissions charged by the ETN issuer are taken though.

How can ETPs be used in a portfolio?

Diversifying across a pool of assets is key to a healthy, well-balanced portfolio. That said, ETPs and their various options aren’t right for everyone. ETFs give investors an opportunity to invest in broader share or bond markets and as such are more popular. ETCs and ETNs are normally used to fit more niche investing needs.

ETPs are only one option. Investors should only invest if the investment’s objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks before they invest, and make sure any new investment forms part of a diversified portfolio.

If you’re looking to invest in ETPs, remember to also consider dealing charges.

To learn more about ETPs, visit our Help & Support page.

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Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.