frequently asked questions

Derivatives are a type of financial contract whose value is dependent on an underlying asset or benchmark. They’re essentially a contract between two parties and the price of the contract comes from any changes in the underlying asset value.

These contracts can be used to trade any number of assets and come with their own risks. Derivatives are commonly used in ETPs to access different markets and can also be used to hedge against certain risks.

For example, a gold futures contract is a type of derivative whose value is based on the market price of gold and therefore aims to track the price of the physical commodity. The benefit of using derivatives over physical commodities can be the cost of ease and use. Agricultural products, for example, would often spoil if held for any length of time, and storing millions of barrels of oil would be difficult, incurring large storage costs which would have to be passed onto the investor.

Derivatives are also used by portfolio managers to reduce the cost of trading in the underlying investments like shares. Trading in shares can incur dealing charges and taxes, whereas derivatives aren’t subject to those costs. This can make it easier for an ETP to replicate index performance at a lower cost and help keep a tighter tracking difference over time.

Currency hedging is a process used to reduce the risk of the potential changes in an exchange rate of one currency in relation to another. Companies or investors with assets or operations across national borders are exposed to these currency risks. This leaves them open to potential losses as the currencies they are exposed to across various countries fluctuates.

To reduce that risk, currency hedged ETPs use derivatives to try and minimise the effect of those exchange rate fluctuations. Using hedging can protect or harm the performance of an ETP depending on the direction of those currency movements.

Currency hedging normally comes with an additional cost to the ETP.

Leveraged ETFs are designed to multiply the short-term performance of a particular stock market, index or commodity – such as the FTSE 100 index or the price of gold.

Let’s take a FTSE 100 2x daily leveraged ETF as an example. It aims to replicate two times the daily percentage change in the FTSE 100 index. If the index goes up by 5%, the ETF should go up by 10%. Likewise, if the index went down by 5%, the ETF should go down by 10%.

Leveraged ETFs are intended to be held for a very short period of time, often less than 24 hours. Leverage is very much a double-edged sword. On one hand, the value of your investments can climb rapidly if the market moves in your favour. On the other hand, with any losses your original investment can be wiped out quickly. Over the longer term, leveraged returns can vary significantly from the index.

“Inverse ETPs” are another type of ETP that are used to provide a positive return when the price of the market or asset they track falls. For example, if the FTSE 100 index fell 5% in one day, a FTSE 100 2x Daily Short ETF should provide a 10% positive return.

Leveraged and inverse ETPs are complex investments, and most are generally only suitable for knowledgeable investors who can fully understand and accept their risks.

Some ETFs lend the investments they hold in the fund to a third party in exchange for a fee, which can help offset some of the fund's management charges, reducing the cost to the investor. All physical ETFs are permitted to lend stock, though not all currently do. Synthetic ETFs, which use derivatives to track a benchmark, and ETCs generally do not lend stock.

At all times the fund remains the beneficial owner of the investments it lends and is entitled to all dividends. It also has the right to recall the investments that have been lent to the third party at any stage. The ETF is normally given collateral (often cash or a different stock) to hold whilst the security is on loan. This collateral would be used to cover any losses in the event that the third party can’t return the investments on loan.

Some fund groups also provide protection for investors using indemnities to reduce the risk of any loss if borrowers can’t return the investments on loan.

Like all stock market investments, the value of an ETP will rise or fall and neither the amount invested, nor any income is guaranteed. All ETPs are linked to the value of an asset or index, but in times of market uncertainty or setbacks any money invested in an ETP could be lost. For example, an ETP that tracks the S&P 500 index should fall around 10% if the index fell 10%.

In extreme events, ETPs can be suspended from trading, which means investors can’t buy or sell an investment and may lose their money.

Counterparties are third parties, often investment banks, who are involved with some aspect of running the ETP. For example, a counterparty might be an institution providing a "swap" derivative to help the ETP track an index, borrowing a stock as part of a securities lending programme or the financial institution issuing an ETN.

If a counterparty ran into financial difficulties, there is a chance that the ETP and subsequently the investor could lose money. This could involve larger costs to the ETP, the ETP could cease trading temporarily or, in the worst-case scenario, be wound up altogether.

Investors can assess counterparty risk by considering the followings:

• Is there an indemnity provided with counterparties to protect investors from any potential loss?
• Do counterparties accept or provide collateral like shares or bonds to cover any potential losses?
• How many counterparties are used?
• Which counterparties are used?
• For securities lending, are there limits to the amounts the ETP issuer will lend from each fund?
• Has the ETP issuer ever suffered losses from the securities lending program? If so, why?

This information can usually be found on the ETP provider’s website or by contacting them directly.