What it means
Before ETPs existed, an investor wanting exposure to a broad market, such as a share index or gold, usually had to buy a mutual fund or many individual holdings. An ETP packages that exposure into a single line that can be bought and sold like a share.
The investor sees a ticker, a live price and a brokerage statement, rather than a forms-based fund purchase. The term covers several different structures.
An exchange-traded fund (ETF) is a fund that holds assets and issues shares. An exchange-traded note (ETN) is an unsecured debt obligation of a bank that promises to pay a return linked to an index, and an exchange-traded commodity (ETC) is a security linked to a raw material.
The differences matter because the legal structure determines the risks. An ETF holds assets on behalf of investors, which are normally separate from the manager's own money.
An ETN depends on the issuer's creditworthiness, so if the issuing bank fails, investors may lose money even if the index has performed well. Costs are usually modest.
Investors pay an annual fee, normally shown as a percentage, and a bid-ask spread (the small difference between the buying and selling price) each time they trade. Some products, especially those using leverage or futures contracts, can behave very differently from the underlying asset over long periods.
Businesses and professional investors use ETPs for treasury management, pension fund allocation and quick adjustments to market exposure. Their liquidity and low cost have made them popular, but the variety of products means that each needs to be checked before buying.
A finance team should read the fact sheet, understand what the product holds and know who is responsible if something goes wrong. Tax treatment can also differ between structures.
Some products distribute income, others reinvest it, and the rules on gains vary by country and by product type. A company or individual should check how the product is taxed before investing, particularly when holding it across borders.
In practice
Real-world examples.
Example
A retail investor wants broad exposure to large US companies without choosing individual shares. She buys an index-tracking exchange-traded fund through her brokerage account in a few clicks. The annual fee is a fraction of what she paid for her old actively managed fund.
Example
A treasurer at a mid-sized manufacturer wants to hold gold for diversification. He buys an exchange-traded commodity backed by physical bullion, which avoids storage and insurance costs. He notes the fee and the issuer in his investment policy file.
Example
A hedge fund buys an exchange-traded note that tracks volatility for a short period. The note performs as expected for a few days, but over several weeks it falls behind the underlying index because of the way it is constructed. The fund manager reduces the position and records a lesson about holding such products for too long, because the note was designed for short-term trading rather than as a long-term investment.
Formula
Calculation
Annual cost = Amount invested x Annual fee percentage + Amount invested x Round-trip spread percentage
Suppose a company invests $20,000 in an ETP with an annual fee of 0.20%. The bid-ask spread costs 0.10% of the amount for buying and selling together.
Fee = $20,000 x 0.20% = $40.
Spread cost = $20,000 x 0.10% = $20. Total cost in the first year = $40 + $20 = $60, which is 0.30% of the amount invested.Case study
Seen in the real world.
Greenfield Pension Trust is a fictional scheme with $300 million in assets. The trustees wanted a low-cost way to add emerging market exposure without hiring a new specialist manager.
The investment consultant compared several products and explained the differences between ETFs, ETNs and ETCs. The trustees chose a broadly diversified ETF, rejecting an ETN because of its reliance on the creditworthiness of a single bank. They also asked the consultant to check how easily the fund could be sold in a stressed market.
In this illustrative case, the trust invested $15 million, or 5% of assets. The product tracked its index closely, and the trustees reviewed fees, size and trading volume every year to make sure it still met their needs.
Watch out
Common mistakes.
- Assuming all ETPs are the same, when ETFs, ETNs and ETCs have different legal structures and risks.
- Ignoring the issuer's credit risk on notes, which can cause losses even when the index performs well.
- Holding leveraged or inverse products for long periods, when they are designed mainly for short holding periods.
Questions
People also ask.
What is the difference between an ETP and an ETF?
ETP is the broad category, while an ETF is one type of ETP that is structured as a fund.
Are ETPs safe?
They are as safe or as risky as the assets and structure behind them, so a broad share index product behaves very differently from a leveraged oil note.
How do I find out what an ETP holds?
The issuer publishes a fact sheet and a prospectus, which describe the index, the structure, the fees and the main risks.
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