ETFs, popular with retail investors, belong to a much broader category of financial products: What are ETPs, ETFs, ETNs, ETCs? What are the advantages and limitations of these investment products? All our explanations.
What are ETPs?
Among the various types of investment products listed on the stock market, ETFs (or ” Trackers ” as the French like to call them) have become very popular. ETFs are widely used by both retail and institutional investors. Yet, ETFs (Exchange Traded Funds) are only a sub-category of product in a much larger universe, that of ETPs (Exchange Traded Products).
In short, ETPs are investment products that offer exposure to different asset classes such as equities, fixed income, commodities, currencies and cryptocurrencies. They are mostly managed passively, following a benchmark.
All ETPs are open-ended and open-ended products, meaning that securities will be created and redeemed based on investor demand and with the only restriction being the liquidity of the underlying asset.
Why invest with ETPs
So ETPs offer access to a variety of global markets through an instrument that trades on the stock market from any securities account as easily as a stock. As with any regulated investment product, ETP issuers make available to investors fact sheets (KIDs/DICIs) about their products, which can usually be found on the issuer’s website or sometimes directly from your stockbroker’s platform. These fact sheets contain important data such as: the type of ETP, investment objectives and risk, key product features and details of the underlying indices or reference assets.
The benefits of ETPs
The main benefits of ETPs are :
- facilitated access to financial markets ;
- instant diversification with a single product;
- competitive prices/costs for publicly traded products ;
- the ability to buy and sell during exchange hours ;
- physically backed products, or backed by collateral held with a third-party custodian (for collateralized synthetic ETPs) ;
- transparent products, tracking indices calculated by independent providers (such as MSCI, S&P, FTSE Russell, Solactive, etc…).
The disadvantages of ETPs
The main disadvantages of ETPs are :
- a possible credit risk ;
- the time difference (e.g. for ETPs listed in Europe that track US Equities) ;
- the fact that they are not all eligible for PEA.
ETFs, ETNs, ETCs: What are the different ETPs?
Now let’s find out together what the different types of ETFs are as well as their characteristics.
ETFs
As I said in the introduction, ETFs are without a doubt the most popular ETPs. ETFs offer diversified exposure with the requirement of tracking a minimum of sixteen underlying securities. In order to be classified as a UCITS ETF, ETFs must meet several criteria, for example one asset cannot represent more than 10% of the ETF’s weighting.
ETFs can track various traditional asset classes such as stocks, bonds and commodities. Indices will generally be weighted by market capitalization, but indices that give equal weighting to each constituent are also available.
For equities, many sector and theme indices are available, the latter allowing investors to access areas such as robotics, cybersecurity, etc. Smart Beta type indices (such as the XOUT US38747R6036 ETF) are also popular with some investors looking to optimize the performance of a benchmark – the indices are constructed based on factors such as momentum, quality, value and volatility.
ETFs will either physically or synthetically replicate the performance of the index. And for the synthetic ETF, they will quite often be backed by a guarantee/collateral.
Leverage and Short ETPs
These ETPs have the particularity of offering an exposure ” down ” or ” up ” with leverage on a variety of asset classes, including equities, fixed income, commodities and currencies. Short ETPs offer inverse exposure based on the daily performance of an index or stock; this provides the opportunity to make a profit even if the value of an index or stock is falling. Leveraged “Long” ETPs offer exposure with a multiple of the daily performance of an index or stock.
For example : GraniteShares’ 3x or -3x leveraged ETPs are designed to reflect three times the daily change in U.S. stocks and the FAANG and GAFAM indices.
Capitalization or accumulation effects should be kept in mind when investing in this type of leveraged ETP. The performance of these ETPs is reset daily, so the leverage factor shown is constant over time. The daily reset results in compounded returns for holding periods longer than one day, which means that depending on the nature of the daily price movements, there will be a positive or negative deviation from the leverage factor. Compounding effects are likely to be more pronounced if a leveraged ETP is held for a long time. This highlights a key point: these ETPs are designed as short-term investments for sophisticated investors.
The benefits of Leverage and Short ETPs
The main advantages of ETP ” Leveraged and Short ” are :
- the ability to commit less capital to achieve a given level of exposure ;
- losses cannot exceed the amount invested and there is no margin call ;
- an intraday circuit breaker mechanism in case of high volatility ;
- dividends are factored into the overall return;
The drawbacks of Leverage and Short ETPs
The main disadvantages of ” Leveraged and Short ” ETPs are :
- a reduced leverage compared to other option-type derivatives ;
- a Beta Slippage that can work against you for long term positions ;
- a limited choice of underlying assets.
ETNs
ETNs (Exchange Traded Notes) are debt products usually issued by a bank and they do not hold any assets. They depend entirely on the creditworthiness of the entity issuing the ETNs. The exposure, which can be to a very wide range of assets, is held as a debt to the issuing bank. They are not limited by the diversification requirements found in other types of products, allowing them to provide more concentrated exposures that are not otherwise permitted under UCITS rules. ETNs may carry additional risk because they are not rated by any nationally recognized securities rating agency. The holder of the ETN is exposed to the creditworthiness of the bank issuing the security. The credit risk can be reduced on the ETN if it is collateralized with assets deposited with a third party bank.
The ETCs (Commodities / Currencies / Cryptocurrencies)
When we talk about ETCs, we can mean :
- Exchange Traded Commodities (on commodities) ;
- Exchange Traded Currencies (on currencies);
- Exchange Traded Cryptocurrencies (on cryptocurrencies).
ETCs give exposure to a basket of assets or a single asset, and like ETNs, they do not fall under UCITS rules. They can be structured in two different ways: physically or synthetically. Physical ETCs are backed by specific quantities of a commodity (or currency, or cryptocurrency), usually precious metals, and offer exposure to its spot prices. Synthetic ETCs have no tangible assets to back them, although a commonly accepted structure in Europe is to back them with collateral so that credit risk remains limited. ETCs track futures contracts and are constructed to have continuous exposure to futures returns. Futures contracts are an agreement to buy a commodity at a specific price, with payment and delivery occurring at a specific time in the future. In the case of ETCs that track futures contracts, the exposure is rolled over between contracts on specific dates so that there will never be delivery of the commodity.
Currency ETCs are structured to offer investors access to currencies in a basket of currencies or with a single currency pair. More recently have appeared ETCs on cryptocurrencies, the principle is the same and it is possible to make an ETC only on cryptocurrencies.
Bitcoin ETPs and ETFs
While the news of a first SEC (Securities and Exchange Commission)-licensed Bitcoin ETF on the New-York Stock Exchange has made headlines in financial news around the world, there have long been ETCs and ETPs tracking Bitcoin in Europe. Like the American BITO ETF which is based on futures contracts, European ETCs like BTCE offer physical replication with Bitcoins held by BitGo or ABTC whose Bitcoins are held by Coinbase. In Europe, regarding futures, we have futures contracts on Eurex that track the BTCE ETC. So it’s funny to see that in the US things are organized in the opposite way to what is happening in Europe. On the US side, there is an ETF that tracks futures contracts and in Europe a futures contract that tracks an ETP.
Note that we certainly won’t see a Bitcoin ETF coming to Europe because UCITS regulations prohibit an ETF from being composed of only one asset. So ETPs will certainly be the European solution for investors who want to integrate cryptocurrencies into their securities account.
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