Understanding Exchange Traded Products
Find out more about the exchange traded products and the differences between ETFs, ETNs, and ETCs.
Exchange-traded products are financial instruments that often track indices, stocks, bonds, and commodities. They can be actively managed and may embed derivatives. ETPs are regularly priced while trading on national exchanges throughout the day. The number of issued units changes in tandem with supply and demand so that the ETPs trade near their NAV. This article explains the differences between the most common types of exchange-traded products.
What are Exchange-Traded Funds (ETFs)?
Exchange-Traded Funds (ETFs) are often framed as being the offspring of a marriage between stocks and index funds. ETFs inherited traits from each parent. Like index funds, most ETFs are passively managed, diversified, and low cost. Similar to stocks, they trade through a brokerage account on exchanges at any time during the day. This mash-up of desirable traits made ETFs increasingly popular investment vehicles.
ETFs hold many types of underlying assets such as stocks, commodities, bonds, and others. The funds can invest in thousands of stocks across industries or focus on a particular sector. Such features amplify the diversification benefits of adding ETFs to any given portfolio. By investing in ETFs, investors can generate income, speculate, and/or hedge risks.
Benefits and Limitations of ETFs
ETFs are a simple and easy way to invest. They benefit investors with tax efficiency and diversification potential. However, they are subject to tracking errors when tracking an index. Moreover, ETFs may not own exactly the same number of shares in the same proportion of the index. Another drawback of ETFs is that when compared to trading stocks, costs can be higher.
What are Exchange Traded Notes (ETNs)?
Exchange-Traded Notes (ETNs) are senior unsecured debt notes underwritten by a bank or a financial institution. They are close relatives of ETFs in that they track an index of underlying securities such as stocks, commodities, or currencies. ETNs resemble bonds as they are issued with 10 to 30-year maturities and do not represent any ownership of shares. However, the notes don’t pay any coupons over their life. Instead, they return the performance of the index they are tracking minus expenses.
Benefits and Limitations of ETNs
One of the major benefits of ETNs is that there is no tracking error because they are not physically buying any underlying securities. Moreover, ETNs can be structured to track anything that generates a return providing investors access to niche products and strategies. Another benefit is their tax efficiency since ETNs are considered prepaid contracts. In this context, capital gains are realized when the investors choose to sell their notes, or when the notes mature. ETNs tax treatment is considered more favorable since long-term capital gains are treated more favorably than short-term capital gains and interest.
On the flip side, ETNs are subject risk of default of the issuer. Even though the possibility of such an event is relatively low, it ought to be measured and accounted for. Illiquidity is another drawback of ETNs given their relative newness.
What are Exchange Traded Commodities (ETCs)?
Exchange-Traded Commodities (ETCs) are asset-backed securities trading on stock exchanges. They track the price of a commodity or a commodity index. Their share price moves in tandem with the price movement of the underlying commodity while providing exposure to spot and futures prices. ETCs are open-ended securities, created and redeemed on demand by the issuer, like ETFs. On the other hand, ETCs are structured as debt instruments underwritten by a bank for the issuer of the ETC. The difference is that they are backed by the commodities they track as collateral.
The two forms of ETCs
They come in two broad forms: physically-backed ETCs and collateralized ETCs. Most of the precious metal ETCs generally track the spot price and are physically secured. The former is when the physical commodity is stored in the treasury of a trustee as security. While for the latter, the collateral is not the physical commodity, rather cash investments and securities with high credit ratings.
Benefits and Limitations of ETCs
ETCs provide several advantages such as exhibiting low tracking error and high tradability since market makers are committed to providing two-way prices throughout the trading day. Additionally, ETCs allow investors to concentrate on a single commodity compared to ETFs that tend to invest in a more diversified basket of underlying securities.
