An exchange-traded fund (ETF) is an index-tracking fund that trades on a stock exchange and are generally used to track the performance of a specific market index. They change in value throughout the trading day as they mimic the performance of their designated index.
According to Morningstar’s European passive fund analyst team, it is important to know that ETFs are only a part - albeit the biggest part - of a broader family now commonly referred to as exchanged-traded products (ETPs).
Also falling under the broad ETP umbrella are exchange-traded commodities or currencies (ETCs) and exchange-traded notes (ETNs). While the large majority of European-domiciled ETFs are Ucits-compliant instruments, Morningstar warns ETCs and ETNs are not.
Like traditional mutual funds, Ben Thompson, director of business development, listed products and ETF UK for Lyxor, says exchange-traded funds are highly regulated according to the European Ucits IV directive, which applies to all investment funds.
Frank Spiteri, executive director and head of retail distribution strategy for ETF Securities, says advisers Ucits requirements provide a number of important safeguards for investors, including:
1) segregated assets to minimise risk in the event of bankruptcy of the provider;
2) increased transparency; and
3) diversification limits to protect investments becoming concentrated in a single asset.
The big difference from traditional mutual funds is that ETFs are listed on an exchange such as the London Stock Exchange. As such, Mr Thompson states they provide advisers with intraday price transparency and the ability to buy or sell holdings as easily as trading a share.
Exchange traded commodities, which are structured as debt securities that pay no interest, have emerged because the Ucits regulations mandate a minimum level of investment diversification and restrict the asset types that can be held by ETFs.
In Europe, Mr Spiteri says the solution was to use a debt security issued by a special purpose vehicle (SPV) with segregated assets. These vehicles are not restricted by the Ucits diversification requirements and can offer exposure to a single or small number of commodities.
Mr Spiteri said the ETC legal structure has also been used to offer investors access to currencies, whether as individual currency pairs or a ‘currency basket’.
Like ETCs, Mr Spiteri explains ETNs are non-interest bearing debt securities that are designed to track the return of an underlying benchmark or asset. They are generally issued by banks, hold no assets and, unlike the two exchange-traded alternatives, are not collateralised.
Mr Spiteri states ETNs are similar to unsecured, listed bonds and as such are entirely reliant on the creditworthiness of the issuing entity. A change in that creditworthiness might negatively impact the value of the ETN, irrespective of the performance of the underlying benchmark or asset.
In extreme circumstances, he said default by the issuer would leave the investor to claim as an unsecured creditor against the issuing entity.
Mr Spiteri said: “The primary appeal of ETNs is that they guarantee exposure to a benchmark or an asset’s return (minus fees) even when the underlying markets or sectors suffer from liquidity shortages, since the return is guaranteed by the issuing entity and not reliant on the liquidity of and access to the underlying assets.