Different types of exchange-traded products

Exchange-traded funds

An exchange-traded fund 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.

ETFs are structured as shares in a fund, and pretty much all ETFs are Ucits compliant meaning they must conform to diversification rules on maximum weights within the fund and exposure to counter-parties.

Ben Seager-Scott, senior research analyst at Bestinvest, says: “Essentially anything that can be put in a Ucits structure can made as an ETF, though at the moment the overwhelming majority are in passive trackers.

“These cover both mainstream equity and bond indices, as well as more niche sub-indices (such as country or sector specific equity indices and specific bond maturity ranges) to more sophisticated structures such as alternative beta strategies and leveraged or inverse index trackers.”

Exchange-traded commodities

ETCs issue debt securities that trade on exchange offering investors direct exposure to commodities.

By investing in ETCs, a spokesman for iShares says investors gain the desired exposure without the need to trade physical commodities or commodity futures contracts.

An ETC can be either physically-backed, or derivative-based.

In the first case, a spokesman for iShares says physical ETCs will seek to track the daily movement of the spot price of the relevant commodity by holding and valuing the physical commodity.

Most physically-backed ETCs are to be found in precious metals: gold, silver, platinum and palladium.

A spokesman for iShares says precious metals lend themselves to a physical holding structure as they are simple to standardise and relatively inexpensive.

In the second case, a spokesman for iShares says a derivative-based ETC typically seeks to track the daily movements of an index based on collateralised commodities futures contracts, for example the S&P Agriculture Total Return Contract.

Derivative-based ETCs can have various degrees of collateralisation: from fully collateralised (limited counterparty risk) to partially or not collateralised (partial or full counterparty risk).

ETCs are neither funds nor exchange-traded funds.

Exchange-traded notes

Similar to ETCs, ETNs are debt instruments that tend to be issued off the balance sheets of the issuing entity rather than an SPV.

ETNs offer exposure to a broad range of asset classes and trading strategies. ETNs are neither funds nor exchange traded funds and the level of counterparty risk can vary depending on the issuer.

Typically a spokesman for iShares says ETNs in Europe are underwritten by the creditworthiness of the issuer or guarantor.

Distinguishing between ETPs

Mr Seager-Scott says the most common types of ETP that a typical retail investors is likely to encounter are exchange-traded funds and exchange-traded commodities.

Other types of ETPs include exchange traded notes, which tend to be similar to structured products, and exchange traded instruments, which Mr Seager-Scott says is effectively a catch-all term anything else.

Mr Seager-Scott says investors should be careful to distinguish between ETFs and ETCs since there are some key structural differences, which could have implications for investors, particularly during times of market stress.

He says ETFs are structured as shares in a fund, and pretty much all ETFs are Ucits compliant meaning they must conform to diversification rules on maximum weights within the fund and exposure to counter-parties.

“ETCs, on the other hand, are structured as debt instruments that sit on the balance sheet of the ETC issuer.

“They tend to be focused onto either a single commodity or a small range of commodities, and since the Ucits rules only allow a maximum of 10 per cent exposure, most are not Ucits eligible, though exceptions do exist such as those tracking broad commodity indices.”

Crucially, Mr Seager-Scott says non-Ucits eligibility means there are no regulatory requirements to mitigate counter-party risk, though most providers of ETCs would institute such a policy to make the instruments more attractive to investors.

He says ETCs can cover broad indices such as the Dow Jones-UBS Commodity index, though most of the range is dominated by small sub-indices such as previous metals, energy or agriculture, as well as individual commodities such as gold, natural gas or wheat.

Currencies also trade as ETCs, and Mr Seager-Scott says these are often leveraged to magnify what are often rather limited changes in cross-currency rates for developed economies.