The ETF market has become more sophisticated

This article is part of
Passive Investing - June 2014

The first ETF is widely believed to have been launched in 1993 in the US in the form of the SPDR S&P 500 ETF from State Street. Since then the US market has expanded rapidly to more than 1,500 products and $1.8trn (£1.1trn)assets under management as of May 2014.

But part of this development and the evolution of the industry in the UK, Europe and Asia, is the introduction of the ETCs and ETNs as well as the generic ETF.

Tim Huver, ETF manager at Vanguard, says: “I think traditionally when we’ve talked about ETFs we have been talking about funds that provide exposure to indices in a fund structure, typically Ucits compliant that have rules around segregation of assets and diversification limits.

“Now when we talk about ETPs this classification tends to include commodities and exchange traded notes (ETNs), and they are structured a little bit differently.”

An ETC tends to generate return through a collaterialised debt instrument that will provide exposure to commodities, either a single one or a wider basket, meanwhile ETNs provide exposure to an index, many of which are strategy indexes, and therefore as well as taking market risk investors also have to be aware that they have counterparty risk to the issuing bank.

“It is important for investors to understand how the product is structured and how the return of the index will be achieved,” adds Mr Huver.

“It is things like understanding how the returns are generated, is it generated through holding the physical assets, such as gold, or if it is through a derivative contract and if so who the counterparties are for that contract and how the collateral is managed.”

Neil Jameson, head of UK & Ireland at ETF Securities, agrees that four years ago the generic term for all these products would have been ETFs, but that as the market has become more sophisticated, so the terminology has changed.

“The reason is that effectively ETFs are just one portion of the market, albeit the most important portion in terms of listed products.

“But they are very different from the vehicles used to track commodities and currencies.”

Arne Noack, head of ETP product development, EMEA at Deutsche Asset & Wealth Management, notes that when it comes to different ETPs, although it’s important to understand the basic differences in structure, the first thing to focus on is understanding the market risk they are looking to take.

He explains: “That means getting a good sense of the underlying index or commodity. As well as the basics, such as recognising single emerging market country exposure is likely to be more volatile than a broad developed market equity exposure, it is also worth examining the index for things like sector concentration.”

Once the investor is comfortable with the market risk, then they might want to look at the different structures.

“In Europe, ETFs listed outside of Switzerland comply with the Ucits regulations, which sets high standards for investor protection,” he says.

“Some people make a distinction between physical replication and synthetic replication ETFs, but as long as the ETF is a Ucits fund then investors know that they’re investing in a product that meets high standards in terms of regulation.”