Find out more about exchange-traded products (ETPs), their benefits and risks.
Exchange traded products (ETPs) are investments that are traded on a stock exchange and which invest in underlying securities or assets. They often passively follow an index or other benchmark, but they may be actively managed.
- There are several types of ETP, these include: exchange traded funds, exchange traded notes and exchange traded commodities.
- ETPs help you gain investment exposure to a wide range of markets or securities, but they are not suitable for all investors.
- You can buy or sell shares in an ETP whenever the relevant exchange on which the securities are traded is open, and they are not suspended or de-listed by the issuer.
- The price of an ETP will fluctuate depending on the value of its underlying investments, which may be illiquid (hard to sell), and on other factors including the creditworthiness of the issuer.
Remember, while there is potential to make money investing in ETPs, you may end up losing money as well.
If you are having difficulty understanding ETPs, you should think about whether other investment opportunities might be a better fit for you. If you would still like to invest in ETPs, you should seek professional advice.
There are several types of ETP. Some provide exposure to shares or bonds of (or derivatives relating to) companies in an index (like the FTSE 100), others invest in securities linked to the price movements of commodities such as oil, gold or currencies.
Exchange traded funds
Exchange traded funds (ETFs) are the most popular type of ETP in the UK. ETFs provide a certain level of protection to investors as they must be either FCA authorised funds, or recognised schemes that are subject to regulatory requirements.
Funds that follow the performance of an index or market are commonly known as passive, or tracker funds.
Exchange traded notes and exchange traded commodities
Other types of ETPs include: exchange traded notes (ETNs) – these are debt securities issued by an institution - and exchange traded commodities (ETCs) – these invest in commodities or follow commodity indices.
Unlike ETFs, these ETPs do not need to comply with rules for FCA authorised funds, and have not otherwise been subject to scrutiny by a regulator as meeting certain minimum standards. So they can offer less investor protection. They may also use certain financial techniques that can increase risks for investors.
Consider the risks of all exchange traded products
As different ETPs follow different strategies and have different characteristics, you need to consider the related risks carefully.
- Index tracking: ETPs often track indices, and each index has different risks. An ETP tracking an established index like the FTSE 100 will have different risks and potential returns to an ETP tracking more volatile, riskier markets such as oil or gas, or emerging markets, like India or Brazil.
- Investment strategies: Some issuers may engage in investment strategies that are designed to increase the potential returns for investors but which may also increase the level of risk. These strategies may include holding derivatives as underlying assets, borrowing to invest, or engaging in stock lending activities.
- Creditworthiness of the issuer: The value of an ETP could decline if there is a downgrade in the issuer's credit rating, even if the underlying assets perform well. In the case of an ETN, the potential risk of the issuer being unable to redeem the notes at maturity, is directly dependant on the creditworthiness of the issuer.
Different types of ETP investment strategy
Some ETPs buy and hold securities that are included in the index they are tracking. This approach is known as a physical investment strategy, because the ETP buys the actual securities that make up the index it wants to track.
Other ETPs use special transactions, known as swaps, to track the price of the index.
The ETP reaches an agreement with a counterparty (such as a bank) that it will pay the ETP the same amount that the index returns. This is known as a synthetic investment strategy. It is usually cheaper than buying all the securities in an index and is useful, for example, in less developed markets where shares are not always readily available to buy and sell.
Some types of ETP may incorporate security arrangements, which may be available if a relevant counterparty in the product structure is unable to meet its payment obligations. Such security ordinarily constitutes a pool of assets (collateral) which may be sold if the relevant counterparty is unable to pay.
Benefits of ETPs
While they are not suitable for all investors, there are benefits to ETPs. These include:
- Diversification: By buying ETPs you can gain exposure to a range of markets or securities, which may be difficult to access directly.
- Cost: A passively-managed ETP that tracks an index will usually have lower fees than an actively managed fund. However, some other investment products, such as mutual funds, may provide similar benefits in terms of variety of investment choice and cost.
- Liquidity: A key difference between mutual funds and ETPs is that you can deal in ETPs on a stock exchange at any time when the market is open.
Before you invest in ETPs
If you are considering investing in ETPs, make sure you ask yourself:
- Is the market I want to invest in suitable for my investment goals?
- Is passively tracking an index the best way for me to invest in this market?
- Do I understand the strategy used and the risks associated with this ETP, compared to the other investment options I have?
- Do I need to be able to trade during the day?
- Do I understand the nature and extent of any protections for retail investors which apply to the product or an investment in it?
ETPs may help diversify an investment portfolio, but will not be suitable for all investors.
You should ask about the risks your ETP is exposed to and if you are not sure, or if you are having difficulty understanding ETPs, you should seek professional advice.