Exchange-traded products (ETPs) are a broad category of investments that are listed on stock exchanges and trade like stocks. ETPs comprise various products, including exchange-traded funds (ETFs), exchange-traded notes (ETNs) and exchange-traded commodities (ETCs). In other words, ETFs are a type of ETP – not an alternative to them. A financial advisor can help you better understand the vast array of investments that are available and build a portfolio aligned with your goals.
What Is an Exchange-Traded Product (ETP)?
An exchange-traded product (ETP) is a type of security that tracks an array of underlying securities, indices or financial instruments and trades on stock exchanges like individual stocks. This design allows investors to buy and sell shares throughout the trading day, as opposed to traditional mutual funds that are only priced and traded at the market’s close. The capability to trade ETPs in real-time gives investors a measure of agility and control over their investment strategies, enabling them to swiftly adjust to market fluctuations or changes in their personal financial circumstances.
The spectrum of ETPs encompasses a variety of financial instruments. The most well-known among them are ETFs, although ETNs and ETCs also qualify as exchange-traded products.
The development of ETPs has a unique place in financial history. The first ETF was introduced in the early 1990s, and since then, the variety and complexity of ETPs have expanded significantly. This evolution reflects the growing demand for flexible and accessible investment options in the global financial markets.
ETPs provide access to a broad spectrum of assets, which is pivotal for diversifying one’s portfolio. For example, an investor keen on the technology sector could invest in an ETP – in this case, an ETF – that follows a technology index, thereby securing a varied stake in several tech firms. ETPs are also known for their high liquidity since they are readily traded on the market, as well as their potential tax advantages, which may be more attractive when compared with traditional investment options.
These factors contribute to making ETPs a valuable tool for both beginner and seasoned investors, highlighting their importance in contemporary investment portfolios.
What Is an Exchange-Traded Fund (ETF)?
Imagine a basket that contains the stocks of dozens of different companies. This is essentially how an ETF works, allowing investors to conveniently own a collective basket or portfolio of assets. And like a stock, ETFs can be bought and sold on the stock exchange throughout the trading day.
ETFs offer investors diversified exposure to a portfolio of assets, such as equities, commodities or bonds. One key feature of ETFs is the arbitrage mechanism – a system designed to help the ETF’s trading price stay close to its net asset value (NAV). However, there might be times when the prices don’t match up perfectly.
Characteristics of ETFs
ETFs are often described as being passively managed, which means they are designed to follow the performance of a market index. For example, an S&P 500 ETF aims to mirror the index by holding the same stocks in the same proportions.
This passive management leads to lower fees when compared with actively managed funds, where fund managers are constantly making decisions in the hopes of beating the market. These lower fees can make a significant difference in your investment returns over time.
When it comes to trading, ETFs share many characteristics with stocks. They can be traded throughout the day, and investors can use a variety of order types. For those new to investing, “limit orders” allow you to set a specific price at which you want to buy or sell an ETF, while “stop orders” help you sell the ETF when it reaches a certain price to limit losses. Additionally, investors have the option to short sell, betting that the ETF’s price will decline.
ETFs vs. Mutual Funds
Mutual funds and ETFs are both types of investment funds that pool investors’ money to purchase a diversified portfolio of assets. However, the two investment products have distinct differences.
While ETFs are purchased and sold on stock exchanges throughout the trading day, mutual funds priced at the end of each trading day and can only be bought or sold at that day’s closing price. They also often have higher expense ratios due to management fees and operational costs. However, mutual funds may offer more hands-on management, potentially providing active strategies and personalized investment approaches that better align with an investor’s goals.
In terms of taxation, ETFs are generally more tax-efficient than mutual funds. ETFs’ unique structure allows for tax minimization strategies, such as in-kind redemptions, which can help reduce capital gains distributions. Mutual Funds, especially actively managed ones, may generate more taxable events due to frequent buying and selling of securities within the fund.
Other Types of ETPs
As mentioned earlier, ETFs aren’t the only variety of exchange-traded product that’s available. Exchange-traded notes (ETNs) and exchange-traded commodities (ETCs) offer unique structures and cater to diverse investment strategies. Understanding their distinct attributes could help you make informed investment decisions:
Exchange-Traded Notes (ETNs)
ETNs are unsecured debt securities issued by financial institutions. They are engineered to mimic the performance of a specific index, commodity or currency. Unlike conventional bonds, which offer periodic interest payments and have a predetermined redemption value at maturity, the payout of an ETN at its maturity is linked to the performance of its associated index. And unlike some ETFs, ETNs do not pay dividends.
The contrast between ETNs and traditional bonds is stark, with the former providing an investment experience more akin to that of the underlying index, rather than a fixed-income stream.
Imagine an ETN designed to track the S&P 500 Index. An investor purchasing this ETN would expect, at maturity, to receive a return equivalent to the performance of the S&P 500 during the holding period. If the index performs well, the investor stands to gain accordingly. However, if the issuer of the ETN encounters financial difficulties and defaults, the investor may face the loss of their principal investment, highlighting the importance of credit risk – the possibility that the issuer of the ETN may not be able to fulfill its financial obligations.
Exchange-Traded Commodities (ETCs)
ETCs offer investors a way to gain exposure to the prices of commodities such as gold, oil or wheat without the need for physical ownership. ETCs can reflect the price movements of a single commodity or a basket of commodities by using futures contracts or sometimes by holding the actual physical commodity, such as gold bars stored in a secure vault.
The allure of ETCs lies in their ability to diversify an investment portfolio. Commodities typically have a low correlation with more traditional asset classes like stocks and bonds. This means that when equities are down, commodity prices might not be affected in the same manner, thereby providing a diversification benefit.
Moreover, some investors turn to commodities, particularly gold ETCs, as a potential hedge against inflation and its erosive effects on currency value.
Bottom Line
Exchange-traded products (ETPs) such as ETFs, ETNs and ETCs offer investors a buffet of options for portfolio diversification, real-time trading and potential tax efficiency. They cater to a variety of investment strategies, from gaining broad market exposure with ETFs to specific sector plays or hedging against inflation with ETCs. ETFs are the most common and accessible type of ETP, having grown in popularity since their inception in the early 1990s.
Investing Tips
- Rebalancing stocks, bonds and cash can help you diversify your portfolio and minimize risk. SmartAsset’s asset allocation calculator can help you identify what your strategic mix may be based on your risk tolerance.
- A financial advisor can guide you in selecting and managing your investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Article by Smart Asset
