What Are Exchange Traded Products?

Exchange-traded products (ETP) are types of securities that track an underlying security, index, or financial instrument. ETPs trade on exchanges similar to stocks meaning their prices can fluctuate from day-to-day and intra-day. However, the prices of ETPs are derived from the underlying investments that they track.

Exchange Traded Products Explained

Exchange-traded products can be benchmarked to a myriad of investments including commodities, currencies, stocks, and bonds. Since prices of ETPs can fluctuate, investors have the potential to earn gains but also have risks of market losses. ETPs can contain a few or hundreds of investments. Below are two types of ETPs.

Exchange-Traded Funds or ETFs

An exchange-traded fund contains a basket of investments that can include stocks and bonds. An ETF usually tracks an underlying index such as the S&P 500. An exchange-traded fund's price can rise and fall just like other investments. The popularity surrounding ETFs stems from their low fees since they're passively managed. For example, a passively-managed ETF might track the S&P 500 whereby the ETF owns all 500 stocks in the index. Conversely, an actively-managed fund involves an investment manager buying and selling securities, which can lead to higher fees. Some ETFs share a combination of both passive and active attributes.

Exchange-Traded Notes or ETNs

Exchange-traded notes (ETNs), like ETFs, also track an underlying index of securities and trade on major exchanges. However, ETNs are debt securities that pay investors the return from the index they track at the maturity date of the ETN. ETNs are similar to bonds in that investors are paid their original amount invested, called the principal, at maturity. However, the ETN doesn't pay any interest payments. Also, investors who buy ETNs don't own any of the securities in the index they track. As a result, the likelihood that investors will be paid back the principal and the returns from the underlying index is dependent on the creditworthiness of the issuer.

Different tax treatments apply to the various types of ETPs. Investors should speak with a tax professional for any potential tax ramifications from investing in ETPs.

Key Takeaways

  • Exchange-traded products (ETP) are types of securities that track an underlying security, index, or financial instrument.
  • ETPs trade on exchanges similar to stocks meaning their prices can fluctuate from day-to-day and intra-day. However, the prices of ETPs are derived from the underlying investments that they track.
  • ETPs are usually a low-cost alternative to mutual funds and actively-managed funds.

Exchange-Traded Products vs. Mutual Funds

Exchange-traded products were developed with the goal of creating investments that had more flexibility than mutual funds. Mutual funds are funds that are comprised of a basket of securities that are funded by a collection of investors and managed by professional money managers.

Mutual funds are typically priced just once at the end of the trading day whereas ETPs trade like stocks and can be bought and sold throughout the day. For example, an investor can place an order with ETFs to buy or sell at a specific price throughout the day with a broker. Investors can buy the ETF in the morning and sell it by the end of the day whereas mutual funds don't have that flexibility. ETPs often carry lower expense ratios than their mutual fund counterparts.

ETPs also require a brokerage account to trade, so buying and selling ETP shares is likely to result in brokerage commission costs. Additionally, differences in the bid price and ask price of a security, (or buy and sell prices), could add to the cost of trading ETPs. Some no-load or no-fee mutual funds, on the other hand, can be bought and sold without any trading commission, and they do not require a brokerage account.

Growth of Exchange-Traded Products

Since the debut of the first ETF in 1993, these funds and other ETPs have grown significantly in size and popularity. In 2018, ETFs throughout the globe had over $5 trillion in total assets under management (AUM), according to Yahoo Finance. The low-cost structure of ETPs has contributed to their popularity, which has attracted assets away from higher-cost actively managed funds.

Pros

  • ETPs offer investors access to many securities and indices that they track

  • ETPs are usually a low-cost alternative to mutual funds and actively-managed funds

  • Many ETPs, particularly ETFs are gaining in popularity allowing investors to easily trade them

Cons

  • ETPs like any security have the risk of market losses since their prices fluctuate

  • Not all ETPs are the same since some behave like debt instruments such as ETNs

  • ETPs have become popular, but investors should monitor trading volumes to be sure they can trade in and out easily

Real World Example of an Exchange-Traded Product

The largest ETF in the marketplace is the SPDR S&P 500 ETF, with assets of more than $250 billion as of April 2019. The ETF owns shares of all 500 stocks in the S&P including some of the most well-established companies in the world such as:

  • Mastercard Inc.
  • Home Depot Inc.
  • McDonald's Corporation
  • Facebook Inc.
  • JPMorgan Chase & Co.
  • Amazon.com Inc.

Let's say an investor invested $10,000 in the SPY on January 1, 2017, at a price of $227.21 and sold the ETF on March 31, 2019, at a price of $288.57; the investor would have a gain of 27% minus any broker fees.