What Is an Exchange Traded Product (ETP)?

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

Key Takeaways

  • Exchange-traded products (ETP) are types of securities that track underlying security, index, or financial instrument.
  • ETPs trade on exchanges similar to stocks.
  • The price of ETPs fluctuates from day-to-day and intraday.
  • The share price of ETPs come from the underlying investments that they track.
  • ETPs are usually a low-cost alternative to mutual funds and actively-managed funds.

Types of Exchange Traded Products

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

Exchange-Traded Funds (ETFs)

Similar to a mutual fund, 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 but can follow an industry, sector, commodities, or even currency. An exchange-traded fund's price can rise and fall just like other investments. These products trade throughout the day just as a stock would trade.

The popularity surrounding ETFs stems from their low fees since they are passively managed. For example, a passively-managed ETF might track the S&P 500. Here, the ETF owns all 500 stocks contained 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 (ETNs)

Exchange-traded notes (ETNs), like ETFs, also track an underlying index of securities and trade on major exchanges. However, ETNs are baskets of unsecured debt securities. The ETN pays investors the return received from the index they track at the maturity date, less any fees or commissions.

ETNs are similar to bonds in that investors receive the return of their original invested amount—the principal—at maturity. However, the ETN does not pay periodic interest payments. Also, investors who buy ETNs do not 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.

Exchange-Traded Products vs. Mutual Funds

Exchange-traded products were developed to create 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. ETPs trade like stocks and can be bought and sold throughout the day and have prices that move throughout the day. For example, an investor can place an order with ETFs to buy or sell at a specific price with a broker. Investors can buy the ETF in the morning and sell it by the end of the day whereas mutual funds do not 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 and ask—buy and sell—price 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.

Pros

  • ETPs offer investors access to many securities and indices.

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

  • Many ETPs, particularly ETFs are gaining in popularity providing additional liquidity.

Cons

  • ETPs have the risk of market losses since their prices fluctuate.

  • Some ETPs behave like debt instruments such as ETNs.

  • ETPs are popular products but have varying trading volumes which can affect liquidity.

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. According to Yahoo Finance, in 2018, worldwide, ETFs had over US$5 trillion in total assets under management (AUM). The low-cost structure of ETPs has contributed to their popularity, which has attracted assets away from higher-cost actively managed funds.

Real World Example of an Exchange-Traded Product

The largest ETF in the marketplace is the SPDR S&P 500 ETF (SPY), with assets of more than US$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 Corp.
  • Facebook Inc.
  • JPMorgan Chase & Co.
  • Amazon.com Inc.

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