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Everything You Need to Know About ETPs

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Publication Type: Viewpoints
Everything You Need to Know About ETPs

Exchange traded products (ETPs) are investments that provide exposure to different asset classes such as equities, fixed income, commodities and foreign exchange.  They are mostly passively managed, tracking an index or another underlying benchmark. ETPs are traded on stock exchanges such as London Stock Exchange. They trade and settle like shares in the market and provide continuous liquidity during market hours. Are you thinking about investing in ETPs? GraniteShares offers a wide range of short and leveraged single stock ETPs for sophisticated investors!

ETP is an umbrella term encompassing different investment strategies.

Type of ETPs

There are several different kinds of ETPs, including exchange traded notes (ETNs), exchange traded commodities or currencies (ETCs), and exchange traded funds (ETFs).  The breadth of possible exposure is extensive, ranging from global equity and bond indices down to exposure to individual stocks and commodities, e.g. gold and oil, as well as currency pairs like EURUSD and GBPUSD. 

The ETPs, which are listed on a stock exchange like London Stock Exchange, can be bought and sold through investment platforms, advisory stockbrokers or wealth managers,  In order to be listed on London Stock Exchange, the issuing prospectus behind each ETP has to be approved by the regulator, the Financial Conduct Authority. 

ETPs are all open-ended, meaning that share or securities will be created and redeemed based on underlying investor demand – this makes them similar to funds like unit trusts, however an important difference with funds is that the ETPs can be bought and sold throughout the day when the stock exchange is open.

ETNs

Exchange-traded notes (ETNs) are normally issued by a bank and do not hold assets. They are entirely reliant on the creditworthiness of the entity that issues the ETNs. They can be less restricted by diversification requirements, allowing them the ability to provide exposures that are not permitted otherwise under UCITS rules. ETNs can carry an additional risk since they are not rated by any nationally recognized securities rating agency. The ETN holder is exposed to the credit worthiness of the bank issuing the note.

ETCs

Exchange-traded commodities (ETCs) give exposure to either a basket of products or individual ones, and like ETNs do not fall under UCITS rules. They can be structured in two different ways: physically or synthetically. Physical-backed ETCs are backed by specific quantities of a commodity, typically precious metals, and provide exposure to its spot prices. Synthetic ETCs do not have a tangible asset backing them up although a commonly accepted structure in Europe is to have them backed with collateral so credit risk is limited. They track commodity futures indices constructed to have continuous exposure to futures contract returns. Futures contracts are an agreement to purchase the commodity at a specific price, and the payment and delivery take place at a specified point in the future.  In the case of the indices tracking futures, the exposure is rolled between contracts at specific dates so there will never be a delivery of the commodity.

Currency ETCs are structured to offer investors access to currencies in a basket or a pair. They track forward indices that are constructed to simulate continuous exposure to the currency forward returns that are rolled on a daily basis.

ETFs

Exchange-traded funds (ETFs) are a popular ETP wrapper in the UK. The ETFs, provide exposure to diversified indices with a minimum of sixteen underlying holdings. ETFs are offered different mainstream asset classes:  equities, bonds and commodities.  The indices will typically be market cap weighted but indices that give equal weight to each constituent are also available.  In relation to equities, many sector and thematic indices are available, the latter enabling investors to take access to areas such as robotics, cybersecurity, and gaming.  Smart beta indices are also popular among some investors – this is where indices are constructed based on factors such as momentum, quality, value and volatility.  As with the ETCs, the ETFs will either replicate index performance physically or synthetically, and for the synthetic ETF will be backed with collateral.  

Short and Leveraged ETPs

These ETPs provide short and leveraged exposure to a variety of asset classes including equities, fixed income, commodities, and currencies. Short ETPs give inverse exposure based on a benchmark’s performance; this provides the opportunity to profit if an underlying benchmark’s value goes down. Leveraged ETPs provide exposure to a multiple of a benchmark’s return. A 3x or -3x leveraged ETP is designed to reflect three times the change of a daily percentage in an unleveraged underlying asset or index.

The effects of compounding are something to keep in mind when investing in short and leveraged ETPs. These exchange-traded products reset daily; the stated leverage factor is constant and is applied to the underlying return on each trading day. The daily reset leads to compound returns for holding periods longer than a day, which means that depending on the nature of the daily price moves there will either be positive or negative deviation relative to the leverage factor. The effects of compounding are likely to be more pronounced the longer a short and leveraged ETP is held.  This highlights a key point:  these ETPs are designed as short-term investments for sophisticated investors, they are not designed as buy and hold investments.

Benefits of ETPs

Exchange-traded products offer investors diversification and provide access to various sectors and global markets through a single instrument that is traded like a share. Issuers of ETPs offer factsheets to their products that can usually be found on their websites. These factsheets contain investment objectives, key features and details of the indices or underlying reference asset(s).

General benefits include:

  • Facilitate market access
  • Instant diversification with one trade
  • Listed on exchange with competitive, independent pricing
  • Ability to buy and sell during stockmarket hours
  • Physically-backed or backed with collateral held with a third party custodian, e.g BNY Mellon
  • Transparent, track indices calculated by providers such as MSCI, S&P, FTSE Russell, Solactive
  • Cost-effective
  • Stamp duty exempt on London Stock Exchange
  • Eligible for self-select ISAs and SIPPs in the UK

Benefits of short & leveraged ETPs

  • Opportunity to commit less capital to achieve a given level of exposure
  • No margin calls and losses cannot exceed amount invested
  • Indices potentially incorporate intraday stop loss mechanism
  • Tracked indices, if total return, will factor dividends into the overall return

ETP Investment Strategies

Dollar exchange stock market graph

ETPs can be used in different ways to build a diversified portfolio

Core holdings

The ETPs can be used as the building blocks of a portfolio through exposure to benchmark indices across different asset classes to build a diversified portfolio.  This could be complemented with exposure to thematic indices that capture megatrends.

Some investors like to blend ETPs with actively managed funds and even specific stock positions.

Tactical asset allocation

Investors who like to be more active in portfolio management may also use ETPs tactically. Here, investors look to take positions to take advantage of short-term trends in markets or situations, for example, where prices have fallen very quickly, but where the fundamental conditions have not changed, so there is a perception that they will bounce back.  It could also include the use of smart beta indices when particular factors are seen to be driving overall market returns.

For more sophisticated investors, this is where the use of short and leveraged ETPs, will potentially come into play.  On the one hand, they can commit less capital to obtain exposure to a particular index, potentially keeping cash in reserve, but they can also use short ETPs across different asset classes either to hedge or simply with a view to profiting from falling prices.

Before Investing

If you are considering ETPs as an investment, make sure that you understand your own investment goals and how the investment fits into your overall portfolio. Think about questions like:

  • Will this investment be suitable to meet my investment goals?
  • Is the best way to invest in this market by purchasing an ETP?
  • What assets back the ETP, and if it is synthetically-backed, what is the eligible collateral and where is it held?
  • Do I understand the key features of the ETP such as the investment objective, the management fees or expenses?
  • How well does the ETP track the index or benchmark over time? Is it tracking consistent or quite variable?
  • Do I understand the index methodology? Is it market cap or equal weighted?  How are dividends treated?  For indices tracking commodity futures, what is the roll methodology?
  • Do I understand the different risks both with respect to the investment and the ETP, the latter’s risks will be discussed extensively in the issuing prospectus?
  • Do I understand the extent and nature of any retail investor protections?

Understanding the Risks of ETPs

It is important to understand the risks before investing, the following are some of the factors to consider:

Market Risk

The value of ETPs are driven by the value of the benchmark or index that it tracks.  Understanding the various factors that drive the value of index, which will include factors ranging from broad macroeconomic and geopolitical factors down to company-specific risks in the case of equity and corporate bond indices.

Liquidity Risk

ETPs are traded on an exchange, but that doesn’t mean that an active trading market will necessarily develop.  And, like any financial product, it is possible for ETPs to be closed or delisted if there is no or very little demand from investors. There may also be times when the trading volumes are low or non-existent, and then spike when the investment theme or company becomes the focus on investor attention.  When it comes to liquidity in ETPs its important to underline that liquidity is derived from the underlying market being tracked by the ETP.  As highlighted earlier, ETPs are open ended, which means that new securities or shares can be created or redeemed in line with changes in investor demand.  With ETPs that are consistently thinly traded, it may be that it is difficult to deal in large sizes.   

Price Tracking Risk

There are two aspects to this.  First, investors will typically look at tracking difference, which over a given time period will be the difference in performance between the index and the ETP.  The difference will be caused in part by the product costs associated with the ETP.  The second element that some investors will consider is tracking error, which is annualised standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index. Tracking error may increase, for example, when there is a spike in market volatility.

Currency Risk

Investors in the UK will take on currency risk if they have exposure to indices that are based in other currencies.  This currency risk can be both positive or negative depending on the performance of GBP relative to the other currencies.  Sometimes, it is possible to buy currency-hedged indices, alternatively some sophisticated investors might look to hedge out currency risk by taking out a separate FX position.

How to Invest

Stock exchange numbers

Investors can buy and sell ETPs through execution-only investment platforms. Alternatively, some investors will prefer to deal through advisory brokers or wealth managers. 

Before investing, it is crucial to understand the underlying benchmark, the rationale for the investment, as well as the costs and performance of the different ETPs that provide exposure to the particular index.  If you are in any doubt about the suitability of an investment, you should seek advice from a suitably qualified financial adviser.

Are you a sophisticated investor looking for alternative investment solutions? GraniteShares short and leveraged single stock ETPs could be exactly what you’ve been looking for!


GraniteShares accepts no responsibility for any loss or damage resulting directly or indirectly from the use of this blog or the contents. GraniteShares Limited (“GraniteShares”) (FRN: 798443) is an appointed representative of Duff & Phelps Securities Ltd. (FRN: 466588) which is authorised and regulated by the Financial Conduct Authority.

This blog does not constitute an offer to buy or sell or a solicitation of an offer to buy securities in any company. Nothing contained herein constitutes investment, legal, tax or other advice nor is to be relied upon in making an investment or other decision. No recommendation is made positive or otherwise, regarding individual securities or investments mentioned herein. Any summary list of risk factors does not purport to be a complete enumeration or explanation of the risks involved in a particular investment. Prospective clients must consult with their own legal, tax and financial advisers before deciding to invest. This email contains the opinions of the author and such opinions are subject to change without notice. The source of data is GraniteShares unless otherwise stated. No guarantee is made to the accuracy of the information provided which has been obtained from sources believed to be reliable. This email and the information contained herein is intended only for the use of persons (or entities they represent) to whom it has been provided. Past performance is not a reliable indicator of future results.  The value of an investment may go down as well as up and can result in losses, up to and including a total loss of the amount initially invested. Investments may involve numerous risks including, among others, company risks, general market risks, credit risks, foreign exchange risks, interest rate risks, geopolitical risks and liquidity risks.  Please note that GraniteShares short and leveraged Exchange Traded Products are for sophisticated investors.

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