Exchange-Traded Products (ETPs) vs. Exchange-Traded Funds (ETFs): An Overview

Exchange-traded products (ETPs) offer investors diversity and liquidity through pooled investments that trade on stock exchanges, akin to individual stocks. But ETPs are not stocks; they are sophisticated financial instruments that can pool a variety of investment types, including funds and commodities, traded like stocks.

Among ETPs, exchange-traded funds (ETFs) are the best known, and offer flexibility, cost efficiency, and comparatively lower fees. ETFs often mirror the performance of indexes, sectors, or commodities prices, providing a transparent and effective way to invest in entire markets or specific economic niches without having to buy the underlying assets.

With ETPs, the pooling of different investment types enables both seasoned and novice investors to access a broad range of assets, from traditional stocks and bonds to more niche markets like commodities or specific industry sectors, all with the ease of buying and selling shares throughout the trading day. ETPs not only provide a platform for portfolio diversification but also enhance the financial ecosystem’s adaptability, allowing investors to respond swiftly to market changes and opportunities.

ETPs include other securities beyond ETFs, such as exchange-traded notes (ETNs) and exchange-traded commodities (ETCs). ETNs are debt instruments that track an index while carrying credit risk, while ETCs offer exposure to commodities and currencies, but can face unique risks discussed below.

Exchange-Traded Products (ETPs)

ETPs bundle securities into a portfolio to provide exposure to a wide array of assets, all while trading like stocks on major stock exchanges. These products are designed to offer diversified exposure, high liquidity, transparency, and cost efficiency.

The first ETP is thought to be the Standard & Poor’s Depositary Receipts (SPDRs), commonly known as “Spiders.” The first SPDR was introduced in 1993 and is now known by its ticker symbol, SPY. This product was designed to track the S&P 500 Index, allowing investors to buy shares in a portfolio that mirrors the performance of the S&P 500.

The approval process for the first ETP was a significant milestone in financial markets, requiring collaboration among the American Stock Exchange, the Securities and Exchange Commission (SEC), and State Street Global Advisors, which developed and sponsored the ETP.

Before SPY’s debut, trading the S&P 500 Index was difficult, and investors had to dig into each component stock. SPY would be efficient for gaining exposure to the broad index through a single product. Given the novelty of this product, there were regulatory and logistical hurdles to overcome. Until then, stock exchanges focused on individual company stocks rather than pooled investment products. SPDRs adopted a unique share creation/redemption mechanism to assuage regulators to keep their prices closely aligned with the index it tracked. This mechanism allowed large broker-dealers to exchange underlying stocks for shares of the SPY ETP with the fund manager.

SPDRs paved the way for the ETP industry by proving the appeal and feasibility of packaged financial products that supply diversified exposure to indexes through a publicly traded security. SPY remains the world’s largest and most actively traded ETP, with an average of over 77.5 million shares exchanged daily and $490 billion in assets as of the first quarter (Q1) of 2024.

Key Characteristics of ETPs

ETPs have these main elements:

• Basket of securities in one security: Each ETP contains a portfolio or basket of assets rather than a single security. The basket can include stocks, bonds, commodities, currencies, and more. This provides instant diversification.
• Traded on exchanges: ETPs trade on major stock exchanges like individual stocks, allowing investors to buy and sell them throughout the trading day via their broker.
• Intraday pricing: The price of an ETP fluctuates throughout the day based on supply and demand, allowing for real-time pricing and trading flexibility.
• Cost-effective: A pivotal feature of ETPs is that they often offer low management fees and expense ratios, making them less costly to trade than mutual funds or even the underlying securities they hold. In addition, many brokerages today offer commission-free trading for these products.

Benefits of ETPs

Several advantages make ETPs an appealing investment vehicle:

• Diversification: ETPs provide instant diversification across asset classes, market sectors, industries, geographic regions, and more. Investors gain broad exposure through a single ticker.
• Liquidity: The ability to trade ETPs seamlessly throughout the day on major exchanges provides constant liquidity. This distinguishes them from mutual funds that trade just once a day.
• Low costs: ETPs have lower expense ratios than actively managed mutual funds since they passively track an index. This means saving substantially on fees.
• Tax efficiency: ETPs are structured in a tax-efficient manner compared with mutual funds in most cases, saving investors further costs.

ETP Regulations

While they may be structured differently, all ETPs in the United States are regulated by the SEC for investor protection and transparency. The SEC reviews ETP prospectuses, requires regular disclosures, oversees market trading, and enforces rules around practices like manipulation and fraud. This oversight applies across the ETP spectrum, no matter its structure.

However, the level of oversight depends on the type of ETP. For example, ETNs operate as unsecured debt securities issued by financial institutions. This differs from ETFs, which directly hold underlying assets.

As a debt instrument, ETNs carry credit risk should the issuing institution default. As a result, the SEC monitors ETNs more closely than it does the diversification and tracking error risks of ETFs. While both are ETPs, the SEC tailors its approach based on each structure’s characteristics to safeguard investors.

Exchange-Traded Funds (ETFs)

ETFs are popular financial instruments designed to offer investors an easy and efficient way to gain diversified exposure to an entire index or market segment through a single trade. They are easily the most traded and best-known of the ETPs.

Unlike mutual funds, ETFs trade on stock exchanges like equities. This gives ETFs the advantage of continuous pricing and trading throughout the day. ETFs hold a basket of assets that can include stocks across various sectors and industries, government and corporate bonds, commodities like natural gas or precious metals, and foreign currencies. The basket of assets held by an ETF is carefully selected and weighted to closely replicate the performance of a specific underlying index or benchmark.

For example, a total stock market ETF would hold hundreds or even thousands of different stocks in proportion to their weight in a broad stock market index. By buying a share of the ETF, an investor instantly gains diversified exposure to the returns of the entire equity market rather than buying each stock separately.

ETFs offer efficient, liquid, low-cost market access in a transparent, tax-efficient vehicle. Investors can also choose from various ETFs targeting more specialized market sectors based on their financial goals and risk tolerance.

Types of ETFs

ETFs track many different market segments. Here are the most common:

• Stock index ETFs: These track indexes like the S&P 500, Nasdaq 100, Dow Jones Industrial Average, etc.
• Industry/sector-specific ETFs: These focus on and track specific industries or sectors like technology or financials.
• Bond ETFs: These track government, corporate, or municipal bond indexes.
• Commodity ETFs: These track the prices of gold, silver, oil, grains, and other commodities. They either directly hold these commodities or use derivative products like futures.
• Currency ETFs: These track foreign currency exchange rates.
• Inverse ETFs: These furnish returns that move the opposite of benchmarks. This allows for short-market exposure.
• Leveraged ETFs: These want multiple returns, such as plus or minus two or three (or more) times the return of an underlying index or asset.
• Crypto ETFs: These track one or more major cryptocurrencies such as Bitcoin or Ethereum. They may directly hold cryptocurrencies or use derivatives contracts to gain exposure.

Difference Among ETFs, Mutual Funds, and Single Stocks
Feature	ETFs	Mutual Funds	Stocks
Pricing/Trading	Intraday pricing and trading	End-of-day pricing; trades once per day	Intraday pricing and trading
Costs	Lower expense ratios than active mutual funds	Typically higher expense ratios	May have commission fees on trades
Tax Efficiency	More tax-efficient in most cases	Can have capital gains distributions	Taxes on dividends and capital gains
Diversification	Holds basket of securities	Holds basket of securities	A single security
Risk Profile	Potentially lower volatility than individual stocks because of multiple holdings	Often lower volatility than individual stocks	Higher volatility as a single security
Transparency	Full portfolio holdings disclosed daily	Periodic portfolio disclosures	Public filings from a single company
Index Tracking	Follows underlying index	Actively managed or passive index tracking	Follows the performance of a single company

Other Types of ETPs

In addition to ETFs, other types of ETPs include ETNs and exchange-traded commodities (ETCs).

Exchange-Traded Notes (ETNs)

ETNs combine bond investing with the tradability of stocks. Unlike ETFs, which hold underlying assets, ETNs are structured as unsecured debt securities issued by financial institutions. These notes promise to pay the holder a return based on the performance of a market index or other reference measure, minus applicable fees, at maturity.

ETNs, however, have some unique risks and benefits:

• Credit risk: Since ETNs are debt instruments, their value is dependent, in part, on the creditworthiness of the issuing bank. If the issuer faces financial difficulties, the ETN could lose value, no matter the performance of the underlying index.
• Price tracking: ETNs aim to closely track the performance of their underlying index or benchmark. They do not experience tracking errors the same way that ETFs might.
• Liquidity risk: Some ETNs may have lower trading volumes than ETFs, potentially leading to wider bid-ask spreads and impacting the ease with which they can be bought or sold at desired prices.
• Tax efficiency: ETNs can offer unique tax benefits in certain situations. For instance, since they do not distribute dividends, investors might not incur taxes until the sale of the ETN or its maturity, potentially deferring tax liabilities.
• Market exposure: ETNs can provide exposure to many assets, including hard-to-reach markets and strategies. This includes commodities, emerging markets, private equity, or specific investment strategies that might be difficult or costly to access directly.

Exchange-Traded Commodities (ETCs)

ETCs offer exposure to commodities, including metals, energy, and agricultural products, without directly investing in physical commodities or futures contracts. ETCs track the commodity’s price or a basket of commodities, allowing investors to gain exposure to commodity markets through a security that trades on a stock exchange.

There are differences between ETCs and ETFs that track commodities. Commodity ETFs are structured as funds and regulated under the Investment Company Act of 1940 in the U.S. They hold either physical commodities (like gold or silver) or futures contracts on commodities. Commodity ETFs are considered equity products and are regulated like mutual funds and other ETFs.

Exchange-traded commodities, like ETNs, are structured as debt securities, even though they track commodity prices. They are not considered funds in the traditional sense, but are debt instruments issued by a single entity. This means there are credit risks involving the issuer.

ETCs can be broadly classified into two categories:

• Physical ETCs: These ETCs hold physical commodities, such as gold or silver bars, in secure vaults. Investors in physical ETCs have a claim on the underlying metal, and the value of the ETC is directly tied to the price of the physical commodity.
• Synthetic ETCs: Instead of holding physical commodities, synthetic ETCs use derivatives like futures contracts to replicate the performance of the underlying commodity. This approach can provide exposure to a broader range of commodities, including those difficult or impractical to store physically.

As with ETNs, ETCs also present unique risks and benefits:

• Direct commodity exposure: ETCs offer a straightforward way to invest in commodities, which can serve as a hedge against inflation or a diversification tool outside traditional stocks and bonds.
• Variety: Investors can choose from various commodities, from gold and silver to oil and agricultural products, depending on their investment goals and market outlook.
• Transparency: ETCs offer transparency in holdings and pricing, with the value of the ETC closely tracking the underlying commodity or commodities.
• Volatility: Commodity markets can be highly volatile, with prices influenced by various factors, including geopolitical events, weather conditions, and changes in supply and demand.
• Counterparty risk: Synthetic ETCs can involve counterparty risk since their performance depends on the ability of the issuer or counterparty to fulfill their obligations under the derivative contracts.
• Credit risk: Because they are structured as unsecured debt instruments from a single issuer if the issuer faces financial difficulties, the ETN could lose value, whatever the performance of the underlying commodities.

What to Consider When Choosing Between ETPs and ETFs

When deciding whether an ETP or ETF makes the most sense for an investment strategy, investors should weigh several key factors:

• Expenses and fees: ETPs and ETFs often have lower expense ratios than actively managed mutual funds, but fees vary between products. All else being equal, an ETP with a lower expense ratio is preferred. ETFs typically have lower fees than other ETPs since they have less complex structures. Consider the expense ratio, commission fees, bid-ask spreads, and premiums/discounts.
• Liquidity: ETFs tend to have higher daily trading volumes and tighter bid-ask spreads. Some ETPs have limited secondary market liquidity, which can impact prices. Assess the average trading volume and bid-ask spread for a particular ETP or ETF—the higher the volume and the tighter the spread, the better.
• Performance and tracking: ETPs are often highly efficient at replicating their benchmark index performance, but some have more tracking errors. Research historical returns and compare them with the ETP’s benchmark.
• Diversification: ETFs offer exposure to various indexes across all major asset classes. Some ETPs zero in on narrow commodities or niche assets. Other times, two or more ETFs may hold the same assets; for example, if a stock is represented as a significant part of the S&P 500 and a sector index. This could mean doubling the exposure to specific stocks. Assess how well an ETP or ETF aligns with your asset allocation and diversification goals.
• Reputation of issuer and regulatory compliance: The trustworthiness and track record of the ETP issuer matter. A well-regarded issuer with a history of regulatory compliance and transparency is likely to offer low-cost products managed in the best interest of investors. Investigate the issuer’s reputation, experience in managing investment products, and history of adherence to regulations.
• Tax efficiency: ETFs are generally known for their tax efficiency, especially those that track broad-market indexes because of their unique creation and redemption process, which can minimize capital gains distributions. Depending on their structure, ETPs might not offer the same level of tax efficiency. Understand the tax implications of each investment, including how distributions are taxed and the potential for triggering taxable events.

Costs and Fees Associated with ETPs and ETFs

All ETPs have costs that affect the total return on investment.

• Expense ratios: This annual fee, expressed as a percentage of assets under management, covers the operational costs of the fund, including management fees, administrative fees, and other operating expenses. ETFs often have lower expense ratios than actively managed mutual funds, and ETCs can vary widely based on the complexity of the commodity exposure and management.
• Trading costs: Investors also have trading costs, such as commissions when buying or selling shares, including brokerage commissions (if applicable) and bid-ask spreads. Some ETFs today may be part of commission-free trading programs offered by brokers.
• Premiums/discounts: ETPs can trade at a premium or discount to their net asset value (NAV), depending on market demand and the underlying securities. These differences can mean more costs or benefits when entering or exiting positions.
  

The Bottom Line

ETPs offer investors an efficient way to gain exposure to diverse assets pooled and traded on stock exchanges. ETPs have advantages like low costs, tax efficiency, liquidity, and transparency. ETFs are a subset of ETPs regulated by the SEC under the 1940 Investment Company Act, while ETPs can fall under further regulations depending on their assets. Investors should weigh factors like expenses, tracking ability, liquidity, diversification, and risks when choosing between ETPs and ETFs. Thorough research is vital to successfully incorporating these worthwhile investments in a portfolio. Both ETPs and ETFs can serve a valuable role in asset allocation when they match an investor’s strategy, goals, and risk tolerance.

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