There are thousands of different ETPs and several different product structures that can impact any single ETP’s risk-reward trade-off, investor protections, tax consequences and efficiency, and costs. Product structures generally fall into two primary categories: ETFs and ETNs. However, there are many variations within these categories, including a range of complex offerings, and there are a number of other ETP structures used to provide exposure to commodities and currencies.
Take time to understand and evaluate the portfolio and/or investment strategy of any ETPs you purchase.
ETFs
ETFs, like mutual funds, are pooled investment products that offer investors the opportunity to purchase shares of a fund that holds the assets it tracks. Unlike mutual funds, ETFs are listed on an exchange, can be traded throughout the day, and generally don’t sell shares to, or redeem shares from, retail investors directly.
Instead, ETFs—and ETPs more generally—employ a unique share issuance and redemption mechanism. An ETF enters into contracts with financial institutions (typically large broker-dealers) to act as “authorized participants” (APs). APs purchase and redeem shares directly with the ETF in the primary market in large blocks of shares called creation units. APs typically sell some or all of their ETF shares in the secondary market, on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly traded company.
The assets held by an ETF might pay interest or dividends, which may be either reinvested or paid periodically to shareholders, depending on the way the ETF is structured.
ETFs either passively track the performance of an underlying index or other benchmark or are actively managed investments. Those that are actively managed rely on a fund manager to make decisions for the fund in accordance with an investment strategy rather than tracking an index. Actively managed products might have higher expense ratios than similar products tracking an index, which has the potential to eat into returns over time. While some actively managed ETFs are required to disclose their holdings on a daily basis, others disclose such information periodically like mutual funds.
Also, be aware of potential overlaps in the holdings or exposures provided by ETFs and how these might impact your overall level of diversification. For example, some ETFs with sustainable or socially responsible objectives might have very similar holdings to those of popular indexes that don’t have those objectives, and the same might be true of some actively managed ETFs.
While ETFs can include investments across many asset classes, including crypto assets through futures ETFs (bitcoin and ether), they primarily focus on stocks and bonds.
- Equity funds – Equity funds are ETFs that invest in baskets of stocks. This category includes many subtypes, and some have complex investment strategies. Many equity funds track a specific market sector, like health care or technology, while others are focused on companies of a particular size or from a single country. Some funds, such as inverse and leveraged ETFs, factor ETFs, emerging market ETFs, and environmental, social and governance (ESG) ETFs have more specialized investment objectives and might also carry unique risks. Some even offer exposure to the stock of a single company.
- Bond funds – These fixed-income funds invest in bonds and therefore might have lower volatility than some other ETFs. Unlike individual bonds, bond ETFs trade on exchanges throughout the day. They typically provide an income stream to the investor through regular interest or dividend payments. Most offer continuous exposure to bond investments, while some have portfolios with a given targeted maturity date.
Learn more about how ETFs compare to mutual funds.
ETNs
Like ETFs, ETNs trade on exchanges, and their returns are linked to a market index or other benchmark. But ETNs aren’t pooled vehicles and don’t buy or hold shares of stock or other underlying assets. They’re unsecured debt obligations that, similar to bonds, are typically issued by a bank or other financial institution. Unlike bonds, however, ETNs generally don’t pay periodic interest to investors (though some that are income-focused might), and the return is primarily based on the performance of the index or benchmark to which they are linked.
The return on an ETN generally depends on price changes, if the ETN is sold prior to maturity, or on the payment, if any, if the ETN is held to maturity or redeemed.
Like other ETPs, ETNs can be linked to well-known, broad-based stock indexes or to indexes tied to emerging markets, commodities, volatility, a specific industry sector (e.g., oil and gas pipelines), foreign currencies or other assets. This might offer investors convenient and cost-effective exposure; however, these investment vehicles can also be complex and carry additional risks.
Inverse and leveraged ETNs, for example, seek to deliver set positive or negative multiples of the performance of a given benchmark or index over a specified period of time, often from the close of one trading day to the next. Returns can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark over the same period, which can make these products risky long-term—or even medium-term—investments, especially in volatile markets.
While similar to the creation and redemption mechanism for other ETPs, ETNs don’t use APs. Instead, an ETN issuer has primary control over ETN issuance and redemption, as this directly impacts the issuer’s balance sheet. Other risks of ETNs include the risk of issuer default or other issuer actions that may impact the price of the ETN. Research publicly traded issuers using the SEC’s EDGAR database.
Other ETPs
There are other ETP structures that are very similar to ETFs but that aren’t registered under the Investment Company Act of 1940. These ETPs are used mostly for investments in physical commodities like gold, hard currencies like euros, and crypto assets through spot bitcoin ETPs. These ETPs are classified as grantor trusts for tax purposes. ETPs are also used for investing in the futures markets. (These ETPs are typically structured as commodity pools—although some might in fact be registered investment companies, which instead invest in a foreign subsidiary that transacts in the futures markets.)
- Commodity ETPs – Commodity ETPs might invest in physical commodities, such as gold or silver, or commodity futures contracts. Some of these products offer exposure to single commodities, while others might offer exposure to a basket of commodities. Relatedly, certain commodity-focused ETFs might invest in companies that produce, store and transport commodities, such as oil drilling or agriculture product companies. These funds can provide an avenue for investors interested in accessing this asset class without holding individual commodities, and they might be used as a hedge against inflation.
- Currency ETPs – Currency ETPs offer investors exposure to foreign currencies and the foreign exchange market (forex) and exchange rates. These ETPs, which are often used by investors to hedge against exchange rate risk, tend to involve speculative trading. They’re sometimes backed by bank deposits in a foreign currency, but the products—and their risks—vary.
- Crypto Asset ETPs – Bitcoin and ether futures ETPs invest in bitcoin futures or ether futures contracts as their underlying asset. Spot bitcoin ETPs, on the other hand, invest in spot bitcoin as their underlying asset.
ETPs that invest in commodities, currencies or related futures may be structured differently, and some may even be registered under the Investment Company Act of 1940. Know what type of ETP you’re investing in, since the structure can impact the product’s costs, risks and tax consequences. Some ETPs, including spot bitcoin ETPs, may be referred to as ETFs or funds, but it’s important to note that these products might not be registered as investment companies and so might operate under different regulatory frameworks and provide different investor protections than ETFs.