ETPedia - the educational guide to ETPs
WisdomTree believes investors should always understand and fully appreciate the risks involved in their investments. In light of this, we have produced ETPedia, which aims to provide investors with an unbiased reference to Exchange Traded Products (ETPs).
Investors can watch our series of short animated videos for an overview of ETPs, or visit the relevant online sections of our ETPedia for more in-depth information.
- INTRODUCTION
- ETPs AT A GLANCE
- ETP STRUCTURE
- BENEFITS AND RISKS OF ETPs
- TRADING AND PRICING
- COSTS AND PERFORMANCE
- ACTIVE AND PASSIVE INVESTMENTS
ETPs Explained in Six Short Videos
1. ETPs at a glance
2. ETP structure
3. Benefits and risks of ETPs
4. Creation and redemption
5. Costs and performance
6. Active and passive investments
If you would like any further information of ETPs not included within our guide, please contact us.
Introduction to ETPs
Since the first Exchange Traded Product (ETP) launched in 1993, the industry has undergone tremendous growth. There is now more than US$5.12 trillion invested in over 7,000 ETPs worldwide1.
Originally, ETPs combined the cost-efficient, benchmark replication strategy of equity index funds with the listed, intra-day tradability of shares. As the market has matured, ETPs have expanded to cover exposure to an increasing number of asset classes. Now, along with providing equity benchmark replication, ETPs also offer investors the ability to diversify their portfolio by providing exposure to assets previously difficult to access such as commodities like gold or oil.
The popularity of ETPs seems set to continue. Despite a trebling of the amount invested in ETPs over the last decade, the European industry is still underdeveloped in comparison to the American marketplace when you compare the value of assets stored within the ETP structure.
The ETP industry at a glance
Did you know?
The world's first Exchange Traded Product launched in 1993.
There is now more than US$5.12 trillion invested in ETPs worldwide spread across over 7,000 products 1.
ETPs are open-ended like mutual funds, but can be traded intra–day, which means they can be bought and sold whenever the stock exchanges are open with prices being quoted throughout the day.
As the market has matured, ETPs have expanded to cover an increasing number of asset classes – including many that had previously been difficult for investors to access (e.g. gold and oil).
In Europe, ETPs are typically divided into three categories: Exchange Traded Funds, Exchange Traded Commodities/Currencies and Exchange Traded Notes.
It is possible to gain short and leveraged exposures using ETPs – and doing so does not require direct borrowing, options trading or the maintenance of margin accounts unlike many alternatives.
- 1 Source: ETFGI, Growth in Global ETF and ETP assets as of the end of June 2018.
Active and Passive Investment
Active Fund Management
The active fund manager makes investments in selected assets (whether stocks, bonds, commodities, etc.) with the goal of beating the market (usually a benchmark, like the FTSE 100).
Passive Fund Management
A passively managed fund or investment does not seek to beat the market. Instead, the passive investor tries to replicate the benchmark performance as accurately as possible.
The majority of ETPs are passive investments, since their aim is to track a benchmark or asset.
It might be questioned why someone would choose passive over active investment. Settling for achieving, rather than exceeding, the market return may be seen as defeatist. After all, the idea of consistent, market-beating returns that transform a small initial investment into great wealth is always alluring.
However, no matter how attractive the claims of active management, the performance above the benchmark is not guaranteed. Many investors choose a passive investment strategy because, historically, a large number of active investors have failed to consistently beat the market. Instead of uncritically relying on the claims of active investment, investors should consider the historical performance of active versus passive investment.
For further information on active and passive investments please refer to 'Active and passive investment' section.
What is an ETP?
An Exchange Traded Product (ETP) is a financial instrument traded on a stock exchange whereby typically the aim is to provide the same return as a specified benchmark or asset (before fees). Although ETPs can take a number of forms, they share some common characteristics.
Characteristic | Benefit |
Listed on a stock exchange | Shows exactly how your investment is performing |
Trade like shares | Buying and selling as easily as shares any time the market is open |
Liquid asset | Liquidity provided by authorised participants and market makers |
Tracks an underlying | Aims to provide the same return as underlying benchmark or asset |
Passive investment | Cost-effective way of gaining exposure to a benchmark or asset as management fees are generally lower |
What types of exchange traded product (ETP) are there?
In Europe, ETPs are typically divided into three categories; exchange traded funds (ETFs), exchange traded commodities (ETCs) and exchange traded notes (ETNs).
ETF
Provides access to, among others:- equity indices
- commodity indices
- fixed income
- money markets
- private equity indices
- fund of hedge funds indices
ETC
Provides access to, among others:- individual commodities (e.g., gold, oil, agriculture, industrial metals, etc.)
- commodity baskets
- currencies
ETN
Provides access to an asset or benchmark using an uncollateralised debt security.Why use an ETP?
01 Flexible
ETPs can provide access to an entire index, or alternative asset classes (such as commodities), with a single trade
02 Accessible
ETPs can be bought and sold whenever the stock exchange is open as prices are quoted throughout the day
03 Cost-effective
ETPs provide a cost-effective way to gain diversification through a benchmark or exposure to assets previously difficult to access
04 Transparent
Unlike other investments, ETP constituents are published on a daily basis - this transparency makes it easier for the investor to see exactly what they own
05 Simple
ETPs are listed and trade in a similar way as shared through the same brokers and platforms
The Types of ETP
1. Exchange traded funds (ETFs)
An Exchange Traded Fund is an investment fund that trades on a stock exchange as a single security. It is designed to track an underlying benchmark. ETFs are open-ended, which means ETF shares can be created as necessary to meet demand. Since the first ETF launched in 1993, the range and variety of ETFs have drastically increased. Some examples of the types of exposure ETFs can now provide are outlined below.
Exchange traded funds (ETFs) - examples of asset types
Equity | Fixed income | Money market | Alternatives | Commodities |
Global | Government | EONIA | Private equity | Diversified indices |
Sectors | Corporate | SONIA | Hedge funds | |
Emerging markets | Inflation-linked | Federal Reserve funds | Volatility | |
Single country | High yield | Property | ||
Mortgage backed | ||||
Emerging markets |
Exchange traded funds (ETF) - safeguards for investors (UCITS)
In Europe, most ETFs are governed by laws regulating collective investment schemes, known as Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS provide a number of important safeguards for investors:
- Segregated assets: to minimise risk to investors in the event of bankruptcy by the ETP provider.
- Increased transparency: requires that certain information is made available to investors.
- Diversification limits: to protect investments becoming concentrated in a single asset.
2. Exchange traded commodities (ETCs)
Exchange Traded Commodities are debt securities that pay no interest. They are designed to give exposure to an individual commodity or a basket of commodities.
Exchange traded commodities (ETCs) - examples of asset types
Precious metals | Energy | Agriculture | Industrial metals | Livestock | Diversified |
Gold | Brent crude | Grains | Aluminium | Lean hogs | All commodities |
Silver | Western Texas intermediate | Cocoa | Copper | Live cattle | Ex-agriculture |
Platinum | Carbon | Coffee | Lead | Ex-energy | |
Palladium | Natural gas | Corn | Nickel | ||
Refined products | Cotton | Tin | |||
Soybeans | Zinc | ||||
Sugar | |||||
Wheat |
Exchange traded commodity (ETC) - structure
Since UCITS mandate a minimum level of diversification for collective investment vehicles and restrict the asset types that can be held, product providers needed an alternative structure to provide investors access to individual commodities. In Europe, the solution was to use a debt security issued by a special purpose vehicle (SPV) with segregated assets:
- Debt structure: means ETCs are subject to different regulatory treatment to ETFs and are not restricted by the UCITS diversification requirements. This allows them to offer investors exposure to a single or small number of commodities.
- SPV: being issued by an SPV means the product's assets are segregated from the product provider and could not be used to discharge the product provider's liabilities if it were to go bankrupt.
- Collateralised: ETCs are often backed by either the physical asset or a derivative that gives exposure to an asset. Obligations under a derivative contract in an ETC are usually collateralised.
3. Exchange traded notes (ETNs)
Like ETCs, ETNs are non-interest bearing debt securities that are designed to track the return of an underlying benchmark or asset. However, whilst ETCs are issued by special purpose vehicles (SPVs) with segregated assets, ETNs are generally issued by banks, hold no assets and are not collateralised. Apart from the fact that their yield references an underlying benchmark or asset, ETNs are similar to unsecured, listed bonds.
As such, ETNs are entirely reliant on the creditworthiness of the issuing entity. A change in that creditworthiness might negatively impact the value of the ETN, irrespective of the performance of the underlying benchmark or asset. In extreme circumstances, default by the issuer would leave the investor to claim as an unsecured creditor against the issuing entity.
The primary appeal of ETNs is that they guarantee exposure to a benchmark or an asset's return (minus fees) even when the underlying markets or sectors suffer from liquidity shortages, since the return is guaranteed by the issuing entity and not reliant on the access (direct or via a directive) of the underlying assets.
It should be noted that since ETNs hold no assets and are not collateralised, they operate very differently to ETFs and ETCs. As such, much of what is said about ETPs in this guide only applies to ETFs and ETCs and not to ETNs.
Comparison of ETFs, ETCs and ETNs
ETF | ETC | ETN | |
Security type | Collective investment vehicle | Debt security | Debt security |
Governed by UCITS | Yes | No | No |
Commodity access | Limited1 | Yes | Yes |
Issuer credit risk | Limited | Limited | Yes |
Eligible by UCITS | Yes | Yes | Yes |
1 - UCITS prohibits ETFs from holding physical commodities and requires a minimum level of diversification. This means that ETFs can only be used to access certain diversified commodity indices.
Short & Leveraged ETPs
An investor can gain both short and leveraged exposure to a variety of different asset classes through tactical use of short and leveraged ETPs.
Unlike traditional short and leveraged positions in shares, these positions do not involve borrowing but use derivatives to deliver their returns. Furthermore, because ETPs are usually structured as shares or debt securities, losses cannot exceed the initial amount invested.
Compounding and volatility
Short and leveraged ETPs generate their offered return for a stated period (e.g. daily or monthly) only. If you hold short and leveraged ETPs for longer periods, compounding and volatility can distort the expected return. This is most noticeable in a volatile market.
To illustrate this, the example below shows £100 invested in a daily 2x (leveraged) short ETP tracking a volatile index. After 5 days the index has declined 5%, so the investor might expect the value of the ETP to have increased by 10%. However, let's consider the performance of the ETP and the underlying index for each stated period. We are using a daily compounding ETP in this example so we will consider the value of the ETP and the index at the end of each day.
By the end of day 1 the index value has declined by 2.9% to 97.10. The 2x short factor is applied to the daily index movement to give the corresponding value of the ETP.
In this example the 2x daily short ETP will increase in value by 5.8% to 105.80 (2 x 2.9% = 5.8%). During day 2 the index value increases by 1.9%, rising from 97.10 to 98.94, and the ETP value declines by 3.8% (2 x 1.9% = 3.8%), falling from 105.80 to 101.78. The 2x short factor is applied for the index movements of each day, and then re-applied for the movements of the next day and so on - an example of a compounding ETP.
By the end of day 5 the value of the ETP has increased by 9.48%, even though the index has declined by 5%. The 5 day performance of the index should not be multiplied by -2 as a means of estimating the 2x short ETP return. Due to the potential for volatility of any exposure, short and / or leveraged ETPs should be actively monitored.
Short and leveraged compounding - A numerical example
Day | Index value | Daily variation | 2x short ETP value (GBP) |
0 | 100 | 100 | |
1 | 97.10 | -2.9% | 105.80 |
2 | 98.94 | 1.9% | 101.78 |
3 | 95.98 | -3.0% | 107.89 |
4 | 98.47 | 2.6% | 102.28 |
5 | 95.00 | -3.5% | 109.48 |
Performance | -5.00% | 9.48% |
Source: WisdomTree,hypothetical example.
Source: WisdomTree,hypothetical example.
Long Position
A position that profits if an asset's value rises.
For example, an investor buys a company's shares. If the shares rise in value, they can be sold for profit.
Short Position
A position that profits if an asset's value falls.
For example, an investor borrows shares from a broker to sell, which eventually must be returned. If the shares fall in value after being sold, the investor can buy them back, in order to return them, for less than the amount received from their sale.
Leveraged Position
A position that uses financial instruments or borrowing money to increase the potential return of an investment. Both short and long positions can be leveraged.
For example, an investor invests £500 in a company's shares: £250 from their own account and £250 borrowed interest-free from a broker.
If those shares increase by 20%, the investor has £600. Returning the borrowed £250 leaves the investor with £350: a gain of £100. Investing only with the investor's own money would have yielded only £50 (a gain of 20% from £250 to £300).
If those shares decrease by 20%, the investor has £400. Returning the borrowed £250 leaves the investor with £150: a loss of £100. Investing only with the investor's own money would have yielded a loss of £50.
Currency ETPs
The impact of currency fluctuations on investments
Currency risk is the risk that the value of an investment, denominated in a currency other than an investor's home currency, might be affected by the exchange rate between the two currencies. Investors often neglect the impact of currency risk on their investments.
However, it is important to note that currency risk may have a significant effect on the value an investment. Practically, any investment abroad will be affected by currency movements: from buying a Spanish retirement home to owning shares in a US-listed company.
Currency impact on equity returns
US equities (MSCI US) | Local Returns (USD) | EUR/USD | Currency returns (unhedged) | Total Return | |
31 Dec 2016 |
2,261 | 2.79% | 1.0456 | 1.36% |
4.15% |
30 Nov |
2,199 | 3.36% | 1.0599 | 3.38% | 6.74% |
31 Oct |
2,126 | -1.96% | 1.0963 | 2.45% | 0.49% |
30 Sep |
2,168 | -0.12% | 1.1235 | -0.69% | -0.81% |
31 Aug |
2,171 | -0.12% | 1.1158 | 0.14% | 0.02% |
31 Jul | 2,174 | 3.50% | 1.1174 | -0.91% | 2.59% |
30 Jun |
2,099 |
0.09% | 1.1073 | 0.59% | 0.68% |
31 May |
2,097 | 1.52% | 1.1139 | 2.76% | 4.28% |
30 Apr |
2,065 | 0.27% | 1.1451 | -0.61% | -0.34% |
31 Mar | 2,060 | 5.58% | 1.1381 | -4.01% | 1.57% |
28 Feb |
1,948 | 0.40% | 1.0934 | -0.95% | -0.54% |
31 Jan 2016 | 1,940 | -5.94% | 1.0831 | 11.08% | 5.14% |
Total | 9.36% | 14.60% | 23.96% |
Source: Bloomberg, MSCI USD (Jan 2016 - Dec 2016).
Even investments in an investor's home market can be subject to currency fluctuations if those assets are denominated in foreign currencies (such as commodities which are usually priced in US dollars). Investors often worry whether the value of their investments will fall but rarely consider the impact of a rise or fall in the value of their currency.
Currency fluctuations can assist or negate the gains from an underlying asset for a foreign investment. As can be seen in the table, a US investor in US equities would have received a positive return of 9.36% over the year to December 2016. As a result of the Euro depreciating 14.6% over the period against the US Dollar, a European investor would have experienced a 23.96% for the same equity investment.
Currency Hedged ETPs
Overview
A currency hedge can be used to mitigate the effect of currency fluctuations. Historically, such strategies required significant expertise and infrastructure to execute and constantly ensure the currency hedge corresponds precisely with the commodity exposure, meaning they could only be implemented by institutional investors.
However, a currency hedged ETP not only provides exposure to the underlying asset but also includes a built-in currency hedge to mitigate the currency impact. This allows investors to focus on assessing the underlying asset based on its fundamentals without having to worry about the currency risk.
Tracking difference of daily vs. monthly hedged commodity indices
* Source: Bloomberg, monthly data (November 2007 - November 2017). Difference between Bloomberg Daily and Monthly EUR Hedged All Commodities Monthly Index Returns and Bloomberg Commodities Monthly Index US Dollar returns.
Currency hedged vs. unhedged commodity returns for a Euro-based investor
Source: Bloomberg: Daily data, (2001-2017)
ETPs and other vehicles
Investment vehicles come in a number of forms in the UK, of which ETPs are one. Understanding the differences between the vehicles will help an investor to determine which is the most suitable for their needs.
Since they are listed on a stock exchange, they can be traded throughout the day, just like an ETP or listed company. Investment trusts are closed-ended: they have a fixed number of shares. The value of each share will change depending on supply and demand, as well as the underlying NAV. Therefore, the price of an investment trust can trade away from its NAV.
An OEIC is open-ended shares can be created or redeemed according to demand. This means the value of each share is directly related to the NAV of the OEIC.
The main difference between unit trusts and OEICs is that a unit trust is constituted as a trust and not as a company. Thus, instead of issuing shares, the trust issues units instead.
Comparing ETPs with Investment Trusts, Open-Ended Investment Companies (OEIC) and Unit Trusts
ETP | Investment Trust | OEIC (non-exchange traded) | Unit Trusts | |
Legal structure | Issues equity or debt security | Issues equity | Issues equity | Trust |
Open or close ended | Open | Closed | Open | Open |
Pricing | Remains very close to NAV through arbitrage | Indirectly linked to NAV, driven by demand | Directly linked to NAV | Directly linked to NAV |
Bid / ask spread | Bid / ask spread applies | Bid / ask spread applies | No Bid / ask spread; single price | Bid / ask spread applies |
Trading | During market hours at quoted prices | During market hours at quoted prices | At most, once a day | At most, once a day |
Access | On-exchange, through brokers | On-exchange, through brokers | Directly with fund manager | Directly with fund manager |
Investment method | Passive (small number of active) | Active (small number of passive) | Active or passive | Active or passive |
ETP Structure
When considering an investment in an ETP, the structure is an important consideration. A product's structure impacts its risks, its costs and how accurately it tracks its underlying.
As a passive investment, ETPs replicate the return of an underlying benchmark or asset. ETPs can be structured in two ways to achieve this: physically or synthetically.
Physical ETP
Physical replication is where the ETP buys the underlying assets it is designed to track. Physical replication differs slightly between products that track a benchmark (usually ETFs) or a commodity (usually ETCs).
Synthetic ETP
A synthetic ETP does not hold the underlying assets the product is designed to track. Instead, the ETP issuer enters into a swap agreement with a counterparty that contracts to provide the return of the underlying assets.
Physical Replication
Physical ETFs
A physically replicating ETF either owns all, or a sample, of the assets that comprise the underlying benchmark. These types of ETF are known as, respectively, 'full replication' and 'sampling replication'.
A key benefit of full replication is that, since the product holds the same assets as the index, it should track the index very accurately. However, the disadvantage is the potential for high transaction costs if the index changes a large number of its constituents frequently.
With sampling replication, transaction costs are kept lower. However, because the ETP's holdings are not the same as those that comprise the index, the product's return may not correspond exactly to the index's return.
With physical replication, counterparty risk can be introduced if the product engages in securities lending.
Physical ETCs
Physical ETCs are backed by a specific quantity of that commodity. This is only possible if the asset can be easily stored for long periods. Consequently, physical replication is only possible for precious and industrial metals.
The value of a physical ETC comprises:
Physical ETCs are backed by the corresponding amount of bullion deposited in a vault (precious metals) or warehouse (industrial metals). This bullion is reserved for the product and segregated from the general stock of metal stored in that vault or warehouse. There are a number of organisations that oversee and standardise the trade of precious and industrial metals such as the London Bullion Market Association (LBMA), the London Platinum and Palladium Market (LPPM) and the London Metal Exchange (LME). These bodies ensure a standardised market for trading metals by ensuring metal quality and inspecting storage. Precious metals are stored in vaults located in London, Zurich or Singapore; industrial metals are stored in warehouses inspected by the London Metal Exchange.
The most significant benefit for investors of physically backed ETCs is that they provide exposure to commodity price movements, safe in the knowledge that each ETC is backed by an entitlement to high quality, securely stored, physical metal.
Full Replication
All the underlying assets are held in the same proportion as their weighting on the index being replicated.
This method is employed if the underlying assets are readily available, reasonably small in number and do not significantly alter (e.g. the 102 shares listed on the FTSE 100, reviewed quarterly).
Sampling Replication
Instead of holding all assets that constitute an index, the product holds a sample of some of the index constituents.
This approach might be used if the benchmark contains a large number of assets which change frequently (e.g. the MSCI World Index, with more than 1,600 constituents, sometimes changing over 300 shares annually) or if some constituents suffer from low liquidity.
Securities Lending
Where the owner of an asset lends it to a borrower in return for a fee. The borrower may also be required to post collateral to protect its obligations under the loan.
While the fee from securities lending can reduce the cost of an ETP, it creates counterparty risk. That is, the loaned securities may be lost if the borrower defaults. In such an event, the product could be left holding assets unrelated to those on the index it is meant to track.
Synthetic Replication
An ETP provider might choose to use a swap structure for a number of reasons:
- Accuracy: Because the return of a synthetic ETP is guaranteed by a counterparty, it can match the underlying asset return accurately.
- Cost-effective: A synthetic ETP has limited transaction costs relating to buying and selling the underlying assets.
- Commodities: Non-metal commodities can only be accessed synthetically because of the difficulties associated with storage.
- Variety: Synthetic ETP structures can offer products which could not be offered physically, including short and leveraged products, volatility indices and emerging market securities.
The most significant risk with synthetic ETPs is that of counterparty default, known as counterparty risk. If a counterparty defaults on its obligations under the swap, the ETP would not provide the return of the asset it is designed to track which could also expose investors to losses.
To minimise the impact of any default, most synthetic ETFs and ETCs are backed by collateral.
Swap
An agreement where the parties swap the return of one investment for another; or, alternatively, one party pays a fee for the return of a particular investment.
For example, an ETP may agree to pay a fee for the performance of the FTSE 100. If the FTSE rises by 1%, the counterparty will pay this to the ETP. If it falls by 1%, the ETP will pay the difference to the counterparty.
Collateral
Generally, the asset(s) that a borrower offers as security for a debt. In the context of ETPs, it usually refers to assets provided by swap providers to secure their payment obligations under a swap agreement.
Types of Synthetic Replication
Synthetic replication comes in two main forms, depending on the type of swap used: fully funded or unfunded.
Synthetic ETPs - Fully Funded Swap
Haircut
A percentage reduction to the market value of an asset used for collateral.
Haircuts are imposed to provide a cushion to protect the ETP issuer in case the market value of the collateral falls.
Under a fully funded swap, the title to the collateral may be owned by the counterparty or the ETP depending on how the ETP has been structured. Where the counterparty defaults in both cases, the ETP will have title to the collateral as well as be able to sell the collateral and return the proceeds to the investors.
UCITS require the collateral deposited by the swap counterparty to meet certain requirements in terms of asset type, liquidity and diversification for ETFs. Appropriate haircuts must also be applied to protect against the risk of price fluctuations. The level of haircut depends on the asset type, and laws of the jurisdiction in which the product is domiciled. The collateral is marked-to-market daily.
Fully Funded Swap | |||||
Fully Funded Swap | Day 1 | Day 2 | Day 3 | ||
Index value | 100 | 105 | 105 | ||
Swap value | 100 | 105 | 105 | ||
Before | After | Before | After | ||
Collateral value | 111 | 111 | 117 | 108 | 117 |
Explanation | Assuming an index level of 100, initial investment of 100, and the haircut applied is to be 10%. The counterparty must post 111 of collateral (100 / 90% = 111). | The index rises by 5. To maintain sufficient collateral after the haircut, the counterparty must deposit more collateral. The counterparty must deposit enough collateral to bring its value up to 117 (105 / 90% = 117). | Although the index value is unchanged, the value of the collateral has fallen. The counterparty must, again, deposit additional collateral. |
Synthetic ETPs - Unfunded Swap
In an unfunded swap, the money investors have paid to buy the ETP is not directly transferred to the swap counterparty. Instead, a proportion of the money is used to pay the swap fee. The rest of the money is managed by the ETP provider. How the money is managed differs between providers:
- Reference basket: Some providers use the money to buy a basket of assets, usually from the swap counterparty, unrelated to the assets being tracked. The basket's return is then exchanged for the return of the assets the ETP is designed to track.
- Repurchase agreement: Some providers invest the money with the swap counterparty in a reverse repo to generate a return.
Repurchase Agreement (Repo)
An agreement where one party agrees to sell an asset temporarily and repurchase it in the future.
Reverse Repo
The same agreement, but from the perspective of the party purchasing the asset and selling it in the future.
UCITS and ETPs
UCITS, the 'Undertakings for Collective Investment in Transferable Securities', are a set of European directives that impose a common framework for regulating collective investment schemes throughout the European Union. UCITS have been embraced by ETP providers because it allows easy and cost-effective distribution throughout the fragmented European market via registration in an EU country.
UCITS require specific diversification criteria and therefore, only ETFs can be UCITS compliant.
UCITS, ETCs and ETNs
ETCs and ETNs are not issued as shares in funds but as debt securities. As such, they are not collective investment schemes for the purpose of the UCITS directive, and are therefore not governed by the UCITS regulations. However, while they are not UCITS compliant, they may be UCITS eligible. This means that they are investments which, while not themselves compliant with UCITS, are capable of being an eligible investment for another UCITS fund.
The benefits of UCITS for investors
This means that the fund’s assets could not be seized to pay creditors of the fund issuer were it to default.
Furthermore, the UCITS regulations oblige the fund to reduce its exposure to any counterparties in case such counterparties default on their obligations under the derivative contracts. One way of doing this is to post collateral. This collateral should meet minimum criteria. For example, the collateral must be valued on at least a daily basis and assets that exhibit high price volatility should not be accepted unless suitably conservative haircuts have been applied.
The prospectus must set out information such as a description of the index being tracked, the method of tracking and a description of the factors that contribute to the ETF’s performance. The amount of information required in the prospectus will vary according to the type of ETF.
Since prospectuses can be extremely long and dense documents, the KIID is a plain and concise summary of the important facts about the ETF. Usually, it is limited to two A4 pages in length. However, it should be noted that the KIID will inevitably omit certain information and investors should always read the full prospectus..
Finally, the annual and semi-annual reports will provide details of the investments and performance. It will include commentary from the fund issuer about developments over the financial year.
ETP Risks
There are many benefits of using ETPs. However, as with all investments, there are risks. Certain risks only apply to certain ETPs - it is important to distinguish what risks any individual ETP is subject to before making an investment.
Physical ETFs | Synthetic ETFs | Physical ETCs | Synthetic ETCs | ETNs | |
Market risk | • | • | • | • | • |
Tracking difference | • | • | • | • | • |
Tax | • | • | • | • | • |
Costs | • | • | • | • | • |
Currency | • | • | • | • | • |
Securities lending | (•) | ||||
Sampling | (•) | ||||
Counterparty risk | (•)* | • | • | • | |
Credit risk | • |
() = if engages
* if engages in securities lending
ETPs replicate the price movements of their underlying benchmark or asset so their performance is affected by the volatility of their underlying markets.
Tracking difference
The structure and cost of an ETP means it may not track its underlying exactly.
Tax
As with the majority of investments, ETPs will usually incur some form of taxation. Each investor should obtain independent tax advice.
Costs
All ETPs incur costs, whether internal costs (related to the product) or external costs (incurred in trading the product).
Currency
Any investment involving a non-local currency will be affected by exchange rate fluctuations (unless the product incorporates a currency hedge).
Physical ETFs that engage in securities lending can help reduce the cost of the product. However, securities lending introduces counterparty risk.
Sampling
Physical ETFs that engage in sampling replication may reduce transaction costs but may not track its underlying as accurately as synthetic or fully replicated physical ETFs.
Synthetic ETPs rely on swaps to track their underlying exposure. If the counterparty defaults, it is likely that the return will not be provided by the counterparty. Synthetic ETFs and ETCs are collateralised to minimise the impact of this possibility.
Trading and Pricing
Investors often judge ETP liquidity by the volumes traded on-exchange. In fact, there are 2 sources of ETP liquidity:
- The amount traded on-exchange
- The liquidity of the underlying asset
An understanding of how ETPs are created and redeemed, and the role of arbitrageurs, will help investors fully appreciate the mechanics of ETP pricing and how best to trade them.
Creation
Investors in Exchange Traded Products purchase and sell securities on the stock exchange. This is referred to as the secondary market. There is also a primary market, where APs are able to deal directly with the issuer of the ETP. A closer look at this process is detailed below for informational purposes. However, all of the interactions retail investors have with ETPs will take place only on the secondary market via the stock exchange.
The creation process
1. The AP submits an application to the ETP provider to purchase (i.e.'create') securities.
2. The AP then delivers the underlying reference asset or the cash equivalent to the ETP provider (e.g. if the ETP is tracking the FTSE 100 index, the AP will deliver the FTSE 100 shares according to their weighting in the index or the cash value of such shares).
3. In exchange, the ETP provider transfers the same value in ETP securities to the AP.
4. The AP then sells the ETP securities to intermediaries and investors via the stock exchange.
Authorised Participant (AP)
APs are financial institutions that source the underlying assets or cash needed to create the ETP. Only APs can create or redeem ETPs. They are typically investment banks or specialist market makers.
Redemption
The redemption process
1. The AP submits an application to the ETP provider to return (i.e.'redeem') securities.
2. The ETP provider then delivers the underlying reference asset or the cash equivalent to the AP.
3. In exchange, the ETP provider cancels the same value in ETP securities.
Pricing and Net Asset Value (NAV)
ETPs can be created and redeemed according to demand, which means the number of ETP units issued is variable. This is unlike company shares. Companies issue a fixed number of shares (unless a corporate event takes place to issue additional shares) that trade at a variable price determined by supply and demand.
This is important because the purpose of an ETP is to track an underlying benchmark or asset. If the price of an ETP fluctuated depending on supply and demand, it would no longer track its underlying accurately.
In theory, the price of an ETP should be determined by its net asset value (NAV) divided by the number of units. The NAV will fluctuate depending on the price movements of the underlying assets. This filters down to alter the price of each ETP.
Physical ETCs do not have a NAV. Instead, a physical ETC's price is determined by the metal entitlement multiplied by the spot price of that metal. The spot price will fluctuate depending on the supply and demand for the underlying metal.
NAV or Net Asset Value
Generally, NAV refers to the value of an entity's assets minus its liabilities.
In the context of ETFs, NAV is calculated as the value of assets held by the ETF (whether equities bonds, swaps, cash, etc.) minus its liabilities (management fee, swap fee, etc.). ETCs are valued according to their price, as securities are issued as debt securities and not as shares. That price is calculated by reference to a formula that references the underlying asset. The price of an ETC is sometimes referred to as its NAV for convenience purposes.
Arbitrage
If supply and demand for an ETP causes it to trade away from its NAV value, an arbitrage opportunity arises.
IF ETP PRICE ˃ UNDERLYING ASSETS
The AP can buy the underlying assets and exchange them for ETP securities. These securities can then be sold to intermediaries and investors. Since the ETP securities are worth more than the underlying assets, the AP profits.
IF ETP PRICE ˂ UNDERLYING ASSET
The AP can buy ETP securities and exchange them for the underlying assets. These assets can then be sold to intermediaries and investors. Since the underlying assets are worth more than the ETP securities, the AP profits.
With ETPs, the creation / redemption process allows arbitrage to take place. The AP can continue the arbitrage until there is no price difference between the ETP and the underlying assets, hence the process of arbitrage will no longer be profitable. This ensures that ETPs will only trade away from its NAV for short periods.
For example, bread costs £2 in London but £1 in Manchester. It costs 50p to transport the bread from Manchester to London. There is an opportunity to buy bread in Manchester and sell it in London for a profit.
As it buys the ETP and sells the underlying assets, it reduces the price difference between them. Eventually, the prices converge and the arbitrage will no longer be profitable. Through this process, the AP has returned the ETP to its NAV.
Liquidity
Since ETPs can take advantage of the liquidity of its underlying assets, large transactions can be executed without significant impact on costs. For example, average daily volume of all LSE-listed ETPs that track the FTSE 100 is approximately £61 million.
Looking at this metric alone, an investor might conclude liquidity in these products is limited. However, the liquidity available to FTSE 100 ETPs is actually much larger, since average daily volume of FTSE 100 shares is over £4.7 billion. ETP volume represents only 1.31% of the underlying asset volume.
ETP Liquidity explained
FTSE 100 ETPs | FTSE 100 shares | ETP volume as % of underlying | |
Daily volume (£) | 61,657,355 | 4,724,042,460 | 1.31% |
Source: WisdomTree, Bloomberg – Average Daily Volume (September 2016 - August 2017).
Therefore, investors thinking about an investment in ETPs should consider underlying asset liquidity as a more accurate measure of an ETP's liquidity and not just on-exchange volumes.
Understanding Order Types
ETPs can be bought and sold on-exchange in the same way as shares in companies. They can be traded through an online platform or through a broker. This means with a few clicks of a mouse, an investor can add commodity diversification with an ETC or gain exposure to an entire benchmark with an ETF in a single transaction.
Buying an ETP
Execution slippage
Because ETPs are traded on-exchange, investors can be exposed to execution slippage. This is the difference between the best price an asset could be traded at and the actual price achieved.
A stock exchange uses an order book to record the best bid and ask price for all market makers quoting a particular security. In the hypothetical order book below, the 'Ask' column shows the prices at which an ETP security can be purchased. The 'Size' is the number of securities available in the market, and the 'Order' is the number of market makers selling securities at each ask price. To illustrate this concept we introduce a hypothetical order book below.
Imagine an investor wants to buy 3,000 ETP securities:
A hypothetical order book
Ask (£) | Size | Order | Total |
10.83 | 2,000 | 1 | 2,000 |
15.50 | 180 | 1 | 2,180 |
16.30 | 100 | 1 | 2,280 |
17.25 | 120 | 1 | 2,400 |
20 | 160 | 1 | 2,560 |
21.10 | 1,000 | 1 | 3,560 |
Source: WisdomTree, hypothetical example.
An investor's order is filled by purchasing the cheapest securities first and progressing onto the more expensive securities. If the investor in this example wants to fill the order for 3,000 securities of the ETP immediately, he will first purchase the 2,000 securities available in the market at the lowest ask price of £10.83. The rest of the order is filled by purchasing the 180 securities available at the next best ask price of 15.50 before progressing onto the more expensive securities. The process continues until the entire order of 3,000 securities is filled. Note that, despite there being 1,000 securities of the ETP available at £21.10, only 440 securities need to be purchased at this price.
The average price of each ETP security is the sum of each ask price multiplied by the number of securities purchased at that price and divided by the total order size (3,000). As explained in the table, the total order of 3,000 securities would be executed at an average price of £13.54, compared to a best price of £10.83. The investor has paid a significant premium for the asset, reducing the prospective gain. This is called execution slippage.
Potential investors can protect themselves against execution slippage by using different order types.
Calculating the average price of an ETP security
Ask (£) | Shares purchased | Order cost (£) | ||
10.83 | x | 2,000 | = | 21,660 |
15.50 | x | 180 | = | 2,790 |
16.30 | x | 100 | = | 1,630 |
17.25 | x | 120 | = | 2,070 |
20 | x | 160 | = | 3,200 |
21.10 | x | 440 | = | 9,284 |
Total | 40,634 |
Total order cost (£) | 40,634 |
Total order size | 3,000 |
Price (£) | 40,634 / 3,000= 13.54 |
Order types
There are four key order types; market order; limit order; stop loss order; and stop limit order.
Market orders are immediately executed, but suffer from execution slippage. A market order is illustrated in the example below.
Market order | Pros | Cons | Often used when... |
Trade immediately at bestmarket price | Immediate | No guaranteed price and risk of execution slippage | It is more important to make the trade quickly than achieve a specific price |
If an investor seeks to execute at a specific price, a limit order is often be used.
Pros | Cons | Often used when... | |
LIMIT ORDER Trade only at a specified price or better |
Transact only at a particular price the investor is comfortable with | If that price is not reached, there will be no transaction | The aim is to execute a trade at a particular price |
Limit orders are cancelled after a set time, usually at the end of the day, but can be specified to last for a longer period. Limit orders can be amended or cancelled provided they have not already been executed.
Stop loss order | Pros | Cons | Often used when... |
Execute as market order once designated stop price is achieved | More likely to transact than limit order, when transacting close to specified price | Slight risk of execution slippage (price may change after order is triggered) | The aim is to protect a profit or limit a loss |
Pros | Cons | Often used when... | |
STOP LIMIT ORDER Trigger a limit order once designated stop price is achieved (i.e. set both a stop and limit price) |
Maximum execution protection to achieve desired price | Price must reach two set limits before there is a transaction | The aim is to protect a profit or limit a loss and speed is not a big priority |
Costs and Performance
Cost is one of the most important factors to take into consideration when making an investment. While performance is difficult to predict, costs are not.
Unfortunately, ETP costs are not always clear. The most widely reported cost figure, the total expense ratio (TER), is often incomplete and can neglect a number of internal and external expenses, including transactions costs, swap spreads and bid / ask spreads on exchange.
In this section, we attempt to outline the most common components that contribute to an ETP's total ownership cost, dividing them between internal costs (related to the product) and external costs (incurred in trading the product).
Calculating the Total Cost of Ownership
Internal Costs
Total Expense Ratio (TER)
The total expense ratio is the annual cost of managing the product, expressed as a percentage. The costs included within the TER can vary among providers, but usually incorporate:
Management expense ratio (MER) |
Administrative costs |
Index license fee |
Storage costs (for physical ETCs) |
Rebalancing costs
The cost incurred by physical ETFs when they buy and sell securities.
When the underlying index changes its constituents, the ETF must do likewise. Transaction costs depend on how many and often the index constituents change: the greater the number and frequency, the more expensive the rebalancing costs.
Swap spread
The fee paid by the synthetic ETP provider to the swap counterparties for the swaps agreements.
The swap fee is a matter of negotiation between the provider and the counterparty, considering commercial factors such as the cost of the counterparty hedging its swap exposure, the cost of collateral, its credit rating and its own profit margin. Generally, more illiquid or exotic exposures have more expensive swap spreads.
Sometimes the swap spread is incorporated into the TER of ETPs.
External Costs
There are three factors that contribute to the external costs of an ETP; bid / ask spread; the brokerage fee; and tax.
Bid / ask spread
As with trading any asset on-exchange, there is a spread of prices at which an ETP can be bought or sold.
Bid | Ask | Bid / ask spread |
The price at which buyer is willing to buy an asset. | The price at which a seller is willing to sell an asset. | The difference between the bid and ask price. |
Bid / ask prices are quoted by market makers (MMs), who ensure there is always a price at which an asset can be bought and sold. MMs compete for customers by trying to offer the most competitive prices. For an ETP, the costs that MMs consider are the creation / redemption fee, the market maker spread and the underlying spread.
If any of these 3 costs rise, the MM will widen the bid / ask spread to try to make a profit.
Typically, the more MMs offering bid / ask spreads on an ETP, the tighter the bid / ask spread. ETPs with more MMs will generally trade at a price closer to that of the underlying asset they are designed to track. This, in turn, means the investor pays less money to buy the product and receives more money on its sale.
Brokerage fee
Cost paid by the investor to a broker to buy or sell an ETP.Tax
Different ETPs will incur different taxes, depending on the product itself, the jurisdiction it is domiciled in and the circumstances of the individual investor. Investors are advised to contact tax experts in their own jurisdiction to clarify what charges will apply.Creation / redemption Fee
The fee the ETP provider charges to create or redeem shares.
Market Maker (MM)
MMs are firms that provide liquidity to the market by quoting bid / ask prices. Their profit comes from buying an asset at a lower price than which it is sold or, vice versa, selling an asset at a higher price than which it is bought. The MM wants to hold the asset for as little time as possible, ideally buying and selling simultaneously.
For example, for ETP 1, a MM may quote an ask price of £100 and a bid price of £99. If you sell your shares of ETP 1 at £99, the MM can go on to sell them to another buyer at £100, making a £1 profit.
Market maker spread
MMs do not attempt to profit from changes in an asset's price; what most investors consider investment exposure is actually risk to the MM. Instead, they attempt to buy and sell simultaneously. This is not always possible, therefore the MM will hedge against the price fluctuation of an asset. The cost of doing so is the market maker spread passed on to the investor.
Underlying spread
The cost of buying the underlying assets, which also have bid / ask spreads, needed to create the physically backed ETP. This cost is greater for illiquid assets than liquid ones.
Beyond TER
In the following simplified example, ETP 1 has a cheaper TER by 15 basis points. However, when all the costs of ownership are considered it becomes 9 basis points more expensive. Investors should resist the impulse to judge an ETP by TER alone and adopt a more holistic view about ETP costs.
Beyond TER numerical example
TER (bps) | Swap spread (bps) | Securities lending (bps) | Bid / ask spread (bps) | Total cost (bps) | |
ETP 1 | 25 | 15 | -5 | 10 | 45 |
ETP 2 | 40 | 5 | -15 | 6 | 36 |
Source: WisdomTree, hypothetical example
Base Point / BPS
One hundredth of a percentage point
(1 basis point = 0.01%)
Tracking
Tracking Error and Tracking Difference
Tracking error
The volatility of the difference of the returns between a product and its benchmark.
Tracking error is calculated as the standard deviation of a product's returns against its benchmark. It shows how consistent the ETP has been in replicating its benchmark.
Tracking difference
The difference between a product's return and that of its benchmark over a specific time period.
Tracking difference is calculated by accessing the difference between the return of a benchmark and the return of the ETP designed to track it. It shows the magnitude of underperformance. There will always be an element of tracking difference because of fees.
Tracking difference is usually negative, meaning that the ETP underperforms its benchmark. However, sampling replication and revenue from securities lending can both cause physically backed ETFs to have a positive tracking difference, in which case the ETF has outperformed its benchmark.
ETP tracking error calculation
Source: WisdomTree, hypothetical example.
In the hypothetical example above, the volatility of the difference of the returns between the benchmark and the product is the cause of tracking error. However, if measured between day 1 and day 36 there is no tracking difference since both the benchmark and the product returned the same amount over 36 days. Nevertheless, if we were going to measure returns across a different time frame, such as over 20 days rather than 36, there would have been tracking difference.
Tracking difference tends to vary over time and is therefore sensitive to the time horizon that is selected. As such, tracking error does not necessarily impact the magnitude of tracking difference over a given time period.
While tracking difference is easily calculable, tracking error is much more complex because there are numerous methodologies that providers use to calculate tracking error.
Tracking error inconsistency can arise from:
- frequency of data used (daily, weekly, monthly)
- time period (one year, three years, five years)
- issues around rounding
- issues posed by holidays
Currently, there is no standardised methodology to calculate tracking error, which means the figures supplied by ETP providers may not be a like-for-like comparison.
Causes of Tracking Error and Difference
Cost is one of the largest sources of tracking error and tracking difference. Given that the total holding cost comprises both fixed elements (TER) and variable elements (bid / ask spreads) such costs can contribute to the absolute difference between a product and its benchmark's return (tracking difference), as well as the volatility of that difference (tracking error). However, there are a number of causes of tracking error and tracking difference that are not covered by costs.
Cost factors that impact tracking | Non-cost factors that impact tracking |
TER | Dividend reinvestment |
Rebalancing costs | Withholding taxes |
Swap spread | Sampling |
Tax | Securities Lending |
Non-cost causes of tracking error and tracking difference
There are a number of causes of tracking error and tracking difference that are not covered by costs.
Some indices assume immediate reinvestment of dividend proceeds on the ex-dividend date but a product must wait to receive the dividend before it can re-invest. During this period, there will therefore be a difference between the performance of the ETP and its benchmark.
While these taxes are factored in the index calculation, they may not apply to all investors. Please consult an independent financial adviser in order to determine how tax implications will affect your investment.
Importance of Tracking Error and Difference
Understanding Indices
Total return index (TR)
An index in which any cash distributions from the underlying assets are reinvested.
For instance, the FTSE 100 total return index (Bloomberg code: TUKXG). There are also total return indices for bonds and commodities, which are calculated in a slightly different way.
Price return index (PR)
An index which only tracks the price movements of the underlying assets and does not reinvest cash distributions.
For instance, the FTSE 100 price return index (Bloomberg code: UKX).
FTSE 100 total return index (TR) vs. FTSE 100 price return index (PR)
Source: Bloomberg (December 2011 - December 2014)
This distinction is important because whenever cash dividends are made, PR indices will fall but TR indices will not be affected by the distributions. For instance, if a number of FTSE 100 companies pay out dividends on a particular day, UKX would drop as a result of the dividends, but TUKXG would not be affected by the dividends. As such, TUKXG has outperformed UKX by over 11% over the last 3 years11. Since news media almost exclusively quote PR indices, this can cause some confusion among investors who have invested in an ETP that tracks a TR index. Thus, potential investors should be aware of which version of an index (TR or PR) a particular ETP tracks.
Futures, Contango and Backwardation
As such, ETCs tracking non-metal commodities usually track futures indices. However, there are certain costs inherent in futures that investors should be aware of when purchasing an ETP that tracks their performance, especially in relation to the impact of contango and backwardation.
Futures (contracts)
An agreement where one party will buy and the other party will sell an asset at a future date at a predetermined price.
Futures contracts are standardised in that they will stipulate an amount and quality of the asset which is the subject of the contract. For instance, 5,000 bushels at #1 soft red winter grade are the set requirements for wheat futures on the New York Mercantile Exchange. This makes establishing a liquid market easy because buyers and sellers know exactly what they are getting.
Futures contracts have varying maturities (when the commodity is to be delivered), ranging from 1 month to 3+ years.
Futures Contracts and Indices
The price of a futures contract is based on the spot price of the underlying asset and additional costs of carry which are explained below. Instead of buying the futures contract, the investor could buy the commodity and store it for the length of the future. For example, an investor who wants to receive 1,000 barrels of oil in 3 months time can buy the appropriate futures now or buy 1,000 barrels of oil and store it for 3 months.
However, buying the commodity immediately for use in the future incurs extra costs: interest, storage and insurance. These are known as the costs of carry.
Roll yield
Futures contracts are generally closed out of just before the term of the contract expires and new longer dated contracts are entered into in order to avoid taking actual delivery of the commodity in question (a process known as 'rolling'). This ensures that continuous exposure to the commodity is maintained.Contango
The contracts being purchased may be more expensive than the contracts being sold which would cause an investor in commodity futures to make an additional loss. This market trend is known as 'contango' and the price difference is commonly referred to as 'roll yield'. As the roll yield is incorporated into the calculation of the value of the Index, it will have a negative impact on the value of the Index.For example, imagine an investor holds 100 front month oil futures that are nearing expiry, so the futures need to be rolled. According to the graph on the right, they can be sold for US$79, yielding US$7900. This money is then invested in futures that expire a month later (M2 futures), which cost US$79.4. The US$7900 will only be sufficient to buy 99 M2 oil futures. Thus, the investor has lost 1% of his investment due to the cost of rolling.
Oil futures curve in contango
Sources: WisdomTree, hypothetical example
Backwardation
Alternatively, the contracts being purchased may be cheaper than the ones being sold which would result in an additional gain, known as 'backwardation'. Rolling futures when the market is in backwardation results in a profit to an investor. This is because the current futures contract can be sold for a higher price than it costs to buy the new futures contract.
Oil futures curve in backwardation
Sources: WisdomTree, hypothetical example
Collateral yield
With a futures contract, the majority of cash due to be paid on delivery of a commodity does not change hands immediately. In contrast, futures indices presume that the entire contract value is paid up-front. However, this would mean a futures index investor would lose the interest on cash that could have been earned by using futures contracts. As such, the index calculation includes a collateral yield to more accurately simulate a rolling futures exposure.Thus, a futures index can be said to be composed of three elements: the spot index return, the roll yield and the collateral yield. A commodities index that incorporates all three elements is known as a total return index.
Composition of returns - Bloomberg WTI Crude Oil Subindex annual return
Sources: WisdomTree, Bloomberg (1991 - 2016)
Note that some ETPs track price return indices. These are indices which omit the collateral yield component.
Impact of Contango and Backwardation
Since non-metal ETCs track futures indices, the return of an ETC will similarly be composed of these three elements - spot return, roll yield and collateral yield. As can be seen from the graph 'Composition of returns - DJ-UBS crude oil annual return, from 1991 to 2012' on the previous subchapter 'Understanding futures indices', the roll yield is the largest reason why a commodity ETC will not match the spot return. The roll yield, in turn, depends on whether the futures market is in contango or backwardation. The magnitude of the impact of these market traits on ETC returns should not be underestimated. For instance, in 2009, although the spot price of crude oil increased over 50%, contango negated almost all the gains.
ETCs can track futures indices that simulate exposure to both short dated and long dated futures contracts. One way to mitigate the effects of contango and backwardation in the short-term is to invest in these longer dated contracts. ETCs tracking short dated futures indices need to roll futures contracts more frequently than ETCs tracking long dated futures, giving the investor more exposure to short-term price movements and the slope of the futures curve.
The price of longer dated futures tends to be driven more by structural supply / demand considerations. In the graph opposite we can see that the roll return is closer to 0 for the ETP tracking the longer dated futures index. ETPs tracking shorter dated futures indices can have much more variability in roll returns.
Short term drivers | Long term drivers |
Immediate supply / demand concerns, affected by:
|
Structural supply / demand concern, affected by:
|
An investor can seek to limit and, in certain cases, benefit from the impact of contango and backwardation. To minimise the occasions in which a futures contract needs to be rolled over, and possibly track the spot price more closely, an ETP can track a longer dated futures contract.
It is worth noting that, if the futures curve is in backwardation, an ETC investor with a long position can benefit from a positive roll yield. There are ETCs which track indices that dynamically adjust the maturity of the futures contract in order to optimise the roll yield. However, the effect of these strategies is uncertain given the scarcity of data available to assess their performance.
Contango / backwardation of Brent 1mth & 2 yr vs. US Oil Inventories
Ultimately, investors need to consider their investment aims. If an investor is seeking to profit from temporary supply / demand imbalances, then an ETP that tracks a short dated futures index may be considered to achieve the investment aim. If an investor is attempting to benefit from structural discrepancies, a longer dated ETP may be worth considering further.
Active and Passive Investment
Comparing active vs passive product costs
Below we compare the hypothetical costs associated with an actively managed fund and a passively managed ETP. Imagine £10,000 is invested in both an active fund and an ETP, neither of which generate any return. The active fund charges 2% where the ETP charges only 0.5%. The table below shows how much money would remain over various periods:
1 year | 3 years | 5 years | 10 years | 20 years | |
Active fund (2% charge) | £9,800 | £9,411.92 | £9,039.21 | £8,170.73 | £6,676.08 |
ETP (0.5% charge) | £9,950 | £9,850.75 | £9,752.49 | £9,511.10 | £9,046.10 |
Source: WisdomTree, hypothetical example.
Over a 20 year time frame, the actively managed fund has cost almost £2,500 more than the ETP. This is an extreme example but the savings are significant even over shorter periods.
The Risks of Passive Investment
Index distortion
Investing in a passive index fund offers the benefit of owning a broad range of assets. However, owning an index does not always guarantee diversification: indices can become particularly concentrated in one sector. In July 2007, the height of the pre-crisis boom, financial services constituted 24.5% of the FTSE 100. Over the next 2 years, financial services shrank to 12.5% of the FTSE, losing £30 billion in market capitalisation and contributing to a 48% decline in the FTSE for that period.
A diligent active manager may have been able to mitigate their losses by reducing their financial services exposure in a way that a passive investor could not. However, many index methodologies will cap sector and single company exposures to mitigate this risk.
Tracking inaccuracy
ETPs attempt to replicate indices as closely as possible but they are not perfect.
In practice, there will usually be tracking difference between the benchmark and the product. For most liquid markets, these differences are limited, but tracking difference can be much more significant for individual ETPs in less liquid market segments. An ETP that significantly underperforms its benchmark may return less than an active fund
Combining active and passive investments
ETPs should be used as building blocks in an investment portfolio. Ultimately, investors can benefit by combining active and passive investments in a single portfolio. Incorporating passive funds into the core of a portfolio will help to minimise the overall costs and volatility of a portfolio. Additional positions, known as satellites, harness the ability of active funds to incorporate forward looking projections and possibly outperform the market. This core / satellite method of portfolio construction is a flexible approach to investing designed to provide the best of both active and passive strategies.
ETPs can be used as building blocks in an investment portfolio. Ultimately, investors can benefit by combining active and passive investments in a single portfolio. Incorporating passive funds into the core of a portfolio will help to minimise the overall costs and volatility of a portfolio.