ETF Vs ETP: Know What You're Invested In

ETF Vs ETP: Know What You're Invested In

How can an ETP structure itself and what are the implications for investors?  

ETF.com
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Reviewed by: etf.com Staff
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Edited by: etf.com Staff

[This article was first published on the Learn section of our website, a comprehensive database of educational tools and resources]

 

There’s a distinction in legal structure between two different types of exchange-traded products: exchange-traded funds (ETFs) and nonfund ETPs.

Before highlighting the differences between the two legal structures, let’s remember the similarities:

-All ETPs are quoted and traded on stock exchanges throughout the trading day, like ordinary shares

-Most ETPs calculate their prices with reference to an underlying index or reference asset

-ETPs commonly transact with third parties (for example, counterparties in derivatives transactions, or stock-lending counterparties) to achieve and enhance their return, often taking collateral as part of such transactions

But ETFs are funds, and most of Europe’s ETFs are regulated in accordance with the region’s UCITS regime. UCITS allows funds to invest in certain categories of eligible asset, set minimum diversification requirements, and separate the functions of fund depositary (custodian) and auditor from that of the manager/issuer.

Nonfund ETPs may operate in a very similar way and are another type of collective investment vehicle. But nonfund ETPs are typically debt securities, issued by special purpose vehicles (SPVs) that are usually domiciled in an offshore centre. Such SPVs needn’t comply with the UCITS rules, such as the minimum diversification requirements or leverage limits.

As debt securities, nonfund ETPs’ performance depends directly on the creditworthiness of the issuer, increasing risk for investors. Many nonfund ETPs are collateralised, however, meaning that investors have recourse to a separate pool of assets in the event of an issuer default.

In Europe, exchange-traded commodities and leveraged ETPs with a leverage factor exceeding 2 must be issued as nonfund ETPs, as these investment exposures would not be permissible within UCITS.

 

It’s worth remembering that noninvestment risks such as counterparty credit exposure can arise in UCITS funds too. This happens, for example, when a UCITS uses derivatives or when it lends securities. In both cases, exposures are capped because of the diversification limits inherent to UCITS.

If the ETP incurs counterparty and collateral exposures, it’s worth performing a few key checks:

-What are the collateral guidelines; who can change them; how are they enforced?

-Does the ETP have full legal title to the collateral?

-How quickly can the ETP access the collateral?

-Does the ETP disclose the quantity and makeup of its collateral and, if so, how often?

A key takeaway for investors is to be prepared to conduct extra due diligence if an ETP operates outside the UCITS rules, as nonfund ETP structures are by definition less standardised than UCITS funds and they can incur greater counterparty and other risks. But this doesn’t mean investors should shun or be wary of nonfund ETPs. Indeed, one of the greatest success stories of the ETP market—gold trackers—operates with precisely this structure.

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