If Your ETF Ain’t UCITS, It’s Pretty Special

[This article first appeared on the Learn section of our website, a comprehensive database of educational articles]

In Europe, many types of instrument or financial index cannot be tracked by a UCITS fund (see "Fund Regulations" for more details of the UCITS rules).

Even though the diversification rules within UCITS have been relaxed for index-tracking funds, certain indices may still be too concentrated to qualify as the underlying index for an ETF.

For the same reason (concentration), a single asset (for example, a single commodity or a foreign exchange rate) cannot be tracked by a UCITS fund.

And since Europe's securities market regulator, ESMA, issued new guidelines for ETFs and UCITS in 2012, any index that does not disclose its underlying methodology and historical weights is also ineligible to be used in a UCITS.

Special Purpose Vehicles (SPVs) are therefore widely used to track individual asset types or otherwise-ineligible indices.

SPVs do this by issuing debt securities (notes or bonds), whose value is linked to the underlying asset or index. SPVs operate at arm's length from the originator or sponsoring organisation, and have a separate legal name and identity.

ETPs following the SPV structure include exchange-traded commodities and currencies (ETCs) and exchange-traded notes (ETNs). ETCs and ETNs have many characteristics of ETFs: notably their stock exchange listings and the provision of intraday liquidity by market makers.

But whereas ETFs are bound by law to engage the services of a third-party custodian, who is in charge of safeguarding the assets of the investors in the fund, ETCs and ETNs have no formal obligation to do so. As a result, their structure merits closer examination by investors. This means reading the ETC/ETN prospectus, paying attention to the entities involved and their interrelationship, and reading the prospectus statements on risk factors.

The most popular type of ETC—precious metals ETCs—are almost all backed by physical holdings of precious metals, held at a separate custodian.

Many ETCs/ETNs enter into derivative contracts with a third party to ensure that they are able to generate the return that is being offered to their investors. This means that an investor in the ETC/ETN is exposed to the risk that the derivative counterparty might default. To offset this risk, the counterparty may post collateral to a third-party custodian, which effectively insures investors against a default on the derivatives contract.

Some ETCs and ETNs, however, are uncollateralised, meaning that an investor depends fully on the ability of the counterparty to fulfil its obligations.

It's also worth paying attention to the nature and identity of the entities involved in providing the index to the ETC/ETN (if it tracks an index), and in providing market-making support to the ETC/ETN.

If all these roles are performed by a single entity (usually the originator of the structure), then there's an additional risk if the firm gets into trouble. There have been prior cases of ETN issuers struggling to meet their obligations to quote continuous prices to investors.

If the index provision and market-making roles are performed by third parties, the structure is more robust and investors have additional reassurance, though this may mean extra costs.

Just because an ETP is not a fund and follows the ETC/ETN route, there's no need to shun it. Some of the most successful ETPs of all (gold trackers) are not funds (they can't be under Europe's fund rules). But if you're investing in an ETC/ETN, you need to perform your due diligence.