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ETPs are basically exchange-traded products that derive their value from underlying assets like an index, security, etc. They are hybrid investment companies registered with SEC (Securities and Exchange Commission). They continuously trade their security portfolio at a market price throughout the day. They are listed in national exchanges and are traded just like stocks. They are very much similar to mutual funds with some functional differences. They are not managed as no one takes decisions like composition, sizing, etc. on behalf of the investor rather dependent on the value of the underlying instrument only. This is also the reason that ETPs are cheaper option to deal with instead of other instruments like mutual funds.
Exchange Traded Funds Vs Mutual Funds
Mutual funds are pool of stocks securities or any other instruments that actively managed by fund managers. The proportion of various components can be altered depending on market situations under certain SEC (U.S. Securities and Exchange Commission) restrictions. These decisions have to be made public and are based on fundamental analysis, technical analysis and even backed by Artificial intelligence now a days. In order to provide services fund managing firms charge fees.
However, in ETF (Exchange Traded Funds) are just mirror to underlying instrument. No fund managers are involved here. Investors just get direct exposure to value of underlying and this is the reason investing in exchange traded product is easier and less costly. ETF(Exchange Traded Funds)) price changes in coherence with the underlying asset. Any rise of fall in value of underlying gets directly reflected in ETF (Exchange Traded Funds) price.
What is an ETN?
ETN is Exchange traded note which is an unsecured debt security issued by a bank. It ensures payment on maturity. They have inherent credit risk of the issuer bank. The return is linked to a market index or other underlying. However, since the debt structure, the cost of holding currencies, commodities, and futures is eliminated and the tax liabilities of investors get reduced and also easy to manage and at the same time come under the category of IRS Schedule K-1.
ETN vs ETF
ETF (Exchange Traded Funds)
ETN (Exchange Traded Notes)
ETFs are popular exchange traded funds characterized by the ability to buy (in cash and carry position) a fund that derives its value from the underlying instruments.
ETNs are less popular Exchange Traded Notes. They are similar to Bonds however, they also reflect the underlying instrument’s price. They are unsecured Debt note.
It invests in bonds, gold, commodity, stock, or combination.
Exchange Traded notes are based on index as underlying asset.
They can be bought or sold anytime.
Exchange Traded notes can be bought or sold at will and can also be held until maturity.
Taxation is applicable under IRS Form 1099 just like capital gain tax.
Taxable under IRS Schedule K-1. Thus, taxation is slightly less.
Investors may have liquidity issues sometimes and may not get the exact proportion gain corresponding to the underlying asset.
However, in case of ETNs, issuer is obliged to pay the proportional gain in underlying asset.
Exchange traded funds have to pay dividends or interest.
There is no provision of dividends or interest in the case of Exchange traded notes.
Exchange traded funds draw their value from market price only.
They draw their value from market price along with the health of issuer institution.
ETFs have less options in terms of diversity in underlying instruments with NASDAQ 100 and S&P 500 being the most popular.
They have a wide range of underlying asset availability from commodities, currencies to emerging markets.
The risk profile is better as chances of the extreme losses are only in case of black swan events.
Risk is higher because there is a possibility of defaulting by issuer institution along risk derived from the market.
Advantages of ETP
- They are low-cost alternative Mutual Funds.
- Wide range of investment options are there.
- Liquidity is comparatively higher in an Exchange Traded Products.
Liquidity in ETP
These funds are open ended fund thus can be created and redeemed on demand. ETPs liquidity is a function trading volume of ETP itself and trading volume individual securities in its portfolio.
In case of demand increasing supply market maker first supply those units to investors and issue securities to sponsors. Then sponsor will sell these securities in exchange to supply those units to market maker. Thus, market maker acts like a buffer and create liquidity. The flow will reverse in case supply exceeds demand.
Risk profile of ETP
Thought ETPs contain more than one instrument that does not make them immune to market risks. Large fluctuations and high volatility pose sufficient risk. ETPs also provide easy access to instruments traded in global exchanges thus are subject international policies and dollar index also.
There is also issue of low liquidity in some funds. Thus in general trend in gap between bid and ask price should always be considered while making choice of ETPs. .
There is also presence of tracking error between actual return and return in underlying asset. Though these errors are minor and can be neglected.
Also, investor do not have any say in composition of fund. Thus, even if they expect a upcoming risk in particular element of underlying composition they cannot avoid it unless they exit whole position.
There is also issue of capital gain taxation as capital gains are distributed among shareholders thus investor have to pay capital gain tax. Had they invested it, it could reduce tax liability of particular financial year. Also, if investor want to reinvest this capital gain, then he has to further pay ne fees.
ETPs and NYSE ARCA
NYSE Acra is owned by Intercontinental Exchange (ICE) U.S. electronic securities exchange that specializes in ETP listings with almost 7$ trillion assets under management. It was the result of the merger of the New York Stock Exchange and Archipelago. It is the world largest Exchange in terms of ETF volume traded. It has more than 8000 stocks and ETPs listed.