Exchange traded products [ETPs] are widely held instruments with some unique benefits over mutual funds, particularly for traders. However if the product risk is not completely understood, those benefits can quickly be outweighed. The addition of actively managed instruments and master limited partnerships [MLPs] translate to increasing complexity in the ETP world.
In this article series the original exchange traded product, close-end funds, is excluded.
ETP Types
- Exchange Traded Fund [ETF]: open-end investment company or unit investment trust
- Exchange Traded Note [ETN]: Unsecured, unsubordinated debt of issuer
- Exchange Traded Vehicle [ETV]: Commodity, Currency, Certificate
An interesting partial history of ETPs can be found at the New York Stock Exchange [NYSE] web site: https://etp.nyx.com/etp-20/timeline.
When first introduced ETP benefits touted included:
- Transparency
- Tax efficiency
- Liquidity
- Availability of Options
With new products introduced and tax law changes, such comments can no longer be made on the wide-ranging instruments that make up the ETP world. The last time I took an in-depth look at the products actively managed ETPs were on the horizon. At issue and unresolved for me as I research the topic again is whether issuing companies could have the daily holdings disclosure requirement waived. Although it appears there is potential for an ETP to operate this way, I can’t seem to track one down.
One argument favoring such a waiver is that the existence of an Intraday Net Asset Value (INAV) quote meets the transparency requirement. However, it seems with only the value of the underlying basket—no specific information about what’s in the basket—makes arbitrage impossible. I’ll provide more on this topic when actively managed ETPs are tackled.
Risk
Two key things investors and traders should know to assess the risks associated with ETPs seem to remain:
- Understand the type of ETP (ETF, ETN or ETV) you are considering and
- Understand the market and instrument risks associated with the underlying basket of securities.
At the end of the day there’s no better resource then the product’s prospectus which will include a section summarizing risks. These are usually very accessible on-line and the old rule of thumb applies: if you don’t understand the risk you need to hold off.
Investment Risk Shortlist
The risks identified here are not intended to be an exhaustive list, but rather a starting point addressing basic investment risks. It first appeared in the 2008 white paper from Optionetics titled: Risks & Rewards: Achieving Your Bottom Line with ETFs.
Market Risk: Risk in the market that cannot be diversified away. This type of risk is also referred to as systematic risk and will be present in all funds.
Interest Rate Risk: Investing in funds that invest in bonds and other fixed income products runs the risk of locking in a rate of interest that may prove to be inferior if rates rise after the position is taken. This results in returns that are lower than prevailing rates.
Political Risk: Investments in foreign countries with less stable governments are deemed to have greater political risk than those with both stable governments and longer standing financial markets. For example, if you buy a fund representing shares of stock in a given country and the government subsequently nationalizes certain businesses, the price of those shares may be adversely affected.
Default Risk: Fixed income investments receive interest payments based on the principal amount borrowed and a return of principle when the investment matures. Default risk refers to the potential that the borrower may be unable to make those interest payments and/or return the principle amount.
Counterparty Risk: Contractual obligations for derivative products which represent non-standardized agreements and do not clear through an exchange or clearing corporation are dependent upon each party’s ability to meet the financial terms of the agreement. Good faith deposits held with a third-party may serve to off-set such risk.
Currency risk: ETFs and related products tracking foreign equity and fixed income indices may need to purchase securities in the local currency, creating currency fluctuation risk for the fund if that risk is not hedged in some way.
Diversity Risk: Although a fund may provide returns for a narrow, but diversified index, the manner in which the fund achieves its returns may include a non-diversified approach. By reviewing the fund’s holdings and prospectus you can assess this risk (less common).
Tracking Risk: Passive ETFs and related products seek to replicate returns for a stated index. However, it’s rare for the actual returns to track perfectly given fund expenses, supply/demand issues, securities within the fund used to track returns and timing issues. Therefore, the buyer of a passively managed ETF assumes the risk that the fund may underperform its intended benchmark.
Resources
Optionetics. (2008). Risks & Rewards: Achieving Your Bottom Line with ETFs [White paper].
Ferri, R., CFA (2008). The ETF Book. Hoboken, NJ: John Wiley & Sons, Inc.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.
