Exchange-Traded Product (ETP) vs. Exchange-Traded Fund (ETF): What’s the Difference?

Other Types of ETPs

In addition to ETFs, other types of ETPs include ETNs and exchange-traded commodities (ETCs).

Exchange-Traded Notes (ETNs)

ETNs combine bond investing with the tradeability of stocks. Unlike ETFs, which hold underlying assets, ETNs are structured as unsecured debt securities issued by financial institutions. These notes promise to pay the holder a return based on the performance of a market index or other reference measure, minus applicable fees, at maturity.

ETNs, however, have some unique risks and benefits:

• Credit risk: Since ETNs are debt instruments, their value is dependent, in part, on the creditworthiness of the issuing bank. If the issuer faces financial difficulties, the ETN could lose value, no matter the performance of the underlying index.
• Price tracking: ETNs aim to closely track the performance of their underlying index or benchmark. They do not experience tracking errors the same way that ETFs might.
• Liquidity risk: Some ETNs may have lower trading volumes than ETFs, potentially leading to wider bid-ask spreads and impacting the ease with which they can be bought or sold at desired prices.
• Tax efficiency: ETNs can offer unique tax benefits in certain situations. For instance, since they do not distribute dividends, investors might not incur taxes until the sale of the ETN or its maturity, potentially deferring tax liabilities.
• Market exposure: ETNs can provide exposure to many assets, including hard-to-reach markets and strategies. This includes commodities, emerging markets, private equity, or specific investment strategies that might be difficult or costly to access directly.

Exchange-Traded Commodities (ETCs)

ETCs offer exposure to commodities, including metals, energy, and agricultural products, without directly investing in physical commodities or futures contracts. ETCs track the commodity’s price or a basket of commodities, allowing investors to gain exposure to commodity markets through a security that trades on a stock exchange.

There are differences between ETCs and ETFs that track commodities. Commodity ETFs are structured as funds and regulated under the Investment Company Act of 1940 in the U.S. They hold either physical commodities (like gold or silver) or futures contracts on commodities. Commodity ETFs are considered equity products and are regulated like mutual funds and other ETFs.

Exchange-traded commodities, like ETNs, are structured as debt securities, even though they track commodity prices. They are not considered funds in the traditional sense but are debt instruments issued by a single entity. This means there are credit risks involving the issuer.

ETCs can be broadly classified into two categories:

• Physical ETCs: These ETCs hold physical commodities, such as gold or silver bars, in secure vaults. Investors in physical ETCs have a claim on the underlying metal, and the value of the ETC is directly tied to the price of the physical commodity.
• Synthetic ETCs: Instead of holding physical commodities, synthetic ETCs use derivatives like futures contracts to replicate the performance of the underlying commodity. This approach can provide exposure to a broader range of commodities, including those difficult or impractical to store physically.

As with ETNs, ETCs also present unique risks and benefits:

• Direct commodity exposure: ETCs offer a straightforward way to invest in commodities, which can serve as a hedge against inflation or a diversification tool outside traditional stocks and bonds.
• Variety: Investors can choose from various commodities, from gold and silver to oil and agricultural products, depending on their investment goals and market outlook.
• Transparency: ETCs offer transparency in holdings and pricing, with the value of the ETC closely tracking the underlying commodity or commodities.
• Volatility: Commodity markets can be highly volatile, with prices influenced by various factors, including geopolitical events, weather conditions, and changes in supply and demand.
• Counterparty risk: Synthetic ETCs can involve counterparty risk since their performance depends on the ability of the issuer or counterparty to fulfill their obligations under the derivative contracts.
• Credit risk: Because they are structured as unsecured debt instruments from a single issuer if the issuer faces financial difficulties, the ETN could lose value, whatever the performance of the underlying commodities.

What To Consider When Choosing Between ETPs and ETFs

When deciding whether an ETP or ETF makes the most sense for an investment strategy, investors should weigh several key factors:

• Expenses and fees: ETPs and ETFs often have lower expense ratios than actively managed mutual funds, but fees vary between products. All else being equal, an ETP with a lower expense ratio is preferred. ETFs typically have lower fees than other ETPs since they have less complex structures. Consider the expense ratio, commission fees, bid-ask spreads, and premiums/discounts.
• Liquidity: ETFs tend to have higher daily trading volumes and tighter bid-ask spreads. Some ETPs have limited secondary market liquidity, which can impact prices. Assess the average trading volume and bid-ask spread for a particular ETP or ETF: the higher the volume and the tighter the spread, the better.
• Performance and tracking: ETPs are often highly efficient at replicating their benchmark index performance, but some have more tracking errors. Research historical returns and compare them with the ETP’s benchmark.
• Diversification: ETFs offer exposure to various indexes across all major asset classes. Some ETPs zero in on narrow commodities or niche assets. Other times, two or more ETFs may hold the same assets, for example, if a stock is represented as a significant part of the S&P 500 and a sector index. This could mean doubling the exposure to specific stocks. Assess how well an ETP or ETF aligns with your asset allocation and diversification goals.
• Reputation of issuer and regulatory compliance: The trustworthiness and track record of the ETP issuer matters. A well-regarded issuer with a history of regulatory compliance and transparency is likely to offer low-cost products managed in the best interest of investors. Investigate the issuer’s reputation, experience in managing investment products, and history of adherence to regulations.
• Tax efficiency: ETFs are generally known for their tax efficiency, especially those that track broad-market indexes because of their unique creation and redemption process, which can minimize capital gains distributions. Depending on their structure, ETPs might not offer the same level of tax efficiency. Understand the tax implications of each investment, including how distributions are taxed and the potential for triggering taxable events.

Costs and Fees Associated with ETPs and ETFs

All ETPs have costs that affect the total return on investment.

• Expense ratios: This annual fee, expressed as a percentage of assets under management, covers the operational costs of the fund, including management fees, administrative fees, and other operating expenses. ETFs often have lower expense ratios than actively managed mutual funds, and ETCs can vary widely based on the complexity of the commodity exposure and management.
• Trading costs: Investors also have trading costs, such as commissions when buying or selling shares, including brokerage commissions (if applicable) and bid-ask spreads. Some ETFs today may be part of commission-free trading programs offered by brokers.
• Premiums/discounts: ETPs can trade at a premium or discount to their NAV, depending on market demand and the underlying securities. These differences can mean more costs or benefits when entering or exiting positions.

The Bottom Line

ETPs offer investors an efficient way to gain exposure to diverse assets pooled and traded on stock exchanges. ETPs have advantages like low costs, tax efficiency, liquidity, and transparency. ETFs are a subset of ETPs regulated by the SEC under the 1940 Investment Act, while ETPs can fall under further regulations depending on their assets. Investors should weigh factors like expenses, tracking ability, liquidity, diversification, and risks when choosing between ETPs and ETFs. Thorough research is vital to successfully incorporating these worthwhile investments in a portfolio. Both ETPs and ETFs can serve a valuable role in asset allocation when they match an investor’s strategy, goals, and risk tolerance.

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