OTHER EXCHANGE-TRADED PRODUCTS
The concept introduced by exchange-traded funds has carried over to other products. However, due to the nature of these exchange-traded products’ (ETPs’) underlying products, the deliverables and some other features found in ETFs are treated differently.
Exchange-traded commodities are offered either as a single commodity or in the form of index tracking. Unlike ETFs, which track a basket of equities or equity indices, ETCs are debt securities that may or may not be collateralized. In some cases, the commodity itself determines whether or not the ETC is collateralized. Those that track hard commodities such as gold and silver, which are easy to store and require little if any maintenance, are more likely to be collateralized than those tracking cattle and live hogs.
The ETC may invest directly in and track the performance of a commodity or an index that is designed to track the product. Some of the process for deciding whether to track the product’s values or use an index depends on the ease or difficulty of obtaining accurate and timely information. The London Stock Exchange offers ETCs on the following individual products: natural gas, crude oils, gasoline, heating oil, aluminum, zinc, copper, nickel, gold, silver, live cattle, lean hogs, wheat, corn, soybeans, sugar, cotton, coffee, and soybean oil. They also offer various commodity index ETCs. ETC shares are traded on an exchange, just like an ETF, where there is a basket of securities forming an index that the ETF will trade against. An ETC could be a product with only one commodity or, like an ETF, one that has multiple products. These products can be bought and sold on a stock exchange in the same manner as if you were trading exchange funds. The ETCs track an index in the same manner that an ETF does. The index generally indicates total return, which means it’s exposed to three sources of returns.
The most obvious source of the index’s returns is the change in the future price, which is a result of the change of the spot or cash price. The second, which is more of an adjustment, occurs when the front month of the future product “rolls out” into delivery and the near month “rolls in.” There usually is a price difference that must be accounted for, a gain or loss, and it becomes part of the index value. The third source is interest or other income earned on the collateral being used in margining the position. The ETC and ETF trade the same way; they share a format, and they go through the clearing corporation the same as stock. The essential difference is the underlying assets.
ETCs that trade as a single product include aluminum, Brent oil, coffee, crude oil, gasoline, heating oil, soybean oil, soybeans, sugar, wheat, zinc, and others. As with the shares of an ETF, those of an ETC on a commodity are all equal.
Here’s an example:
In silver, the trading lot is one unit, and as of March 1, 2013, the last price in U.S. dollars was $28.58. The ETCs are backed by silver bars which are maintained and serviced by a trust. The silver currently backing each share is .9910722 ounces per share. It would require 99,107.22 ounces to create a basket that would represent 100,000 shares of this product. In dollars, it will cost $2,883,745 to create this basket.
The above works for ETCs of physical silver shares and for ETCs of physical Swiss gold shares.
Another variation on the theme, exchange-traded currencies track a currency or group of currencies against another currency. It is a helpful product for those looking for an easy way to hedge a position. Unlike currency options and currency futures, they do not force an action. Options expire, futures become deliverable, but these do neither. The issuer of the ETC deposits either the foreign currency or futures to back the ETC.
An ETC may be an exchange-traded fund or an exchange-traded note. When it’s an ETF, it’s supported by cash deposits of future contracts. ETNs, on the other hand, have non-interest-bearing debt obligations tied into them. Therefore, the ETN is tied to the existence of the issuer.
There are single-currency ETFs or ETNs, as well as multicurrency, inverse currency, and leveraged currency. It is the multicurrency ETF, though, that affords the investor exposure to the widest geographical area.
This product has little use in long-term investment portfolios. Currency ETFs tend to track either the foreign deposits of another currency or futures contracts on that currency. They trade in a very small window moving up or down gradually over time, in step with the global economy. Also, there is always the possibility of government intervention. Recently, we have seen more volatility in certain currencies caused by the financial crisis. As an income-producing asset, on the scale of income-producing products, currency is among the lowest.
An ETN or exchange-traded note is a debt security that is a senior and perhaps unsecured instrument. Senior debt means that there isn’t any debt that has a priority over it in the case of payments, or problems such as default. The term “unsecured” relates to the fact that there may not be any assets backing the note except for the intangible good name of the issuer, which is usually a bank. Other derivative products have some sort of assets behind them via securities, or in the case of commodities, the commodity itself; perhaps the assets could even be in the form of cash or some other asset. Not with ETNs, however.
In the last ten years, the percentages of exchange-traded notes that are collateralized have grown. Even though they are a debt instrument, they do not pay interest periodically and the returns are based on the performance of a benchmark, another market index, or whatever is used to set the value of the note as a benchmark. FINRA has issued warnings about this product, calling the following risks to investors’ attention:
After the demise of Lehman Brothers, issuers of ETNs began to place assets underlying the notes so that they would have a resiliency, or value, in case the bank itself got into financial trouble. The value of the asset as a percentage of the note’s value must be understood by the potential investor. An investor thinking of acquiring an ETN should read the prospectus, offering circular, term sheet, or other official document and determine where the asset is and how obtainable it is should the need be to either liquidate it or convert it into cash by some other means.
There have also been several articles written about hidden fees on ETNs. These articles do not appear to include ETCs or ETFs. As a matter of fact, several articles have been published recently calling ETFs a very good investment idea but mentioning that some of the products following after are not as good an investment and should be examined very carefully. ETPs allow individuals, hedge funds, and other investors to gain access to a wide range of diversified portfolios without owning the underlying products, which would cost considerably more. Take care in investing in these products as there are differences. Some of them, if an entity or individual owns a large enough position, can send the product to the issuer and have the assets that are behind the ETF delivered in its place. This is a service that other products, such as mutual funds, do not offer.
Tracker certificates resemble ETFs, but they are not permitted to be sold in the United States. They are offered in two forms: total return trackers and excess return trackers. The total return tracker will track an index or group of assets that is underlying the certificate. The value includes dividends and other payouts, which are added back. The excess return tracker excludes dividends and other payouts, and therefore may sell at a discount to the total return tracker. Since total return trackers usually sell at a premium to the index they are not as popular as the excess return, which is usually issued at a discount. There is also the actively managed certificate (AMC). This type of tracker is flexible and can have many different attributes. It can be structured to resemble a mutual fund, without the regulatory concerns, or even a hedge fund. The cost is a fraction of the underlying index value, yet depending on its structure, may give the investor full benefits.
Deutsche Bank issues its db X-trackers for trading in Europe and Asia, for instance. These are compliant with the Undertakings for Collective Investment in Transferable Securities, otherwise known as UCITS. The UCITS is a set of European directives which permits open-end funds to operate freely between the member states. SICAV (Société d’Investissement à Capita), for example, operates under UCITS and is an open-end collective investment scheme operating across Western Europe.