Start with the legal structure
The abbreviation does not tell the whole story. Two products tracking the same index or commodity may have different issuers, collateral arrangements, fees, liquidity and redemption terms. The analysis should therefore start with the legal documentation rather than the name or how the product appears in an investment account.
For investors, the key documents will normally include the prospectus or other issue terms, final terms and the PRIIPs key information document. For issuers, the structure must also work with marketplace rules, product governance, distribution, valuation and the operational process for issuance and redemption.
Terminology is not used in precisely the same way in every market. It is therefore better to ask how the product is actually constructed than to assume that an abbreviation automatically determines its risk profile.
ETF – units in a fund
An ETF is an exchange-traded fund. The investor holds units and the fund generally tracks an index, sector or defined strategy. The assets are held within the fund structure and are subject to the custody and other rules applicable to the fund.
Many European ETFs are UCITS funds, although exchange-traded funds are not all structured in the same way. Exposure may be created by holding the underlying assets or by using derivatives. Investors therefore need to understand both the investment policy and the replication method.
The fund structure generally creates a different relationship with the provider than a debt instrument. It does not, however, remove market risk, tracking error, liquidity risk or counterparty risk where derivatives and other counterparties are used.
ETN – a security carrying issuer risk
An ETN is generally a debt instrument linked to an underlying asset, index or strategy. The investor does not necessarily own the assets tracked by the product, but instead has a contractual claim under the terms of the instrument.
Issuer risk is therefore central. If the instrument is unsecured, the investor depends on the issuer’s ability to pay. If it is secured, the investor must understand what collateral is provided, where it is held, how it is valued, who has rights over it and what happens if the issuer fails to perform.
The ETN structure can be flexible and may accommodate exposures that are difficult to place in a traditional fund. That flexibility also requires clear terms, robust valuation and a reliable operational structure.
ETC – commonly used for commodities
ETCs are often used for exchange-traded products linked to a commodity or commodity basket. Despite the similarity in name to an ETF, an ETC is generally not a fund. In many structures it is instead a debt instrument with dedicated collateral.
A physically backed gold ETC may, for example, be secured by allocated gold held with a custodian. Investors need to understand the metal entitlement per security, how the ongoing fee reduces that entitlement, applicable quality standards and how the collateral is verified.
A synthetic commodity product may instead use derivatives. Its risk profile will be different. The descriptions ‘physically backed’ and ‘secured’ are relevant, but do not replace a review of the terms and the parties involved.
Collateral reduces risk but does not remove it
A secured instrument may offer stronger protection than an unsecured claim, but the protection depends on the legal and operational design. Assets must be properly segregated, identifiable and sufficient. There must also be a workable process for enforcement and distribution of proceeds to investors.
Currency risk may arise even when the underlying asset performs as expected. A product traded in Swedish kronor may track an asset priced in US dollars. Unless the product is currency hedged, the return will reflect both movements.
Market, liquidity, operational, counterparty and legal risks also remain relevant. A sound structure manages and explains those risks; it does not suggest that they disappear.
Price, fees and trading
The quoted market price is affected by more than the underlying asset. Ongoing product fees, structural costs, exchange rates and bid–ask spreads all affect the investor’s actual return.
A market maker will generally provide bid and offer prices, but liquidity is not unlimited. During rapid market movements or disruption affecting the venue, price source or another service provider, spreads may widen and trading may be affected. The terms should also address circumstances in which valuation, issuance, redemption or trading needs to be adjusted or suspended.
For the issuer, pricing, NAV or indicative value, creation and redemption and reconciliation against collateral must function each trading day. The operational chain is therefore as important as the legal documents.
What should be checked?
A practical investor checklist is: What legal right am I acquiring? Who is the issuer? Is the instrument secured and, if so, how? How is the exposure created? What fees, currency effects and redemption rules apply? What liquidity is available?
A company seeking to issue an exchange-traded product must also address the marketplace, prospectus, PRIIPs disclosure, product governance, custodian, issuing agent, administrator, market maker, price data, collateral verification and continuing reporting. These components must form a coherent model.
The short conclusion is that ETFs, ETNs and ETCs should not be compared solely by their performance charts. The legal construction determines the rights and risks that accompany the investment.