The first thing most people think about when they hear about the stock market is stocks of individual companies. But the stock market is made up of multiple exchanges, and stocks aren’t the only asset classes you’ll find on them.
Funds, notes, and other financial instruments are also traded on major exchanges like the New York Stock Exchange (NYSE) and Nasdaq. That fact makes these products exchange-traded products (ETPs).
Several flavors of exchange-traded products — exchange-traded funds (ETFs) in particular — have become popular among retail investors. These products typically offer low-cost exposure to heavily diversified portfolios that capture the entire market or specific sectors of the market, although there are some exceptions.
What Are Exchange-Traded Products (ETPs)?
Exchange-traded products are diversified investment vehicles that trade on stock exchanges using brokerage accounts throughout the trading day. Common examples include ETFs and exchange-traded notes (ETNs). Other ETPs like exchange-traded commodities (ETCs) may offer exposure to diversified groups of commodities or a single type of commodity. Trading these products is just like trading individual stocks, but that’s where the similarities between the two end.
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ETPs are either passively or actively managed. Actively managed products are managed by a team including a fund manager, professional traders, and analysts. Passively managed funds, including ETNs, ETCs, and some ETFs are designed to track the performance of a benchmark like the S&P 500 index, Nasdaq composite index, or the price of the underlying commodity. These types of products don’t require much manpower to operate.
Exchange-traded investment products collect money from a large group of investors to buy assets according to their prospectuses — documents that tell you about the specific ETP’s strategies, benchmarks, fees, and disclosures. Individual investors share in the price appreciation of these investment products as well as any income they generate, including dividends.
How ETPs Work
All ETPs fit into one of two main categories: traditional products or derivative products. Both categories are similar, but their inner workings are different.
Traditional Products
Traditional exchanged-traded products include exchange-traded funds (ETFs) and exchange-traded commodities (ETCs). Here’s how they work:
- Assets. When you invest in an ETP, you may be buying a group of stocks, commodities, or simply making an unsecured loan to the issuer, depending on the type of product you purchase.
- Cost. Expense ratios, or the annual cost of owning shares of an ETP, can vary widely from one product to the next. Typically, passively-managed products are far less expensive than actively managed products.
- Secured. Traditional ETPs are secured products. For example, ETFs are secured by the underlying assets held in the fund’s portfolio. Should the fund fail, its assets are liquidated and investors receive their share of the funds generated through the liquidation.
When you purchase shares in traditional exchange-traded products, you own a percentage of the underlying assets the fund holds in its portfolio. The exact percentage is based on the number of shares you buy.
For example, say you buy 10 shares of a fund with 1,000 outstanding shares (most funds have millions but we’ll use 1,000 to keep things simple). You own 1% of this exchange-traded product. As an owner, you share in price appreciation when the market price of the product is up and losses when the price is down. You also receive a percentage of any income the fund generates. If the fund receives $1,000 in dividend payments, you receive $10 with your 1% ownership.
There are also fees to consider. Stock market pros don’t work for free. Exchange-traded products come with expense ratios that cover the cost of managing the fund. Expense ratios vary widely depending on the fund manager and whether the fund is actively or passively managed. It’s important to compare expenses on products you’re considering before you invest.
Derivative Products
Derivative exchange-traded products like exchange-traded notes (ETNs) work just like their traditional counterparts, for the most part. However, when you buy them, you’re not buying shares in an underlying portfolio. Instead, your investment value is derived from movement in underlying assets, which is why these are named derivatives.
For example, an issuer of a derivative product may promise to provide returns equal to the S&P 500 without actually owning anything on the index. If you buy a product like this, you don’t own shares in S&P 500-listed companies, but the value of the investment is derived from the index.
However, derivative products come with two important differences:
- Passive Management. All derivative ETPs are passively managed. That means their gains are derived from movement in an underlying benchmark.
- Unsecured. ETNs are a form of unsecured debt. When you buy them, you don’t actually own anything. Instead, the issuer of the note makes a promise to pay you returns upon the maturity of the debt, which generally ranges from 10 to 30 years.
These products are freely traded on public exchanges and move up and down based on three primary factors:
- Benchmark Performance. The value of these products at maturity is derived from the value of the underlying benchmark. As a result, these products have a strong correlation with the benchmarks they track.
- Issuer Credit. Derivative ETPs are like unsecured loans. When you invest in them, you’re putting your faith in the issuer’s ability to meet their financial obligations. If the issuer fails to maintain a solid credit rating, the price of the product falls.
- Supply and Demand. Changes in the supply of shares or demand for those shares have an effect on the product’s price as well. These changes can happen quickly because these products are traded on public exchanges.
Types of ETPs
There are three types of ETPs available on the market. Of course, each type has its own quirks that you should be aware of before you make an investment.
Exchange-Traded Funds (ETFs)
ETFs are the most popular type of exchange-traded product on the market today. They account for about one-quarter of stock market activity in the United States. ETFs are traditional ETPs; when you buy ETF shares, you own a small percentage of each asset held in the fund’s portfolio.
Fund managers either actively or passively trade a basket of securities. In most cases, these funds are highly diversified, consisting of hundreds or even thousands of stocks and bonds. There are a few different types of ETFs on the market:
- Index Funds. Index ETFs are passively managed funds that track an underlying index like the S&P 500 or Nasdaq composite index. These funds usually only make trades when their underlying market index is adjusted.
- Actively Managed Funds. Actively managed funds employ teams of traders and market analysts to actively take advantage of opportunities in the market. These funds follow complex trading strategies in an attempt to beat the overall market performance. However, most actively managed funds fail to accomplish their goal of beating the market.
- Bond ETFs. Most index funds and actively managed funds invest the vast majority of their assets — if not all — in stocks. It’s important to allocate some of your portfolio to bonds to taper down market volatility. Bond ETFs are a great way to do so because they invest in a diversified portfolio of fixed-income securities. When you invest in a bond ETF, you own a percentage of the fund’s bonds and receive income when interest payments are made.
Exchange-Traded Notes (ETNs)
Exchange-traded notes are derivative financial products with similar characteristics to index funds and bonds.
ETNs are unsecured debt securities usually issued by banks. The issuing bank accepts loans from investors and promises to pay returns based on the movement of an underlying benchmark. Upon maturity, the issuer pays the full price of the note plus or minus gains or losses that happened in the underlying index. ETNs usually mature somewhere between 10 and 30 years from their date of issuance.
As with all ETPs, ETNs are traded on public exchanges, and you can access them through your preferred broker.
Exchange-Traded Commodities (ETCs)
Exchange-traded commodities (ETCs) are traditional ETPs that work just like ETFs. The only difference is in the underlying assets the fund invests in. Whereas ETFs invest in securities like stocks and bonds, ETCs invest in commodities and currencies. ETCs offer simplified exposure to assets like gold, silver, oil, wheat, and iron ore.
When you invest in an ETC, you own a percentage of the commodities the fund owns. So, if you buy 10 shares of a gold ETC that owns 1,000 ounces of gold and has 1,000 shares outstanding, you own 10 ounces of gold.
These funds provide an easy way to invest in commodities and currencies without tapping into the derivatives market or having to take possession of the commodities you purchase.
Pros & Cons of ETPs
Every investment you make has its benefits and its risks. ETPs are popular investment vehicles because of the many benefits they provide, but they’re also well short of being a one-size-fits-all solution.
Pros
These investment products have become incredibly popular because they bring a high level of simplicity to the investment process. They give you access to market gains while using diversification to protect your portfolio from market volatility. Some of the biggest benefits of investing in exchange-traded products include:
- Heavy Diversification. Although some exchange-traded products only invest in a small group of assets, the vast majority are heavily diversified. For example, the Vanguard Total Stock Market Index Fund ETF (VTI) is one of the most popular ETFs on the market today. It protects investors from volatility by investing in more than 4,000 stocks.
- Less Research. You should always research your investments before you make them, but researching ETPs is far less intensive than researching individual stocks, bonds, and other assets.
- Pros Take the Lead. If you’re like most, you call a plumber when you have a leak. As a consumer, you lean on experts when you don’t think your expertise is up to par with the job at hand. However, accessing investment experts can be expensive. When you invest in ETPs, the experts manage your portfolio for you with minimal expenses.
- Tax Benefits. Most ETPs are passively managed and hold assets for a long period of time, so gains tend to qualify for low long-term capital gains taxes. However, actively managed funds are the exception to the rule because their investments are generally short-term.
Cons
ETPs have become the darlings of Wall Street, but even darlings have some blemishes. These products aren’t all created equal, and fees, performance, and liquidity vary widely from one product to the next.
- Varying Liquidity. Liquidity describes how quickly you can turn an investment into cash. Some ETPs are highly liquid and easily sold when you decide it’s time to exit the investment. Other products are far less liquid, and you may find it difficult to exit your investment when the time comes.
- You May Pay Brokerage Commissions. ETPs can only be traded through brokerages. Most online brokers have moved to commission-free models, but some brokers still charge commissions on trades. These additional fees cut into your gains.
- No Control. Although you have control over the ETPs you buy, once you buy them, you have no control over their portfolios. If you want to make your own investment decisions on an asset-by-asset basis, these products aren’t for you. Moreover, when you invest in ETPs with portfolios of stocks, your voting rights on important business decisions like acquisitions and management changes are handed over to the fund manager because they own the underlying shares.
Should You Invest in ETPs?
Sure, there are a few drawbacks to consider before diving in, but the vast majority of Americans would benefit from investing in these products. Warren Buffet shares the same opinion, suggesting that most investors should buy low-cost index funds.
Chances are, you’re not an investing pro. Even if you have a proficient understanding of the inner workings of the market, you probably don’t have the time that’s required to actively manage a diversified investment portfolio composed of individual assets.
Index funds and other ETPs solve those problems. Investments are managed by professionals who’ve made the market their life.
Moreover, these funds attract large audiences, so fund managers generate meaningful incomes even though each individual investor pays a relatively minimal fee. In fact, there are plenty of funds with expense ratios below 0.1%, which equates to an annual fee of just $1 per $1,000 invested.
ETPs offer an effective, simplified way to tap into potential market gains at a low cost. The only reason they shouldn’t be in your portfolio is if you want to maintain complete control over your investments.
Exchange-Traded Product FAQs
Albert Einstein once said “Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning.” The fact is that questions are the building blocks of wisdom, and you should never make investment decisions without having your questions answered.
What’s the Difference Between ETPs & Mutual Funds?
Exchange-traded products are traded on public exchanges like the Nasdaq and New York Stock Exchange (NYSE). They are traded intraday, or at any time during open trading sessions.
Mutual funds are similar investment vehicles, but shares are not traded on exchanges. Instead, mutual funds are purchased through your broker or directly from the issuer. They only trade once per day at the close of the trading session.
What Are Some Examples of ETPs?
The Vanguard Total Stock Market Index Fund ETF (VTI) is one of the most popular ETPs on the market today. It’s an index ETF with a portfolio of more than 4,000 stocks. There are countless other popular ETFs that track components of the stock market. Other examples of ETPs include:
- Teucrium Wheat Fund (WEAT). WEAT is an ETC with a portfolio of investments in wheat.
- JP Morgan Alerian MLP Index ETN (AMJ). The AMJ is an ETN that’s attached to an energy-related index. So, the fund does well when energy prices are up and poorly when prices fall.
What Is a Leveraged ETP?
Leveraged ETPs are exchange-traded funds or notes that use derivatives and advanced trading strategies to multiply the returns of their underlying index. For example, an S&P 500 3X leveraged ETF would have a daily goal of producing three times the gains or losses generated by the S&P 500 market index.
Final Word
Exchange-traded products have simplified the world of investing. Years ago, if you wanted to invest, you had to either pay an investment advisor for help or spend the time it takes to build a quality investment portfolio.
Today, there are thousands of these products to choose from, each providing low-cost access to a prebuilt portfolio managed by professionals.
Although exchange-traded products do provide simplified access to the market, they’re not all created equal. Some perform better than others, and some have higher fees than others. You should still do some research into what you’re buying before diving in.