What is an Exchange Traded Fund (ETP)?
An exchange traded fund (ETP) is an investment vehicle that combines key features of traditional mutual funds and individual stocks. Like index mutual funds, ETPs represent diversified portfolios of securities that track specific indexes. Like stocks, they can be bought and sold (long or short1) on an exchange throughout the trading day. In addition to trading flexibility, the key benefits include instant portfolio diversification, tax efficiency, and transparency of cost and holdings.
ETP providers use a variety of methods to reproduce the return of the underlying reference index as closely as possible:
An ETF may either buy all securities in the reference index it tracks (full replication), or just some of them (optimized sampling). Or, an ETF may rely on a swap to replicate index moves accurately.
The first ETFs reproduced moves in stock indices by physically buying all securities in an index. If such an ETF reproduced an index with 50 stocks like the Euro Stoxx 50 Index, all 50 stocks would be held in proportion to their weighting in the index. In some cases, full index replication is not possible. In such cases, the reference index is replicated by using a method called "optimized sampling". Optimized sampling creates a portfolio using a limited number of securities to replicate the characteristics of the index as closely as possible. But with some indices and asset classes, even this is hard to do. MSCI Global Equity Indices cover over 14,000 securities in over 70 countries. Buying and selling stocks in some markets might be difficult or impossible. Markets can be illiquid. It may be especially difficult to access individual emerging markets, or very large indexes.
To solve such problems, ETFs based on swaps were developed. These reproduce the performance of the benchmark without the ETF having to physically own all, or even any of its constituents. Besides making it easy to reproduce a variety of indexes and assets, a swap-based ETF virtually eliminates tracking error.
In order to ensure that the index is replicated as accurately as possible, an ETF invests in a substitute basket as well as an index swap, and the return of the substitute basket is offset on a daily basis against the index return on the swap. The substitute basket consists of high quality, liquid, blue chip European securities and is compiled with a view to minimizing costs and maximizing tax considerations, while complying with legal requirements such as UCITS III at the same time.
ETPs with full index replication − full replication
ETPs using a full replication method hold positions in all the securities of the underlying reference index in proportion to their weighting in the index. This simple and transparent approach results in minimal deviation between the fund’s return and the performance of the index. Although the concept seems straightforward, the approach requires a large capital base and an efficiently organized portfolio management team, since all adjustments to the index have to be made to the fund simultaneously.
ETPs with representative sampling − optimized sampling
Full index replication is not always possible. Some indices include securities that cannot be easily bought by all investors. Insufficient liquidity of individual equities or the adverse taxation of income may make full replication inadvisable. In such cases, representative sampling is the recommended course of action. Representative sampling creates a portfolio using a limited number of securities to replicate the characteristics of the index as closely as possible. Product providers then uses a mathematical optimization process to determine the allocation of these portfolios.
ETPs with synthetic index replication − swap-based
Synthetic replication allows less liquid indices to be replicated accurately and efficiently without investors having to forego the desired high level of transparency. In order to ensure that the index is replicated as accurately as possible, an ETP invests in a substitute basket as well as an index swap, and the return of the substitute basket is offset on a daily basis against the index return on the swap. The substitute basket is compiled with a view to minimizing costs and maximizing tax considerations, while complying with legal requirements such as UCITS III at the same time.
Another benefit of ETPs is the fact that they are designed to track market indexes that may contain hundreds or even thousands of securities. This can offer ETP investors diversification of a typical index mutual fund with the trading flexibility of a stock. Any time during the trading day, an investor can execute a single ETP trade and obtain broad exposure to an entire asset class, country, region, or sector.
Because ETPs seek to track market indexes, their turnover is typically lower than that of actively managed funds. Lower turnover can result in increased tax efficiency for investors when securities are sold at a gain. In addition, with traditional mutual funds, the buying and selling activities of some shareholders can trigger capital gains distributions for all of the fund's shareholders. For example when the fund must sell securities to raise cash in order to meet redemptions, any related capital gains are distributed to all remaining investors in the fund. In contrast, ETP trading occurs on an exchange just like stocks; there is no fund company in the middle. Thus ETP investors are generally insulated from the tax consequences of their fellow shareholders' actions and will primarily be affected when they decide to complete ETP trading by either buying or selling an ETP.
Unlike many investment vehicles and investing strategies that only disclose their holdings quarterly, most ETP index funds publish their exact holdings on a daily basis, so you can always know what you own. ETP Transparency makes it easier to see exactly what you own and to respond accordingly to market activity.
Clever arbitrage mechanism
ETPs are a clever combination of closed and open-end investment funds: as with closed-end funds, the fund units can be traded on an exchange. The investor does not purchase his units from the fund management company, but instead on the secondary market. A purchase and redemption mechanism prevents price divergence of the fund units from net asset value, as is often the case with closed funds. If the ETP’s price is higher than its net asset value, authorized participants can return shares or add cash to the fund and sell the newly created units in the market, which then pushes the price back to the net asset value. However, if the ETP is trading below its net asset value, arbitrage is performed in the opposite direction; the authorized participants then purchase units in the secondary market and redeem them from the fund in exchange for securities or cash, which brings the price back to net asset value. This procedure prevents the ETP from building up a premium or a discount to its net asset value. The investor can therefore always be sure of buying or selling the ETP at a price close to its fair value.
ETP success story
The advantages of ETPs have been demonstrated by their success, and for years the ETP market segment has seen remarkable growth. Introduced in the U.S. in 1993, and traded on European exchanges since 2000, global ETPs have seen assets rise from $75 billion at the end of 2000 to $1,300 billion at the end of 2010.
ETPs benefit from multiple cost savings. First, because index funds do not require active management, so there are no research costs, resulting in low management fees for investors. Second, the total turnover in a typical ETP is only about 3-7% of assets per year, therefore generating fewer transactions than an active fund. Such low cost levels support the long-term returns of the fund.
Index constituents are available to all investors, therefore ETP investors are always aware of all the securities in their fund. With the help of the indicative net asset value (iNAV), the fund assets can be compared with current bid and ask prices reliably.
ETPs are traded throughout the day on the stock market. This allows investors to react quickly to short-term trends without being dependent on closing prices.
Ability to implement complex investment strategies
There are a variety of ways in which ETPs can be used in investment strategies, for instance as a broadly diversified core investment in a portfolio, complemented by one or several more focused ETPs for example with a focus on Emerging markets, Small cap value stocks, and even Hedge Fund Strategies.
How to trade ETPs
While Cranberger does not provide a solution to trade ETPs over it’s present website, because ETPs are exchange traded you are free to use any online broker or existing investment account at your choice. The neat thing about Cranberger is that it is easy to find all the available product within the users interest, and subsequently contrast them against each others. Users are also able to see listed derivatives like ETP options or Index Futures for more sophisticated strategies. Engage with other investors on subject of interest or read relevant blog posts.