7 min readIn the world of financial services, there is often a plethora of overlapping acronyms and terminology used to describe different products, which can make it difficult for investors to understand the subtle differences between them.
ETPs (Exchange Traded Products) have become incredibly popular among investors across Europe due to their flexibility, transparency and availability. But what are the different types of ETP products?
In this article, we will explore the main differences between the two main types of ETP available in Europe: ETFs (Exchange Traded Funds) and ETCs (Exchange Traded Commodities).
What are the different types of ETP products?
Exchange Traded Product (ETP) is an umbrella term for products structured as funds or notes that aim to replicate the performance of an underlying asset, benchmark, or strategy. However, different types of ETPs are available in the European market, and it is important to understand the key characteristics of each.
Exchange Traded Funds (ETFs)
History of the ETF
Exchange-traded funds (ETFs) were first introduced in the United States in the early 1990s as a way for investors to gain exposure to a diversified portfolio of stocks or bonds with lower fees and greater flexibility than traditional mutual funds. ETFs quickly gained popularity and have since become a major force in the global investment landscape.
In Europe, the first ETFs were launched in the early 2000s, with the first UCITS-compliant ETFs being introduced shortly thereafter. UCITS (Undertakings for Collective Investment in Transferable Securities) is a regulatory framework established by the European Union to govern the distribution of investment funds in the region. The framework provides a high degree of regulation and investor protection as products must adhere to strict rules on portfolio diversification, risk management, and disclosure requirements, which help to protect investors from potential losses.
Key characteristics of an ETF
ETFs (Exchange Traded Funds) are the most popular type of ETPs in Europe. The vast majority of ETFs are UCITS funds structured as investment companies that invest in a broad range of financial instruments or derivatives, including equities, fixed income, and broad commodity baskets.
The main advantage of ETFs is that they provide exposure to a diversified portfolio of securities in a single trade, making them a suitable investment option for investors seeking broad market exposure.
Exchange Traded Commodities (ETCs) & Exchange Traded Notes (ETNs)
How the note structure opened up access to hard-to-access markets
Exchange Traded Notes (ETN) were developed in the early 2000’s by investment banks to facilitate investor access to asset classes otherwise not easily accessible via traditional investment products. They are generally issued off a bank balance sheet and involve credit risk to the bank. One key difference between ETNs and other ETPs is that ETNs are not backed by any underlying assets. Instead, they are generally issued off a bank balance sheet and involve credit risk to the bank.
Later that decade, Europe’s first ETCs (Exchange Traded Commodities) were made available to trade. ETCs are debt instruments similar in structure to ETNs, but with added protections such as:
Collateral - Either backed by the underlying assets themselves (such as gold or bitcoin), or collateral such as cash or equity equal or more than the value of the underlying asset.
Limited recourse - investors are not exposed to the credit risk of the issuer beyond the value of the collateral backing the ETC.
Bankruptcy remote issuer - Mitigation of issuer bankruptcy risk by assigning collateral to either a trustee or a collateral agent, who holds the rights to the collateral on behalf of investors.
Historically, ETCs were designed to provide exposure exclusively to the commodity market; however their scope has since evolved to include various asset classes such as FX and crypto. In contrast to ETNs, ETCs are structured as bankruptcy-remote Special Purpose Vehicles (SPVs) whose sole purpose is to issue debt securities to investors. Because ETCs are not funds they can track single assets, or smaller, more focused baskets.
ETCs and UCITS
Because of their structure, ETCs do not fall under the category of collective investment schemes according to the UCITS directive and are not subject to UCITS regulations. Despite not being UCITS compliant, they may still be eligible for inclusion as one of the building blocks in the portfolio of a UCITS fund, depending on the local rules. They have proved a popular and useful tool for European investors looking to add alternative investments such as gold and bitcoin to their portfolios.
What is the difference between ETF and ETC?
The main differences between ETFs and ETCs are related to the underlying assets they track, their diversification requirements, and their structure.
Underlying assets
ETFs provide investors with exposure to a diversified portfolio of securities, including equities, fixed income, and broad commodities.
ETCs are designed to provide investors with more targeted exposure to assets such as single commodities, cryptocurrencies or smaller baskets of assets.
Diversification requirements
European ETFs are subject to UCITS minimum diversification requirements, which means that they must hold a diversified portfolio of securities.
ETCs are not subject to UCITS minimum diversification requirements, which allows them to track smaller, more focused baskets of assets such as commodities or crypto.
Structure
ETFs are typically structured as investment companies, and unitholders have a claim to the ETF issuer’s assets by operation of law.
ETCs achieve something similar by operation of contract, generally relying on a 3rd party trustee and security assignment. The ETP Issuer commits to deliver the agreed payoff and pledges the underlying assets to secure that commitment.
Where do Crypto ETPs fit in?
Physically-backed crypto ETPs are technically classified as ETCs since they are structured as special purpose vehicles (SPVs) that issue debt securities. Much like the physical gold ETPs that have been used by investors across Europe for nearly two decades, physically-backed crypto ETPs are backed by the physical asset they track; in this case, cryptocurrencies such as bitcoin or ether. The underlying assets are held in secure custody, with each share of the ETP representing a certain amount of the underlying asset.
For more information about CoinShares Physical ETPs, click here.
Conclusion
In summary, there are two main types of Exchange Traded Products available in Europe: ETFs and ETCs. ETFs are the most popular type of ETP typically providing exposure to diversified equities and fixed income, and therefore often make up a larger percentage of an investor’s portfolio. ETCs originated from the ETN structure pioneered by banks in the early 2000s, and were originally designed to provide more focused exposure to commodities. They have since evolved to cover FX and crypto too.
While both types of ETP benefit from the liquidity, flexibility, and transparency features that have made ETPs so popular across Europe, it is important for investors to carefully consider the specific characteristics and risks of each type of ETP before making an investment.