Exchange-Traded Funds and Products

There's no single definition of an exchange-traded product (ETP). In general, though, an ETP is a security that’s listed on a U.S. exchange and seeks to provide exposure to the performance of a benchmark (such as the price of gold), an index (such as the S&P 500) or an actively managed strategy. Exchange-traded funds (ETFs) are the most common and most well-known type of ETP, but ETPs also include exchange-traded notes (ETNs), commodity pools and other product types.

ETFs and other ETPs generally combine aspects of mutual funds and conventional stocks. Like stocks, ETPs are listed on a securities exchange, are publicly traded throughout the day and have prices that can fluctuate based on market forces. ETPs can also be sold short, purchased on margin or have options contracts written on them. And, like mutual funds, they track an underlying index or asset or might reflect an actively managed strategy.

Some ETPs can offer a convenient and cost-effective way for investors to diversify their portfolio. Others might be designed for more tactical use or specialized exposure, such as single stock ETFs or ETNs that are tied to a narrow index or esoteric benchmark. As with any investment, ETPs can expose you to a range of risks, so understanding the products and how they work is important.

A significant feature of ETPs is that they offer two layers of liquidity. Transactions in ETPs can occur:

• directly with issuers in the primary market—where newly issued securities are sold to investors—through a specific, unique creation (issuance) and redemption mechanism typically involving broker-dealers and large transactions worth millions of dollars; or
• more commonly, through transactions that occur in the secondary market— where existing securities are bought and sold—through transactions on an exchange or other venues (such as alternative trading systems or over-the-counter) just like stocks.

Historically, the vast majority of ETP activity has occurred in the secondary market, which is where most retail investor trades occur.

Some ETPs are more similar to mutual funds than others. ETFs, like mutual funds, are pooled investment funds that offer investors an interest in a professionally managed, diversified portfolio of investments. But unlike mutual funds, ETF shares trade like stocks and can be bought or sold throughout the trading day at fluctuating prices. They're also subject to bid-ask spreads, which represent the difference between the highest price a buyer will pay and the lowest price at which a seller will sell shares of a stock at any given time.

On the other hand, while ETNs also trade like stocks, they're more similar to corporate bonds in that they're debt issued by a financial institution and subject to the credit risk of that issuer. Unlike a mutual fund or ETF, an ETN has no underlying portfolio of assets. Unlike a corporate bond (but similar to a structured note), an ETN represents a promise to pay a return at maturity reflecting the performance of some benchmark or index, so repayment at maturity may be greater than or less than par value, or face value. Some ETNs might make periodic distributions, but others don't.

All ETP trading is regulated under the Securities Act of 1933 and Securities Exchange Act of 1934. Depending on their particular structures (such as ETF or commodity pool), ETPs may also be subject to regulatory requirements and oversight by different Securities and Exchange Commission (SEC) divisions or the Commodity Futures Trading Commission (CFTC) and may offer different levels of investor protection. 

Most ETPs are structured as ETFs, which are registered with and regulated by the SEC as investment companies under the Investment Company Act of 1940. ETFs generally focus their investments in stocks or bonds and have diversification requirements. Alternatively, some ETPs investing in commodities, currencies or commodity- or currency-based instruments such as futures aren’t registered under this act, which can subject investors to differing degrees of regulatory protection. ETNs, on the other hand, aren’t registered as investment companies because they're corporate debt and don’t hold an underlying portfolio of assets.

Investment objectives and strategies, which are detailed in prospectuses and related documents, can vary from one ETP to another. The vast majority of ETPs are designed to track the performance of a particular market index or benchmark and are similar to index mutual funds. Importantly, ETPs tracking the same index may do so in different ways, so be sure to compare.

Some ETPs are designed to provide returns that are leveraged (such as two- or three-times) or inverse (such as the opposite or twice the opposite) of the return of the index or benchmark they track. These are typically referred to as leveraged or inverse (collectively, “geared”) ETPs. This geared exposure is usually for a specific period, like one day or one month, and such products are generally not designed to be held for periods that deviate from that. In addition to leveraged and inverse products, many single-stock ETFs offer geared exposure but to individual stocks.

ETPs can track a wide variety of indexes across many asset classes, as well as different investment or trading strategies. Some are very well-known or broad market benchmarks or indexes, such as total stock or bond market indexes. Other ETPs track indexes that are more narrowly focused, such as those made up of companies in a specific industry sector or country, corporate bonds with particular credit ratings, or individual commodities or currencies. Some of the indexes and investment strategies used by ETPs can be quite sophisticated and might not have much performance history or, in some cases, easily accessible information.

Before making any investment, know your financial objectives and understand the risks of the exact type of product you’re considering.

There are thousands of different ETPs and several different product structures that can impact any single ETP’s risk-reward trade-off, investor protections, tax consequences and efficiency, and costs. Product structures generally fall into two primary categories: ETFs and ETNs. However, there are many variations within these categories, including a range of complex offerings, and there are a number of other ETP structures used to provide exposure to commodities and currencies.

Take time to understand and evaluate the portfolio and/or investment strategy of any ETPs you purchase.

ETFs

ETFs, like mutual funds, are pooled investment products that offer investors the opportunity to purchase shares of a fund that holds the assets it tracks. Unlike mutual funds, ETFs are listed on an exchange, can be traded throughout the day, and generally don’t sell shares to, or redeem shares from, retail investors directly.

Instead, ETFs—and ETPs more generally—employ a unique share issuance and redemption mechanism. An ETF enters into contracts with financial institutions (typically large broker-dealers) to act as “authorized participants” (APs). APs purchase and redeem shares directly with the ETF in the primary market in large blocks of shares called creation units. APs typically sell some or all of their ETF shares in the secondary market, on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly traded company.

The assets held by an ETF might pay interest or dividends, which may be either reinvested or paid periodically to shareholders, depending on the way the ETF is structured.

ETFs either passively track the performance of an underlying index or other benchmark or are actively managed investments. Those that are actively managed rely on a fund manager to make decisions for the fund in accordance with an investment strategy rather than tracking an index. Actively managed products might have higher expense ratios than similar products tracking an index, which has the potential to eat into returns over time. While some actively managed ETFs are required to disclose their holdings on a daily basis, others disclose such information periodically like mutual funds.

Also, be aware of potential overlaps in the holdings or exposures provided by ETFs and how these might impact your overall level of diversification. For example, some ETFs with sustainable or socially responsible objectives might have very similar holdings to those of popular indexes that don’t have those objectives, and the same might be true of some actively managed ETFs.

While ETFs can include investments across many asset classes, including crypto assets through futures ETFs (bitcoin and ether), they primarily focus on stocks and bonds.

• Equity funds – Equity funds are ETFs that invest in baskets of stocks. This category includes many subtypes, and some have complex investment strategies. Many equity funds track a specific market sector, like health care or technology, while others are focused on companies of a particular size or from a single country. Some funds, such as inverse and leveraged ETFs, factor ETFs, emerging market ETFs, and environmental, social and governance (ESG) ETFs have more specialized investment objectives and might also carry unique risks. Some even offer exposure to the stock of a single company.
• Bond funds – These fixed-income funds invest in bonds and therefore might have lower volatility than some other ETFs. Unlike individual bonds, bond ETFs trade on exchanges throughout the day. They typically provide an income stream to the investor through regular interest or dividend payments. Most offer continuous exposure to bond investments, while some have portfolios with a given targeted maturity date.

Learn more about how ETFs compare to mutual funds.

ETNs

Like ETFs, ETNs trade on exchanges, and their returns are linked to a market index or other benchmark. But ETNs aren’t pooled vehicles and don’t buy or hold shares of stock or other underlying assets. They’re unsecured debt obligations that, similar to bonds, are typically issued by a bank or other financial institution. Unlike bonds, however, ETNs generally don’t pay periodic interest to investors (though some that are income-focused might), and the return is primarily based on the performance of the index or benchmark to which they are linked.

The return on an ETN generally depends on price changes, if the ETN is sold prior to maturity, or on the payment, if any, if the ETN is held to maturity or redeemed.

Like other ETPs, ETNs can be linked to well-known, broad-based stock indexes or to indexes tied to emerging markets, commodities, volatility, a specific industry sector (e.g., oil and gas pipelines), foreign currencies or other assets. This might offer investors convenient and cost-effective exposure; however, these investment vehicles can also be complex and carry additional risks.

Inverse and leveraged ETNs, for example, seek to deliver set positive or negative multiples of the performance of a given benchmark or index over a specified period of time, often from the close of one trading day to the next. Returns can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark over the same period, which can make these products risky long-term—or even medium-term—investments, especially in volatile markets. 

While similar to the creation and redemption mechanism for other ETPs, ETNs don’t use APs. Instead, an ETN issuer has primary control over ETN issuance and redemption, as this directly impacts the issuer’s balance sheet. Other risks of ETNs include the risk of issuer default or other issuer actions that may impact the price of the ETN. Research publicly traded issuers using the SEC’s EDGAR database.

Other ETPs

There are other ETP structures that are very similar to ETFs but that aren’t registered under the Investment Company Act of 1940. These ETPs are used mostly for investments in physical commodities like gold, hard currencies like euros, and crypto assets through spot bitcoin ETPs. These ETPs are classified as grantor trusts for tax purposes. ETPs are also used for investing in the futures markets. (These ETPs are typically structured as commodity pools—although some might in fact be registered investment companies, which instead invest in a foreign subsidiary that transacts in the futures markets.)

• Commodity ETPs – Commodity ETPs might invest in physical commodities, such as gold or silver, or commodity futures contracts. Some of these products offer exposure to single commodities, while others might offer exposure to a basket of commodities. Relatedly, certain commodity-focused ETFs might invest in companies that produce, store and transport commodities, such as oil drilling or agriculture product companies. These funds can provide an avenue for investors interested in accessing this asset class without holding individual commodities, and they might be used as a hedge against inflation.
• Currency ETPs – Currency ETPs offer investors exposure to foreign currencies and the foreign exchange market (forex) and exchange rates. These ETPs, which are often used by investors to hedge against exchange rate risk, tend to involve speculative trading. They’re sometimes backed by bank deposits in a foreign currency, but the products—and their risks—vary.
• Crypto Asset ETPs – Bitcoin and ether futures ETPs invest in bitcoin futures or ether futures contracts as their underlying asset. Spot bitcoin ETPs, on the other hand, invest in spot bitcoin as their underlying asset.

ETPs that invest in commodities, currencies or related futures may be structured differently, and some may even be registered under the Investment Company Act of 1940. Know what type of ETP you’re investing in, since the structure can impact the product’s costs, risks and tax consequences. Some ETPs, including spot bitcoin ETPs, may be referred to as ETFs or funds, but it’s important to note that these products might not be registered as investment companies and so might operate under different regulatory frameworks and provide different investor protections than ETFs.

Investors can buy and sell ETP shares throughout the trading day, at prices that may fluctuate. Like with stocks, ETP investors are typically faced with a bid-ask spread. This might be almost zero for some ETPs but much wider for other products, so do your homework. The intraday pricing of ETPs provides trading flexibility because you can monitor how the price is doing and don’t have to wait until the end of the day to know your purchase or sale price.

Unlike with a mutual fund, retail investors may transact at prices that can deviate—sometimes significantly—from the underlying value of the ETP. Be sure to compare an ETP’s market price with published estimates of its value (such as an intraday indicative value) and also consider order types other than market orders. Public sources, as well as your investment professional, generally can provide timely information on the extent to which an ETP’s current market price might be at a premium or discount to its estimated value. As with other investments, you can make money with ETPs if you sell for more than you paid. Of course, an ETP may also decline in value. If the value falls and you sell, you may have a loss.

Some ETPs, such as geared ETPs, are generally not intended to be buy-and-hold investments. Know the objectives of any particular product you’re considering in order to determine whether it’s right for you.

Fees and Expenses

Investors purchasing or selling ETNs or shares of an ETP through an investment professional typically pay a brokerage commission on each transaction, as with purchases of individual stocks. Depending upon your level of trading, the sales charges you pay for each purchase or sale could erode your investment return.

ETPs are also available on many online investing platforms that offer commission-free trading. While this can be advantageous to investors, the no-commission sales angle shouldn’t be the sole factor in determining which ETP to purchase. Read the fine print with regard to no-fee trades to understand whether a particular ETP has any other potential associated costs.

In addition to any brokerage commission that you might pay, ETPs have expense ratios, like mutual funds, calculated as a percentage of the assets invested, but they don’t have loads or 12b-1 fees.

In general, actively managed products, including ETFs, might have higher expense ratios than similar index-tracking products. But fees and expenses for ETPs can vary widely, and some indexes also include embedded costs, which can add up over time. Before purchasing these investment products, carefully read all of an ETP’s available information, including its prospectus or related documents such as a pricing supplement, and ask your brokerage firm or investment professional to explain the associated fees and expenses and other potential costs.

FINRA provides an easy-to-use, online Fund Analyzer that allows you to compare expenses among ETPs. Using a live data feed that captures expense information for thousands of products, the analyzer can help you understand the impact fees and expenses have on your investment over time. Once you select up to three products and type in the amount you plan to invest and how long you plan to keep the investment, the analyzer does the rest. See our overview of the Fund Analyzer and the different comparisons that can be modeled in the tool.

Tax Considerations

Because of the way they’re structured, ETPs might reduce capital gains distributions to investors and can be more tax efficient than similarly invested mutual funds. You’ll have to pay taxes on any realized capital gains when you do ultimately sell, however, and are also responsible for reporting any dividend and interest payments you receive from ETPs.

ETPs can be owned in a number of different types of accounts, such as tax-advantaged accounts, like retirement accounts, or brokerage accounts. Read more about tax considerations of investment accounts.

The tax treatment of ETPs varies depending on the nature of the product, and not all ETPs offer the same tax efficiencies. Leveraged and inverse ETPs, precious metal and other commodity ETPs, and currency ETPs, for example, can create tax liabilities. Certain types of ETFs also might subject investors to different tax issues as well.

For more information about the tax treatment of a particular ETP, make sure to read the prospectus or pricing supplement. Consult a tax professional if you need clarification of tax implications before making an investment.

ETPs can provide diversification, flexibility and exposure to a wide array of markets at a relatively low cost. In addition, asset types and investment strategies previously only available to more sophisticated investors have been increasingly made available more broadly to investors through ETPs. But as is the case with any investment product, it pays to be informed and understand the risks before making any financial decisions.

ETPs also assume the risks of the underlying assets in which they invest, such as commodities and bonds. For more on asset class-specific risks, review the appropriate investment product information.

Call Risk

Some ETNs are callable at the issuer's discretion. In some instances, ETNs can be subject to early redemption or an "accelerated" maturity date at the discretion of the issuer or one of its affiliates. Since ETNs may be called at any time, their value when called may be less than the market price that you paid or even zero, resulting in a partial or total loss of your investment.

Credit Risk

As unsecured debt instruments, ETNs don’t hold any underlying assets. Therefore, their value is tied to the strength of the issuer. If the issuer defaults on the note, you might lose some or all of your investment.

Liquidity Risk

ETPs are exchange-traded, but they do carry some liquidity risk. With thousands of available ETPs, not all will have the same level of marketability, and trading volume can impact their liquidity. Sometimes, an ETP may have wide bid-ask spreads or may trade at a large premium or discount to its value, depending on a product’s trading volume and other market factors. And if an ETP is delisted from its listing exchange and limited to over-the-counter quotation, liquidity can dry up.

Market Risk

ETPs are market-linked products and, just like any stock, can increase or decrease in price. Market fluctuations and volatility can affect your investment returns. Other factors, such as those related to socioeconomic and political risks, might also impact market pricing. Know what the index being tracked by a particular ETP is measuring and the trading strategies it uses.

Redemption Risk

Some ETNs may be called at the issuer’s discretion, meaning they can be subject to early redemption or an accelerated maturity date. This could lead to a loss if the value of the ETN when called is less than the market price you paid. Other ETPs may be liquidated for various reasons as well, which in some cases can occur with little warning.

Tax Risk

Some ETPs offer greater tax efficiencies than others. Understand the tax implications of any investment product you’re considering, and consult a tax professional if you’re uncertain about how you might be affected.

Tracking Risk

Most ETPs are designed to track the performance of an underlying index; however, sometimes their performance may diverge. So-called “tracking error” occurs when the returns of the ETP deviate from the returns of its underlying benchmark, which can impact investor performance (either negatively or positively). An ETP’s price also might diverge significantly from the underlying value of its portfolio if, for example, there's a disruption in the share redemption or creation process.

Other Risks

In addition to the risks noted above, ETPs that invest in bitcoin or other crypto assets, whether in the “spot” or in futures, might face additional risks associated with crypto assets. Apart from significant volatility, these include risks related to the potential for fraud or manipulation in the underlying market, on crypto asset trading platforms and with the infrastructure of crypto asset markets.

The following resources provide additional information about investing in ETPs:

• FINRA:
  • Day Trading
  • Investor Insights: Exchange-Traded Notes—Avoid Unpleasant Surprises
  • Investor Insights: Volatility Investing
  • Investor Insights: Smart Beta—What You Need to Know
• SEC:
  • Investor Bulletin: Exchange-Traded Funds (ETFs)
  • Investor Bulletin: Exchange-Traded Notes (ETNs)
  • Investor Bulletin: Leveraged and Inverse ETFs
  • Statement on the Approval of Spot Bitcoin ETPs
• CFTC Customer Advisory: Learn About Risks Before Investing in Commodity ETPs or Funds
• North American Securities Administrations Association (NASAA): Informed Investor Advisory: Single Stock ETFs