ETFs or exchange traded funds are familiar concepts in India. However, ETPs are exchange traded products and ETF is actually a subset of an ETP. Globally, ETFs actually account for 97% of all exchange traded products. However, for an investor it is essential to know the difference between ETP and ETF.
What to know about the difference between ETFs and ETPs?
Here are some key takeaways in your understanding of ETFs versus ETPs.
- The ETP market overall is worth nearly $5 trillion of which nearly $4.8 trillion is accounted for by ETFs alone. ETFs are plain vanilla, traditional passive funds. On the other hand, ETPs are financially engineered investments that bet on or even against the very indexes that they track. ETPs are bets and not assets.
- ETFs are like mutual fund and just manage the money by investing the same in an index linked asset class. ETPs are not plain vanilla but they are normally either long / short products or even leveraged products with borrowing permitted to enhance returns.
- The goal of most ETFs is to help investors target returns on stocks and bonds via benchmark indices. The lion’s share of ETF assets are in major, broad-based market indexes that are the building blocks of global asset allocation. ETPs are normally benchmarked to global indices promoted by the MSCI or FTSE Russell.
- Quite often, ETPs (or at least a handful of ETPs) use financial engineering in an effort to magnify returns on different markets and under different macroeconomic assumptions. These niche products are worth roughly $80 billion in assets, or just about 1.5% of the overall ETP market. However, their ability to create systemic risk is huge.
- The financial engineering employed in ETPs, especially the more aggressive ETPs, includes the use of borrowed money (leverage) to magnify returns, as well as derivatives like options that stand to gain or lose money based on fluctuations in market prices. For example, there are Inverse ETPs that deliver the opposite of the indexes they track.
- Leveraged inverse ETPs seek to deliver a multiple of the opposite. For example, if the index is down by 10% then you earn 20% returns. However, if index is flat then you lose 5% returns. These are the type of bets you get to see in ETPs.
- ETPs are normally situation specific and hence they may work during short phases. Indeed, prospectus disclosures for geared ETPs generally state that they may not be suitable for a longer duration of holding.
- One advantage of traditional ETFs is that they have been rigorously stress-tested under different market scenarios. During the Jan-March period when the volatility was at a record high, many of these ETPs have done extremely well. However, ETPs are high cost products and hence in the absence of commensurate returns they do not make sense.
- There is also a distinction in legal structure between two different types of exchange-traded products: exchange-traded funds (ETFs) and non-fund ETPs. All ETPs are quoted and traded on stock exchanges like ordinary shares and they also calculate their prices with reference to an underlying index or reference asset.
- Normally ETFs are regulated under the relevant capital market regulations like SCRA / SEBI Act etc. However, ETPs tend to be outside the regulatory ambit and hence investors / traders must be extra careful of such products. They can be extremely risky.
- ETFs generally operate in a way that is similar to collective investment schemes like mutual funds. However, ETPs are typically debt securities or quasi-debt issued by special purpose vehicles (SPVs) domiciled in an offshore centre. This gives greater leeway to ETPs but also makes them less regulated and more risky.
How do ETFs and ETPs operate in India?
In India index ETFs and gold ETFs have been in existence for some time now. Bond ETFs also exist but they are yet to pick up in a big way. The ETPs exist as structured products that are normally listed. However, such structures in the past have been quite risky and have been largely restricted to HNI investors and corporate investors only.