The Difference Between an ETF and an ETP: Part II

Part II of our guide to exchange-traded products looks at ETFs and the specifics of the replication techniques they use

Gordon Rose, CIIA, CAIA, 20 April, 2011 | 9:19AM
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Click here for Part I of this guide to exchange-traded products.

Financial literature is flooded with acronyms many investors struggle to keep up with. It seems as though every new financial product comes with at least two new acronyms. The ETF world is no exception. In fact, already at this point is where we find the first misconception, as we define them Exchange Traded Fund or ETF is not an umbrella term but rather a specific product-type within a wider range.

In part I of this guide, I gave a broad definition of the different categories of Exchange Traded Products (ETPs) that exist. Part II looks at Exchange Traded Funds (ETFs), which represent about 90% of the overall ETP market in terms of total assets under management. Here I will provide a more detailed analysis of the key aspects of ETFs, especially their different structures.

Exchange Traded Funds (ETFs)
ETFs generally track equity or fixed income indices. However, depending on their structure, ETFs can also track commodity indices. At this point, it is probably worthwhile to make a short excursion to examine the UCITS rules which determine whether an ETP can be labelled as ETF or not.

A UCITS fund is typically an open-ended, diversified, and liquid fund. It has to pledge its securities in a segregated account with an independent custodian or depositary for safekeeping. From the perspective of fund providers, one of the main advantages of a UCITS-compliant fund is that it is eligible to be ‘passported’, that is, compliant funds can be distributed throughout the European Union once approved by any single member country.

Perhaps the most relevant feature as it pertains to ETPs is the diversification requirements of the UCITS regulations. In order to be UCITS III compliant an ETP cannot invest more than 20% of its NAV in instruments (such as shares or debt securities) issued by the same body. This limit can be raised to 35% under exceptional market conditions or with prior regulatory approval.

Coming back to the topic at hand, I will focus on the structure of ETFs rather than the general use, advantages and disadvantages of ETFs. We would recommend that investors preferring to go back to basics read one of our previous ETF articles, Are ETFs Right for You?

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Gordon Rose, CIIA, CAIA,

Gordon Rose, CIIA, CAIA,  is an ETF analyst with Morningstar Europe.

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