If you’re a savvy investor looking for ways to diversify your portfolio, you may have heard about ETPs. And you may be completely mind-boggled about them. Not to worry—you’re in good company.
Here’s the thing: They’re complex and they’re trendy, these ETPs. And while those aren’t bad things, necessarily, you don't want to sink your hard-earned money into something, trendy or not, without understanding how it impacts your finances. That’s part of taking control of your money.
So, without further ado . . . the ETP. And don’t worry. We’re keeping it simple(ish).
What Is an ETP?
Exchange-traded products, ETP for short, are considered complex investments, even in more financially informed circles. For a little extra context, we’ll go back to the beginning.
Picture it: America—the 1990s. Teens were searching for hidden tracks on their CDs, a humble Seattle coffeeshop was spinning out the first baristas, and the finance folks were thinking, What the people need is an investment option that’s a little like a mutual fund, but gives them more flexibility. And the ETP was born. Finance people are so cool.
The Difference Between ETPs and Mutual Funds
Like a mutual fund, one ETP can contain lots of individual investments like stocks and bonds, and people are essentially pooling their money together to invest in it. But unlike the mutual fund, which is priced once a day at the end of the day and can therefore only be bought or sold at the end of the day, an ETP follows an index up and down all day long and can be bought or sold throughout trading hours. The individual investments are put into one basket that tracks an index throughout the day, so generally, the ETP will do whatever the index as a whole does on that day, rather than what a bunch of individual stocks are doing.
Types of ETPs
All three types of ETPs—the exchange-traded fund (ETF), exchange-traded commodities (ETC) and exchange-traded notes (ETN)—function in similar ways, but they tend to be specialized based on product type and index groups.
Exchange-Traded Funds (ETF)
Betcha some of you read the title of this article and thought, Don’t they mean ETF? ETF is definitely a more well-known acronym than ETP. But an ETF, or exchange-traded fund, is just one type of ETP. The ETF is the broadest of exchange-traded products, since the funds might include individual stocks, bonds, real estate investments, money market funds—a whole variety of funds, both physically backed and not.
Exchange-Traded Commodities (ETC)
The commodities—those are raw materials and agricultural products—sector has always been a little harder to access for the average investor. Why? Because a lot of commodities investing is done in futures (financial-ese for a legal agreement to buy or sell in the future at a predetermined price) and the path to futures investing contains hurdles: 1) You need a futures account and 2) You need a financial advisor who deals in futures in order to set up a futures account.
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The ETC, however, is available directly through a brokerage account, and is traded on the exchange like stocks and bonds. That means you won’t have to learn a whole new way of trading like you would with futures.
Exchange-Traded Notes (ETN)
Yep, we’re talking exchange-traded stuff again, but this one is the exchange-traded note. So, you’ve got the broad-spectrum ETF, the commodities-specific ETC, and now the ETN, which specializes in unsecured debt securities—loans, or in this case, the “notes.” A secured loan is tied to something physical like a car or a house, which can be seized if the loan isn’t paid. Unsecured loans don’t have that kind of collateral, so they’re riskier. You, the investor, are loaning money to an entity that has created this ETN—often a bank—and that bank is now indebted to you and all its other ETN investors.
How does that bank use the money when you loan it money by investing in its ETN? Well, first, when it sets up the ETN, it chooses an index that the ETN is going to track, or basically mirror. Let’s say they’re following gold. You find out they’re following gold, you trust the bank, and you invest your money in the ETN. Now the bank can use that money in whatever way it needs to, promising you that your returns will match whatever the index is doing. So if, at the time you withdraw your money, gold is up 200%, your investment will also be up 200%. See how that works?
Let’s put it into even simpler terms.
Bear in mind, the ETN is not a simple investment strategy—we’re just trying to make it a little easier to understand. Meet Sue and Bobby.
Sue has $100 burning a hole in her pocket, and she’s looking for a way to make it into $300. While looking, she comes across Bobby. Bobby has a ton of bold money ideas he needs investors for right now, and he hears that Sue is looking for something to do with that $100.
Bobby: “Hey Sue, if you’ll loan me that hundo today and give me some time, I think I can make you some money.”
Sue: “How do you figure?”
Bobby: “I’ve been watching Ricky play baseball lately and he’s getting really good. I think that in six years, he’ll be in the majors. I’ll keep a close eye on his baseball career, and I guarantee you that if he’s making millions in the MLB like I think he will, I’ll triple your money.
Sue: “Bobby, what does Ricky’s baseball career have to do with you being able to pay me big bucks later?”
Here’s the thing: Ricky’s baseball career doesn’t have anything to do with how Bobby will make money. He’s just using that so he and Sue have an agreed-upon benchmark about how Sue gets paid back.
Banks do the same thing by saying they’ll pay you back based on a specific stock index. Meanwhile, they’re hoping to take your money and invest it somewhere else that outperforms the index. That’s what Bobby’s doing too—he’s hoping to take Sue’s $100 and turn it into $1,000. Then when Ricky makes the big league, he pays her back $300 and everyone’s happy. That’s the best-case scenario. Worst case is that Bobby goes bankrupt on his investment and Sue gets nothing—even if Ricky makes the majors.
That’s basically how ENTs work. They’re risky, because there are two ways you could lose your money—either if the index doesn’t do well or if the ENT owner (Bobby, in this case) tanks his investment and can’t pay you back. They’re a little less risky if the institution behind the ENT is credible and has a long history of making good on its promises.
Are ETPs a Good Investing Strategy?
Depending on who you’re talking to, investing in exchange-traded products could be the best thing since the Cardinals took the World Series in 2011—legendary, by the way. Or it could be more like the 1919 Black Sox—the guys who ruined their baseball careers and didn’t get the big bucks they bargained for. They’d probably say the reward was not worth the risk.
Generally, investors in the first camp choose ETPs for a couple of reasons.
- They usually cost less than mutual funds. Tracking an entire index is easier and cheaper than tracking the individual securities that make up a mutual fund, so fees are lower.
- In some cases, ETPs give investors access to indexes and commodities that are usually more complicated to invest in, especially the ones that you’d normally need a futures account to invest in.
And . . . truth: It can be pretty exciting to trade often and get out when an index is spiking.
But we’re more camp Black Sox. ETPs carry a lot of risk and the potential rewards don’t balance that out. Sure, it can be enticing to invest in stuff like gold bars and get access to indexes you couldn’t get to before—but you’ll stay more interested and involved in an investment that you can understand.
And the exciting, day-trading aspect of ETPs—knowing that you can buy and sell anytime the index is spiking—that’s not the way to build long-term wealth! Long-haul, ride-out-the-waves investing over time is the kind of solid investing strategy you need, and a financial advisor worth his salt is going to say the same thing.
Get Help With Your Investment Plan
We’re all for you diversifying your investment portfolio. People say, “Don’t put all your eggs in one basket,” for a reason—because it’s good advice. If you’re looking for a way to keep things interesting while you diversify, ETPs are one way to do that.
But there are safer, more well-lit routes to the same destination. A professional financial advisor can help you weigh the pros and cons of all of them. We always recommend solid growth stock mutual funds to diversify while sticking to a long-haul strategy.
If you’re ready to dive in, look for a financial advisor who will answer all your questions, no matter how basic you think they are. Because to really understand your finances—which is crucial to taking control of your money—you need help from an expert with the heart of a teacher. We’ve vetted and coached some of the most trustworthy, money-savvy folks out there and are proud to call them Ramsey SmartVestor Pros.