Complex exchange-traded products (ETPs)
What are complex ETPs?
What are complex ETPs?
While many investors are familiar with traditional exchange-traded products (ETPs) that invest in stocks and bonds, fewer investors may be familiar with complex ETPs, including some types of exchange-traded funds (ETFs) and exchange-traded notes (ETNs). Complex ETPs feature structures or investment strategies that may differ from traditional ETPs, may be more difficult to understand, and may come with additional or increased risks. For example, the payout structure may differ, the products may perform in unexpected ways in various market and economic conditions, and/or the product may be exposed to derivatives or engage in short sales. An ETP that combines features of multiple products and strategies may also be complex.
Complex ETPs, if used correctly, may help provide portfolio diversification, substantial growth opportunity, or downside protection. However, complex ETPs have complicated structures with additional or heightened risks and features, such as the use of derivatives or lack of diversification. Some complex ETPs are designed to be held for short periods, such as leveraged and inverse ETPs. These investments may not be appropriate for you, and you should consider your own investment experience, objectives, goals, risk appetite, and time horizon before investing. Investors should refer to an ETP's prospectus for more information.
What are examples of complex ETPs and what are the potential benefits and risks?
Buffer ETFs seek to provide investors with limited upside of an asset's returns (generally up to a capped percentage) while also providing limited downside protection on the first predetermined percentage of losses (for example, on the first 10% or 15%). However, exposure is typically limited to the price returns of the index (i.e., dividends are not included).
Learn more: What are Buffer ETFs?
Buffer ETFs may offer downside protection against market losses while providing capped exposure to market growth.
Buffer ETFs may limit an investor's losses up to the ETF's stated buffer limit; however, in the event of a decline in the underlying investments in excess of the buffer limit, there is no guarantee against losses. Buffer ETFs have a cap on potential upside returns.
For investors purchasing a buffer ETF during the outcome period, typically one year, the current cap and buffer levels may differ from what is stated in the prospectus due to market movement, meaning the investor may have limited to no gains available while remaining vulnerable to significant downside risks.
These ETFs use flexible-exchange or FLEX options. Like other types of options, FLEX options give their buyers the right, but not the obligation, to buy or sell a security at a set price in the future. FLEX options may be less liquid than traditional options or other securities, which may negatively impact the value of an investment in a buffer ETF.
Commodity ETPs provide access to asset classes that might otherwise be difficult to invest in, such as agricultural goods, energy, and precious metals, via futures contracts or the physical commodity itself which may be held in secure vaults or other storage locations.
ETPs may be a relatively low-cost and convenient way to gain exposure to commodity prices (as compared to owning the physical commodity). Many investors turn to commodities for diversification or to seek a level of protection against inflation.
Investments in commodity ETPs may be extremely volatile, illiquid, and can be significantly affected by underlying commodity prices.
For commodity ETPs that invest in futures contracts, contango may occur, which could cause the ETP to perform worse than the commodity. Contango is when the futures price is above the spot price. Contango occurs when investors are willing to pay a premium today to be sure of the price they will get in the future. This can cause the ETPs to lose value.
Investing in commodity ETPs may create unusual tax issues. Funds that invest in futures and other derivatives contracts may be structured as partnerships, which issue a K-1 tax form. The K-1 tax form makes the tax-filing process more complicated.
Cryptocurrency-linked ETFs provide exposure to the prices/values of virtual currencies through crypto-linked futures contracts.
To learn more about cryptocurrency-related ETFs, read Cryptocurrency Investing.
Some investors believe that cryptocurrencies may provide diversification to a portfolio of traditional asset classes such as stocks and bonds.
Cryptocurrency ETFs allow investors to gain exposure to digital asset prices with the convenient access of a traditional brokerage account. Additionally, ETFs are regulated investments that may offer greater consumer protections than direct investments in cryptocurrencies.
Cryptocurrency prices historically have been highly volatile, and fluctuations could result in significant financial losses regardless of whether you have direct or indirect exposure via futures contracts.
The performance of products with indirect exposure to cryptocurrency may not be consistent with the performance of the spot market. Gains and losses may be greater or less than the actual performance of the cryptocurrency.
Indirect exposure to cryptocurrencies through futures contracts held in ETFs creates volatility and is not backed by any central bank or government. Cryptocurrencies lack many of the regulations and consumer protections that legal-tender currencies and regulated securities have. Due to the high level of risk, investors should view cryptocurrency as a purely speculative instrument.
ETNs are debt instruments backed by the credit of the issuer and carry inherent credit risk. They are different from ETFs because they do not invest in the underlying securities, such as stocks, bonds, or commodities.
To learn more about ETNs, read Exchange-Traded Notes: The Facts and the Risks.
The issuer promises to pay exactly the return on an index, minus expenses, so there's little risk of tracking error, which means the ETN is expected to closely match the performance of the index. Additionally, ETNs may carry tax benefits for some investors.
ETNs rely on the creditworthiness of their issuers, just like unsecured bonds. Therefore, their value may be less than the market price that you paid or even zero, resulting in a partial, or total, loss of your investment.
At times, ETN issuers may be unable to create new notes. When this occurs, ETNs may trade at a premium to their indicative value. Investors who purchase ETNs at a premium are at risk of losing money when issuance resumes and the premium dissipates, or if the note is called by the issuer who returns only the indicative value.
ETNs may delist from national exchanges. Investors who wish to sell these ETNs before they mature must trade in the over-the-counter market, where bid-ask spreads may be wider than on national exchanges.
Leveraged and inverse ETPs are designed to multiply or invert the performance of a certain index or benchmark on a daily basis.
To learn more about leveraged and inverse ETPs, read What Are Leveraged & Inverse ETFs & How Do They Work?
Investors might buy a leveraged ETP in an attempt to potentially boost returns on a stock index they think will go up in the short term or an inverse ETP to provide the potential for temporary protection from falling markets. These benefits may only be applicable if the product is traded as intended.
Leveraged and inverse ETPs are designed for daily use and are not intended to be held overnight. These ETPs use aggressive investment techniques by utilizing futures and swap agreements, which can increase volatility and decrease performance.
The amount of leveraged or inverse exposure resets each day, and the daily resetting has a compounding effect that can cause securities to perform worse than their multiple would suggest over a period longer than one day.
If held over longer time periods, the products will likely diverge from performance targets, meaning that these ETPs may experience losses even in situations where the underlying index or benchmark has performed as hoped.
These investments aim to provide diversification and/or downside protection through exposure to complex investment strategies such as long-short equity and event driven. These strategies leverage non-traditional investments such as derivatives.
Liquid Alternative ETPs may help diversify a portfolio by generating returns that have a low or limited correlation to traditional assets.
Liquid Alternative funds cover a wide range of strategies, each of which may contain unique risks. Common risks include high volatility from use of leverage, negative performance impact from legal/tax/regulatory regime shifts, and tax risk from frequent trading. Attempts to mitigate market exposure may prove unsuccessful, exposing the investor to full equity and/or bond market risk.
Single-stock ETFs offer exposure to the daily performance of a single stock and usually aim to multiply or invert that daily performance.
Investors might buy a leveraged single-stock ETF in an attempt to potentially boost returns on a stock they think will go up in the short term or an inverse single-stock ETF to provide the potential for temporary protection from stock price declines.
Single-stock ETFs may use leveraged and inverse strategies as they seek a multiple on investment returns for a particular frequently traded stock. Investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.
Since they track exposure to a single stock, they typically reduce or eliminate the benefits of diversification. Single-stock ETFs employ leveraged and inverse strategies, which are designed for daily use and are not intended to be held overnight.
Volatility-Linked ETPs invest in derivatives typically tied to the Chicago Board of Options Exchange Volatility Index (VIX). The types of derivatives used by these funds may include futures, options, and/or swap contracts.
To learn more about Volatility-Linked ETPs, read VIX ETFs: The Facts and Risks.
VIX ETPs provide exposure to derivative contracts based on the VIX index, which may help limit future downside risk.
These ETPs are short-term investments and should be monitored daily. Correlation with the underlying index may diverge in certain market scenarios.
VIX contracts approaching expiration typically have lower prices than those with expiration dates further out. Therefore, ETFs investing in VIX are typically selling low and buying high with every contract rollover—a condition known as contango.
What are factors I should consider before investing in complex ETPs?
Your investment objectives and risk tolerance:
- You should consider your own investment experience, objectives, goals, risk appetite, and time horizon before investing.
- If used correctly, some complex ETPs may enhance diversification in a well-constructed portfolio. However, complex ETPs have complicated structures with additional or heightened risks and features, such as the use of derivatives or lack of diversification. Some complex ETPs are designed to be held for short periods, such as leveraged and inverse ETPs. These investments may not be appropriate for you.
The additional risks and considerations of investing in complex ETPs:
- Derivatives risk may expose you to larger losses or smaller gains than if you invested directly in the underlying holding. Derivatives may be difficult to understand and may depend on the financial stability of a counterparty (the opposite party in the transaction).
- Volatility risk where the investment may be subject to greater price fluctuations, and you could lose your entire investment.
- Leverage may lead to performance that is significantly different from what you may expect.
- Complicated limits or formulas for the calculation of gains and losses. For example, buffer ETFs limit gains.
The costs and tax considerations of complex ETPs:
- Complex ETPs may have higher expense ratios than traditional ETPs because of the way they are structured.
- In addition, complex ETPs may be less tax efficient than traditional ETPs as the funds may be more frequently traded or may realize significant capital gains that may not be offset by losses.
Complex ETPs require regular monitoring:
Complex ETPs should be assessed regularly (daily with leveraged and inverse or volatility-linked ETFs) to ensure that they are meeting your goals and objectives. Complex ETFs may require you to rebalance your portfolio more frequently.
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