What are Exchange Traded Products?

How do ETPs replicate an index?

There are three main ways an Exchange Traded Product (ETP) replicates an index. Other strategies might be used, so investors should ensure they’ve read the prospectus and other relevant documentation before investing.

Fully replicated ETPs - These ETPs hold every investment, in proportion, within the index they’re aiming to track. For example, a fully replicated S&P 500 ETF would hold all 500 companies in the index and in the same relative proportions. Investors should in theory get the same return as the index, less the investment manager’s fees.

In some indices, fully replicated products need to hold and balance lots of smaller holdings, which can increase costs.

Partially replicated ETPs - These ETPs don’t hold every investment in the index. Instead, the manager chooses a portfolio designed to perform in line with the index, without including every asset. This process is often called ‘optimisation’ or ‘partial replication’ for shares and ‘sampling’ for bonds.

Partial replication is common when there are a lot of holdings in the index. This is because it can be costly to buy and sell the smallest investments which don’t make much difference to its performance.

There are different ways to partially replicate an index. Some investment managers exclude investments that fall below a certain threshold, whereas others look to find a substitute basket of assets to represent the performance of the index.

Synthetic ETPs - These ETPs don’t hold the investments in the index they aim to track. Instead, the ETP will buy derivatives (often swaps), usually from an investment bank which agrees to match the return of the index.

Synthetic ETPs can be useful for tracking the underlying asset without incurring the costs that the ETP issuer would otherwise have had to pay, such as for storing the assets.

For example, a physically backed ETP that tracks gold will have to pay costs associated with its safekeeping. Because synthetic ETPs use derivatives to track the price instead, they don’t have these additional costs. However, the biggest risk for synthetics is often counterparty risk. This is due to the reliance on the investment bank as the ETP could run into issues if that third party defaulted.

What are the risks associated with ETPs?

• Market risk – the ETP structure doesn’t remove the risks of investing in shares, bonds and other assets. All investments and any income they produce can fall as well as rise in value so you could get back less than you invested.
• Liquidity risk – not all ETPs have a large asset base or high trading volume. If the ETP has a large bid/offer spread and low volume it can be more difficult and costly to sell shares in the ETP.
• Concentration risk – some ETPs focus on a single sector, commodity or currency which can result in losses if that specific sector or asset doesn’t perform well. Therefore, these ETPs should only form a small part of a well-diversified investment portfolio.
• Tracking error risk – not all ETPs successfully track their underlying index, commodity or currency, leading to higher tracking error. This discrepancy can result in returns that don’t closely match what the ETP aims to track. Tracking error can be caused by many things, for example, trading costs, fees and commissions, taxes and capital gains distributions, the experience and skill of the portfolio managers and the methods used by the ETP to track the index, commodity or currency.
• Currency risk – movements in exchange rates can impact the value of an investment. If investors receive payments in a currency that is different to the ETP’s base currency, the value of their investment may increase or decrease subject to movements in exchange rates.
• Volitility risk - ETPs can be more volatile than index funds because they trade on exchanges, so their prices can fluctuate throughout the day like shares. Whereas index funds are only priced once a day.
• Price deviation risk - The market price can be different to the net asset value of the ETF based on changes in supply and demand. This will likely be minimal as the redemption mechanisms keep the values close.
• Leveraged and inverse ETPs – these types of ETPs use complex strategies and may deviate from the performance of the underlying index or asset over longer time periods, they are only designed for very short-term trading. They amplify market movements and can lead to substantial losses. They are riskier and not suitable for inexperienced investors. They are riskier and not suitable for inexperienced investors. Learn more about complex instruments such as leveraged investment products.

ETFs, ETCs and ETNs all have their own specific risks, which you can find on the relevant pages in this section.

Will an ETP perform identically to the index it’s tracking?

It's not possible to invest directly in an index and while ETPs try to perform as closely as possible to an index, this often isn’t perfect.

For example, the index that an ETP tracks doesn’t incur the costs of buying, selling, and owning securities. Whereas a fund will incur these charges – these costs detract from performance, so it can be slightly different to the index.

The most common measure of an ETP's ability to track its index closely is called tracking error. Tracking error is the difference between the performance of the ETP and its corresponding benchmark. A more precise ETP is said to have a lower tracking error.

While a lower error is preferable, not all tracking errors are easy to predict or explain.

Tracking error can also be influenced by changes made to an index. Sometimes securities might be added or removed from an index, or the proportion of a security might go up or down. An ETP that tracks that index might also need to make the same changes. These don’t necessarily happen instantaneously, and the lag and costs of trading can contribute to tracking error.

Tracking difference versus tracking error

Tracking difference and tracking error are key measures that help evaluate the performance of passive funds.

Tracking difference is the difference between a passive fund's performance and its benchmark over a certain period. It tells you the extent to which a fund has performed worse or better than its benchmark.

For example, if a benchmark returned 10% over a year and the fund returned 9.98%, the tracking difference for that period would be -0.02%. Tracking difference is usually negative for passive funds due to the costs involved that detract from performance.

Tracking error gives us the consistency of a passive fund's tracking difference over the same period of time. It measures the extent to which a passive fund's return differs from its benchmark. It's the annualised standard deviation of the tracking difference data points for the given time period.