Exchange-traded products: A simple and cheap way to trade online

Exchange-traded products (ETPs) are an increasingly popular choice with traders because of the wide variety of assets and markets they offer. An ETP is a security that trades on the stock exchange whose value tracks the value of an underlying asset or index. ETPs can be traded through any stockbroker, just like a normal share, making them extremely convenient and easy to use (see below).

The simplest ETPs which are often known as exchange-traded funds (ETFs) are those that track stockmarket indices on a one-for-one basis. For example, let's assume you hold an ETP that tracks the FTSE 100. If the FTSE rises by 3%, the value of your ETP rises by 3% as well. These products are the most widely used types of ETPs and are popular with long-term investors as well as traders due to their low costs (the annual charge onsome ETPs can be less than 0.2%, compared to more than 0.75% for a typical managed fund).

However, ETPs aren't restricted to tracking stockmarkets. Another popular type are those that track commodities. These products are sometimes referred to as exchange-traded commodities (ETCs) and offer a straightforward way to invest in precious metals, such as gold, or to speculate on the price of agricultural products, such as wheat. These are certainly a far easier solution for most traders than the traditional approach of buying physical metal or trading in commodities futures market. However, these ETPs can be more complex than simple ETFs that track stockmarkets, so it's important to understand exactly what you're buying.

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Some commodity ETPs are "physically backed", which means that they actually own the underlying commodity: this is common with gold ETPs and can make them a cost-effective way to buy and hold gold for the long term. Conversely, many other ETPs invest in commodity futures rather than directly in the underlying commodity. Due to the way that commodity markets trade, this can mean that returns from these products are worse than returns from the underlying commodity over time, meaning that they not suited to long-term investments.

Leveraged and short ETPs

require even more care. These products return a multiple of, or the inverse of, the return on the asset they track. Let's say you hold a 2x leveraged FTSE 100 ETP. If the FTSE 100 rises 1% during the day, your ETP will rise 2%. However, if you hold the same ETP for a month and the FTSE rises 10%, you might find your ETP only goes up by 3% or even loses money. That's because the return on the ETP is not equal to twice the FTSE return over the entire month, but a series of daily returns and in choppy markets, these can be very different things.

Imagine an index rises 10% one day (from 100 to 110), but consequently falls by 10% the next (from 110 to 99) in sum it has lost 1%. However, a twice-leveraged ETF would be down by more than the 2% you expect. Why? Because assuming a starting level of £100, on the first day it will have fallen 20% (from 100 to 80), then on the next day it will have risen 20% (from 80 to 96) leaving it down 4%.

This discrepancy means that holding leveraged and inverse ETFs over long periods is likely to lose you money regardless of what markets do. They are best suited to trades of a few days at most.

Four things to watch out for

ETPs are simple to buy and sell through most stockbrokers, but there are a few point to keep in mind when choosing and trading them. Here are four things to look out for.

1. Check the total expense ratio (TER) of the ETP

The TER includes various administration costs, including the ETP manager's fee. The cheapest ETPs have a TER of under 0.15% per year for some major stockmarkets, although trackers for more exotic assets and markets will have higher costs.

2. The measure of a good ETP is how closely it tracks its index

An ETP will never match the performance of its benchmark index exactly, because it incurs some running costs. But over the long term, the difference should be broadly equal to the impact of the TER. If an ETP has a TER of 0.5% but is falling short of its index by 1% a year, that suggests that it isn't tracking the index as closely as you'd hope. That may be due to poor management of the tracking process, or to other costs that aren't included in the TER.

3. Check whether the ETP is trading at the right price

The share price of an ETP should usually trade in line with its net asset value (NAV), but it may temporarily rise above this or fall below. Avoid buying when an ETP is at a large premium.

4. Watch the bid/offer spread

The bid/offer spread is the difference between the price at which you can buy and the price at which you can sell. For large, highly liquid ETPs, this should be small but with more lightly traded ETPs, it can sometimes be much wider. Check the spread before you trade and consider using a limit order in order to avoid being caught out by a sudden widening in the spread at the time you place your trade.