ETPs 101

30 Nov, 2012

Exchange traded products (ETPs) are a type of structured financial derivative that are priced based on an underlying composition of bonds, stocks, commodities or indices. This product is then subsequently listed on a public exchange. ETPs allow individual investors with limited access to derivatives or capital to focus on specific market exposure otherwise unattainable. Exchange traded products come in various types including Exchange Traded Notes (ETNs), Exchange Traded Funds (ETFs) and Closed End Funds (CEFs). Each instrument has unique and complex characteristics; however, the common denominator is their inherent theta exposure, also known as time-value decay.

The reasons for this decay are threefold. Firstly, theta risk exists when the ETP holds an underlying comprised of front and back month option derivatives. Option products always contain an embedded maturity date at which point the product expires. The option’s market price converges to the market price of the underlying security as the current date approaches expiration (nèt). Time decay is even more pronounced with out-of-the-money options since they expire worthless.

Secondly, when the ETP is comprised of an underlying future derivative, the effect of contango in the respective underlying’s market contributes to an increase in decay. Just as a refresher, contango is when near-term future prices are cheaper than late-dated futures prices (upward sloping futures curve). Most futures related ETPs use the front month futures contract since they best represent the spot price of the underlying and keep a constant 1 month duration. As each day passes, the ETP must sell ~1/20 of its original position to buy back month futures. If the futures market is in contango (back month futures’ prices are higher) then less futures contracts are purchased. This results in theta decay in the both the future product and consequently, the ETP.

Thirdly, all exchange-traded products charge an expense fee, albeit smaller than a mutual fund, but still representing 0.1% – 1%. Therefore, the longer an exchange traded product is held; the more returns are deteriorated by the expense fee.

Furthermore, theta risk is exacerbated by the use of leverage. Typically leveraged ETFs and ETNs use 2:1 leverage to amplify exposure, however there are even products that use 3:1 leverage. In addition to the geometric time decay in the underlying, leveraged exchange traded products also account for interest costs related to the borrowing of margined capital.

Position

VXX

VIX Spot

Time Decay

Date

% Change % Change Difference

2012-11-01

-19.64%

-16.67%

-2.98%

2012-10-01

2.81%

18.25%

-15.44%

2012-09-04

-21.81%

-9.96%

-11.85%

2012-08-01

-15.62%

-7.71%

-7.90%

2012-07-02

-10.32%

10.83%

-21.15%

2012-06-01

-26.95%

-29.01%

2.07%

2012-05-01

25.80%

40.29%

-14.49%

2012-04-02

-1.37%

10.65%

-12.02%

2012-03-01

-31.57%

-15.90%

-15.67%

2012-02-01

-8.71%

-5.20%

-3.52%

2012-01-03

-24.40%

-16.92%

-7.48%

Exchange traded products are relatively easy to enter and exit, but are increasingly more difficult to understand. Each exchange traded product and its respective underlying product must be fully comprehended when buying or selling due to the inherent time-value decay. The best strategy for new traders is to minimize theta risk by avoiding derivative comprised ETPs.

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