Complex instruments

ETPs is a blanket term which includes exchange traded funds (ETFs), exchange traded commodities (ETCs), and exchange traded notes (ETNs). While not all ETPs will be complex instruments, they have the potential to be, because they can sometimes be leveraged products or invest in an area which is not as straightforward as a typical fund.

These instruments are listed on an exchange and trade like shares, which means the price can fluctuate throughout the day. The risks that come along with an ETP will depend on what kind of product it is. 

Many ETFs aim to track an index or sector. But there are types of ETF that may use complex strategies to try and deliver higher returns than a particular index or sector.

• Leveraged ETFs use complex techniques to try and amplify the actual gains or losses of a particular index.
• Short ETFs use derivatives to try and deliver the inverse performance of a particular index. This means if the performance of that index declined, your investment would go up in value. However, the reverse is also true, meaning you could lose money if the index did well.  

Synthetic ETFs don’t hold the underlying assets of an index. They instead enter derivatives, known as swap agreements, with a counterparty to provide a return based on the performance of the underlying assets. 

Additional risks: Like with exchange traded commodities (ETCs), there’s the possibility that a counterparty might fail and you lose money as a result. The use of leverage can also result in losses that are more extreme than they would be with the use of a standard ETF. These instruments may not precisely match the performance of the index depending on other fees and agreements. In particular, the daily resets of leveraged ETFs means that the gains and losses are unlikely to compound the same as the underlying assets and, as such, they are designed for short-term trading, rather than buy-and-hold investing. 

These are types of exchange-traded products that allow investors to track the performance of a specific commodity or commodity index. Examples of commodities are oil, precious metals, livestock or currencies.

• Physical ETCs are structured as zero-interest debt instruments, collateralised by direct holdings of the commodity itself, via purchase and storage of the underlying asset. They can be sensitive to changes in the underlying commodity prices, movements in the index and/or exchange rate risks.
• Synthetic ETCs are structured as zero-interest debt instruments and use swaps or futures contracts to gain exposure to the price of the commodity. Futures contracts are traded on exchanges and are a standardised legal agreement to buy or sell an asset, at a predetermined price, on a specified future date.

However, because futures have a limited lifespan, the ETC must regularly "roll" its positions by selling expiring contracts and buying new ones. The outcome of this process can affect the ETC's performance.

Additional risks: ETCs, as debt instruments, are exposed to counterparty risk of all parties involved with the contracts. They may also fail to match the exact performance of the commodity or index being tracked. ETCs may also introduce leverage via use of futures contracts or engaging in borrowing to increase exposure to the commodities that can amplify losses as well as gains.

Cryptocurrency (Crypto) exchange-traded notes (ETNs) are a way to access the cryptocurrency market through a security that is traded on a stock exchange, rather than the cryptocurrency itself. The ETN tracks the price of the asset by physically holding the underlying cryptocurrency, such as Bitcoin. Crypto ETNs are debt securities, meaning that instead of directly owning the cryptocurrency, you have a promise that the issuer will pay the value of that asset. Investors can only access ETNs that hold Bitcoin and Ethereum.

Additional risks: Crypto ETNs are a high risk and volatile asset class, with sharp rises and falls in price. You may walk away with less than you invested. There are security concerns when it comes to investing in assets linked to cryptocurrency, as technology advancements could lead to cyber-attacks putting the cryptocurrency at risk. As the product is an ETN, there is also risk of the issuer being unable to repay. These investments are not protected under the FSCS investor compensation scheme.

Access to Crypto ETNs: Investors who would like to invest in the asset will be required to take an additional Cryptocurrency ETN appropriateness test before gaining access.

A warrant gives you the right to buy shares or other securities at a specific price, within a particular time frame. The price of warrants can be very volatile, as a small movement in the price of the underlying investment can lead to large change in the price of a warrant. After a warrant expires, it has no value.

Additional risks: If you do not choose to take up the rights under the terms of the warrant, you may not get any returns for holding that warrant. During the time you hold a warrant, there is a chance that a better price will emerge for the underlying security than the one you have agreed upon. 

A convertible allows you to exchange an existing investment (usually bonds or preference shares) into a fixed number or proportion of ordinary shares in the same underlying company at a future date. A convertible investment usually pays a lower rate of return than a non-convertible investment and the value of the convertible will be affected significantly by price movements in the underlying investment itself.

Additional risks: Because convertibles often cross between bonds and shares, this means that they are sensitive to the factors of both markets. So, they could be sensitive to elements like interest rates as well as the typical share fluctuation factors. 

These include hedge funds, private equity, infrastructure, property or other illiquid asset classes. The investment may have a sophisticated structure and/or complex performance related charging and may have exposure to specialist geographical areas or other security types.

Additional risks: These asset classes have limited levels of liquidity, meaning they cannot be easily sold and converted to cash. Some of the funds may have specified exit periods, where you can only remove your money after a certain number of years, for example. Additionally, because these investments are not all public, there is less transparency when it comes to the value of the assets and reporting. 

A structured product offers a pre-packaged investment strategy that uses derivatives to deliver a return (known as a payout) if certain conditions are met. The return could depend on the performance of a single investment, a basket of investments, an index, interest rate(s), commodities, debt, foreign currency or any combination of these. They are typically fixed-term investments with little or no liquidity or ability to trade them before maturity.

Additional risks: Low levels of liquidity mean that it could be difficult to sell the investment and there may be penalties if you sell before the agreed exit date. 

Venture capital trusts (VCTs) use tax reliefs to encourage investment in smaller, early-stage companies. Some VCTs may be lower risk than others, but overall, they’re still likely to carry higher risk than investing in more established companies on the stock market. You must hold a VCT for five years to keep the tax relief. You also cannot claim tax relief if you reinvest into a VCT you’ve sold within the last six months.

Additional risks: Although venture capital trusts can offer tax relief, this does not apply once they are initially offered on the market, meaning some of the benefits of the asset are not available if you buy the shares on the secondary market. Like structured products, VCTs can have low levels of liquidity, making them difficult to sell. 

Leveraged ETPs are investments that use derivatives (usually swaps, but sometimes futures or options) to try and amplify the gains of a commodity or index.

They’re designed to deliver this return one day at a time, ‘resetting’ at the end of each day and starting again, meaning performance over longer periods may differ significantly from the performance of the underlying market. This makes them more complex and adds extra risk. While there’s potential for larger returns, there’s also a higher risk of significant losses.

For example, if the market goes up 1% in a day, a 3x Leveraged ETP will aim to go up 3%. If the market falls 1%, it would be expected to fall by around 3%.

Many Leveraged ETPs are designed for short-term trading and the manufacturer recommended holding periods can be as short as one day. Their volatile nature means this type of investment is typically suited to short-term strategies rather than long-term holding.

Additional risks

Because returns are amplified, losses can be much larger. If the market falls by 3% in one day, a 3x Leveraged ETP could fall by around 9%.

After a loss, it takes a larger percentage gain to recover. For example, a 9% loss would need a gain of around 9.9% to break even.

Volatility decay can also occur. This happens when the market moves up and down frequently. Because Leveraged ETPs reset daily, these fluctuations can reduce the value of the investment over time, even if the market ends up at a similar level to where it started.

Short or inverse ETPs are similar to Leveraged ETPs, but they aim to move in the opposite direction of a commodity or index. This means if the price of the underlying market falls, the value of the ETP is designed to increase.

Some Short or inverse ETPs also use leverage (such as -2x or -3x) to amplify these opposite returns. Like Leveraged ETPs, they typically reset daily, meaning they’re designed to deliver a return over one day, rather than longer periods. This added complexity increases risk.

For example, with a -3x Inverse ETP, if the value of the index it tracks falls by 1% in a day, the investment would aim to rise by 3%. However, if the market rises by 1%, the investment could fall by around 3%.

Additional risks

Because returns are amplified, losses can increase quickly if the market moves in the opposite direction. In extreme market conditions, you could lose all of your investment.

As with Leveraged ETPs, gains and losses compound. This means that over time, returns may differ from what you expect, especially in volatile markets.

After a loss, it also takes a larger percentage gain to recover. For example, a 9% loss would require a gain of around 9.9% just to break even.