35 (PM) - ETFs: Mechanisms & Applications

Question 1

Exchange-traded Funds (ETFs)

Answer 1

A security that is an index-tracking portfolio that trades on secondary markets like a stock.

Question 2

How are ETFs traded?

Answer 2

ETFs trade on the secondary markets just like any other stock.

Question 3

What is unique about European ETFs?

Answer 3

There is significant market fragmentation in Europe and ETFs tend to be listed on multiple exchanges and have multiple classes. As a result, the quoted bid-ask spread of an ETF will often widen.

Question 4

Tracking Difference

Answer 4

The divergence between an ETF’s return (based on its NAV) and the return of the tracked index. This measure indicates the ETF’s ability to follow its underlying benchmark.

Question 5

Tracking Error

Answer 5

The annualized standard deviation of the daily tracking difference. This measure indicates the impact of portfolio management and expenses over a period of time.

Question 6

What are the primary sources of tracking error?

Answer 6

1. Fees and expenses of the fund
2. Sampling and optimization used by the fund
3. Investment in depository receipts (DRs), as opposed to underlying shares directly
4. Changes in the index
5. Regulatory and tax requirements
6. Fund accounting practices
7. Asset manager operations

Question 7

Indicated NAV (iNAV)

Answer 7

An exchange’s intraday fair market value estimate of an ETF’s NAV.

Question 8

ETF Premium v. ETF Discount

Answer 8

ETF Premium: Market Price > NAV
ETF Discount: Market Price < NAV

Question 9

Two major sources of ETF premiums/discounts

Answer 9

1. Timing differences - foreign securities trading in different time zones.
2. Stale Pricing - Infrequently-traded ETFs may reflect noncurrent prices.

Question 10

When would an ETF market price be more informative than NAV or indicated NAV?

Answer 10

1. The market for the underlying securities is closed.
2. Underlying securities are highly volatile and illiquid.
3. There is a time lag between the pricing of the ETF and the pricing of the underlying securities.

Question 11

What are the major costs associated with ETFs?

Answer 11

Trading costs and management fees.

Question 12

When are trading costs lower/higher?

Answer 12

Lower = More -liquid ETFs

Higher =Less-liquid ETFs.

Question 13

What costs do ST investors care about?

What cost do LT investors care about?

Answer 13

ST - Want lower trading costs.

LT - Want lower management fees.

Question 14

What is the ETF liquidity ratio?

Answer 14

Average dollar volume/average assets.

The higher the better/more liquid.

Question 15

What are the major risks of investing in ETFs?

Answer 15

1. Counterparty risk
2. Settlement risk (only for ETFs using OTC derivative contracts)
3. Security lending - ETFs can lend their securities to short sellers for a fee
4. Fund closures with adverse tax consequences.
5. Creation/redemption halts
6. Expectation-related risk - The outcome of the investment may differ from investor expectations because the strategy may be very complex.

Question 16

What are the three primary uses of ETFs?

Answer 16

1. Efficient portfolio management - Liquidity management, portfolio rebalancing, portfolio completion, and transition management.
2. Asset class exposure management - Tactical trading strategies or getting core exposure to an asset class or sub-asset class.
3. Active investing - Factor investing (smart beta), risk management, dynamic asset allocation, alternatively-weighted ETFs, and discretionary-active ETFs.

Question 17

Authorized participants (APs)

Answer 17

large broker-dealers that make the market for ETFs by being primary market participants. APs are permitted to create additional shares or redeem existing shares, for a service fee payable to the ETF manager.

Question 18

Creation basket

v.

Redemption basket

Answer 18

Creation basket - List of required in-kind securities that the ETF manager publicly discloses each day.

Redemption basket - The specific list of securities that an AP receives upon redeeming an ETF share.

Question 19

Creation unit

Answer 19

The lot size of ETF primary market transactions - typically 50,000 shares that can be traded as part of this creation/redemption process.

Question 20

What purposes does the in-kind creation/redemption process serve?

Answer 20

1. Lower cost
2. Tax efficiency
3. Keep market prices in line with NAV

Question 21

Arbitrage Gap

Answer 21

The price band in which an ETF trades with its underlying NAV.

Question 22

What are the factors that affect ETF bid-ask spreads?

Answer 22

Two major factors:
1. Liquidity
2. market structure of underlying securities