35 (PM) - ETFs: Mechanisms & Applications Flashcards
Exchange-traded Funds (ETFs)
A security that is an index-tracking portfolio that trades on secondary markets like a stock.
How are ETFs traded?
ETFs trade on the secondary markets just like any other stock.
What is unique about European ETFs?
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.
Tracking Difference
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.
Tracking Error
The annualized standard deviation of the daily tracking difference. This measure indicates the impact of portfolio management and expenses over a period of time.
What are the primary sources of tracking error?
- Fees and expenses of the fund
- Sampling and optimization used by the fund
- Investment in depository receipts (DRs), as opposed to underlying shares directly
- Changes in the index
- Regulatory and tax requirements
- Fund accounting practices
- Asset manager operations
Indicated NAV (iNAV)
An exchange’s intraday fair market value estimate of an ETF’s NAV.
ETF Premium v. ETF Discount
ETF Premium: Market Price > NAV
ETF Discount: Market Price < NAV
Two major sources of ETF premiums/discounts
- Timing differences - foreign securities trading in different time zones.
- Stale Pricing - Infrequently-traded ETFs may reflect noncurrent prices.
When would an ETF market price be more informative than NAV or indicated NAV?
- The market for the underlying securities is closed.
- Underlying securities are highly volatile and illiquid.
- There is a time lag between the pricing of the ETF and the pricing of the underlying securities.
What are the major costs associated with ETFs?
Trading costs and management fees.
When are trading costs lower/higher?
Lower = More -liquid ETFs
Higher =Less-liquid ETFs.
What costs do ST investors care about?
What cost do LT investors care about?
ST - Want lower trading costs.
LT - Want lower management fees.
What is the ETF liquidity ratio?
Average dollar volume/average assets.
The higher the better/more liquid.
What are the major risks of investing in ETFs?
- Counterparty risk
- Settlement risk (only for ETFs using OTC derivative contracts)
- Security lending - ETFs can lend their securities to short sellers for a fee
- Fund closures with adverse tax consequences.
- Creation/redemption halts
- Expectation-related risk - The outcome of the investment may differ from investor expectations because the strategy may be very complex.
What are the three primary uses of ETFs?
- Efficient portfolio management - Liquidity management, portfolio rebalancing, portfolio completion, and transition management.
- Asset class exposure management - Tactical trading strategies or getting core exposure to an asset class or sub-asset class.
- Active investing - Factor investing (smart beta), risk management, dynamic asset allocation, alternatively-weighted ETFs, and discretionary-active ETFs.
Authorized participants (APs)
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.
Creation basket
v.
Redemption basket
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.
Creation unit
The lot size of ETF primary market transactions - typically 50,000 shares that can be traded as part of this creation/redemption process.
What purposes does the in-kind creation/redemption process serve?
- Lower cost
- Tax efficiency
- Keep market prices in line with NAV
Arbitrage Gap
The price band in which an ETF trades with its underlying NAV.
What are the factors that affect ETF bid-ask spreads?
Two major factors:
1. Liquidity
2. market structure of underlying securities
