43. Exchange-Traded Funds: Mechanics and Applications Flashcards
In-kind Redemptions
In-kind redemptions are payments made for securities or other instruments rather than money—like a swap. Rarely used in the mutual fund industry, in-kind redemptions are common with exchange-traded funds (ETFs).
Authorized Participants
(APs) A special group of institutional investors who are authorized by the ETF issuer to participate in the creation/ redemption process. APs are large broker/ dealers, often market makers.
Creation/Redemption
The process in which ETF shares are created or redeemed by authorized participants transacting with the ETF issuer.
Creation Basket
The list of securities (and share amounts) the authorized participant (AP) must deliver to the ETF manager in exchange for ETF shares. The creation basket is published each business day.
Range in size from 10k to 60k shares.
Creation Units
Large blocks of ETF shares transacted between the authorized participant (AP) and the ETF manager that are usually but not always equal to 50,000 shares of the ETF.
Redemption Basket
The list of securities (and share amounts) the authorized participant (AP) receives when it redeems ETF shares back to the ETF manager. The redemption basket is published each business day.
Arbitrage Gap
The arbitrage gap— the price( s) at which it makes sense for ETF market makers to step in and create or redeem shares— vary with the liquidity of the underlying securities and a variety of related costs; in some ETFs, the gap can be as small as the minimum tick size in the local market (e.g., –$ 0.01 in the US markets), whereas for other ETFs with underlying securities that are hard to trade (e.g., high-yield bonds), the arbitrage gap can be more than 1% wide. For any ETF, however, the gap creates a band or range around its fair value inside which the ETF will trade. In other words, arbitrage keeps the ETF trading at or near its fair value.
Market Makers Settlement Requirement Period
Because of the time required to create or borrow ETF shares, market makers are given up to six days to settle their accounts.
CFA Institute. 2020 CFA Program Level II Volume 6 Alternative Investments and Portfolio Management (Kindle Location 7195). CFA Institute.
Sources of benchmark tracking error include the following:
Fees and expenses
Representative sampling/ optimization
Depositary receipts and other ETFs
Index changes
Fund accounting practices
Regulatory and tax requirements
Asset manager operations
Benchmark Tracking Error - Fees and expenses
Index calculation generally assumes that trading is frictionless and occurs at the closing price. A fund’s operating fees and expenses reduce the fund’s return relative to the index.
Benchmark Tracking Error - Representative sampling/ optimization
Rather than fully replicate the index, funds may hold only a subset of index securities to track the benchmark index.
Benchmark Tracking Error - Depositary receipts and other ETFs
Funds may hold securities that are different from those in the index, such as American depositary receipts (ADRs), global depositary receipts (GDRs), and other ETFs.
Benchmark Tracking Error - Index changes
Funds may trade index changes at times and prices that are different from those of the benchmark tracked.
Benchmark Tracking Error - Fund accounting practices
Fund accounting practices may differ from the index calculation methodology— for example, valuation practices for foreign exchange and fixed income.
Benchmark Tracking Error - Fund accounting practices
Funds may be subject to regulatory and tax requirements that are different from those assumed in index methodology, such as with foreign dividend withholding.
Benchmark Tracking Error - Asset manager operations
ETF issuers may attempt to offset costs through security lending and foreign dividend recapture. These act as “negative” costs, which enhance fund performance relative to the index.
Representative Sampling
For funds tracking index exposure to small or illiquid markets, owning every index constituent can be difficult and costly. Therefore, fund managers may choose to optimize their portfolios by holding only a portion, or representative sample, of index securities.
ETF Tax Fairness
In a traditional mutual fund, shareholders may have to pay tax liabilities triggered by other shareholders redeeming out of the fund.
If an AP redeems ETF shares, this redemption occurs in kind and is not a taxable event. Thus, redemptions do not trigger capital gain realizations. This aspect is why ETFs are considered “tax fair”: The actions of investors selling shares of the fund do not influence the tax liabilities for remaining fund shareholders.
ETF Tax Efficiency
When an authorized participant submits shares of an ETF for redemption, the ETF manager can choose which underlying share lots to deliver in the redemption basket. By choosing shares with the largest unrealized capital gains— that is, those acquired at the lowest cost basis— ETF managers can use the in-kind redemption process to reduce potential capital gains in the fund. Tax lot management allows portfolio managers to limit the unrealized gains in a portfolio.
ETF Tax Treatment
In most jurisdictions, ETFs are taxed according to their underlying holdings. For example, in the United States, an ETF holding equities or bonds will itself be subject to the same capital gain, dividend, and return-of-capital tax rules that apply to its underlying stock or bond holdings.
ETF Bid-Ask Spread Elements
± Creation/ redemption fees and other direct trading costs, such as brokerage and exchange fees
+ Bid– ask spreads of the underlying securities held in the ETF
+ Compensation (to market maker or liquidity provider) for the risk of hedging or carrying positions for the remainder of the trading day
+ Market maker’s desired profit spread, subject to competitive forces
– Discount related to the likelihood of receiving an offsetting ETF order in a short time frame
ETF prices may be a more accurate reflection than NAVs or iNAVs in the following situations:
When the underlying securities are less actively traded (less liquid or volatile markets),
when the underlying market is closed,
and when the underlying market has time lags (such as the early-closing commodity markets) with respect to the market where the ETF trades.
ETF Risks
Counterparty Risk
Settlement Risk
Security Lending
ETF Causes of Closure
Regulations
Competition
Corporate Actions
Creation Halts
Change in strategy
The primary applications in which ETFs are used include the following:
Portfolio efficiency:
The use of ETFs to better manage a portfolio for efficiency or operational purposes. Applications include cash or liquidity management, rebalancing, portfolio completion, and active manager transition management.
Asset class exposure management: The use of ETFs to achieve or maintain core exposure to key asset classes, market segments, or investment themes on a strategic, tactical, or dynamic basis.
Active and factor investing:
The use of ETFs to target specific active or factor exposures on the basis of an investment view or risk management need.
ETF Portfolio Efficiency
Portfolio liquidity management.
Portfolio rebalancing.
Portfolio completion strategies.
Transition management.
ETF Asset Class Exposure Management
Core exposure to an asset class or sub-asset class.
Equity style, country, or sector; fixed income or commodity segment.
Equity sector, industry, investment theme.
See exhibit 17
ETF Active and Factor Investing
Factor (smart beta) ETFs.
Risk management.
Alternatively weighted ETFs.
Discretionary active ETFs.
Dynamic asset allocation and multi-asset strategies.
See Exhibit 18
