Chapter 19: Exchange-traded funds

Question 1

What is exchange-trade fund?

Answer 1

• is an investment vehicle that combines some features from mutual funds and some from individual stocks
• subject to National Instrument 81-102 and 81-104 (in case of the fund use commodities and derivatives)
• professionally managed products
• listed and traded on a stock exchange or an alternative trading system

Question 2

How are ETFs structured?

Answer 2

ETFs in Canada are structured as mutual fund trusts or as mutual fund corporations. Both ETF classification structures are regulated according to National Instrument (NI) 81-102 and can be bought and sold by many dealers registered with the Mutual Fund Dealers Association (MFDA) of Canada or the Investment Industry Regulatory Organization of Canada (IIROC). Several types of ETFs under these structures include index and active ETFs. Under NI 81-102, the use of leverage and the use of derivatives for nonhedging purposes is generally limited

Question 3

What is ETF facts?

Answer 3

• Is the document that ETFs must produce and file a summary disclosure document.
• Include standard information and address the trading and pricing characteristics of ETFs. (ex: market price and bid-ask spread, as well as to premium and discount of market price to the net asset value (NAV))
• The ETF Facts document is distributed through the dealer where the ETF is purchased. The amendment requires dealers receiving a purchase order for ETF securities to deliver the ETF Facts document to investors, instead of the prospectus, within two business days of the purchase. The dealers are also required to make the prospectus available to investors, upon request, at no cost.
• Under the proposed amendment, investors who do not receive the ETF Facts document have the right to seek
  damages or to rescind the purchase

Question 4

How to launch a new ETF?

Answer 4

• it does so through a designated broker with whom it has entered into a contractual agreement. The designated broker may be a market maker or a specialist representing a large investment dealer

Question 5

What is the prescribed number of units?

Answer 5

ETFs are created or redeemed in blocks of units known as a prescribed number of units – typically consisting
of 10,000, 25,000 or 50,000 ETF units.
If an ETF is designed to track a particular index, the designated broker buys (or borrows from a securities lender) shares in all of that index’s component parts, in increments set by the respective ETF provider. The designated broker then delivers the basket of shares to the ETF provider. In exchange, the ETF provider gives the designated broker the prescribed number of units, which the broker can break up and sell as individual ETF units in the open market
The process also works in reverse: the designated broker can remove ETF units from the market by purchasing enough units to form the prescribed number for a unit. The broker then exchanges the unit with the ETF provider for the underlying shares that comprise the index.

Question 6

Example of a prescribed number of units?

Answer 6

If the designated broker delivers the basket of shares with a value of $396,730 to the ETF provider, the ETF
provider in turn will deliver 50,000 ETF units to the designated broker, where the value per unit would be $7.93 (calculated as $396,730 ÷ 50,000). The total value of the basket of stocks divided by the prescribed number of units determines the value per ETF unit to be sold in the market place

Question 7

why ETFs are relatively cheap in terms of MERs compared to mutual funds?

Answer 7

because designated brokers normally pay trading costs and fees associated with the purchase and sale of the underlying securities that comprise the index. Designated brokers make their money from the bid/ask spread, as investors buy and sell the ETFs. Not only does this system result in lower trading costs, it also creates a fairer system for paying those costs. In the case of mutual funds, all unitholders pay the costs associated with carrying out a single investor’s trading instruction. With ETFs, the trading costs of a single buyer or seller are paid for directly by that buyer or seller, largely through the bid/ask spread of the ETF (as well as any trading commissions)

Question 8

What is in-kind exchange feature of ETFs?

Answer 8

the creation and redemption process involves the designated broker buying and selling ETF units and
exchanging them with the ETF provider for the ETF’s underlying securities. The feature is known as an in-kind exchange because a basket of stocks is exchanged for ETF units, rather than for cash

Question 9

What are the benefits of ETF companies, designated brokers, and investors in in-kind exchange process?

Answer 9

the ETF provider receives the stocks it needs to track the index and the designated broker receives ETF units to resell. investors benefit from lower trading costs because the process keeps the price of the ETF in line with the NAV of its underlying securities

Question 10

What will happen if the traded value of the ETF strays too far above the NAV of the underlying securities?

Answer 10

the designated broker or other institutional players can attempt to profit from this arbitrage opportunity. To do so, they buy the underlying securities in the open market, redeem them for the prescribed number of ETF units, and then sell the units in the open market

Question 11

What are the key features of ETFs?

Answer 11

1. Low cost
2. Tradability, liquidity, and continuous price discovery
3. Low tracking error
4. Tax efficiency
5. transparancy
6. Low cost diversificaiton
7. Targeted exposure

Question 12

Why ETFs generally have a significantly lower management expense ratio (MER) compared to other managed products and mutual funds?

Answer 12

• Most ETFs are passively invested -> not cost of active portfolio management. ETFs also tend to have lower cost than passive managed funds because ETFs are traded on an exchange, where the administrative costs of record-keeping, issuance of prospectus documents and client statements, and handling of client inquiries
  are borne by the dealer member that holds the client‘s account. With index mutual funds, these costs are carried by the mutual fund company and get passed on directly to the investor.
• ETFs have no trading costs related to the need to purchase or sell securities to meet fund flows because they use an in-kind creation and redemption process, whereby the designated broker buys and sells securities to create and redeem shares.
• In terms of advisor compensation, ETF purchasers pay a commission (unless the purchase is within a fee-based
  account, in which case the fee is based on the dollar size of the account). In contrast, mutual funds have a wide
  variety of advisor compensation structures, including front-end, back-end, and low-load options. Investors who purchase ETFs outside of a fee-based account can further minimize their commission costs by purchasing through a self-directed broker which are potentially very low. Some ETFs do offer ongoing compensation in the form of a trailer fee, but they represent only a small portion of the ETF industry in Canada.

Question 13

How is ETFs’ tradability?

Answer 13

As with stocks, ETFs enable investors to buy and sell throughout the day, as long as the respective exchanges are open. They can be held on margin or shorted, and options can trade on them. As well, various kinds of orders such as market, limit, and stop orders can be placed on them.

Question 14

How is ETFs’ liquidity?

Answer 14

The liquidity of ETFs is derived from the underlying securities, rather than the ETF units themselves. Because an ETF is just a basket of securities, and the basket is exchangeable for the underlying assets, the volume of the underlying assets is the true indication of the ETF’s liquidity

Question 15

How is ETFs’ continuous price discovery?

Answer 15

ETFs trade on an exchange; therefore, there is continuous and transparent pricing during trading hours. Although this process adds value to all ETFs, the following two types of ETFs benefit in particular:
• Those that have relatively illiquid underlying assets
• Those that trade on exchanges while the underlying market is closed (for example, when the underlying market is overseas)
In these cases, the underlying asset price discovery process is often accomplished through the ETF. Because it is more accessible than the underlying asset, the ETF can reflect market information as it happens and actually lead the price of the underlying. It is reassuring to investors that the ETF price cannot depart from that of the underlying asset for very long or to a great extent. Arbitrage between the two prices continually forces them to remain in line with each other. Therefore, tracking error is minimized.

Question 16

What is tracking error?

Answer 16

tracking error is usually defined as the simple difference between the return on the underlying index or
reference asset and the return on the ETF. Tracking error can be caused by several factors, including the cost to run the fund, cash drag, and sampling methods

Question 17

Why ETFs have low tracking error?

Answer 17

• because the ETF administrative and trading costs are lower
• ETFs cannot deviate much from their NAV because of the in-kind creation and redemption process. This process allows market participants to create or redeem ETF shares at the end of each day at their NAV. Therefore, they are able to arbitrage between the ETF itself and the ETF’s underlying securities. If the market price of an ETF deviates from the fund’s NAV, market makers can perform arbitrage until this difference is minimized. However, if arbitrage is difficult and costly to implement, the tracking error level will be higher than normal. Two factors that could make arbitrage difficult and costly are a lack of liquidity and a large number of securities making up the underlying index

Question 18

How ETFs have tax efficiency?

Answer 18

• Index-based ETFs, which make up a large portion of the ETF market, tend to have lower portfolio turnover. Stocks
  are sold only when there are changes to the index, which results in fewer realizations of capital gains than other investment products (such as actively traded mutual funds). Therefore, fewer taxable events allow the capital to compound over time. In addition, the in-kind creation and redemption mechanism allows most ETFs to avoid certain taxable events. Such events arise with mutual funds, when redemptions take place and securities must be sold to raise cash within the fund

Question 19

How is ETFs’ transparency?

Answer 19

• Top holdings must be published monthly and all holdings quarterly. Nevertheless, index ETFs do publish their holdings daily, and this information is also available from the provider whose index the ETF is tracking. This transparency allows investors to gauge the attributes offered when the respective ETFs are added to a portfolio. In addition, some ETF providers
  post their tracking errors to their respective indexes. This record provides further transparency, as investors can
  measure how well the ETF has tracked the index and its level of dispersion (phân tán). With respect to actively managed ETFs in Canada, some do publish their holdings daily. However, this is a challenge
  for these ETFs to balance the trade-off between the benefits of transparency for investors and the competitive risks of disclosing their holdings.

Question 20

How ETFs help you to lower the cost of diversification?

Answer 20

With a single ETF you can have exposure to a broad range of stocks, bonds, market segments, and manager styles. You could also hold an ETF that attempts to mimic the performance of a country or group of countries. Given the high correlations between securities within sectors or asset classes, ETFs offer diversification at a lower cost than mutual funds and other managed products. ETFs can also help to mitigate the risk of holding a single stock or bond, given their typical structure of a basket of securities. Traditional stock pickers increasingly use ETFs to implement their asset allocation strategies. The low-cost diversification of ETFs is one key contributing factor supporting this trend

Question 21

What is “targeted exposure” of ETFs about?

Answer 21

• Allow small investors to access a broad range of assets that were previously difficult and expensive to purchase. - Investment opportunities that were once realistically only available to institutional and other large investors have become open to everyone -> democratize the investing process and level the playing field between large and small investors.
  Furthermore, equity ETFs have branched into various sectors and regions, and fixed-income ETFs have been refined for credit quality and term. Investors can therefore now use ETFs to implement investment themes that were previously too difficult and costly to obtain. These new products and innovations have allowed investors to use ETFs to create or supplement their investment portfolios

Question 22

What are the types of ETFs available on the market?

Answer 22

1. Standard (index-based)
2. Rules-based
3. Active
4. Synthetic
5. Leveraged
6. Inverse
7. Commodity
8. Covered call

Question 23

How standard ETFs divided?

Answer 23

Based on either exactly replicated or approximately constructed, depending on the method used. There are 2 types of standard ETF: Full replication and sampling.

Question 24

What are Full replication Standard ETFs?

Answer 24

• Used with equity portfolios of large-capitalization stocks because those stocks are extremely liquid investments. In such case, the ETF holes all of the stocks in the same weight as the respective index. The full replication process tracks extremely close to the benchmark index, with minimal tracking error.

Question 25

What are Sampling Standard ETFs?

Answer 25

Sampling is the process by which the portfolio manager selects securities and their weighting to best match the performance of the index. This method is typically used to construct portfolios of fixed-income and some international and small cap equity ETFs. The purpose of sampling with fixed-income ETFs is to achieve an outcome that replicates the performance of a large number of bonds that may not be accessible in the open markets.

Question 26

What method is most often used for fixed-income ETFs?

Answer 26

Sampling. Also in case there are considerations of either liquidity or index construction. With index construction, if the number of holdings within the index is significantly high, sampling makes the ETF more efficient, given the trading costs to reproduce the full index. With a sampling approach, there could be some differences between the index and the performance of the ETF. In most cases, this tracking error is small, but it should be reviewed regularly

Question 27

What type of ETFs are the most transparent?

Answer 27

Standard ETF. Typically, the holdings of a standard ETF and their weightings within the index are published by the issuer of the ETF. Naturally, this information is available from the index provider as well. In addition, some ETF providers post their tracking errors to their respective indexes

Question 28

what is rules-based ETFs?

Answer 28

Rules-based ETFs take a goal-oriented approach. Rather than following a traditional market-capitalization
weighted index, they follow an index focused on the areas of a market that offer higher returns or lower risks than traditional indexes. At the same time, they retain the positive characteristics of passive investing, including lower costs and increased transparency.
Rules-based ETFs are constructed based on a defined methodology to achieve a specific objective. They are usually associated with an index; however, some rules-based ETFs do not follow a specific underlying index. In these cases, construction rules are generally developed by the ETF provider and published in advance. The ETF provider follows the rules in the same way it would follow an index. Like traditional ETFs, rules-based ETFs generally attempt to use full replication, with general transparency of the holdings published on the provider’s website.
Rules-based ETFs are sometimes called smart beta ETFs because of the strategies they use. Smart beta strategies
attempt to deliver a different outcome than conventional market-cap-weighted indexes. To do this, they use
alternative weighting schemes, which may be based on any one of various criteria. For example, typical criteria may include volatility, dividends, or top-line revenue

Question 29

What is active ETFs?

Answer 29

Construction techniques of the active ETF vary according to the sponsor and its investment style (e.g., value or
growth-based, top-down or bottom-up, and quantitative or qualitative). The active portion of a fund is constructed
and managed no differently than any other active mutual fund. What differs is the timing of trading activity. An
active mutual fund manager trades whenever market conditions and opportunities permit. In contrast, a manager
in charge of the active portfolio of an ETF may have some restrictions as a result of the in-kind creation and
redemption process. Designated brokers must know what is represented by the prescribed number of units, which
means that the units cannot trade unless the designated broker knows about any changes. This communication
process may take some time. For example, the manager may be permitted to make portfolio changes only at the
end of a day or a week.
Active ETFs may charge a lower MER fee than an open-end mutual fund that manages a similar portfolio, but
generally more than another ETF with a passive benchmark.
In the United States, the Securities and Exchange Commission rules dictate that the manager’s trades must be
revealed the day after the transactions. In Canada, such trades do not have to be revealed earlier than on a quarterly
basis, according to NI 81-106. Therefore, the duration of any possible discrepancy between the ETF unit value and its
NAV is minimized in the United States; whereas in Canada, the risk of discrepancy is greater.
Compared to passively managed ETFs, actively managed ETFs have less transparency and higher MERs. They are also
less tax efficient because portfolio turnover is higher.

Question 30

what are Synthetic ETFs?

Answer 30

Synthetic ETFs differ from other types because they do not hold the same underlying exposure as the index they
track. These ETFs are constructed with derivatives, such as swaps, to achieve the return effect of the index. As a
result, the exposure of synthetic ETFs is notional, rather than real.
Swap-based synthetic ETFs are less transparent to the retail investor than their physical versions, where the
underlying assets consist of stocks, bonds, or bullion held in trust. ETFs that use swaps are exposed to counterparty
risk—that is, the risk that the counterparty in the contract will no longer be able to meet its obligations