Chapter 19 Exchange: Traded Funds RQ Flashcards
Identify the correct statement regarding Exchange Traded Funds (ETFs).
A. Investors can short sell ETFs just like a normal stock.
B. ETFs charge either a front-end or back-end load.
C. ETFs are actively managed resulting in higher operating costs than normal mutual funds.
D. ETFs are priced once per day using the closing price of the fund’s
net asset value.
A. Investors can short sell ETFs just like a normal stock.
Like stocks, and unlike index mutual funds, ETFs are traded on an exchange and can be bought and sold throughout the trading day. In this way, ETFs provide investors with a flexible way to participate in the performance of the underlying index. ETFs trade at or very near their net asset value, because investors who hold a specific quantity of an ETF can always exchange their holdings for an equivalent basket of the underlying stocks in the index. Additionally, like stocks and unlike mutual funds, investors can short sell ETFs.
Alessandro has just purchased a leveraged ETF, but is surprised at how sensitive this ETF is to market movements. Point out to Alessandro the key characteristic of leveraged ETFs that makes them more sensitive to market movements.
A. The use of derivatives.
B. The use of physical commodity holdings.
C. The use of active investment management.
D. The use of borrowed capital.
D. The use of borrowed capital.
As is suggested by the name of the product, Leveraged ETFs make use of leverage to increase potential returns. The use of leverage, or borrowed capital, makes them more sensitive to market movements. The fund uses borrowed capital, in addition to investor equity, to provide a higher level of exposure to the underlying index.
Sue Ling is interested in investing in an agricultural commodity ETF, but doesn’t understand what the manager of this ETF would invest in. Identify, for Sue Ling, the securities a manager of an agriculture commodity ETF would use.
Physical-based ETFs. Futures-based ETFs. Equity-based ETFs. A. 1 and 2. B. 1 and 3. C. 1, 2 and 3. D. 2 and 3.
D. 2 and 3.
Physical-based ETFs are limited to only a few non-perishable commodities that are storable, such as gold and silver. Agriculture-based commodities are perishable and thus not suitable for physical exposure in an ETF.
Identify the similarities between ETFs and conventional mutual funds.
Both use active and passive management styles.
Both have similar levels of management fees.
Both have a potential for tracking error.
Both pay embedded compensation to advisors.
A. 1 and 2.
B. 1 and 3.
C. 2 and 4.
D. 3 and 4.
B. 1 and 3.
Both have a potential for tracking error and both can employ active and passive management styles. Mutual funds typically have higher management fees than ETFs and have embedded compensation. Clients pay a commission to the dealer for ETFs.
Mandeep is a client of yours who is interested in investing in exchange-traded funds (ETFs). Identify the features of ETFs that would make this type of investment attractive to Mandeep.
Transparency. Liquidity. Tax efficiency. Customizable. A. 1 and 2. B. 2, 3 and 4. C. 1, 2 and 3. D. 1, 2, 3 and 4.
C. 1, 2 and 3.
Exchange-traded funds have the following key features:
Low cost Tradability, liquidity, and continuous price discovery Low tracking error Tax efficiency Transparency Low cost diversification Targeted exposure ETFs are not customizable
Sarah is an advisor whose client is interested in buying an ETF. Sarah has heard that she should be careful about when and how she places the order for the client. Identify a trading tip for placing trades in an ETF that Sarah should be aware of.
A. Show small portions at a time.
B. Use limit orders.
C. Only trade in the first 15 minutes of the trading day.
D. Only trade in the last 15 minutes of the trading day.
B. Use limit orders.
One trading tip is to use limit orders to attain free protection from sudden price movements.
For large trades, place large portions of the trade at once, so that the market maker understands the need to create new ETFs to meet the demand. Unlike stocks, where a large trade can be shown in small portions at a time, there is limited advantage to doing this for an ETF trade.
Avoid trading in the first 15 minutes or the last 15 minutes of the trading day; studies show that there is less market liquidity, even for stocks, at those times.
Jackson has heard that there are ETFs that are very similar to an index mutual fund that he owns that tracks the performance of the S&P/TSX Composite Index. He is considering switching to ETFs and selling his mutual fund. Identify the type of ETF that would meet Jackson’s needs.
A. Rules-based ETF.
B. Active ETF.
C. Inverse ETF.
D. Standard ETF.
D. Standard ETF.
With standard ETFs, the reference index on which the ETF is based can be either exactly replicated through a full replication process or approximately constructed through sampling.
Marc-Andre is considering purchasing an ETF and asks his advisor, Jean, what additional risks he would be subject to if he does so. What risks will Jean point out to Marc-Andre that are specific to ETFs?
Risk related to securities lending. Risk related to tracking error. Equity risk. Currency risk. A. 2, 3 and 4. B. 1 and 2. C. 1 and 4. D. 1, 2 and 3.
B. 1 and 2.
Whereas general investment risks are a concern for investors in all types of securities, including mutual funds and ETFs, the following risks, among others are specific to ETFs:
Risk related to securities lending
Risk related to tracking error
Concentration risk
Risk related to the composition of the ETF
Identify how exchange-traded notes (ETNs) are different from exchange-traded funds (ETFs).
A. ETNs do not trade on an exchange, unlike ETFs.
B. ETFs can face a call or early redemption, unlike ETNs.
C. ETFs do not face tracking error, unlike ETNs.
D. ETNs are debt obligations issued by a bank, unlike ETFs.
D. ETNs are debt obligations issued by a bank, unlike ETFs.
Exchange-traded notes are not investment funds, but rather debt obligations issued by a bank. Unlike ETFs, ETNs do not have tracking error risk because, as mentioned, the bank issuing them promises to pay a return based on the underlying asset. Note that the bank does not guarantee investment performance, however. If the underlying asset decreases in value so will the ETN. ETNs can face call or early redemption risk from the issuer which may adversely impact the value of the ETNs.
Identify the correct statement regarding the regulation of ETF disclosure documents.
A. ETF clients must receive a prospectus within 2 days of the trade.
B. ETFs are subject to the same continuous disclosure requirements as mutual funds.
C. Additional purchases of the same ETF require that the same documents be sent to the client.
D. ETFs are treated like equities, in that no disclosure documents need to be sent.
B. ETFs are subject to the same continuous disclosure requirements as mutual funds.
Exchange-traded funds are subject to the same continuous disclosure requirements as other mutual funds, including annual audited financial statements and management reports. The prospectus must be mailed or otherwise delivered to purchasers upon their request.
ABC Pension Fund has decided it would like an in-kind exchange for the rules-based ETFs that they own. What will ABC Pension Fund receive?
A. An equivalent number of ETFs of a similar type of rules-based ETF.
B. An equivalent number of ETFs of a different rules-based ETF, based on different rules.
C. The basket of stocks in increments set by the ETF provider.
D. The equivalent cash value of a basket of stocks that the ETF represents.
C. The basket of stocks in increments set by the ETF provider.
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 in increments set by the ETF provider. This process is a key feature of ETFs known as an in-kind exchange. It is so named because a basket of stocks is exchanged for ETF units rather than cash. Through the in-kind exchange process, both parties benefit from the transaction. The ETF provider receives the stocks it needs to track the index, and the designated broker receives ETF units to resell.
Identify a disadvantage specific to covered call ETFs.
A. They do not provide as high a return as the firm uses a covered call strategy which is not as risky as other types of ETFs.
B. They are not as liquid as other ETFs.
C. They have higher trading expense ratios.
D. They have fewer management constraints than other ETFs, which makes them riskier.
C. They have higher trading expense ratios.
Covered call ETFs generally have higher MERs and, in particular, higher trading expense ratios in comparison to other types of ETFs. Depending on the mandate of the product, there can be constraints on the portfolio manager that reflect the type of strategy the product is focusing on.
Susanna has just purchased an ETF. She reads in the ETF Facts document that she could receive distributions that include interest, capital gains, dividends and return of capital and is concerned about her tax obligations. Identify for Susanna which type of distribution is not taxable.
A. Foreign dividends.
B. Return of invested capital.
C. Capital gain from a sale of the units.
D. A capital gain eligible for the capital gains refund mechanism.
B. Return of invested capital.
In some cases, an ETF may distribute to investors an amount that is not taxable to the investors. A return of invested capital (ROC) is not taxable.
Identify the correct statement regarding the ‘satellite holdings’ in a “core and satellite” ETF portfolio strategy.
A. Satellite holdings are those ETFs comprising less than 10% of the portfolio.
B. Satellite holdings are ETFs that trade on foreign exchanges.
C. Satellite holdings are the riskier, sector-based ETFs.
D. Satellite holdings are the passive ETFs, designed to reduce risk in the portfolio.
C. Satellite holdings are the riskier, sector-based ETFs.
Core holdings are typically passive ETF holdings intended to provide the majority of returns. Satellite holdings are more focused on riskier sector ETF holdings. Satellite holdings are used to boost returns above the core asset returns.
Identify the correct statement that illustrates the composition risk in an ETF.
A. MNO Financial Services ETF is made up of the securities in the S&P/TSX Financial Services sub-index.
B. ABC ETF is made up of the top 100 securities in the S&P/TSX, but they are weighted based on profit rather than market capitalization.
C. Due to the low volume of some securities, FFF ETF cannot always mirror the index it duplicates.
D. POP ETF must always hold 5% cash, in order to pay dividends that it owes on the various securities held in the ETF.
B. ABC ETF is made up of the top 100 securities in the S&P/TSX, but they are weighted based on profit rather than market capitalization.
Some ETFs trade on the basis of the same underlying stocks that comprise a particular index, but using different weighting methodologies. Thus, their performance may differ significantly from the standard index.
