Chapter 7: Exchange-Traded Funds (6) Flashcards
What is an Exchange Traded Fund (ETF)?
An investment fund designed to track a particular index.
How does an investor invest in an ETF?
Buys shares in the ETF which are quoted on a stock exchange.
How do ETFs differ from investment funds?
ETFs are open-ended funds, meaning the fund gets bigger and smaller as people invest and withdraw their money.
How much have ETFs assets under management increased by in recent years?
Were $417 billion in 2005 to $7 trillion by the end of 2020.
Which investment management approach do ETFs take?
Passive investment management.
What is Passive investment management?
Managing a portfolio that seeks to match the performance of a broad-based market index.
Why is Passive investment management passive?
Because portfolio managers don’t make decisions about which securities to buy and sell; they invest in the same securities that make up the index.
What are most index tracker funds based on?
Market capitalisation-weighted indices, where the largest stocks in the index by market value have the biggest influence on the index’s value.
How does the fund seek to track the index?
- Physical replication
- Synthetic replication
What 3 tracking methods does physical replication employ?
- Full replication
- Stratified sampling
- Optimisation
What’s meant by ‘full replication’?
Each constituent of the index is tracked and held in accordance with its index weighting. Very accurate.
What’s a limitation of ‘full replication’?
Expensive so only really suitable for large portfolios.
What’s meant by ‘stratified sampling’?
Requires a representative sample of securities from each sector of the index to be held.
What’s a limitation of ‘stratified sampling’?
Although less expensive, the lack of statistical analysis renders it subjective and encourages bias towards stocks with best perceived prospects.
What’s meant by ‘optimisation’?
Uses sophisticated computer modelling to find a representative sample of those securities which mimic broad characteristics of the index tracked.
What’s a limitation of ‘optimisation’?
Costs less than full replication but is statistically more complex.
What is synthetic replication?
Fund manager enters into a swap with a market counterparty to exchange the returns on the index for a payment.
What is the benefit of synthetic replication?
- The responsibility for tracking the index is passed on to the swap provider.
- Costs are substantially lower.
What is the downside of synthetic replication?
The investor is exposed to counterparty risk, namely that the swap provider fails to meet their obligations.
Why do ETF shares trade at a discount to the underlying investments?
Because ETF share prices reflects the value of investments in the fund.
What form is the investors returns in?
- Dividends paid by the ETF
- Possibility of capital gains on sale
In London, where are ETFs traded?
On the LSE.
How are ETFs bought and sold?
Via stockbrokers.
What charges to ETFs exhibit?
- Spread between the price at which investors buy the shares and the price at which they can sell them.
- Annual management charge deducted from the fund, 0.5% or less.
- Stockbroker commission when they buy or sell.
