Chapter 7: Exchange-Traded Funds (6)

Question 1

What is an Exchange Traded Fund (ETF)?

Answer 1

An investment fund designed to track a particular index.

Question 2

How does an investor invest in an ETF?

Answer 2

Buys shares in the ETF which are quoted on a stock exchange.

Question 3

How do ETFs differ from investment funds?

Answer 3

ETFs are open-ended funds, meaning the fund gets bigger and smaller as people invest and withdraw their money.

Question 4

How much have ETFs assets under management increased by in recent years?

Answer 4

Were $417 billion in 2005 to $7 trillion by the end of 2020.

Question 5

Which investment management approach do ETFs take?

Answer 5

Passive investment management.

Question 6

What is Passive investment management?

Answer 6

Managing a portfolio that seeks to match the performance of a broad-based market index.

Question 7

Why is Passive investment management passive?

Answer 7

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.

Question 8

What are most index tracker funds based on?

Answer 8

Market capitalisation-weighted indices, where the largest stocks in the index by market value have the biggest influence on the index’s value.

Question 9

How does the fund seek to track the index?

Answer 9

• Physical replication
• Synthetic replication

Question 10

What 3 tracking methods does physical replication employ?

Answer 10

• Full replication
• Stratified sampling
• Optimisation

Question 11

What’s meant by ‘full replication’?

Answer 11

Each constituent of the index is tracked and held in accordance with its index weighting. Very accurate.

Question 12

What’s a limitation of ‘full replication’?

Answer 12

Expensive so only really suitable for large portfolios.

Question 13

What’s meant by ‘stratified sampling’?

Answer 13

Requires a representative sample of securities from each sector of the index to be held.

Question 14

What’s a limitation of ‘stratified sampling’?

Answer 14

Although less expensive, the lack of statistical analysis renders it subjective and encourages bias towards stocks with best perceived prospects.

Question 15

What’s meant by ‘optimisation’?

Answer 15

Uses sophisticated computer modelling to find a representative sample of those securities which mimic broad characteristics of the index tracked.

Question 16

What’s a limitation of ‘optimisation’?

Answer 16

Costs less than full replication but is statistically more complex.

Question 17

What is synthetic replication?

Answer 17

Fund manager enters into a swap with a market counterparty to exchange the returns on the index for a payment.

Question 18

What is the benefit of synthetic replication?

Answer 18

• The responsibility for tracking the index is passed on to the swap provider.
• Costs are substantially lower.

Question 19

What is the downside of synthetic replication?

Answer 19

The investor is exposed to counterparty risk, namely that the swap provider fails to meet their obligations.

Question 20

Why do ETF shares trade at a discount to the underlying investments?

Answer 20

Because ETF share prices reflects the value of investments in the fund.

Question 21

What form is the investors returns in?

Answer 21

• Dividends paid by the ETF
• Possibility of capital gains on sale

Question 22

In London, where are ETFs traded?

Answer 22

On the LSE.

Question 23

How are ETFs bought and sold?

Answer 23

Via stockbrokers.

Question 24

What charges to ETFs exhibit?

Answer 24

• 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.

Question 25

Do investors have to pay stamp duty on ETF purchases?

Answer 25

No.