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Portfolio Management L2 > ETFS: Mechanics and Applications > Flashcards

ETFS: Mechanics and Applications Flashcards

1
Q

When are mutual funds purchased and sold and at what price?

A
  • Purchase or sold EOD
  • Nav price
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2
Q

What does redeemed in-kind mean for ETF managers as AP’s?

A
  • exchange ETF shares for a basket of securities, rather than cash.
  • exchanging shares market makers already own for shares of ETF
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3
Q

What are authorized participants (AP’s) in the creation/redemption process of ETF’s?

A
  • special group of institutional investors, large brokers/dealers, or market makers who are authorized by the ETF issuer to participate in the creation/redemption process.
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4
Q

What is the creation basket and when is it published?

A
  • list of securities (and share amounts) the authorized participant (AP or market maker) must deliver to the ETF manager in exchange for ETF shares.
  • Creation basket is published every day.
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5
Q

What are creation units and how many shares are usually transacted?

A
  • the lot size or number of shares transacted between authorized participant (AP) and ETF manager, usually but not always equal to 50,000 shares of ETF
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6
Q

What is the difference between the creation basket and the redemption basket?

A
  • creation basket: amount of securities AP must deliver to ETF manager in exchange for ETF shares
  • redemption basket: amount of securities AP receives when it redeems ETF shares back to ETF manager.
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7
Q

How do AP’s make arbitrage profits and what’s the difference between ETF share creation and ETF share redemption?

A
  • AP’s make arbitrage profits when there is a discrepancy’s between the ETF price and the fair value price of the underlying securities
  • ETF share creation: when ETF price is trading above the fair value of the underlying securities, AP’s will short ETF and buy underlying securities
  • ETF share redemption: when ETF price is trading below fair value of underlying securities, AP’s will long ETF and sell underlying securities
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8
Q

How do ETF’s shareholders avoid transaction costs?

A
  • when AP’s make transactions the fees are passed along to the trader via the bid-ask spread instead of existing shareholders
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9
Q

Why can’t mutual fund shareholders avoid transactions costs?

A
  • since there are no AP’s, mutual fund managers incur costs to transact, which is passed on to shareholders of the mutual fund.
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10
Q

What does the National Security Clearing Corporation (NSCC) and Depository Trust Company (DTC) do?

A
  • NSCC: they gurantee transactions and clear trades
  • DTC: adds up how many shares each firm is owed or how many the firm owes to a separate firm (eg. E trade owes Schwab 1,000 shares of SPY. Schwab owes BofA 1,000 shares of SPY. Schwab is whole since it’s owed 1,000 and owes 1,000. Therefore, E trade will be debited 1,000 shares and BofA will be credited 1,000 shares.)
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11
Q

How many days does National Security Clearing Corporation have to complete settlement of shares owed to firms and owed by firms?

A
  • T+2 days (Trade date + 2 business days)
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12
Q

What is tracking errors for ETF’s?

A
  • the difference between the performance of the ETF and the index it tracks
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13
Q

Why would one expect an ETF to underperform its benchmark and by how much?

A
  • to account for the expense ratio, the tracking error for fund performance vs benchmark performance should be close to its expense ratio
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14
Q

What are a 5 sources of tracking error? FSAIF

A
  • fees and expenses
  • sampling or optimization (only holds some of the funds the benchmark holds)
  • ADR’s instead of real securities
  • index or benchmark change
  • fund accounting practices (markets close at different times causing different closing prices)
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15
Q

What is counterparty risk for exchange traded notes (ETN), and what are ETN’s?

A
  • risk that ETN issuer defaults (eg. Lehman brothers backed ETN’s defaulted due to Lehman Brothers bankruptcy)
  • ETNs are unsecured, unsubordinated debt obligations.
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16
Q

What is settlement risk for ETF’s?

A
  • the possibility that one or more parties will fail to deliver on the terms of a contract at the agreed-upon time, effects funds that use OTC derivatives (especially commodity funds)
17
Q

What are 5 risks with ETF’s? FRCCI

A
  • fund closures
  • regulations
  • competition
  • change in investment strategy
  • investor related risk (leverage or inverse ETF’s)
18
Q

What are cash drags?

A
  • ETF’s that have cash holdings, or the time between receiving cash in a fund and investing the cash
19
Q

What are the 3 primary applications ETF’s are used? PAA

A
  • portfolio efficiency: better manager portfolio for efficiency or operational purpose. includes reasons like cash or liquidity management, rebalancing, portfolio completion, and active manager transition.
  • asset class exposure management: use of ETF’s to maintain exposure to certain asset classes segments, etc.
  • active or factor investing: investing for active management or factor investing (factors include inflation, credit, size, etc)
20
Q

When do ETFs trade on both the primary market and on the secondary market?

A
  • primary market: primary market is over-the-counter (OTC) with trades between authorized participants (APs) and ETF managers during creation/redemption process.
  • secondary market: when AP gives ETF managers shares of securities in exchange for ETF shares, they trade the ETF shares on the secondary market
21
Q

What are the 2 main sources of ETF premiums and discounts to NAV?

A
  • timing differences: if ETF bases its prices on close price in foreign market, the ETF price can deviate from benchmark when domestic markets are open.
  • stale pricing: greater premiums or discounts if they are traded less frequently.
22
Q

What is arbitrage gap?

A
  • size of the discrepancy between NAV of ETF and price of underlying securities that cause the AP to act and try to make arbitrage profits
23
Q

In Europe who makes up the majority of ETF owners?

A
  • institutional investors make up the majority of ETF owners, so most ETF trades are made between institutions
24
Q

What are 2 things that make ETF’s and ETN’s similar?

A
  • Like ETFs, exchange-traded notes (ETNs) have a creation/redemption mechanism and pay a return based on a specified index.
25
Q

What is a soft closure?

A
  • when a fund (ETF issuer or ETN creator) does not actually close but halts all creation of new units or completely changes its investment strategy
26
Q

Why would a ETN trade at a significant premium to NAV when the issuer does a soft closure (stopping further creation of new shares)?

A
  • because of limited amounts of ETN’s available in the secondary markets, investors may be willing to pay more to acquire the limited available ETNs
27
Q

What’s the difference between strategic, dynamic, and tactical strategies?

A
  • strategic refers to a long-term investment plan based on your overall financial goals and risk tolerance.
  • tactical involves making short-term adjustments to your portfolio based on current market conditions.
  • dynamic sits somewhere in between tactical and strategic.
28
Q

What if the difference in the creation for ETF’s between leveraged or inverse ETFs and regular ETF’s?

A
  • levered and inverse ETFs often use cash creation (rather than in-kind transactions) in order to manage their underlying swap positions.
29
Q

What’s the difference between counterparty and settlement risk?

A
  • counterparty risk: risk that a counterparty will default on their contractual obligations
  • settlement risk: risk that a counterparty will not deliver on their obligations at the agreed-upon time
30
Q

Are inverse or leveraged ETF’s exposed to settlement risk or counterparty risk?

A
  • settlement risk: levered ETFs are exposed to settlement risk through their over-the-counter (OTC) swap agreements, this risk is mitigated with frequent (daily or weekly) settlements.
  • counterparty risk: leveraged ETF’s don’t have counterparty risk
31
Q

Do mutual funds use swaps?

A

yes, to gain exposure to certain asset classes

32
Q

Are ETFs that use swaps required to publish full details about the terms and counterparties on a daily basis?

A
  • Some information about ETF swap positions is published daily, although not all details about terms and counterparties are made available.

Portfolio Management L2 (6 decks)

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