HOFIS 21 - Exchanged Traded Funds Flashcards
Overview of ETFs
- Hybrid investment vehicle
- Exchanged-traded
- Provides more transparancy and liquidy than OTC bond market
- Created from a “basket” of securities (e.g. bonds)
- Shares can be created and redeemed in response to supply/demand
- Can target specific market exposure
- Can be actively managed or indexed (most common)
Benefits of Fixed Income ETFs
- Low investment management fees compared to mutual funds
- Transparency from exchange trading
- Intraday liquidity is greater than mutual funds and bonds
- Tax efficient
- Exposure to a variety of sectors
- Minimal counterparty risk vs. direct bonds or swaps
- Tracking error lower than individual bonds
Why is Intraday Liquidity of Fixed Income ETFs better than mutual funds
- The ability to trade fixed income ETFs throughout the trading day provides investors with greater visibility into portfolio valuation, even during periods of volatility and illiquidity.
- Mutual finds can only be traded at the close of the day when NAV is known at end of the day.
Why is Tax efficiency of fixed income ETFs better than mutual funds?
- ETF shares are redeemed for securities in-kind
- While, mutual funds must sell securities to pay cash
Key Characteristics of Bonds, ETFs, Futures, and Swaps
- Bonds: highly customizable
- ETFs: priced, traded, and settled like stocks
- Futures: low transaction costs since highly standardized and high volume
- Swaps: highly customizable, can target mutiple sectors
- Bonds do not have holding costs, while others do
- ETFs and futures have high cost transparancy; bonds and swaps do not
- Tracking error can be high for bonds, low for others
- Swaps are single-dealer; others are mutil-dealer
- Bonds and swaps are traded OTC; ETFs and futures are traded on exchanges
- Swaps can have significant counterparty risk; low for others
Maturity of bonds, ETFs, futures, and swaps
- Bonds: stated
- ETFs: perpetual
- Futures: quarterly
- Swaps: vary by contract
Fixed Income ETF Strategies
- Retail investors
- Institutional investors
- Advanced applications
Fixed Income ETF Retail Strategies
- Core fixed income exposure
- Custom, targeted exposure
- Exposure to otherwise inaccessible markets
Fixed Income ETF Institutional Strategies
- Cash equitization
- Transition management
- Tactical allocations (move in and out of markets rapidly)
- Portfolio rebalancing (liquidity makes this easier)
- Access liquidity easily to maintain a strategic asset allocation without accessing the less-liquid portion of the portfolio.
Fixed Income ETF Cash Equitization
Investing excess cash in ETFs does not increase tracking error as it might with futures (futures contracts must be rolled periodically)
Fixed Income ETF Transition Management
ETFs offer a cheap, efficient way to maintian market exposure during large-scale portfolio restructurings
Fixed Income ETF Advanced Applications
- ETF options: cheaper, more transparent, and easier than OTC FI options
- Short selling: may be easier than actual bonds
- Leveraged and inverse ETFs: potentially useful for short-term tactical strategies
Inverse ETFs: Move opposite direction of underlying.
Why do ETF have better transparancy than mutual funds?
ETF holdings are disclosed more frequently than mutual funds
Fixed Income ETF fund distributions
- ETFs are required to distribute earned income to investors
- Earned Income = Accrued Interest + Bond Accretion - Bond Amortization + Securities Lending Income - Fund Expenses
- Income earned at the fund level but distributed at the share level
Describe The Primary ETF Market
- Broker-dealers (authorized participants, APs) interact with ETF providers to create/redeem shares
- If excess ETF share demand:
- AP buys securities and delivers them in-kind to ETF provider
- ETF provider issues new ETF shares to AP
- AP sells shares to investors
- If excess ETF share supply: (trading at a discount to NAV)
- AP purchases excess ETF shares in market
- AP exchanges shares for actual securities with ETF provider
- ETF provider retires shares and AP sells securities
How do investors transact ETFs and mutual funds?
- ETF investors transact at the ETF price, not the NAV
- Transaction costs of newly created shares shared by new investors only
- price reflects costs of share creation/redemption
- Mutual fund investors transact at the NAV
- Transaction costs shared by all investors
Compare Secondary market for Fixed Income ETF liquidity vs bonds
ETFs are much more liquid than bonds
- ETF Trading volume is higher
- ETF bid/offer spreads are tighter
- ETF Prices are more uniform
Bond liquidity problems in the OTC market
- Bond trades may involve negotiations
- Investor/dealer incentives may not align
- dealers might not excecute at best available prices
- Bond prices are not always transparent
- difficult to observe transaction costs from bid or offer prices only
How can APs and hedge funds can exploit FI ETF arbitrage opportunities?
- if ETFs are mispriced with respect to the underlying securities
- E,g,. if ETF is overpriced, then long underlying and short the ETF for arbitrage profit
- Price mismatch might be substantial to to account for tansaction costs, etc.
Drivers of FI ETF liquidity
- Observable exchange liquidity (average daily volume)
- Contingent exchange liquidity (unlocked with limit orders)
- provided by existing funds shareholders who are willing to transact at a price that is more favorable to them than currently available in the market
- Liquidity in the underlying bond market
ETF Premiums/Discounts Formula
- ETF Premium/Discount = Creation Cost x Flow Factor + Execution Risk Adjustment
- Usually trades at a premium to NAV
- NAV is based on bid-side pricing if you bidding on smth you wanna pay as little as possible
Execution risk adjustment for FI ETF
- reflects AP’s difficulty in moving in/out of securities and ETF shares
- cost of basket execution and hedging
- Includes compensation for:
- Execution
- Liquidtiy riks
Drivers of Execution risk adjustment for FI ETF
- Market Volatility
- Market Liquidity
Sign of Execution risk adjustment for FI ETF
- Positive for creation
- Negative for redemption
Creation cost for FI ETF and who incurs it?
- = Market Bid/Ask Spread
- Reflects the cost of buying bonds in the underlying market
- Only incurred by new investors
- Some ETFs bypass APs and bear the cost of acquiring bonds themselves
Flow factor for FI ETFs
- ranges from 0 to 1
- 0 = all sell orders
- 1 = all buy orders
- Closer to 1, the higher demand is relative to supply
Compare the price execution of an ETF with transacting at the NAV of
an open-ended mutual fund
- ETF:
- In an ETF, each investor incurs the transaction costs created by their specific transaction, through the market price of the ETF
- Price should reflect the cost of ETF share creation
- Existing ETF investors are unaffected.
- Open-ended mutual fund:
- The securities purchased as a result of the new mutual fund investor’s entry may cost more than the NAV.
- The differential is paid for by existing investors in the fund (all transaction costs are shared by all investors).
- Customary to value securities on the bid, so investor’s entry may cost more than NAV
