HOFIS 21 - Exchanged Traded Funds

Question 1

Overview of ETFs

Answer 1

• 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)

Question 2

Benefits of Fixed Income ETFs

Answer 2

1. Low investment management fees compared to mutual funds
2. Transparency from exchange trading
3. Intraday liquidity is greater than mutual funds and bonds
4. Tax efficient
5. Exposure to a variety of sectors
6. Minimal counterparty risk vs. direct bonds or swaps
7. Tracking error lower than individual bonds

Question 3

Why is Intraday Liquidity of Fixed Income ETFs better than mutual funds

Answer 3

• 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.

Question 4

Why is Tax efficiency of fixed income ETFs better than mutual funds?

Answer 4

• ETF shares are redeemed for securities in-kind
• While, mutual funds must sell securities to pay cash

Question 5

Key Characteristics of Bonds, ETFs, Futures, and Swaps

Answer 5

• 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

Question 6

Maturity of bonds, ETFs, futures, and swaps

Answer 6

• Bonds: stated
• ETFs: perpetual
• Futures: quarterly
• Swaps: vary by contract

Question 7

Fixed Income ETF Strategies

Answer 7

1. Retail investors
2. Institutional investors
3. Advanced applications

Question 8

Fixed Income ETF Retail Strategies

Answer 8

1. Core fixed income exposure
2. Custom, targeted exposure
3. Exposure to otherwise inaccessible markets

Question 9

Fixed Income ETF Institutional Strategies

Answer 9

1. Cash equitization
2. Transition management
3. Tactical allocations (move in and out of markets rapidly)
4. Portfolio rebalancing (liquidity makes this easier)
   
   • Access liquidity easily to maintain a strategic asset allocation without accessing the less-liquid portion of the portfolio.

Question 10

Fixed Income ETF Cash Equitization

Answer 10

Investing excess cash in ETFs does not increase tracking error as it might with futures (futures contracts must be rolled periodically)

Question 11

Fixed Income ETF Transition Management

Answer 11

ETFs offer a cheap, efficient way to maintian market exposure during large-scale portfolio restructurings

Question 12

Fixed Income ETF Advanced Applications

Answer 12

1. ETF options: cheaper, more transparent, and easier than OTC FI options
2. Short selling: may be easier than actual bonds
3. Leveraged and inverse ETFs: potentially useful for short-term tactical strategies

Inverse ETFs: Move opposite direction of underlying.

Question 13

Why do ETF have better transparancy than mutual funds?

Answer 13

ETF holdings are disclosed more frequently than mutual funds

Question 14

Fixed Income ETF fund distributions

Answer 14

• 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

Question 15

Describe The Primary ETF Market

Answer 15

• 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

Question 16

How do investors transact ETFs and mutual funds?

Answer 16

• 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

Question 17

Compare Secondary market for Fixed Income ETF liquidity vs bonds

Answer 17

ETFs are much more liquid than bonds

• ETF Trading volume is higher
• ETF bid/offer spreads are tighter
• ETF Prices are more uniform

Question 18

Bond liquidity problems in the OTC market

Answer 18

• 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

Question 19

How can APs and hedge funds can exploit FI ETF arbitrage opportunities?

Answer 19

• 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.

Question 20

Drivers of FI ETF liquidity

Answer 20

1. Observable exchange liquidity (average daily volume)
2. 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
3. Liquidity in the underlying bond market

Question 21

ETF Premiums/Discounts Formula

Answer 21

• 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

Question 22

Execution risk adjustment for FI ETF

Answer 22

• 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

Question 23

Drivers of Execution risk adjustment for FI ETF

Answer 23

• Market Volatility
• Market Liquidity

Question 24

Sign of Execution risk adjustment for FI ETF

Answer 24

• Positive for creation
• Negative for redemption

Question 25

Creation cost for FI ETF and who incurs it?

Answer 25

• = 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

Question 26

Flow factor for FI ETFs

Answer 26

• ranges from 0 to 1
  
  • 0 = all sell orders
  • 1 = all buy orders
• Closer to 1, the higher demand is relative to supply

Question 27

Compare the price execution of an ETF with transacting at the NAV of
an open-ended mutual fund

Answer 27

• 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