PM Flashcards
How are ETF shares created?
ETF creation/redemption happens in an OTC primary market.
2 groups exist in primary market -> ETF issuer (sponsor, manager) & Authorized participants (Special group of Institutional Investors)
Authorized participant then comes to the secondary market (can be an exchange or OTC) where the ETFs are available for retail investors and trade there.
Important points to remember about ETF?
AP creates new share by transacting in-kind with ETF issuer.
ETF issuer/sponsor publishes a creation basket daily.
Transactions are done in large blocks called creation units.
Redemption is like the opposite of creation process.
Describe why APs will indulge in creation/redemption in ETF?
Every ETF has underlying securities and the price of the ETF shares are usually in a tight gap around the intrinsic NAV of the underlying securities of the ETF.
This gap is called the Arbitrage gap. (costs and liquidity of underlying shares also need to be considered)
The AP then tries to take advantage of this gap and either creates more ETF shares (by buying from Issuer or Sponsor and selling in the secondary market) if the price of the ETF is higher than the price of the underlying security and vice versa if the price is lower.
What about costs incurred for transacting with underlying securities?
AP absorbs all the cost of transacting the securities for the fund’s portfolio.
These costs are passed to investors via the bid-ask spread in the secondary market.
Thus, frequent ETF traders bear the cost of their trading activity and buy-and-hold ETF shareholders don’t (unlike MFs where every party bears cost of trading activity in the fund).
Since creation & redemption happen in kind, ETFs lead to greater tax efficiency.
How does trading and settlement happen in the secondary market?
ETFs go through the same settlement and clearing process as other listed stocks.
US NSCC (National Security Clearing Corp) & DTC (Depository Trust Company) (who looks and tracks only at member level or APs) example.
Market makers are given up to 6 days to settle their accounts as they create liquidity in the ETF markets.
What is an expense ratio?
is a ratio which looks at the expense to run a fund to the AUM of the fund. Thus, lower the expenses = better management of the fund.
Which has higher fees among ETFs and MFs? Why?
ETFs charge lower fees as they don’t have to keep track of individual investor accounts, don’t bear the cost of communicating directly to the individual investors and Index-based folios don’t require extensive research.
How do we measure ETF performance? against what do we compare it to?
There are 2 broad ways to do this, one is Daily tracking error (not much efficient) and the most commonly used one is Periodic rolling tracking difference (shows if ETF is overperforming/underperforming)
Comparison should include a measure of central tendency and a measure of variation. (Periodic tracking difference fulfills both)
Why is their a tracking difference in ETFs?
some reasons are fees and expenses of ETF,
Representative sampling/optimization
Index changes
Regulatory and tax requirements
Tax benefits of Trading with ETFs?
A) Tax fairness (only frequent traders have to bear capital gains taxes and bid-ask spreads)
B) Tax efficiency (In-kind transactions result in low cost basis securities being exchanged to keep unrealized gains and taxes under control).
Imp points about ETF bid-ask spread?
Trade size matters (TS high then BAS low & vice versa)
Also, BAS are the tightest/narrowest for the shares that are very liquid having continuous two-way order flow.
If underlying securities are complex or have high spreads, then BAS spreads of ETF will also be high.
*ETF BAS are higher on Fixed Income relative to equity as underlying bonds trade in dealer markets and hedging is more difficult.
What are the ETF Risks?
A) Counterparty risks (use of ETNs, OTC derivatives like swaps and lending of securities creating counterparty risk)
B) Fund Closures (Creates unexpected tax liabilities, might be cos of regulation, competition and Corporate activity like merger and also soft closures like restricted creation halts and changes in investment strategy)
C) Investor related risk (ETFs have complex asset classes and strategies, makes it imp to understand underlying exposure. Examples can be leveraged and inverse funds)
What are ETF Strategies?
A) Portfolio Efficiency (applications include cash/liquidity management, rebalancing, portfolio completion and active manager transition management.
B) Asset class exposure management (which asset class to invest in based on strategy, style, country and many other factors)
C) Active or factor investing (Use ETFs to get exposure to one or more factors like Quality, dividend growth, value, momentum, low volatility etc allowing us to invest in a multi-asset-class strategy in single product)
Most ETF-related strategies have some component of active investing, either within ETF strategy or in a way the ETF is used.
What is the modern portfolio theory?
It gives us a framework to evaluate assets based on the risk and return characteristics of the entire portfolio.
What is systematic risk?
Systematic risk is the risk associated with investment in every asset (which can’t be taken away with diversification).
is represented by Beta and is priced risk.
Priced risk meaning taking that risk generates a return and thus we can price the risk.
Unsystematic risk is the risk in a portfolio that can be reduced by diversification across different asset categories/classes.
