R38: ETFs

Question 1

Differences between ETFs and Mutual Funds

Answer 1

• mutual fund creates and redeems all shares as Net Asset Value (NAV). ETFs redeem all shares in-kind
• ETFs trade intraday on an exchange
• Authorized participants absorbs costs in the creation process, along with people buying/selling the ETF in the market at the same time, not with mutual funds- shared expense of all mutual fund owners
• ETF lower transaction cost
• ETF has greater tax efficiency

Question 2

Authorized participant

Answer 2

• buys types of shares that the ETF holds (ie underlying stocks), and then swap those shares in exchange for ETF shares with the ETF sponsor
• they then sell those ETFs in the market
• may have more time to settle their trades

Question 3

Creation basket

Answer 3

-all the shares an ETF wants to hold in the weights in wants to hold.

Question 4

Arbritrage in ETF creation process

Answer 4

• when the price of an ETF share is not aligned with the prices of the shares the ETF holds, which dealers take advantage of
• ETF sponsor relies on this process.

Question 5

Arbitrage: ETFs high, stocks low

Answer 5

• short sell the ETFs
• buy the stocks at a lower price
• deliver the stocks to the ETF sponsor in return for ETF shares
• cover the short position in the ETFs

Question 6

Arbitrage: ETFs low, stocks high

Answer 6

• buy the ETFs
• short sell all the shares that would go into a creation basket
• deliver the ETFs to the ETF sponsor in return for the shares of stock
• cover short position in the stocks

Question 7

Dealer bid-ask spread

Answer 7

-Determined by the cost of arbitrage, and a premium for volatility and liquidity risk.

Question 8

Expense ratios

Answer 8

• does not keep record of ETF holders
• no communication
• no active research

Question 9

Tracking error

Answer 9

-ETFs track an index (after fees), take daily return differences between the index and ETF- the standard deviation of those differences (typically for 12 month period) is the tracking error.

Question 10

Sources of TE

Answer 10

• fees & expenses
• representative sampling/optimization - where full replication would be possible or optimal
• sampling may lead to over/under performing vs the overall index
• depository receipts and ETFs
• index changes
• fund accounting principle - timing b/w market close for ETF and market of index securities
• reg and tax requirements - diff countries, withholding tax
• Asset manager ops

Question 11

ETF and Taxes

Answer 11

• no capital gains distributions
• tax fairness: MF has to redeem shares to meet distribution requirements, triggering a taxable event. when investor wants to sell ETF, no distribution, or tax event, is needed.

Question 12

Sources of premiums/discount intraday

Answer 12

Intraday price > indicated NAV: premium
Intraday price < indicated NAV: discount
taken care of arbitrage

Question 13

Sources of premiums/discount after close

Answer 13

-NAV is FV if underlying trade in same exchange
Intraday price > NAV: premium
Intraday price < NAV: discount

Question 14

Sources of premiums/discount after close

Answer 14

-NAV is FV if underlying trade in same exchange
Intraday price > NAV: premium
Intraday price < NAV: discount

Question 15

Counterparty Risk

Answer 15

• ETN: - unsecured debt obligations of the issuer, usually a bank. Bank will issue more ETNs when they want to borrow more cash. We rely on the credit of the bank.
• settlement risk
• securities lending

Question 16

Fund closure

Answer 16

due to regulation, competition, Corp Actions, creation halts (for ETNs when bank has enough debt in books, arbitrage breaks down), change in investment strategy.

Question 17

Investor related risk

Answer 17

lack of understanding of underlying exposure

Question 18

arbitrage gap

Answer 18

the difference between the prices of the ETF shares and the basket of securities at which conducting arbitrage covers the cost to do so