R38: ETFs Flashcards
Differences between ETFs and Mutual Funds
- 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
Authorized participant
- 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
Creation basket
-all the shares an ETF wants to hold in the weights in wants to hold.
Arbritrage in ETF creation process
- 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.
Arbitrage: ETFs high, stocks low
- 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
Arbitrage: ETFs low, stocks high
- 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
Dealer bid-ask spread
-Determined by the cost of arbitrage, and a premium for volatility and liquidity risk.
Expense ratios
- does not keep record of ETF holders
- no communication
- no active research
Tracking error
-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.
Sources of TE
- 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
ETF and Taxes
- 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.
Sources of premiums/discount intraday
Intraday price > indicated NAV: premium
Intraday price < indicated NAV: discount
taken care of arbitrage
Sources of premiums/discount after close
-NAV is FV if underlying trade in same exchange
Intraday price > NAV: premium
Intraday price < NAV: discount
Sources of premiums/discount after close
-NAV is FV if underlying trade in same exchange
Intraday price > NAV: premium
Intraday price < NAV: discount
Counterparty Risk
- 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
Fund closure
due to regulation, competition, Corp Actions, creation halts (for ETNs when bank has enough debt in books, arbitrage breaks down), change in investment strategy.
Investor related risk
lack of understanding of underlying exposure
arbitrage gap
the difference between the prices of the ETF shares and the basket of securities at which conducting arbitrage covers the cost to do so
