Topic 5 - Alternative Investments ((ii) What is an Exchange Traded Fund (ETF) & advantages and disadvantages of ETFs)

Question 1

What is an Exchange Traded Fund (ETF)?

Answer 1

• Exchange Trade funds are index-based investment products that allow investors to buy or sell exposure to an index through a single financial instrument.
• They can be traded at any time during market hours and can be sold short or margined.
• They represent shares of ownership in either open-end funds or unit investment trusts that hold portfolios of stocks or bonds in custody.
• They are designed to track the price and yield performance of the underlying indices, broad market, sector, single country, region or fixed income.

Question 2

Advantages of ETFs

Answer 2

1. Diversification
2. Trading similarly to a stock (e.g. short selling, can be traded anytime)
3. Transparency
4. Cost effectiveness
5. Management of their risk augmented by futures and option contracts on them.
6. Lower tax rate on capital gains
7. Immediate dividend reinvestment for open-end ETFs.

Question 3

Disadvantages of ETFs

Answer 3

1. Only a narrow-based market index tracked in some countries
2. Intraday trading opportunity is not important for long-horizon investors.
3. Large bid-ask spreads on some ETFs

Question 4

Advantages of ETFs (Diversification )

Answer 4

1. Diversification
   - Diversification can be obtained easily with a single ETF transaction.

• With equity orieted ETFs (stocks), investors can gain exposure to different market capitalizations, style (value vs growth), sector or industries, or countries or geographic regions.
• With fixed income ETFs (bonds), they can gain exposure to different maturity segments and bond market sectors.

Question 5

Advantages of ETFs (Trading )

Answer 5

• Although ETFs represent interests in a portfolio of securities, they trade similarly to a stock on an organized exchange.
• For example, ETFs can be sold short and also bought on margin
• ETFs also trade throughout the whole trading day at market prices updated continuously rather than only once a day as closing market prices.

Question 6

Advantages of ETFs (transparency)

Answer 6

• Portfolio holdings are transparent. The ETF sponsor publishes the constituents of the fund on a daily basis.
• This is in contrast to other funds, for which the manager publishes only the list of assets in the fund from time to time

Question 7

Advantages of ETFs (Cost)

Answer 7

• ETFs are cost effective
• There are no load fees
• Because the ETFs are passively managed, the expense ratio can be kept low relative to actively managed funds.
• The expense ratio is comparable to that of an index mutual fund.
• ETFs have a cost advantage over traditional mutual funds because there is no shareholder accounting at the fund level

Question 8

Advantages of ETFs ( futures and option contracts)

Answer 8

-For many ETFs, there exist futures and options contracts on the same index, which is convenient for managing risk

Question 9

Advantages of ETFs ( tax rate )

Answer 9

• The exposure to capital gains distribution taxes is lower than for traditional funds, so the consequences of other shareholders redemptions are limited
• Capital gains resulting from in-kind transfer for redemptions do not create a taz burden for the remaining ETF shareholders.
• For this reason, capital gains tax liability is expected to be lower for ETF shareholders than for mutual fund shareholders.

Question 10

Advantages of ETFs ( dividend)

Answer 10

• Dividends are reinvested immediately for open-end ETFs, whereas for index mutual funds, timing of dividend reinvestment varies

Question 11

Disadvantages of ETFs (narrow-based market index)

Answer 11

• In many countries, actively traded ETFs track a narrow-based market index, including only stocks with large market capitalization
• No ETFs are available for mid or low market-cap stocks
• This is not the case with the US where a variety of ETF products trade actively

Question 12

Disadvantages of ETFs (Intraday trading)

Answer 12

• Many investors do not require the intraday trading opportunity provided by ETFs, because they have a long investment horizon

Question 13

Disadvantages of ETFs (bid-ask spreads)

Answer 13

• Some ETFs do not have large trading volumes and the bid-ask spread can be quite large
• For large institutional investors, the alternative to international ETF is to invest directly in an indexed, or actively managed, international portfolio; the costs could be less and the tax situation equivalent or better