Exchange Traded Funds - Chapter 19

1) Explain the regulatory requirements & different legal structures of ETFs. 2. Describe the key features of ETFS. 3. Differentiate between ETFs. 4. Identify & explain the risk of specific ETFs. 5. Compare & contrast ETFs & MFs. 6. Summarize the taxation impacts of investing in ETFs (NR accounts). 7. Identify the investment strategies involving ETFs. 8. Define MF of ETFs and Exchange traded notes.

What are some regulatory requirements ETFs must follow/have?

• File a prospectus and fund facts doc

• Comply with rules on liquidity, leverage, concentration & derivative use

• Be overseen by a fund manager, custodian and trustee

• Be continuously offered, even though they trade on exchange

What are the types of legal structures for ETFs?

1. MF Trust (most common in Canada): organized as open-end trusts. Investors hold units

2. Corporations (most common in the US): structured as corps. Investors hold shares

3. Limited Partnerships (less common): occasionally used for certain commodities or Alt ETFs

What are key features of ETFs?

Key features of ETFs include:

• They trade on an exchange like stocks.

• They typically have lower expense ratios than mutual funds.

• They offer diversification by holding a basket of securities.

• ETFs allow for liquidity and can be bought and sold throughout the trading day.

• ETFs are exchange-traded, providing flexibility in trading and price transparency.

  • Holdings are disclosed daily

What are the different types of ETFs?

1. Equity ETFs: Focus on stocks

2. Bond ETFs: Invest in fixed income securities

3. Commodity ETFs: Track commodity prices

4. Sector and Industry ETFs: Target specific sectors

5. Leveraged ETFs: Use financial derivatives to amplify returns. Short term use only

6. Index ETFs:Track index performance (passive)

7. Actively Managed ETFs: Managed by a fund manager

8. Currency ETFs: Focus on currency investments and may aim to replicate the performance of specific currencies.

9. Inverse ETFs: Designed to profit from market declines.

What are the types of risks specific to ETFs?

Market Risk: the risk of losses due to overall market fluctuations affecting the value of ETF holdings.

Tracking Error:the difference between the ETF's performance and the benchmark it aims to track.

Liquidity Risk: the risk that investors may not be able to buy or sell ETF shares quickly without affecting the price.

Liquidity Risk: some ETFs trade infrequently which can lead to wider bid-ask spread

Price Premium/Discount: the potential difference between the ETF's market price and its Net Asset Value (NAV), which can occur due to supply and demand factors.

Derivative Risk: the risk associated with the use of derivatives in ETFs, potentially leading to increased volatility and unexpected losses.

Concentration Risk: the possibility that an ETF's holdings may be concentrated in a few securities or sectors, increasing risk exposure. Limited diversification

Cash Drag Risk: occurs when a fund isn’t fully invested in the underlying index or reference asset it is tracking, leading to lower returns than expected due to cash reserves.

Compare & Contrast ETFs and Mutual Funds

ETFs are traded on exchanges like stocks, offering intraday liquidity, while mutual funds are bought and sold at the end of the trading day at the NAV.

Additionally, ETFs typically have lower fees and greater transparency due to daily disclosure of holdings, whereas mutual funds may have higher expense ratios and less frequent reporting (MFs usually reported quarterly).

Tax efficiency is also a key difference, as ETFs generally incur fewer capital gains distributions compared to mutual funds.

Management styles differ, with ETFs usually being passively managed to track indices, while mutual funds can be actively managed by fund managers.

What are some of the taxation impacts of investing in ETFs (non-reg accounts)?

Investing in ETFs in non-registered accounts can lead to capital gains taxes when you sell shares at a profit, and dividend income from ETFs may also be taxable in the year received. Additionally, certain ETFs may distribute foreign income, which could be subject to foreign tax withholding.

Interest income is fully taxable at marginal rate.

ETFs may distribute gains, interest or dividends which are potentially taxable.

Identify the investment strategies involving ETFs.

1. Core Satellite - use broad market ETFs as core; complement with actively managed ETFs or thematic funds for specific exposure.

2. Rebalancing - provide a simple and liquid way to rebalance asset allocation without affecting portfolio holding

3. Cash Management - utilizing ETFs to hold cash or cash equivalents for liquidity purposes, allowing for quick reinvestment when opportunities arise.

4. Tactical Asset Allocation - adjusting the mix of asset classes based on market conditions to enhance returns.

5. Sector Rotation - shifting investments between sectors to capitalize on changing economic conditions.

6. Hedging - use inverse ETFs to hedge against market downturn.

7. Global Diversification - investing in ETFs across various international markets to spread risk and access opportunities. Geographic exposure.

Define Mutual Fund of ETFs.

Mutual fund that invests in a portfolio of ETFs. It allows investors to gain exposure to multiple ETFs within a single fund, often diversifying risk and simplifying management.

Define Exchange Traded Notes

Debt securities that are traded on exchanges and linked to the performance of various financial assets. ETNs provide investors with access to returns based on an index or benchmark, but they carry credit risk as they are unsecured debt obligations of the issuer. They provide no interest payment. Aren’t common in Canada

Debt obligations issued by banks.

What are the two types of standard (Index based) ETFs.

Full replication - investing in all the securities of an index in the same proportions.
Sampling - holds securities & weightings that best match the index's performance instead of all components. Usually done with bond index as it less available on the open market.