CFA Level II: Chapter 35: ETF Risks and Portfolio applications

Exchange-traded funds (ETFs)

represent shares in an index-tracking (i.e., benchmark) portfolio that trades on secondary markets

when a shareholder wants to cash out of an ETF

the shareholder sell his shares at the exchange where the ETF is traded; the ETF issuer is not involved in this transaction

authorized participants (APs)

- large broker-dealers that make the market in that ETF as primary market participants
- permitted to create additional shares, or redeem existing shares, for a service fee payable to the ETF manager

creation basket

ETF manager publicly discloses the list of required in-kind securities
serves as key input in determining Net Asset Value (NAV)

redemption basket

specific assortment of securities that the AP receives upon redeeming an ETF share

creation unit

ETF issuer specifies the size of a block of ETF shares (commonly 50,000) that can be traded as part of this creation/redemption process

Three purposes of in-kind creation/redemption process

1. lower cost
2. tax efficiency
3. keeping market prices in line with NAV

How is this in-kind creation/redemption process lower cost?

creation/redemption process does not force the ETF to sell/purchase investments - and does not incur transaction cost

How is this in-kind creation/redemption process more tax efficiency?

not a taxable event unlike for mutual funds, which at times liquidity needs are met by selling some fund's holdings - triggering transaction costs and capital gains, which are borne by shareholders.

How does this in-kind creation/redemption process keep market prices in line with NAVs?

APs engage in arbitrage transactions if ETFs trade at price different than NAV. If the ETF trades at a premium, APs can sell the etf, purchase the basket and recreate those shares

APs incur transaction costs in (2)

creating the creation basket or selling the redemption basket
service fees that the ETF manager charges for redemption

arbitrage gap

ETFs should trade within a price band of the NAV called
tends to wider for illiquid holdings

National Security Clearing Corporation

guarantees the performance of parties to a trade on an exchange

Depository Trust Company (DTC) (role)

a subsidiary of NSCC, transfers the securities from the account of the seller's broker to the account of buyer's broker at the end of the two-day settlement period

majority of ETF trades occur in

the over-the-counter (OTC) markets, without "live" bid and offer prices

Tracking difference

divergence between an ETF's return (based on its NAV) and the return on the tracked index

Tracking error

annualized standard deviation of the daily tracking difference

Sources of tracking error: (7)

1. fees and expense
2. Sampling and optimization
3. Depository receipts
4. Index Changes
5. Regulatory and tax requirements
6. Fund accounting practices
7. Asset manager operations

Factors affecting ETF bid-ask spreads - primary (2)

1. liquidity
2. Market structure

Securities that have wider bid-ask spreads in ETF (4)

1. Fixed-income securities are larger
2. trading in different time zones
3. specialized commodities
4. thinly-traded

Maximum spread = formula (5)

= creation/redemption fees plus other trading costs
+ spread of the underlying securities
+ risk premium for carrying the trade until close of trading
+ AP's normal profit margin
- discount based on probability of offsetting the trade in secondary market

NAV of a ETF is

its Fair value

indicated NAVs (iNAVs)

publish intraday fair value estimates during the trading day

ETF premium (discount) % =

= (ETF price - NAV per share) / NAV per share

Sources of premiums of discounts (2)

1. Timing Differences
2. Stale pricing - infrequent trading

ETF prices may be more informative than NAV or iNAV when

1. market is closed
2. underlying securities are highly volatile or illiquid
3. time lag between pricing of ETF and pricing of underlying

Costs of owning an ETF (2)

1. Management fees - typically lower
2. trading costs - brokerage/commission

round-trip trading cost =

round-trip commission + spread

ETNS (what kind of risk do they have alot of?)

Counterparty risk

ETF Risks (5)

1. Counterparty risk
2. Settlement risk
3. Security lending
4. Fund closures
5. Expectation-related risk

settlement risk - etf

etfs using otc derivative contracts expose investors to settlement risk of those contracts

security lending - etf

etfs may lend their securities to short sellers for a fee

fund closures- etf

when an etf closes it involves selling the underlying holdings and making cash distributions

soft closure - etf

creation halts and changes to investment strateg caused by changes in regulation, competitive pressures or issuer merger

Expectation-related risk - etf

investor ma be exposure to risk they do not understand - may have derivative products for example

Efficient portfolio management with etfs includes (4)

1. Portfolio liquidity management
2. portfolio rebalancing
3. portfolio completion
4. transition management

Asset class exposure management with etfs include (2)

1. Core exposure to an asset class of sub asset class
2. tactical strategies - moving money into and out of exposures

Active investing with etfs include (5)

1. Factor etfs
2. Risk Management - etfs that are constructed to have higher or lower risk
3. alternatively weighted etfs
4. Discretionary active etfs
5. Dynamic asset allocation and multi-asset strategies