BFIN3020 CH 19

ETF facts

a summary disclosure document that ETFs are required to produce and file

What differentiates ETF facts from mutual Fund Facts?

The ETF Facts document must provide information about trading and pricing characteristics of the ETF. E.g. the ETF Facts includes information about market price and bid-ask spread, as well as premium/discount of market price in relation to NAV.

Dealers receiving a purchase order for ETF securities must deliver ETF Facts document within ___ days of purchase, instead of a ________

2, prospectus

designated broker

A broker that has a contractual agreement with an ETF company to aid in the creation and redemption of ETF units.

prescribed number of units

blocks of units, typically 10 000, 25 000, or 50 000 shares. These units are set by the ETF company.

In an ETF that tracks an index, the _____________ buys shares in all of that index’s component parts, then delivers the basket of shares to the ____________, who then breaks it up into a _______________ and sells those units to investors.

designated broker, ETF provider, prescribed number of units

why might a designated broker remove ETF units from the market?

declining demand for the ETF, or to take advantage of arbitrage when ETF is trading at a discount to its underlying assets.

What is a key reason ETFs are cheaper in terms of MERs?

The designated brokers pay for trading costs.

How do designated brokers make a profit from ETFs?

bid/ask spread. The designated broker buys and sells ETF units and exchanges them with the ETF provider for the ETF’s underlying securities. If the units are at a discount to the value of the underlying securities, the designated broker can turn a profit.

in-kind exchange

the process where a basket of stocks is exchanged for ETF units, rather than cash

why do ETF prices remain close to their NAV

due to the arbitrage mechanism involving designated brokers and ETF providers

why do ETFS have low costs?

passive, traded on exchange, in-kind creation & redemption

tracking error

for ETFS, it is the simple difference between the return on a underlying index and the return on the ETF that tracks the index.

sampling

the process by which the portfolio manager selects a smaller sample of securities and their weighting to best match the performance of the overall index.

what can cause tracking error?

costs to run the fund, cash drag, and sampling methods.

why is there less tracking error with ETFs than mutual funds

administrative and trading costs are lower

In Canada, what is the regulatory requirement for ETF providers to publish holdings?

top holdings must be published monthly, and all holdings must be published quarterly.

What are the key features of ETFs?

low cost, tradability, liquidity, low tracking error, tax efficiency, transparency, diversification, targeted exposure

what types of ETFs benefit the most from being traded on an exchange?

all of them, but especially ETFs with illiquid underlying assets, and those that trade on exchanges while the underlying market is closed (e.g. international)

why are ETFs tax efficient?

lower portfolio turnover, in-kind mechanism

target exposure

the idea that small investors can access diversification that was previously difficult and expensive. ETFs level the playing field between large and small investors.

What are the different types of ETFs?

standard (index), rules based, active, synthetic, leveraged, inverse, commodity, covered call.

with standard ETFs, what are the two replication methods?

full replication and sampling

full replication

the ETF holds all of the stocks in the same weight as the respective index.

when is the sampling method most often used?

to construct portfolios of fixed-income ETFs, or international/small cap equities.

when is it appropriate to use sampling method?

in cases where full replication is not optimal, due to liquidity constraints or if there are too many securities in the index.

what type of ETF has the most transparency around its holdings?

standard ETF

rules based ETF (smart beta ETF)

ETFs that take a goal-oriented approach instead of following a standard index

what do rules based ETFs focus on?

following an index focused on the areas of a market that offer higher returns or lower risks than traditional indexes

what do smart beta strategies aim to do

attempt to deliver a different outcome than market-cap weighted indexes. They do this by using alternative weighting schemes, which may be based on volatility, dividends, or top-line revenue.

active ETFs

Exactly the same as a an active mutual except for the timing of trading activity.

why is the timing of trading different with active ETFs compared to active mutual funds?

Due to the in-kind creation and redemption process, designated brokers are restricted because of a slower communication process; the manager might only be able to make portfolio changes at the end of the day/week.

what are the drawbacks of active ETFs?

less transparency and higher MERs than standard ETFs, less tax efficiency due to higher portfolio turnover.

Synthetic ETFs

They do not hold the same underlying exposure as the index they track. They use derivatives to try to achieve the returns of the index they track. Exposure is hypothetical.

inverse ETF

an ETF that seeks to replicate the inverse performance of a reference index. Can be leveraged or non leveraged.

leverage ETFs

similar to synthetic ETFs in that they use derivatives to achieve return. They are designed to achieve returns that are multiples of the performance of the underlying index they track. They are more risky because they use leverage.

what does it mean to be path dependent in leveraged ETFs?

longer holding periods can create differences between expected and realized return

which types of ETFs use derivatives?

leveraged, synthetic, and inverse ETFs.

what are the 3 types of commodity ETFs

physical commodity ETFs, futures-based ETFs, and equity-based ETFs

physical based ETFs

ETFs that invest directly in physical commodities like gold or silver. It can closely match the spot price of the commodity.

futures based ETFs

invests in futures contracts of different commodities, alongside an underlying portfolio of money market instruments to cover the full value of the contracts.

roll yield loss

the loss that results from a near-term futures contract being rolled over to a longer-term contract.

equity based ETFs

invest in listed companies involved in exploration and development, or processing/refining a commodity.

ETFs are a good indication of the underlying security prices except for what types of ETFs?

Commodity based ETFs

Covered call ETFs

employ covered calls to enhance the yield and reduce the volatility of owning the underlying stock or portfolio.

what are the contraints of covered call ETFs

management constraints, fixed vs variable payments, fees

what is a management constraint of covered call ETFs?

might only be able to use at-the-money or out-the-money approaches.

what risks are specific to ETFs?

tracking error, concentration risk, composition risks, and risks related to securities lending.

how do ETFs and mutual funds differ in transparency?

most ETFs have full transparency, whereas most mutual funds limit disclosure of holdings to once a month

how do ETFs and mutual funds differ in cash drag?

ETFs can handle large infusions of cash without suffering cash drag, whereas mutual funds need time to work new money into the market and tend to keep some cash on hand to fulfill redemption requests.

how do reinvested phantom distributions affect investor taxes?

still taxable to investors in the same way as a cash distribution, however the investors’s ACB of their units is increased by the amount of this in-kind distribution. If the ETF is sold the higher ACB reduces the amount of any capital gain they get.

how do ROC (return of invested capital) distributions affect investor taxes?

not taxable to the investors, but they reduce the adjusted cost base (ACB) of the investment. If the ETF is old, the lower ACB would increase the amount of capital gain they would get

core and satellite portfolio construction strategy

core holdings are typically passive ETF holdings intended to provide the majority of returns, satellite holdings are more focused on riskier sector ETF holdings.

rebalancing ETF strategy

ETFs can help rebalance a portfolio without affecting core portfolio holdings.

exchange traded notes

exchange traded debt obligations issued by a bank that promises to pay investors a return on their investment based on the performance of a specific reference asset such as an index.