L2, R38: ETFs Mechanics and Applications

How can an ETF portfolio manager reduce their capital gain taxes?

Because the creation and redemption process happens in kind, it allows the ETF portfolio manager to manage the cost basis of their holdings. The manager can select low-basis holdings for redemptions to keep capital gains in check leading to greater tax efficiency.

iNAVs

"Indicated" net asset values are intraday "fair value" estimates of an ETF share based on its creation basket.

Which of the following is incorrect: quoted bid-ask spreads for a particular transaction size are (1) negatively related to the amount of the ongoing order flow in the ETF, (2) positively related to the costs and risks for the ETF liquidity provider (3) positively related to the amount of competition among market makers for the ETF

(3) is correct. Several factors determine the width of an ETF's quoted bid-ask spread. First, the amount of ongoing order flow in the ETF is negatively related to the bid-ask spread (more flow means lower spreads). Second, the actual costs and risks for the liquidity provider are positively related to spreads (more costs and risks mean higher spreads); the spread is compensation to the liquidity provider for incurring these costs and risks. Finally, the amount of competition among market makers for that ETF is negatively related to the bid-ask spread (more competition means lower spreads). A is incorrect because Stosur is correct in stating that the quoted bid-ask spread for a particular transaction size is negatively related to the amount of the ongoing order flow in the ETF (more flow means lower spreads). B is incorrect because Stosur is correct in stating that the quoted bid-ask spread for a particular transaction size is positively related to the costs and risks for the ETF liquidity provider (more costs and risks mean higher spreads). The bid-ask spread represents the market maker's price for taking the other side of the ETF transaction, which includes the costs and risks to carry the position on its books and/or to hedge the position using underlying securities or closely related ETFs or derivatives.

What are the two main methods of index tracking?

1 - tracking error: annualized standard deviation of daily returns 2 - tracking difference: periodic performance deviations

Which of the following statements relating to capital gains in ETFs and mutual funds is correct? A ETFs tend to distribute less in capital gains than mutual funds do. B Mutual funds may elect not to distribute all realized capital gains in a given year. C The selling of ETF shares by some investors may create capital gains that affect the remaining ETF investors in terms of taxes

A is correct. ETFs tend to distribute far less in capital gains relative to mutual funds. This is mostly due to the fact that ETFs have historically had significantly lower turnover than mutual funds have had.

Such factors as regulations, competition, and corporate actions relate to: A fund-closure risk. B counterparty risk. C expectation-related risk.

A is correct. Fund-closure risk is the risk that an ETF may shut down. The reasons that lead to an ETF closing down often have to do with changes in regulations, increased competition, and corporate activity (merger and acquisition activity within the ETF industry).

Which of the following statements regarding distributions made by ETFs is correct? A Return-of-capital (ROC) distributions are generally not taxable. B ETFs generally reinvest any dividends received back into the ETF's holdings. C A dividend distribution is a distribution paid to investors in excess of an ETF's earnings.

A is correct. Return-of-capital distributions are amounts paid out in excess of an ETF's earnings and serve to reduce an investor's cost basis by the amount of the distribution. These distributions are generally not taxable.

Consider an ETF with the following trading costs and management fees: Annual management fee of 0.40%, Round-trip trading commissions of 0.55%, Bid-offer spread of 0.20% on purchase and sale. Excluding compound effects, the expected total holding-period cost for investing in the ETF over a nine-month holding period is closest to: A 1.05%. B 1.15%. C 1.25%.

A is correct. The expected total holding-period cost for investing in the ETF over a nine-month holding period is calculated as follows: Total holding-period cost = Annual management fee + Round-trip trading commissions + Bid-offer spread on purchase/sale. Total holding-period cost = (9/12) × (0.40%) + 0.55% + 0.20% = 1.05%.

Assuming arbitrage costs are minimal, which of the following is most likely to occur when the share price of an ETF is trading at a premium to its intraday NAV? A New ETF shares will be created by the ETF sponsor. B Redemption baskets will be received by APs from the ETF sponsor. C Retail investors will exchange baskets of securities that the ETF tracks for creation units.

A is correct. When the share price of an ETF is trading at a premium to its intraday NAV and assuming arbitrage costs are minimal, APs will step in and take advantage of the arbitrage. Specifically, APs will step in and buy the basket of securities that the ETF tracks (the creation basket) and exchange it with the ETF provider for new ETF shares (a creation unit). These new shares received by APs can then be sold on the open market to realize arbitrage profits.

What are the steps in the ETF redemption process?

AP can present the ETF shares to the ETF issuer for redemption and will receive the basket of underlying securities in return (the redemption basket)

What are the steps in the ETF creation process

At the start of each business day, ETF manager publishes a list of required in-kind securities called the creation basket AP exchanges in-kind securities for a certain number of shares in the ETF Transactions between AP and ETF issuer are done in large blocks called creation units AP can then sell these ETF shares to other investors in the secondary market

To best assess an ETF's performance, which reflects the impact of portfolio rebalancing expenses and other fees, an investor should: A review daily return differences between the ETF and its benchmark. B perform a rolling return assessment between the ETF and its benchmark. C compare the ETF's annual expense ratio with that of other ETFs in its asset class category.

B is correct. A rolling return assessment, referred to in the ETF industry as the "tracking difference," provides a more informative picture of the investment outcome for an investor in an ETF. Such an analysis allows investors to see the cumulative effect of portfolio management and expenses over an extended period. It also allows for comparison with other annual metrics such as a fund's expense ratio. Tracking error, as a statistic, reveals only ETF tracking variability; it does not reveal to investors whether the fund is over- or underperforming its index or whether that tracking error is concentrated over a few days or is more consistently experienced. An ETF's expense ratio does not fully reflect the investor experience. That is, the expense ratio does not reflect the cost of portfolio rebalancing or other fees, making it an inferior assessment measure relative to a rolling return assessment.

An ETF's tracking error, as traditionally reported, indicates to investors: A whether the ETF is underperforming or outperforming its underlying index. B the magnitude by which an ETF's returns deviate from its benchmark over time. C the distribution of differences in daily returns between the ETF and its benchmark.

B is correct. An ETF's tracking error is typically reported as the annualized standard deviation of the daily differential returns of the ETF and its benchmark. Therefore, an ETF's reported tracking error indicates to investors the magnitude by which an ETF's returns deviate from those of its benchmark over time. ** Recall tracking error does not tell us whether the ETF is underperforming or outperforming - for this measure we must use tracking difference

The bid-ask spread for very liquid, high-volume ETFs will be least influenced by the: A market maker's desired profit spread. B creation/redemption fees and other direct costs. C likelihood of receiving an offsetting ETF order in a short time frame.

B is correct. ETF bid-ask spreads are generally less than or equal to the combination of the following: ● ± Creation/redemption fees and other direct costs, such as brokerage and exchange fees ● + Bid-ask spread of the underlying securities held by the ETF ● + Compensation for the risk of hedging or carrying positions by liquidity providers (market makers) for the remainder of the trading day ● + Market maker's desired profit spread ● − Discount related to the likelihood of receiving an offsetting ETF order in a short time frame For very liquid and high-volume ETFs, buyers and sellers are active throughout the trading day. Therefore, because most of these ETF trades are matched extremely quickly and never involve the creation/redemption process, the first three factors listed do not contribute heavily to their bid-ask spreads. So, creation/redemption fees and other direct costs are not likely to have much influence on these ETFs' bid-ask spreads.

Which of the following statements regarding exchange-traded funds (ETFs) is correct? ETFs: A disclose their holdings on a quarterly basis. B trade in both primary and secondary markets. C offer a creation/redemption mechanism that allows any investor to create or redeem shares.

B is correct. ETFs trade in both primary and secondary markets. The primary market for ETF trading is that which exists on an over-the-counter basis between authorized participants (APs), a special group of institutional investors, and the ETF issuer or sponsor. This process is referred to as creation/ redemption, and it is only through these primary market transactions that shares of the ETF can be created or destroyed. ETFs also trade in the secondary market on exchanges. Secondary market trading happens between any pair of market participants—individual or institutional investors, market makers, and so on.

The list of securities that a particular ETF wants to own, which is disclosed daily by all ETFs, is referred to as the: A creation unit. B creation basket. C redemption basket.

B is correct. Each day, ETF managers publicly disclose a list of securities that they want to own, which is referred to as the creation basket. This basket also serves as the portfolio for determining the intrinsic net asset value (NAV) of the ETF on the basis of prices during the trading day

Factor (smart beta) strategy ETFs are least likely to be used by investors: A to modify portfolio risk. B for tactical trading purposes. C to seek outperformance versus a benchmark

B is correct. Factor strategy ETFs are usually benchmarked to an index created with predefined rules for screening and/or weighting stock holdings and are considered longer-term, buy-and-hold investment options rather than tactical trading instruments. The strategy index rules are structured around return drivers or factors, such as value, dividend yield, earnings or dividend growth, quality, stock volatility, or momentum. Investors using factor-based investing seek outperformance versus a benchmark or portfolio risk modification.

Which of the following statements is correct? A. Statement 1 Unlike mutual fund shares that can be shorted, ETF shares cannot be shorted. B. Statement 2 In the ETF creation/redemption process, the authorized participants (APs) absorb the costs of transacting securities for the ETF's portfolio. C. Statement 3 If ETF shares are trading at a discount to NAV and arbitrage costs are sufficiently low, APs will buy the securities in the creation basket and exchange them for ETF shares from the ETF sponsor.

B is correct. Statement 2 is correct. A significant advantage of the ETF creation/ redemption process is that the AP absorbs all costs of transacting the securities for the fund's portfolio. APs pass these costs to investors in the ETF's bid-ask spread, incurred by ETF buyers and sellers. Thus, non-transacting shareholders of an ETF are shielded from the negative impact of transaction costs caused by other investors entering and exiting the fund. In contrast, when investors enter or exit a traditional mutual fund, the mutual fund manager incurs costs to buy or sell investments arising from this activity, which affects all fund shareholders. This makes the ETF structure inherently fairer: Frequent ETF traders bear the cost of their activity, while buy-and-hold ETF shareholders are shielded from those costs. Investors cannot short mutual fund shares, but they can short ETF shares. Also, if ETF shares are trading at a discount to NAV and arbitrage costs are sufficiently low, APs will buy ETF shares and exchange them for the securities in the redemption basket. Statement 3 describes the scenario that would occur if the ETF shares are trading at a premium to NAV. A is incorrect because Statement 1 is incorrect. Investors cannot short mutual fund shares, but they can short ETF shares. C is incorrect because Statement 3 is incorrect. If ETF shares are trading at a discount to NAV and arbitrage costs are sufficiently low, APs will buy ETF shares and exchange them for the securities in the redemption basket. Statement 3 describes the scenario that would occur if ETF shares are trading at a premium to NAV

When an authorized participant transacts to create or redeem ETF shares, the related costs are ultimately borne: A solely by the ETF sponsor. B solely by the AP. C proportionally by all existing ETF shareholders.

B is correct. The AP generally absorbs all the costs associated with buying or selling the securities in the baskets or the ETF shares and pays an additional fee to the ETF provider to cover processing fees associated with creation/redemption activities. APs pass these costs to investors in the ETF's bid-ask spread, which is incurred by investors entering (ETF share buyers) and exiting (ETF share sellers) the fund.

For a typical ETF, which of the following sources of tracking error is most likely to be the smallest contributor to tracking error? A Representative sampling B Fees and expenses incurred by the ETF C Changes to the underlying index securities

C is correct. Although additions and deletions of securities from the underlying benchmark index may occur and result in tracking error, such index changes generally occur infrequently (often quarterly). In addition, ETF portfolio managers may work with APs for index rebalance trades to ensure market-on-close pricing to minimize this source of tracking error. Therefore, the resulting tracking error caused by index changes will not likely be as large as the tracking error caused by representative sampling or by fees and expenses incurred by the ETF.

An ETF's reported tracking error is typically measured as the: A standard deviation of the difference in daily returns between an ETF and its benchmark. B difference in annual return between an ETF and its benchmark over the past 12 months. C annualized standard deviation of the difference in daily returns between an ETF and its benchmark.

C is correct. An ETF's tracking error is typically reported as the annualized standard deviation of the daily differential returns of the ETF and its benchmark.

Investors buying ETFs: A incur management fees that decrease with the length of the holding period. B are assured of paying a price equal to the NAV if they purchase shares at the market close. C incur trading costs in the form of commissions and bid-ask spreads at the time of purchase.

C is correct. ETF trading costs in the form of commissions and bid-ask spreads are paid by investors buying or selling ETF shares on an exchange. These trading costs are influenced by the bid-ask spread of the ETF, the size of the trade relative to the normal trading activity of the ETF, and the ease of hedging the ETF by the market-making community. Even the closing price of the ETF on the exchange includes a premium or discount to the NAV, driven by supply and demand factors on the exchange and the market impact costs of executing an exchange transaction. The purchase and sale trading costs of an ETF are paid regardless of holding period, whereas other costs, such as management fees, increase as the holding period lengthens.

Which of the following statements regarding applications of ETFs in portfolio management is correct? A Equity ETFs tend to be more active than fixed-income ETFs. B The range of risk exposures available in the futures market is more diverse than that available in the ETF space. C ETFs that have the highest trading volumes in their asset class category are generally preferred for tactical trading applications.

C is correct. ETFs that have the highest trading volumes in their asset class category are generally preferred for tactical trading applications.

John Smith has invested in an inverse ETF. Smith is a novice investor who is not familiar with inverse ETFs, and therefore, he is unsure how the ETF will perform because of a lack of understanding of the ETF's risk and return characteristics. This risk is best described as: A counterparty risk. B holdings-based risk. C expectation-related risk.

C is correct. Expectation-related risk is the risk that some ETF investors may not fully understand how more complex ETFs will perform because of a lack of understanding of sophisticated assets classes and strategies.

Tracking difference

Calculated as the difference between index returns and fund returns over a series of rolling holding perids

creation units

ETF shares received by an authorized agent in exchange for providing the ETF sponsor with a specified basket of securities (based off creation basket)

How do you calculate the expense ratio for an ETF?

Expense ratio = expenses required to run the fund/ assets under management

True/False: Unlike mutual funds, ETF transaction costs affect all investors

False! The AP absorbs all the transaction cost, thus buy and hold ETF shareholders are not affected by transaction costs, unlike with mutual funds where transaction costs affect all investors equally

T/F : Bid - ask spreads are higher for ETF's that are liquid and have continuous two way order flow

False! They are lower

Do fixed income ETF's tend to have wider or narrower bid-ask spreads than equity etf's?

Fixed income ETF's tend to have wider bid-ask spreads than equity ETF's because the underlying fixed-income securities trade in dealer markets and are not continuously priced

If an ETF decides to close its fund and return cash to investors, how does this impact the investors taxes?

In some scenarios creates an unexpected tax liability for the investor

How to calculate ETF premiums and discounts

Premium / discount = (ETF price - NAV) /NAV

If ETF share price < underlying portfolio NAV

Purchase ETF shares, exchange them with ETF issuer for the underlying basket of securities and sell the basket for a profit - puts upward pressure on the ETF price and downward pressure on NAV

Counterparty Risk

Some ETF legal structures involve a counterparty and thus have risk if the counterparty defaults on its contractual obligations

What are investor related risks

Some ETF's provide access to complex asset classes and strategies, it is therefore important for investors to understand the underlying exposure - for example with leveraged and inverse funds

What are some factors responsible for ETF tracking differences?

Some factors responsible for ETF tracking differences include: fees and operating expenses, representative sampling, use of depository receipts and other ETF's, index changes, fund accounting practices, regulatory and tax requirements, and asset manager operations

ETF's are considered "tax efficient", what does this mean?

Tax Efficiency: In-kind redemption process allows the ETF managers to reduce their tax liability, by choosing shares with the largest unrealized capital gains to deliver in the redemption basket.

ETF's are considered "tax fair", what does this mean?

Tax Fairness: When a mutual fund (MF) investor sells, the MF may have to sell portfolio securities to pay the investor. If the securities are sold at a profit, this is a taxable event, and the liability is spread across all MF investors. In contrast, investors sell ETF shares to other investors, thus the ETF manager does not need to sell portfolio securities to accommodate this transaction. Also if an AP redeems ETF shares the event is not taxable because the redemption occurs in-kind.

arbitrage gap (ETFs)

The difference between the ETF price and the NAV of the underlying securities

What factors affect ETF bid-ask spreads?

The factors affecting bid-ask spreads include: creation/redemption costs, direct trading costs (brokerage and exchange gees), bid-ask spread of underlying securities, risk of hedging or carrying positions by liquidity providers, level of competition in the ETF market, and discount related to chance of broker receiving an offsetting ETF order.

creation basket

The list of securities (and share amounts) the authorized participant (AP) must deliver to the ETF manager in exchange for ETF shares. The creation basket is published each business day by the ETF manager

Tracking Error

The standard deviation of the differences between a portfolio's returns and its benchmark's returns

Which measure of index tracking allows us to determine whether a fund is overperforming or underperforming an index?

The tracking difference NOT the tracking error

Asset class exposure management - ETF strategy

The use of ETFs to achieve or maintain core exposure to key asset classes, market segments, or investment themes on a strategic, tactical or dynamic basis

Portfolio Efficiency ETF strategy

The use of ETFs to better manage a portfolio for efficiency or operational purposes. Applications include cash or liquidity management, rebalancing, portfolio completion and active manager transition management

Active and Factor investing - ETF strategy

The use of ETFs to target specific active or factor exposures on the basis of an investment view or risk management need

Describe the two main sources of ETF premiums and discounts: Timing difference and Stale Pricing?

Timing Difference: NAV is usually a poor indicator for ETF's holding foreign securities because the NAV may be based on the market closing price that occurred hours ahead of when the ETF stops trading in the domestic exchange Stale Pricing: Infrequently traded ETFs may have large premiums or discounts

How do you calculate ETF total holding period cost?

Total holding period cost = (annual management fee)*(length of year held) + round trip trading commissions + bid/offer spread

T/F: APs are large broker/dealers, often market makers?

True!

T/F: Creation units are large blocks of ETF shares transacted between the authorized participant (AP) and the ETF manager that are usually but not always equal to 50,000 shares of the ETF

True!

T/F: The creation and redemption mechanism rewards the authorized participants (AP) for keeping the ETF price in close range to NAV of the basket of securities

True!

Can there be ETF premiums at the market end of day?

Yes! Both intra and end of day - end of day usually when securities in the ETF trade on a different market with different hours

ETF's rely on a creation/redemption process that is carried out in an OTC: a - primary market b - secondary market c - futures exchange

a - primary market

For shorter holding periods which is a greater percentage of total costs: a - trading costs b - management fees

a - trading costs for longer holding periods the opposite is true

For longer holding periods which is a greater percentage of total costs: a - trading costs b - management fees

b - management fees for shorter holding periods the opposite is true

If ETF share price > underlying portfolio NAV

buy basket of securities, exchange with ETF issuer for ETF shares and sell these ETF shares for a profit - puts downward pressure on the ETF price and upward pressure on NAV

representative sample

randomly selected sample of subjects from a larger population - sometimes used for ETFs and can result in tracking differences

Who are the two main participants in the ETF creation / redemption process?

the ETF issuer / sponsor Authorized participants (APs)

Redemption basket

the specific assortment of securities that the AP receives upon redeeming an ETF share - similar to the creation basket