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Chapter 19 Exchange-traded fund - Coggle Diagram

- - - - “ETFs must produce and file a summary disclosure document called ETF Facts”
        
        “designed to look like the Fund Facts document”
        
        “ETFs differ from mutual funds in some key ways”
        
        “ETF Facts document must address the trading and pricing characteristics of ETFs”
        “For example, the ETF Facts document includes information related to market price and bid-ask spread, as well as to premium and discount of market price to the net asset value (NAV).”
      - New disclosure delivery regime
        
        “ The ETF Facts document is distributed through the dealer where the ETF is purchased.
        The amendment requires dealers receiving a purchase order for ETF securities to deliver the ETF Facts document to investors, instead of the prospectus, within two business days of the purchase. ”
        
        “investors who do not receive the ETF Facts document have the right to seek damages or to rescind the purchase”
        
        “a Long Form Prospectus must be filed with the securities commission annually. (It does not need to be updated annually unless there is a change in the affairs of the ETF.)
        
        As with a Simplified Prospectus, the long form must be written in plain language and set up in a standard, easily navigated format.”
        
        “ ETFs are subject to the same continuous disclosure requirements as other mutual funds regarding annual audited financial statements and management reports.”
    - - “When an ETF provider wants to launch a new ETF, it does so through a designated broker with whom it has entered into a contractual agreement. ”
        “The designated broker may be a market maker or a specialist representing a large investment dealer.”
      - “ETFs are open-end funds, which means that there can be an unlimited supply to meet increasing demand.”
      - “ETFs are created or redeemed in blocks of units known as a prescribed number of units – typically consisting of 10,000, 25,000 or 50,000 ETF units”
      - Exchange Process
        
        “If an ETF is designed to track a particular index, the designated broker buys (or borrows from a securities lender) shares in all of that index’s component parts, in increments set by the respective ETF provider. The designated broker then delivers the basket of shares to the ETF provider. In exchange, the ETF provider gives the designated broker the prescribed number of units, which the broker can break up and sell as individual ETF units in the open market.”
        
        he creation and redemption process involves the designated broker buying and selling ETF units and exchanging them with the ETF provider for the ETF’s underlying securities in increments set by the ETF provider. This process is a key feature of ETFs known as an in-kind exchange. It is so named because a basket of stocks is exchanged for ETF units rather than cash. Through the in-kind exchange process, both parties benefit from the transaction. The ETF provider receives the stocks it needs to track the index, and the designated broker receives ETF units to resell.
        
        Example 19.5
        
        “One key reason why ETFs are relatively cheap in terms of MERs compared to mutual funds is because designated brokers normally pay trading costs and fees associated with the purchase and sale of the underlying securities that comprise the index”
        
        “Designated brokers make their money from the bid/ask spread, as investors buy and sell the ETFs. ”
        
        fairer system for paying costs
        
        “n the case of mutual funds, all unitholders pay the costs associated with carrying out a single investor’s trading instruction.
        
        With ETFs, the trading costs of a single buyer or seller are paid for directly by that buyer or seller, largely through the bid/ask spread of the ETF (as well as any trading commissions).”
        
        In-kind exchange
        
        “Basically, the creation and redemption process involves the designated broker buying and selling ETF units and exchanging them with the ETF provider for the ETF’s underlying securities”
        
        book 19.6
        
        “investors benefit from lower trading costs because the process keeps the price of the ETF in line with the NAV of its underlying securities”
        
        “For example, if the traded value of the ETF strays too far above the NAV of the underlying securities, the designated broker or other institutional players can attempt to profit from this arbitrage opportunity. To do so, they buy the underlying securities in the open market, redeem them for the prescribed number of ETF units, and then sell the units in the open market.”
        
        Example on book 19.6
- - - - “The primary reason is that ETFs are traded on an exchange, where the administrative costs of record-keeping, issuance of prospectus documents and client statements, and handling of client inquiries are borne by the dealer member that holds the client‘s account. With index mutual funds, these costs are carried by the mutual fund company and get passed on directly to the investor.”
      - “the efficient market hypothesis states that the prices of securities reflect available information in efficient markets. A passive investing approach is appropriate for investors who believe in the efficient market hypothesis, particularly the strong form. Investors who reject the hypothesis would likely use an active approach.”
    - - “ the ETF does not have to buy or sell securities, trading expenses incurred by the fund are further reduced.”
      - “ETFs, on the other hand, use an in-kind creation and redemption process, whereby the designated broker buys and sells securities to create and redeem shares.”
      - “ Mutual funds have implicit trading costs related to the need to purchase or sell securities to meet fund flows. ”
    - - “ETF purchasers pay a commission (unless the purchase is within a fee-based account, in which case the fee is based on the dollar size of the account).”
        “investors who purchase ETFs outside of a fee-based account can further minimize their commission costs by purchasing through a self-directed broker, where rates are potentially very low.”
      - “mutual fund have a wide variety of advisor compensation structures, including front-end, back-end, and low-load options”
  - - - “enable investors to buy and sell throughout the day, as long as the respective exchanges are open. ”
      - “They can be held on margin or shorted, and options can trade on them. As well, various kinds of orders such as market, limit, and stop orders can be placed on them.”
    - - “The liquidity of ETFs is derived from the underlying securities, rather than the ETF units themselves. Because an ETF is just a basket of securities, and the basket is exchangeable for the underlying assets, the volume of the underlying assets is the true indication of the ETF’s liquidity.”
    - - “ETFs trade on an exchange; therefore, there is continuous and transparent pricing during trading hours. ”
      - 2 types of ETFs benefit in particular
        
        “Those that have relatively illiquid underlying assets
        
        • Those that trade on exchanges while the underlying market is closed (for example, when the underlying market is overseas)”
      - “ETF price cannot depart from that of the underlying asset for very long or to a great extent. Arbitrage between the two prices continually forces them to remain in line with each other. Therefore, tracking error is minimized.”
      - “the underlying asset price discovery process is often accomplished through the ETF. Because it is more accessible than the underlying asset, the ETF can reflect market information as it happens and actually lead the price of the underlying”
  - - - “This process allows market participants to create or redeem ETF shares at the end of each day at their NAV. Therefore, they are able to arbitrage between the ETF itself and the ETF’s underlying securities”
      - “If the market price of an ETF deviates from the fund’s NAV, market makers can perform arbitrage until this difference is minimized. ”
- - - - “Full replication is often used with equity portfolios of large capitalization stocks because those stocks are extremely liquid investments”
      - “ ETF holds all of the stocks in the same weight as the respective index. The full replication process tracks extremely close to the benchmark index, with minimal tracking error.”
    - - “Sampling is the process by which the portfolio manager selects securities and their weighting to best match the performance of the index. This method is typically used to construct portfolios of fixed-income and some international and small cap equity ETFs”
      - “The purpose of sampling with fixed-income ETFs is to achieve an outcome that replicates the performance of a large number of bonds that may not be accessible in the open markets.”
      - “if the number of holdings within the index is significantly high, sampling makes the ETF more efficient, given the trading costs to reproduce the full index. With a sampling approach, there could be some differences between the index and the performance of the ETF. In most cases, this tracking error is small, but it should be reviewed regularly.”
    - - “Typically, the holdings of a standard ETF and their weightings within the index are published by the issuer of the ETF.”
      - “is available from the index provider as well”
      - “In addition, some ETF providers post their tracking errors to their respective indexes.”
  - - - “Smart beta strategies attempt to deliver a different outcome than conventional market-cap-weighted indexes. To do this, they use alternative weighting schemes, which may be based on any one of various criteria.”
      - E.g.typical criteria may include volatility, dividends, or top-line revenue”
  - - - “An active mutual fund manager trades whenever market conditions and opportunities permit. In contrast, a manager in charge of the active portfolio of an ETF may have some restrictions as a result of the in-kind creation and redemption process. ”
      - “Designated brokers must know what is represented by the prescribed number of units, which means that the units cannot trade unless the designated broker knows about any changes. This communication process may take some time. For example, the manager may be permitted to make portfolio changes only at the end of a day or a week.”
  - - - “Swaps are over-the-counter derivatives that are privately negotiated between two counterparties. They can be thought of as a series of forward contracts and are subject to the same pricing factors, namely cost-of-carry (which includes such costs as financing, storage, and insurance). Simply put, each counterparty agrees to swap fixed and variable cash flows based on the price of a reference asset over a period of time.”
  - - - “Typically, a leveraged ETF uses $2 of leverage for every $1 of investor capital. The goal is to generate a return from the borrowed capital that exceeds what it cost to acquire the capital itself.”
      - “ leveraged ETF might attempt to achieve a daily return that is two times the daily return of the S&P 500. The challenge with these structures is that they are path dependent, which means that longer holding periods can create differences between an expected and realized return.”
  - - - “For example, an ETF could be based on a $300 million value swap referenced to the S&P 500. The swap could have a 10-year term, during which time the ETF sponsor makes periodic fixed payments in return for variable payments received every time the S&P 500 declines. ”
  - - - “invest in the commodity directly. They are limited to only a few storable, non-perishable commodities, such as gold and silver. ”
      - “This structure has the benefit of closely matching the spot price (the price at which a commodity is bought or sold for immediate payment and delivery)”
    - - “invests in futures contracts of different commodities, with an underlying portfolio of money market instruments to cover the full value of the contracts”
      - “As near-term contracts approach expiration, they are rolled over into more distant contracts. In a normal market, rolling over the contracts can result in roll yield loss (the loss that results when a near-term futures contract approaches expiration and is rolled over into a more distant contract).”
    - - “invest in listed companies that are involved in exploration and development, or in the processing or refining of a commodity.”
    - - “Commodity-based equities, and the ETFs based on them, often are not great proxies for the underlying commodity price because of factors that affect corporate performance and the general movement of the stock market.
  - - - “By writing a call against an underlying position, the investor would have to sell the stock, if it is assigned by the call buyer, when the market price rises above the call’s strike price. The covered call writer is, in effect, forgoing the opportunity to participate in the stock’s price appreciation over the exercise price. In return, the investor receives a premium, which provides some extra income and downside price protection”
    - - “having a team of professionals look after the investments”
      - “managed products can engage in continuous application of covered call strategies”
        
        “the portfolio manager can write calls as often as needed and then later decide what to do with these contracts”
    - - Management constraints
        
        “constraints on the portfolio manager that reflect the type of strategy the product is focusing on”
        
        “For example, the manager may be constrained to using only at-the-money or out-of-the-money approaches, as well as percentage written. ”
      - Fixed versus variable payments
        
        “A fixed payment provides a consistent cash flow to the investor but can at times deplete capital if the sources of the fund’s yield (dividends and option premium) are not sufficient to cover the payment. ”
        
        “A variable payment preserves principal, but payments can vary significantly, depending on market conditions and the strategy executed.”
        
        “It is usually preferable to avoid depleting principal over time, so investors should look for managed covered call strategies that pay a sustainable distribution.”
      - Fees
        
        “Covered call ETFs generally have higher MERs and particularly higher trading expense ratios, in comparison to other types of ETFs.”
        
        “However, in terms of the costs of directly dealing in covered calls (e.g., bid/ask spreads and commissions), ETFs are price competitive.”
- - - - “tracking error is usually defined as the simple difference between the return on the underlying index or reference asset and the return on the ETF. Tracking error can be positive or negative, but it is most often negative”
        “In other words, the return on the ETF is often lower than the return on the underlying index or reference asset.”
      - “Last year, the return on an ETF linked to the S&P/TSX 60 Index was 8.5%, whereas the return on the S&P/TSX 60 Index itself was 8.75%. The ETF’s tracking error in this case was 0.25%, or 25 basis points”
      - “Tracking error on ETFs is generally lower in comparison to mutual funds because most ETFs are index-based. Also, the in-kind creation and redemption mechanism of ETFs keeps their prices very close to fair value”
      - “there is still a risk of tracking error, particularly with niche ETFs, for the reasons described below”
        
        FEES AND EXPENSES
        
        “The most obvious source of tracking error is the ETF’s fees and expenses, including management fees, trading expenses, and operational expenses such as legal and accounting fees.”
        
        “An ETF should therefore be expected to underperform its underlying index or reference asset by at least the percentage of the fund that goes toward these items. Fees and expenses are generally significantly less than those of mutual funds.
        
        SAMPLING METHODS
        
        “The aim of sampling is to give the ETF a return as close as possible to the return on the underlying index or reference asset. Naturally, there is greater tracking error risk with ETFs that use a sampling approach.”
        
        LIQUIDITY
        
        “The illiquidity of certain sectors of the fixed-income market makes it difficult for the creation and redemption process to keep the NAV close to its true value in a timely manner.”
        
        “it can be difficult for institutional investors to trade size at a reasonable price. For example, a bond ETF based on federal or provincial government debt can have a tighter NAV than an ETF based on a corporate bond index”
        
        CASH DRAG
        
        “Cash drag occurs when a fund is not fully invested in the underlying index or reference asset it is tracking”
        
        “This risk is more pronounced with mutual funds, where time may be needed to work new money into the market. Mutual funds also tend to keep some cash on hand to deal with requests for redemptions.”
        
        “most ETFs are fully invested and thus do not generally have much cash drag”
        “however, it is possible that some will not have fully invested in the reference asset or underlying index. In these cases, ETFs may hold cash for dividend or interest payments, or for trading activity”
        
        Rebalancing
        
        “Indexes are occasionally rebalanced as existing securities are taken out of the index and new ones are added. ”
        
        “It is relatively simple to instantaneously rebalance a hypothetical index, but ETFs must actually go out into the market and buy and sell securities. Although this process is largely automated, tracking error arises when an ETF is unable to execute at the identical time and price as the index.”
        
        “One way to minimize this type of tracking error is to focus on ETFs linked to indexes that require minimal rebalancing—specifically, market capitalization-weighted products.”
        
        “Equal-weighted indexes must rebalance much more frequently to give an equal allocation to each component security.”
        
        CURRENCY HEDGING
        
        “Some ETFs that invest in non-Canadian assets hedge the currency risk by taking an offsetting short position in the foreign currency to match the dollar amount of the underlying asset.”
        
        “If the underlying foreign currency depreciates in value against the Canadian dollar, the performance of the ETF will suffer, in Canadian dollar terms. However, these losses can be offset by the gain in the short foreign currency position. Conversely, if the foreign currency appreciates (which would otherwise help the performance of the ETF in Canadian dollar terms), these gains can be offset by the loss in the short foreign currency position.”
        
        “Currency hedging is done monthly, with no hedging of the market growth or depreciation of the underlying asset during the month”
        
        “A small amount of currency risk results. Also, there is a minimal cost for the hedge. Between these two factors, a small amount of tracking error can occur, compared to the reference asset”
    - - “Concentration risk in an ETF occurs when a small number of holdings make up a disproportionate amount of the overall ETF value”
      - “Both ETFs and mutual funds are prohibited from having more than 10% of their funds invested in the securities of one issuer. ”
        
        “this regulatory restriction in concentration does not apply to index-based funds because it would keep the fund from attaining its investment objectives of matching the index.”
      - “a concern for ETF index funds, particularly those funds that are focused on an index with a small number of components. These funds typically have concentration limits, but they may be considerably higher than the 10% regulatory limit.”
    - - “Some ETFs even trade on the basis of the same underlying stocks that comprise a particular index. However, they may use different weighting methodologies, causing their performance to differ significantly from the standard index.”
      - for example
        
        “The RWL ETF is made up of the same equities found in the S&P 500 Index, but the holdings are weighted according to top-line revenue, rather than market capitalization. This different approach to weighting can produce very different results in performance”
    - - “Securities lending refers to extending a loan of stocks for a fee, with the aim of earning additional income for unitholders to partially offset fund fees.
        Many equity ETFs are active in the securities lending business. These ETFs lend their shareholdings to investors who wish to short sell certain equity issues.
        Short sellers may range from small retail investors to large hedge funds.”
      - “The risk of securities lending comes from the creditworthiness of the money market securities bought and received and the default risk of the share borrower”
      - “Each ETF issuer has its own approach to conducting securities lending. NI 81-102 rules dictate that a maximum of 50% of a mutual fund trust NAV can be on loan at any time. ”
      - “The average utilization rate of a large cap Canadian equity or broad fixed-income fund is less than 5%.”
      - “determine whether it is acceptable, and consider the following factors”
        
        “Does the provider use a third-party securities lending agent? If investment lending is not a specialty of the firm, the use of a lending agent adds value.
        
        • Where is the revenue from securities lending directed, and how much is directed back to the fund?
        
        • Does the ETF issuer retain a portion of lending revenue?
        
        • What type of collateral is required, and how far above the 102% minimum required by regulation does it reach?
        
        • What type of minimum credit guidelines are set for the short-term securities that ultimately serve as collateral?”
        
        “Are there any special exemptions to the rules for fund-of-funds lending? The overall exposure to the risk of securities lending can be higher in this case”
- - - - “Distributions by the ETFs to investors out of the ETF’s dividend and interest income, net of fees, are generally treated as ordinary income to the investors.”
      - “if the ETF pays a distribution out of dividends received from Canadian companies, investors can treat that distribution as if it were a dividend from a Canadian company”
      - “For Canadian residents, distributions from Canadian companies qualify for a lower effective tax rate than those of non-Canadian companies.”
      - “Distributions from an ETF are typically paid in cash, either monthly, quarterly, or annually. Generally, the greater the income generated in the fund, the higher the distribution frequency.”
    - - “The following two factors determine the size of any ETF’s capital gains distribution in a given year”
        
        “The net of the fund’s current capital gains, less any capital losses, plus specific gain allocations (e.g., to a specific institutional investor)”
        
        “Any amount from the Capital Gains Refund Mechanism (CGRM), a method recognized by the Income Tax Act that gives preferential treatment to capital gains generated by redemptions”
        
        The CGRM is based on the recognition that those gains can be subject to taxation twice over as follows
        
        “Once when investors redeeming their units realize a taxable capital gain”
        
        “Again, when the fund sells investments to cover the cost of the redemptions, thus also realizing a taxable capital gain”
        
        “The CGRM allows the fund to retain some of its realized gains generated by redemptions, rather than distributing them to investors. The fund does not pay tax on those gains in that taxation year.”
      - “it is more efficient for an ETF to distribute its realized capital gains by issuing more units, rather than by paying a cash distribution”
        
        “This process is generally known as reinvested phantom distributions (or, reinvested capital gains distributions).”
      - “This type of capital gains distribution is still taxable to investors in the same way as a cash distribution. However, the investors’ adjusted cost base (ACB) of their units is increased by the amount of this in-kind distribution. If the investor were to sell the ETF units, the higher ACB would reduce the amount of any capital gain they would otherwise realize on the sale.”
    - - “In some cases, an ETF may distribute an amount that is not taxable to the investors, such as a return of invested capital (ROC), for example.”
      - “such a distribution decreases the ACB of the investor’s units. If the investor were to sell the ETF units, the lower ACB would increase the amount of any capital gain that would otherwise be realized on the sale.”
      - “For example, accounting methods, combined with market conditions, may transform some of the yield paid out to be classified as ROC.”
        “Such instances are common to any pooled investment where the unitholder base fluctuates over time. This fluctuation makes it impossible to accurately link revenue earned from dividends and income to a changing number of investors.”
      - “This consideration generally applies to the ETF industry as a function of fund growth.”
        
        “An ETF aims to maintain a payout close to the index or market payout, net of fees. When it receives a subscription, it receives the cash component equal to the outstanding income on the fund, in addition to the basket of securities that represent the portfolio. The ETF then pays out the cash components received as part of its distribution to maintain the ETF’s yield. This payout results in a small amount of beneficial ROC.”
- - - - “They have the benefit of PACs and SWPs, in addition to advisor compensation options that are standard with most mutual fund offerings. The advisor compensation does reflect a higher cost than with ETFs. However, these products tend to average 0.5% lower in MER than traditional mutual funds, which represents a significant cost savings.”
  - - - “ETNs are not investment funds—they are debt obligations issued by a bank”
        
        “promise to pay investors a return on their investment based on the performance of an index or other benchmark. In exchange for the guarantee of delivering the total return of the underlying asset, ETNs charge an annual fee”
      - “ETNs do not have tracking error risk because of the above guarantee—the bank issuing them promises to pay a return based on the underlying asset. ”
        
        “If the underlying asset decreases in value, so will the ETN”
      - credit risk
        
        “ETNs face credit risk—that is, the risk that the issuer will default on the note or that the market price of the ETN dislocates from the NAV because of increased credit risk concerns regarding the issuer.”
      - “ETNs can face call or early redemption risk from the issuer, which may adversely impact the ETNs’ value.”