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ETFs - Coggle Diagram
ETFs
Various Types
Standard
full replication = buys all secs in the index in same weight; liquid large cao eqs, very low tracking error
sampling = buys a representational sample of secs; when full replication is difficult; small cap, international, fixed income; some tracking error
Rules Based
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rules like divs paying stocks only, high beta stocks only
tilt market, still passively managed but have some rules
Active
etfs actively managed by funds to outperform the market; value growth top down or bottom up approach; trading done but less frequent than MF; disclosure quaterly in CAN daily in US; higher than passive ETFs but lower than MFs
Covered Calls
ETF buys stocks & writes calls on it; earn premium from options; misses big upside if stock price jumps - must sell at strike price; safer as it is covered; premiums+divs; higher MER than passive - mroe trading +management
Synthetic
tracks index using derivatives (swaps) instead of owning assets, mimics performance without owning assets
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counterparty risk = party fails to pay, ETF loses
OTC swaps, no central clearing
Leveraged
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resets daily, unsuitable for long term as compounding causes tracking error
Inverse
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resets daily, short term bearish bets
Commodity
physical based etf = holds actual commodities; limited to non perishables; tracks spot price (immediate delivery or market price); matches real comm prices accurately
futures based etf = invests in futures contract; must roll contracts when expire so suffers roll yield loss (buying new contracts at higher prices); roll yield loss causes return erosion
equity based etf = invests in companies related to comm (crops that produce or refine comms); returns depend on company performance, not just comm price
Key features
Low Cost
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ETFs are mostly passively managed (mostly follows & matches index so no active manager constantly deciding what to by or sell)
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investors pay small trading commission when buying or selling - so trailer fee much like MF charged by the manager
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Tradability, Liquidity & Continuous Price Discovery
Tradibility
trade on stock exchange; buy/sell when market is open; held on margin; can be shorted like stocks; can be traded as options (like many stocks); ETFs are quite flexible
Liquidity
depends on the underlying secs it holds; liquidity of ETF = combined liquidity of all stocks / bonds it holds
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types of orders = market order (buy at current market price); limit order (buy /sell at a set price); stop order (trigger buy / sell when price reaches a certain level - stop loss or stop buy)
Low tracking error
tracking error = how closely an ETF follows its benchmark index (diff in returns of ETF as compared to its market index)
Tracking Error = Return of ETF - Return of Index ; if ETF shows returns of 9% but index gives a return of 8.25% then tracking error = 9-8.25=0.75% or 75 basis points
Low tracking error = passively managed (simply copying the index); low MERs (management fees); dont need to keep cash aside for redemptions (less cash drag)
cash drag = uninvested cash kept aside by funds to cover for redemptions or expenses - that cash earns little to no return; MF keeps 5% in cash, market up 10% but cash only up 2% so funds return a bit lower than market as 5% isnt fully invested
Tax efficiency
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usually index based, only buy & sell anything inside them when index itself changes which is rare; suppose bell canada is delisted or is out of s&p/tsx then etf tracking it will also sell Bell; so capital gains tax will be charged only on that sale of Bell stock
Transparency
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most etfs disclose holdings regularly (often daily) - allows investors to know what they're invested in - makes ETFs easier to understand
canada = top holdings monthly, all holdings quaterly; US = all holdings daily
Low-cost diversification
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reduces risk, low trading & management costs, affordable diversification
Target exposure
you can get exposed to a particular sector, industry or region
ability for investors to customise portfolio based to goals, risks, strategy
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Taxation of Investors
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Taxable distributions
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double taxation issue = ETF pays tax, investors pay again when receiving distributions
CGRM (captial gains refund mechanism) = prevents double taxation by allowing ETFs to keep some cap gains without being taxed
Reinvested/phantom distribution = reinvests distribution instead of paying cash, taxable to investor but increases ACB (eg danielle buys 100 ETF units @ 10 = $1k, ETF issues $240 reinvested distribution viz 20 new units @ $12, new ACB = $1240 and owns 120 units, pay tax on $240)
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Purchase & Sale
capital gain (or loss) = proceeds of sale - adjusted cost base; taxcable capital gain (or loss) = capital gain (or loss)/2
bought etf for $1k (100 units @ 10); sold for $1250 (100 units @ 12.50); capital gains = 1250-1000=250, taxable income = 250/2=125
losses can be used to reduce future or past gains; same year, carry back (apply to gains up to 3 yrs back), carry forward (apply to future gains indefinitely)
if ETFs in registered acc (TFSA, RRSP, RRIF) then you dont get taxed; if ETFs in non reg acc then taxed annually on dsitributions & capital gains, divs interests or realized gains
taxed income from ETF = divs, interests, capital gains; non taxed income = return of capital
Risks of investing
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concentration risk
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ETF worth $1M 90% of which is PQR corp so total investment in PQR is 900k. PQR value drops from $10 to $1 investment drops to 90k = 810k loss
regulation = not more than 10% of ETF (& actively managed MF) in one holding; passively managed ETF are exempted as they copy index and should have similar holdings as that of benchmark
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Basics
basket of stocks trading on exchanges; quite similar to MF but basic diff is you can trade ETFs anytime between market open & close
if suppose an ETF contains $500k worth of stocks for 5 diff companies and suppose ETF provider issues 80k units then total NAV would be $6.25 (500k/80k)
if ETF trades close to $6.25 then it is fairly priced; if it trades much higher investors will likely not buy as they can buy those same stocks cheaper; if it trades lower, investors will quickly buy as its cheaper than the actual value of whats inside.
Comparing ETFs and MFs
ETFs = mostly passive, some active; daily disclosure of holdings; low MERs + trading fee; commission on trades; few trailers; cash drag very low - fully invested; distribution in secondary market; bid asl spread present; can trade all day; short sell, limit stop orders available; min 1 unit to be bought; intraday liq present; cant buy fractional units; div reinvestment of whole units only; low tracking error; high tax efficiency
MFs = mostly active, some passive; monthly disclosure of topo 10 holdings; high MERs + trading fee; commission on trades; many trailers; cash drag very high - left some for redemptions & expenses; distribution in primary market; bid asl spread absent (end of day NAV); can trade end of day; no short sell, limit stop orders not available; min $500 to be bought; end of day liq present; can buy fractional units; div reinvestment of fractional units possible; high tracking error; low tax efficiency
Investment Strategies
More complex ETF rules
core & satellite portfolio construction = core holdings (passive ETFs) which give steady income; satellite holdings (high risk high return ETFs) aimed for growth
rebalancing = keeps pf in line with target asset mix; buy more of underweighted & sell more of overweighted, reduce risk, discipline
tactical asset allocation = short term moves between ETFs based on market conditions; switching ETFs when you see better opportunities in another area
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exposure to hard to access markets = reach niche or global markets (bitcoins, blockchains); diversification & growth opportunities
tax loss harvesting = sell ETFs for a loss to realize capital loss for tax purposes, immediately buy similar ETF to stay in markets; reduces taxable capital gains
Tips for Trading ETFs
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large trades = execute large trades at once not in small batches; broker can create / redeem ETF units to balance
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widening spreads = avoid trading when spreads widen due to halted trading or major events; protects against unfair pricing
Other Related Products
Mutual funds of ETFs
mutual fund that holds a basket of ETFs; allows PACs SWPs; automatic rebalancing; built in advisor compensation (trailer fee); lower MERs; slightly higher costs due to trailer fees
Exchange Traded Notes
debt instrument issued by bank, returns linked to index; investor lends money to bank - bank repays based on index perfomrance; no tracking error (just a loan); credit risk (bank could default); built in annual fee; repaid early (call risk); performance tied to benchmark