Reading 35: ETF Mechanics & Application

Parthale ManagementPage No. 1Date / /Reading 35Mechanics& ApplicationETF : Creation / RedemeedAPs pay to ETF mangersTypically track an index & trade on secondary marketsAuthorized Participants (APs) :-does not operate in Secondary Markets markers authorized to create newmarketBasterShares or redeem share (Both transaction are in - - kind)Creation basket : :-etf stocks stock, etfProvided by ETF manager; lists sec that areneeded to create new sharesCreation Unit:-Lot size of this primary market dealingCreationI Ap acquires Sec in creation basket from public markets of own inventory2Sec basket delivered to ETF manager in exch for equal no. of ETPshares at market closeRedeemptionIAP exch ETF Shares for underlying baskets of securities withETF manager2AP sell sec basket or redemption basket in publicmarket. Page No.220th Dec 22 ThuesdayDate/Process of Creation / RedemptionfManager collat service charge from APLower Cost - In-Kind creation l redemption eliminates transaction costTax efficient - Creation / redemption is not a taxable event ALredem ption basket may specify low basis stock to boostHtax efficiency of the fundMarket prices in line with NAV - APs Can arbitrage away anyprice discrepanyArbitrage GapThese APs incur transaction costs and service fees for creation / redeemptransaction Shareholders )are passed on as bid-ask spread (and bone only byHence, ETFs should trade within a band of the NAV, Knownas the arbitrage gop.Arbitrage gop is wider for ETFs with- illiquid holdings-Holdings trading on exch in diff time. zones.Secondary MarketsOwner ship feoid,are maintainedExch trade guaranteed by dearning house (eg NSCC in the us)DTC (a Sub of NSCC) records the transferTwo day settlement period Cup to six days for APsEuropean markets tend to be fregments t with 29 depositorimustly institutional investor.Most trades are oTc with no live price data must ETFs arelisted on multiple exch May widen spreads ROC are distributed in excess of on ETF earning&serves to reduce an invostor cost busis. by the Page No.3amount of distribution. Not taxableDate//All trades in us are submitted to NSECNSCC becomes guarantor of a stock transaction bet" twopartiesittake 6day to settleTrades are settled and deared centrally within 2 biz days.European trading and settlementTrading is Similar totheusTrading & settlement System are fragmented which may head towider Spreads &trading Costs.MultipleDepositoriesInstitutionalTracking ErrorOtc tradesTracking diff bet" NAV and berchmarkreturnAnnualizedstandard deviation of the daily tracking diff is Knownas tracking error. = 5td dev of daily tiacking iffRolling holding period : Cumulative effect of management fees&each expense over longer time.AnnualrollingholdingperiodcanbeComparedtoanETF'sexpense ratioDoesnot distinguish bet" +ve & -vereturnTracking Error : Sources Ignore distributionofdatasetof returnsETF fees & expfavor higher -liquidleadSampling and optimizationto size biasesDepository recepits / other Sector ETFsIndex changesRegulatory and tax requirementsFund accounting practicesAsset manger operationSecurity lending Page No. 4Date/21st Dec 2022 WednesdayExpense RatioETFs charge lower fees Compared to mutual funds-Managing ETF Costs depend on:- Portfdio Complexity- Issues Size economies of Scale1 Competitive landscape*SpreadMostly determined by liquidity and market structer of fundholding Thinly traded ETFs have wider spreads,Spreads on fixed-income ETF are higher than on largecap equity ETFsWhen ETF. and underlying trade in markets with difftimes zones, Spread narrow during the overlapping period.Sptstock) tend to have wider spreads.Specialized ETFs Leg commodities volatility futures small -capMax Spread = + Creation Redemption fees plus other trading costst Risk Spread of the underlying Securities+ normal profit marginAp's prem for carrying until close of day-Diec in based on probability of offselling the tradesecondary market Page No. 5Date / /ETF bid-ask SpreadswithAmt of ongoing order flow (measured by daily share volume)Amt of Competition among market markers for the ETFcosts and risks for the liquidity providerbid-asx spreads are geperstly lessthanofequelto,Bid I Ask Spreads are norrow forLarge activity traded ETFsLiquid ETFsETF Prem / DiscETFs trading at a price above (below) NAV trade at aprem(Disc)ETF prem (disc) % = ( ETF price - NAV)NAVSources of prem disc include- - Timing State diff (eg when underlying trades in foreign market OTC bondspricing for infrequently - traded ETFsIntroday ETF prem or disc % = (ETF price -inav per share )iNAV per shareFactor driving prem (disc:-Timing Stale diff CMP does not refect avail infoPrempricingNew ETF share will be received by APS from the ETF spors Page No.6Date/Purtfolio turnoverTypes of Costs of ETF ownership (TOTT) :-Transaction Costs: Incurred at purchases & sale regardless ofholding periodOngoing Costs: Management fees, portfolio turnover t sec lending proceedsTrading Cost: Commissions / brokerage and spread prem / disc to NAVinclurred only at purchase or sale and return impactTracking error an implicit cost, can be tve or -vediminishes over longer holding period.other implicit trading costs-portfolio turnover costs : reflected in fundreturns and incurred when portfolio manager buys / sell Secto exeute invest" strategyRound - trip trading Cost = round-trip commision + spreadTotal cost = Round - trip trading cost t management fees0Long -term buy and holder investors are more concerned aboutmanagement ees while short-term tactical investors are moreconcerned about trading cost.Example : ETF CostZ&E ETF is quoted at a bid-ask spread of 0-15% ETECommisions are 0.107 of the trade value Management feesare 0.08% per yr.Calculate the cost of holding the ETF for 34 months for 1yr & the for 5yr For the 5-yr holding period, alsoCalculate the vavg annual total Cost. ETF less distribute capital Compains gain to MFPage No. 7Date//501"Round - trip Commission = 2x 0.10% = 0.2%Round - trip trading cost = round -trip commision + spread= 0.2% + 0.15% = 0.35%Holding cost for 3 month = Round-trip trading cost + Mang" fees= 0.35% t (3/12) X 0.08% = 0.37%Holding cost for lys = 0.35% + 0.08% = 0.937.Holding cost for 5yr = 0.35% t (5x0-087.) = 0.75%Aug annual cost Cfor 5-yr holding period) - 0.75% 5 = 0.15ETF RisksdoesnotWhen creation are halted by ETN issuershold underlyingBETNs may trade at premT.Counterparty RiskETNs - Exch trade note (yield on banks unsecured debt would beSettlement riskhigher than the swap fixed rate)Security lending Use creation I redemptionExpectation -related for those those dont understand ETFFund ClosuresFunds may close due to following reasons :-RegulationCompetitionCorporate actionCreation / redemption haltsSoft closures - do not involve actual fund closing such as creationhalf or changes in invest" strategy.Expectations related riskETFs based on Complex Strategies (eg inverse or leveraged ETF)May introduce the investor to risks that they may not fullycomprehend (i.e the outcomes my differ from Investor expectation Page No.822nd Thurday 22Date /These complex ETFs might use derivative products to implementdaily settlement)their investment Strategy that must reset daily ( i.e havePortfotio Uses of ETFsEfficient portfolio management- - folio liquidity mang" - entails equitizing excess cash- falio rebalancing --Transition manyfolio completion - temporary gaps in folio creatio allocationExcess liquidi DrawnAsset - class exposure mang"Core exposere- Tactical stragies ETf with volumes in & underlyingActive investingFactor (smart beta) ETFsRisk mang"Alternatively - weighted ETFsDiscretionary active ETFDynamic asset allocation & multi - asset strategiesAsset Class Exposure MangTypes of ETF exposure based un asset class Page No /Date / /EquityCommodityFixed IncomeDomestic scapGoldGovt of corporate debt ofDomestic Leepother metalsvarious maturitiesSectorBroad Commedity inderesEmerging market debtDiv growthAgriculture productsBank loansMomentumOilIndustriesFloating int rate strategies.International regions orRepresentative Sampling / optimization :- performanceCountries with (withoutis optimised by sympte using optimizedCurrency exposuresample (not all sect is ConsideredPassive ETF StratVInt Rate RICK Int Tette swaActive & Factor InvestingFI Brant Bfocus nor genelating returnsActive are Usedfrom taking credio Risk durati & hedgingFactor (smart beta) ETFs Factors ETF are benchmarked to an indexwith pre defined rules for screening & / or weighting constituent SecRisk Many Some smart B ETF focus on achieving higher or lowerrisk relative to their asset class benchmarkActiveAlternative weighted ETTs : :- ETFs which use weighting schemesother than market cap for consitituent stock can be usedto implement invest" viewsActiveDiscretionary active ETFs:- Largest actively managed ETFs are in fixedincome where passive many is less prominent compared to equityLiquid alternative ETFs:- Attempt to deliver absoute return performanceand or risk diversification of stock & bond holding Page No. toDate //Dynamic asset allocation & multi - asset stragies:- Dynemic assetrisk contribution while others are return focused, but stistegraeallocation stragies may allocate holdings (or on the basis all of theirinvolved adj back to target weights These strategies areeither implemented in -house or by hiring external managers Hellymalti asset strategiesfund closure Risk :- b Change in RegulationCompetionCorporate activity (MPA)