Exchange Traded Funds
READING 35
EXCHANGE-TRADED FUNDS: MECHANICS AND APPLICATIONS
EXAM FOCUS
This topic review covers introductory material on exchange-traded funds (ETFs). Be able to describe costs, risks, and sources of tracking risk for ETFs, as well as the sources of discounts and premiums relative to NAV. Portfolio management applications of ETFs should be well understood.
MODULE 35.1: ETF MECHANICS AND TRACKING ERROR
Video covering this content is available online.
Exchange-traded funds (ETFs) represent shares in an index-tracking (i.e., benchmark) portfolio that trade on secondary markets. While ETFs are similar to mutual funds in that they pool investor capital to hold portfolios of securities, there are significant differences in market structure, costs, and taxation. Most ETFs hold the underlying securities directly, but some ETFs use derivatives, invest via American Depositary Receipts (ADRs), or employ leverage. The issuer (also called sponsor or manager) of the ETF constructs the portfolio to match the stated index or investment style and stands ready to create or redeem ETF shares in kind.
LOS 35.a: Explain the creation/redemption process of ETFs and the function of authorized participants.
Unlike open-end mutual funds, ETFs are traded on exchanges or other secondary markets. When an investor wishes to sell ETF shares, they normally sell those shares on the exchange; the ETF issuer is not directly involved in that secondary market trade.
The ETF issuer designates certain large broker-dealers as authorized participants (APs). APs act as primary market participants and facilitate the creation and redemption of ETF shares. APs are permitted to create new ETF shares or redeem existing ETF shares in return for a fee paid to the ETF manager.
The creation/redemption process is typically in kind: an AP delivers a specified basket of securities and/or cash (the creation basket) to the issuer and receives a specified number of ETF shares in return. Conversely, an AP may tender ETF shares for redemption and receive the redemption basket of underlying securities (and/or cash). The ETF manager publicly discloses the contents of the creation basket each business day; this basket is an input to the ETF's net asset value (NAV) calculation.
The minimum lot size for these primary market transactions is the creation unit; the ETF issuer specifies the size of this block of ETF shares (commonly 50,000 shares, though this varies by ETF) that can be exchanged with the AP in a single creation/redemption transaction.
The in-kind creation/redemption process serves three main purposes:
- Lower cost: Because creations and redemptions are in kind, the ETF manager does not have to buy or sell the underlying securities to satisfy investor flows, avoiding transaction costs that would otherwise be incurred. The ETF manager typically charges a service fee to the AP to cover incidental costs.
- Tax efficiency: In-kind redemptions are not taxable events for the fund because the manager hands over securities rather than selling them. With mutual funds, redemptions commonly require selling securities, which may generate capital gains that are distributed to all shareholders. ETF managers can also select redemption baskets to remove low-basis (high-gain) securities from the fund, improving the tax basis of the remaining holdings.
- Keeping market prices in line with NAV (arbitrage): APs arbitrage price differences between the ETF's market price and its NAV. If the ETF trades at a premium to NAV, APs can create ETF shares by delivering the creation basket and then sell those ETF shares in the market; if the ETF trades at a discount, APs can buy ETF shares in the market and redeem them for the underlying securities. This arbitrage process tends to keep ETF market prices close to NAV.
APs do incur transaction costs to assemble creation baskets or to liquidate redemption baskets and also typically pay creation/redemption service fees; consequently, ETF prices should remain within a band around NAV known as the arbitrage gap. The width of the arbitrage gap is influenced by the liquidity of the underlying securities: ETFs with illiquid holdings tend to have wider arbitrage gaps. Time-zone differences (for ETFs that track foreign indices) can create additional risk and widen the arbitrage gap because APs face uncertainty about the foreign market prices during the time lag between markets.
APs pass their costs into the secondary market through the posted bid-ask spread of the ETF. Thus, only transacting shareholders directly bear these costs, unlike mutual funds, where trading costs and realized capital gains can be borne by all shareholders.
LOS 35.b: Describe how ETFs are traded in secondary markets.
ETFs trade on secondary markets just like ordinary stocks. In the United States, the National Securities Clearing Corporation (NSCC) guarantees the performance of the parties to a trade on an exchange. The Depository Trust Company (DTC), a subsidiary of the NSCC, effects the transfer of securities between brokers' accounts on settlement (normally T+2). Brokers maintain client-level ownership records. Market makers, because of their special role and because the primary market creation/redemption process can require more time, are often afforded extra time (up to six days in some cases) to settle their trades.
European markets are more fragmented, with many exchanges and national central depositories. A significant share of ETF activity in Europe occurs in the over-the-counter (OTC) market without continuous public quotes; many European ETFs are listed on multiple exchanges and may have multiple share classes. Fragmented settlement systems (29 central depositories across Europe) and cross-listings can increase operational complexity and widen quoted bid-ask spreads for European ETF listings.
LOS 35.c: Describe sources of tracking error for ETFs.
Tracking difference is the divergence between an ETF's return (based on its NAV) and the return on the tracked index. This metric indicates the ETF's ability to follow its underlying benchmark. Tracking error is defined as the annualized standard deviation of the daily tracking difference. As a standard deviation, tracking error measures variability but does not show whether the ETF consistently underperformed or overperformed the index, nor does it indicate the timing of differences.
Besides daily tracking measures, investors examine rolling holding-period tracking differences to evaluate cumulative effects of management decisions and expenses over a longer horizon. Over long holding periods, ETFs generally underperform their benchmark by approximately the ETF's expense ratio (all else equal).
Sources of tracking error include:
- Fees and expenses: Management fees and operating expenses reduce fund returns relative to the index.
- Sampling and optimization: Some ETFs use sampling or optimization to replicate an index without holding every constituent. Optimization techniques may favour more liquid or larger-cap securities to minimise trading costs, which can introduce biases (for example, size bias) relative to the index.
- Depository receipts (DRs): Foreign-index ETFs may invest via DRs rather than holding local shares directly. Differences between the DR price and the local share price, and timing differences in price capture, can contribute to tracking error. Additionally, ETFs that invest in other ETFs inherit any tracking errors of those underlying ETFs.
- Index changes: When an index provider rebalances or changes index constituents, ETF managers must adjust portfolios. The creation/redemption process is often used to rebalance, but delays can introduce tracking error. Because index changes are infrequent, this is typically a smaller contributor.
- Regulatory and tax requirements: Differences in tax treatment between foreign and domestic investors, or regulatory constraints, can cause after-tax returns to diverge from the index return.
- Fund accounting practices: Differences in the timing of NAV calculation between the ETF and the index provider, or in the capture of foreign exchange rates, can create discrepancies between reported returns.
- Asset manager operations: Managers may improve fund performance via securities lending and tax-management techniques (such as dividend capture). Such activities can reduce tracking error or even cause the ETF to outperform the index (net of fees) in some periods.
MODULE QUIZ 35.1
1. Z&E ETF is currently trading at $23.45 per share. Its NAV is $23.00. Beta Bank, an authorized participant in the ETF, would most likely:
- A. do nothing.
- B. redeem shares if the arbitrage gap is more than $0.45.
- C. create shares if the arbitrage gap is less than $0.45.
2. The arbitrage gap on an ETF is most likely to be negatively related to the:
- A. liquidity of the securities underlying the index that the ETF is tracking.
- B. service fees that the AP has to pay to the ETF manager for creation/redemption.
- C. timing difference between when the ETF trades and when the securities underlying the tracked index trade.
3. The authorized participants (APs) in an ETF are most likely to be required to settle their ETF trades in:
- A. one day.
- B. two days.
- C. six days.
4. Tracking error for an exchange-traded fund is most accurately described as the:
- A. difference between the ETF's return and the return on the underlying index.
- B. annualized difference between the ETF's returns and the return on underlying index adjusted for ETF expenses.
- C. annualized standard deviation of the difference between daily returns on the ETF and the daily returns of its underlying index.
5. Which of the following is least likely to be a source of tracking error?
- A. Fund accounting practices.
- B. Creation/redemption processes.
- C. Asset manager operations.
MODULE 35.2: SPREADS, PRICING RELATIVE TO NAV, AND COSTS
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LOS 35.d: Describe factors affecting ETF bid-ask spreads.
The primary determinants of an ETF's bid-ask spread are the liquidity of the underlying securities and the market structure in which those securities trade. Other influences include the ETF's own trading volume and the nature of the ETF's investment objective.
Key points:
- Fixed-income ETFs typically have larger spreads than large-cap equity ETFs because underlying bonds are less liquid.
- When ETFs and their underlying securities trade in different markets/time zones, spreads tend to be narrower during periods when both markets are open.
- Specialised ETFs (e.g., those that track commodities, volatility futures, or small-cap stocks) tend to have wider spreads.
- Thinly traded ETFs, irrespective of underlying liquidity, also exhibit higher spreads.
A market maker can offset an ETF transaction either by finding another counterparty in the secondary market or via the creation/redemption process in the primary market. Quoted spreads depend on the market maker's confidence in their ability to complete an offsetting trade quickly in the secondary market. APs can also use primary-market creation/redemption to offset positions.
The maximum spread that an AP might post can be expressed conceptually as:
maximum spread = creation/redemption fees + other trading costs + spread of the underlying securities + risk premium for carrying the trade until close of trading + AP's normal profit margin - discount based on probability of offsetting the trade in the secondary market
Posted quoted spreads typically refer to small order sizes. Larger trades are often negotiated off-quote and transaction costs for large trades depend on liquidity conditions and market volatility. Spreads widen during times of market stress or when significant news is expected.
LOS 35.e: Describe sources of ETF premiums and discounts to NAV.
The ETF's NAV is generally its fair value. When the ETF and its underlying securities trade on the same exchange with contemporaneous pricing, timing-related pricing noise is minimised. Exchanges also publish intraday indicative NAVs (iNAVs) as estimates of fair value during the trading day.
An ETF trading at a price above NAV is said to be trading at a premium. An ETF trading below NAV is trading at a discount. The premium (or discount) percentage using closing prices is:
ETF premium (discount) % = (ETF price - NAV per share) / NAV per share
Common sources of premiums and discounts:
- Timing differences: ETFs that track foreign securities can exhibit price gaps because the ETF may trade when the underlying local market is closed. NAV may be computed using an estimate of where local securities would trade if the local market were open.
- OTC and non-exchange-traded securities: ETFs holding OTC bonds or illiquid securities may use fair-value estimates (often based on dealer bids or pricing services) that diverge from actual market prices; this can cause ETF market prices and NAV to differ.
- Stale pricing: Infrequently traded ETFs may trade at non-current prices. For example, if the ETF's last trade was at 14:00 and markets close at 16:00, the NAV computed at close could differ materially from the stale trade price.
Note: In some circumstances the ETF market price may provide more informative pricing than NAV or iNAV-especially when the underlying market is closed, underlying securities are highly illiquid or volatile, or there is a meaningful time lag in price capture.
LOS 35.f: Describe costs of owning an ETF.
Costs of ETF ownership include:
- Management fees (expense ratio): recurring annual fee charged by the ETF manager; typically lower for passive ETFs than for actively managed mutual funds.
- Trading costs: brokerage commissions and the bid-ask spread paid when buying or selling ETF shares. Large trades may also incur price-impact costs depending on underlying liquidity.
- Premium/discount risk: The premium or discount to NAV at the time of trade can be a hidden cost if the premium/discount reverses after the trade.
- Portfolio turnover implicit costs: Turnover can generate transaction costs within the ETF portfolio; ETFs tracking stable indices typically have low turnover and negligible turnover costs.
Because trading costs are incurred only at the time of transaction, their effect on annualised total cost diminishes over longer holding periods. Short-term traders should prioritise low trading costs and tight spreads; long-term buy-and-hold investors should prioritise low management fees.
Total cost can be expressed conceptually as:
total cost = round-trip trading cost + management fees
round-trip trading cost = round-trip commission + spread
EXAMPLE: Cost of investing in ETFs
Z&E ETF is quoted at a bid-ask spread of 0.15%. ETF commissions are 0.10% of trade value (per side). Management fees are 0.08% per year.
Calculate the cost of holding the ETF for 3 months, for 1 year, and for 5 years. For the 5-year holding period, also calculate the average annual total cost.
Answer:
Round-trip commission = 2 × 0.10% = 0.20%
Round-trip trading cost = round-trip commission + spread = 0.20% + 0.15% = 0.35%
Holding cost for 3 months = round-trip trading cost + management fees for 3 months
Holding cost for 3 months = 0.35% + (3/12) × 0.08% = 0.35% + 0.02% = 0.37%
Holding cost for 1 year = 0.35% + 0.08% = 0.43%
Holding cost for 5 years = 0.35% + (5 × 0.08%) = 0.35% + 0.40% = 0.75%
Average annual cost (for 5-year holding period) = 0.75% / 5 = 0.15%
Interpretation: For short holding periods, trading costs dominate total cost. For long-term investors, management fees become relatively more important. Short-term tactical traders therefore generally prefer ETFs with low trading costs and high liquidity even if management fees are higher; long-term investors focus on low management fees.
MODULE QUIZ 35.2
1. The maximum quoted spread on an ETF is most likely to be negatively related to the:
- A. AP's profit margin.
- B. quoted spreads of securities underlying the tracked index.
- C. probability of completing an offsetting trade in the secondary market.
2. If an ETF is trading at a price above its iNAV, it is most likely:
- A. overvalued.
- B. trading at a premium.
- C. trading at a discount.
3. Of the various components of ETF cost, a long-term buy-and-hold investor is most likely to focus on:
- A. management fees.
- B. trading costs.
- C. creation/redemption service fees.
MODULE 35.3: ETF RISKS AND PORTFOLIO APPLICATIONS
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LOS 35.g: Describe types of ETF risk.
Risks associated with ETFs include:
- Counterparty risk: Certain ETF-like structures, notably exchange-traded notes (ETNs), are unsecured debt obligations of an issuer (typically a bank) that promise to pay returns tied to an index less fees. ETN investors are exposed to the issuer's credit risk: if the issuer defaults, investors may suffer losses. Historical example: several ETNs defaulted during the 2008 financial crisis. Investors can estimate counterparty credit risk using the issuer's credit default swap (CDS) spreads; a one-year CDS spread above 5% generally indicates high risk.
- Settlement risk: ETFs that use OTC derivatives expose investors to the settlement risk of those contracts. Managers mitigate settlement risk via frequent settlement and collateral arrangements.
- Security lending risk: ETFs often lend portfolio securities to short sellers for fees. These loans are typically overcollateralised, and collateral is invested in short-term, low-risk instruments. Lending fees are usually passed on to investors, but default risk of borrowers is a residual, though small, risk to the fund.
- Fund closure risk: Like mutual funds, ETFs may close if they fail to attract sufficient assets or if the issuer chooses to cease the strategy. Closures entail selling underlying holdings and distributing cash to investors, which may have tax consequences. Soft closures (e.g., halting creations) and strategy changes by issuers can also affect investors.
- Creation/redemption halt risk: If creators or issuers stop creating new ETF shares, the arbitrage mechanism can break down, and ETNs or ETFs may trade at persistent premiums or discounts.
- Expectation-related risk: Complex ETFs-especially inverse and leveraged ETFs-may produce returns that differ materially from what some investors expect, particularly over multi-day horizons. Many such ETFs reset exposure daily via derivatives contracts.
Example to illustrate expectation-related risk for a leveraged ETF:
Consider an ETF with initial NAV of $100 that seeks to deliver 2× the daily return of an index via daily-resetting derivatives.
If the index returns +5% on day 1, the ETF's NAV increases by 2 × 5% = 10%.
NAV after day 1 = 100 × (1 + 0.10) = $110.
If the index returns -5% on day 2, the ETF's NAV changes by 2 × (-5%) = -10%.
NAV after day 2 = 110 × (1 - 0.10) = $99.
A less sophisticated investor might expect that +5% then -5% on the index would net to zero and thus expect the leveraged ETF to return to $100; however, compounding with leveraged, daily resets results in a terminal NAV below $100 in this example. This demonstrates why leveraged ETFs can be inappropriate for long-term buy-and-hold investors.
LOS 35.h: Identify and describe portfolio uses of ETFs.
ETFs are widely used in portfolio management due to low costs, tax efficiency, tradability, and the wide range of available exposures. Common portfolio uses include:
- Efficient portfolio management:
- Portfolio liquidity management: Managers can quickly invest excess cash into ETFs to reduce cash drag. ETFs typically offer superior liquidity and lower transaction cost relative to trading many individual securities.
- Portfolio rebalancing: ETFs can be used to rebalance portfolios cost-effectively to target asset allocation weights; ETFs can also be shorted to reduce exposures quickly.
- Portfolio completion: ETFs can fill temporary allocation gaps (for example, if a manager exits a small-cap mandate, an investor can maintain small-cap exposure via a small-cap ETF).
- Transition management: During manager transitions, new managers may use ETFs to maintain market exposure while liquidating positions from the outgoing manager's portfolio.
- Asset-class exposure management: A wide variety of ETFs provide exposure to asset classes, sub-asset classes, sectors, and themes, often cheaper than buying underlying securities. Examples:
- Core exposures: Use passive ETFs to gain broad exposure to equities, bonds, commodities, and other asset classes.
- Tactical strategies: Rotate funds tactically into sectors or themes expected to outperform; for tactical trades, liquidity and low trading costs are more important than low management fees. Liquidity can be evaluated by the ratio of average dollar volume to average assets (higher is better).
- Active investing using ETFs:
- Factor (smart beta) ETFs: These are rules-based ETFs that weight holdings according to fundamentals or factor exposures (e.g., value, momentum, size). Smart beta ETFs seek to capture systematic return drivers and may appeal to long-term investors seeking specific factor exposure.
- Risk-management ETFs: Low-volatility ETFs or currency-hedged ETFs are designed to provide targeted risk exposures. For example, currency-hedged international equity ETFs remove currency risk; duration-hedged bond ETFs focus on credit exposure while hedging interest-rate risk.
- Alternatively weighted ETFs: ETFs can be constructed with equal weights or fundamental weights rather than market-cap weights.
- Discretionary active ETFs: Actively managed ETFs that operate like mutual funds but trade on exchanges; active fixed-income ETFs are prominent in this group.
- Dynamic and multi-asset ETFs: ETFs that implement top-down asset allocation or dynamic asset allocation across stocks and bonds are used by managers and funds-of-funds for asset allocation strategies.
With the proliferation of specialised and alternative ETFs, investors should perform due diligence on index methodology, holdings, and historical performance to assess suitability.
MODULE QUIZ 35.3
1. Exchange-traded notes are most likely to be described as having a high:
- A. settlement risk.
- B. counterparty risk.
- C. fund closure risk.
2. Inverse leveraged ETFs are most likely to be described as having a high:
- A. expectation-related risk.
- B. counterparty risk.
- C. fund closure risk.
3. Smart beta strategies are most likely to be used by investors seeking to:
- A. outperform the benchmark.
- B. match the benchmark risk.
- C. trade for tactical purposes.
4. Active ETF strategies are most likely to be used:
- A. for fixed income rather than for equity.
- B. for tactical trading.
- C. to reduce the tracking risk.
KEY CONCEPTS
LOS 35.a
Authorized participants (APs) can create additional ETF shares by delivering the creation basket to the ETF manager; redemption is the reverse process. These primary market transactions are in kind and require a service fee payable to the ETF issuer. The in-kind mechanism shields non-transacting shareholders from the transaction costs and tax consequences of individual creations/redemptions. The creation/redemption process helps keep ETF market prices within a narrow band around NAV.
LOS 35.b
ETFs are traded like other shares on secondary markets. Market fragmentation and settlement complexity (as in Europe) may widen quoted spreads for ETFs.
LOS 35.c
Tracking error is the annualized standard deviation of daily tracking differences between the ETF's NAV returns and the tracked index returns. Sources include fees and expenses, sampling/optimization, use of DRs, index changes, regulatory and tax rules, fund accounting practices, and asset manager operations.
LOS 35.d
ETF spreads increase with higher creation/redemption costs, wider underlying security spreads, greater risk premium for carrying trades to market close, and the APs' profit margin. Spreads decrease with a higher probability of offsetting trades in the secondary market. Creation/redemption fees and other trading costs also affect spreads.
LOS 35.e
ETF premium (discount) % = (ETF price - NAV) / NAV
Sources of premium or discount include timing differences between markets (e.g., foreign underlying securities) and stale pricing when ETFs trade infrequently.
LOS 35.f
ETF costs comprise trading costs and management fees. Short-term investors prioritise low trading costs; long-term investors focus on low management fees. Liquidity is often measured as the ratio of average dollar volume to average assets (higher is better).
LOS 35.g
ETF risks include counterparty risk (especially for ETNs), settlement risk, security-lending risk, fund closure risk, creation/redemption halt risk, and expectation-related risk (notably for inverse or leveraged ETFs).
LOS 35.h
Portfolio uses of ETFs include:
- Efficient portfolio management: liquidity management, rebalancing, portfolio completion, and transition management.
- Asset-class exposure management: core exposure, tactical sector and thematic exposure.
- Active investing: smart beta, risk-management ETFs, alternatively weighted ETFs, discretionary active ETFs, and dynamic asset-allocation ETFs.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 35.1
1. C The AP would earn a profit by selling the shares in the market at $23.45 while creating shares at $23.00 plus costs. These costs (or arbitrage gap) would have to be less than $0.45 per share for the AP to make a profit. ((LOS 35.a))
2. A The arbitrage gap varies with transaction costs, service fees payable to the ETF manager, and the timing difference between when the ETF trades and when the underlying securities trade (due to time zone differences for foreign securities). Illiquid securities will generally have higher transaction costs and hence higher arbitrage gaps, while liquid securities will have a lower arbitrage gap. ((LOS 35.a))
3. C APs are typically given 6 days to complete settlement, reflecting the amount of time needed for creation/redemption. ((LOS 35.b))
4. C Tracking error is the annualized standard deviation of the daily tracking difference, which is the difference between daily returns on an ETF and daily returns of the underlying index. ((LOS 35.c))
5. B The creation/redemption process may actually mitigate tracking error when the index changes. The other two are sources of tracking error. ((LOS 35.c))
Module Quiz 35.2
1. C A higher probability of completing an offsetting trade results in a reduction (i.e., discount) in the quoted spreads. The other two components are positively related to the quoted spread. ((LOS 35.d))
2. B ETFs trading at a price above their iNAV are said to be trading at a premium. The ETF need not be overvalued; the premium may be the result of timing differences. ((LOS 35.e))
3. A While all costs are important, long-term investors should be more concerned with recurring annual management fees as opposed to one-time trading costs. Creation/redemption fees are paid by the AP to the ETF manager and are reflected in the quoted spread (which is part of trading costs). ((LOS 35.f))
Module Quiz 35.3
1. B While ETNs are exposed to counterparty, fund closure, and settlement risks, the most severe is counterparty risk whereby the ETN issuer may default. ((LOS 35.g))
2. A Inverse and leveraged ETFs may not be well understood by their investors, leading to a gap between expectation and actual outcome; this is expectation-related risk. ((LOS 35.g))
3. A Smart beta strategies are active ETF strategies that seek to outperform the benchmark. Long-term buy-and-hold investors seeking a desired factor exposure may choose to invest in these ETFs in the expectation of outperformance of that factor. ((LOS 35.h))
4. A Due to the low liquidity of most fixed-income securities, active fixed-income ETFs are more popular than active equity ETFs. Generally, active ETFs are suitable for long-term buy-and-hold investors. Because active strategies seek to beat the benchmark, tracking risk is expected to be higher than for passive ETFs. ((LOS 35.h))
