Exchange-Traded Funds (ETFs) Overview

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Questions and Answers

What is a key benefit of ETFs compared to mutual funds?

  • ETFs are exclusively for institutional investors.
  • ETFs typically offer lower-cost diversification. (correct)
  • ETFs provide guaranteed returns regardless of market conditions.
  • ETFs require a higher minimum investment than mutual funds.

Which type of ETF allows for the replication of a reference index?

  • Active ETFs
  • Standard ETFs (correct)
  • Inverse ETFs
  • Synthetic ETFs

How have ETFs changed the landscape of investing for small investors?

  • ETFs have made complex investments simpler but with no access to diversified assets.
  • ETFs have restricted investment opportunities to only large investors.
  • ETFs eliminate all risks associated with investing in stocks and bonds.
  • ETFs have democratized access to a broad range of assets that were once only available to large investors. (correct)

What type of ETFs are designed to provide exposure to a selected group of assets typically seen as high-risk?

<p>Leveraged ETFs (A)</p> Signup and view all the answers

Which of the following ETFs would most likely use a strategy that seeks to profit from falling prices?

<p>Inverse ETFs (C)</p> Signup and view all the answers

What is a defining characteristic of rules-based ETFs compared to traditional ETFs?

<p>They are constructed based on a defined methodology to achieve specific objectives. (A)</p> Signup and view all the answers

Which option correctly describes the alternative weighting schemes used by smart beta ETFs?

<p>They may include criteria such as volatility and dividends. (A)</p> Signup and view all the answers

What is the primary goal of rules-based ETFs?

<p>To target higher returns or lower risks than traditional indexes. (A)</p> Signup and view all the answers

What distinguishes the BMO MSCI USA High Quality Index ETF as a smart beta ETF?

<p>It screens for criteria like high return on equity and stable earnings growth. (A)</p> Signup and view all the answers

How do rules-based ETFs usually provide transparency about their holdings?

<p>By publishing the rules used in their construction. (C)</p> Signup and view all the answers

What category of distributions from ETFs is treated as ordinary income to investors?

<p>Dividend and interest distributions (C)</p> Signup and view all the answers

What is the main purpose of using a sampling approach in ETFs?

<p>To achieve returns that are as close as possible to the underlying index (B)</p> Signup and view all the answers

Which of the following is NOT a potential taxation impact for investors holding ETFs in a non-registered account?

<p>Taxed on capital contributions to the ETF (B)</p> Signup and view all the answers

Which factor generally causes a higher risk of tracking error associated with mutual funds compared to ETFs?

<p>Mutual funds are actively managed more frequently (D)</p> Signup and view all the answers

What factor contributes to the tracking error risk associated with ETFs using a sampling method?

<p>Limited trading of certain bonds (D)</p> Signup and view all the answers

Distributions from Canadian companies lead to a different tax treatment for which type of investors?

<p>Canadian residents (A)</p> Signup and view all the answers

How does cash drag affect the performance of a fund?

<p>It leads to trailing performance compared to the index being tracked (A)</p> Signup and view all the answers

Under which circumstance are investors likely to see a higher frequency of distributions from an ETF?

<p>When the ETF generates more income from its investments (A)</p> Signup and view all the answers

What is one reason ETFs may hold cash even though they typically minimize cash drag?

<p>For dividend or interest payments, or trading activity (A)</p> Signup and view all the answers

Which of the following is a challenge faced by ETFs when rebalancing?

<p>Immediate execution at the same time and price as the index (C)</p> Signup and view all the answers

Flashcards

Standard ETF

An ETF that seeks to replicate the performance of a specific index.

Rules-Based ETF

An ETF that follows a set of rules or criteria to achieve a specific investment objective.

Smart Beta Strategy

A strategy employed by rules-based ETFs to achieve a specific investment goal, such as prioritizing high-quality companies or targeting sectors with growth potential.

Active ETF

A type of ETF that uses active management techniques to try to outperform its benchmark index.

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BMO MSCI USA High Quality Index ETF

A rules-based ETF designed to replicate the performance of an index that focuses on companies with high return on equity, stable earnings growth, and low financial leverage.

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Tracking Error

The difference in return between an ETF and its underlying index.

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Sampling

ETF's use a sample of the securities in the index instead of all of them.

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Cash Drag

When an ETF holds cash instead of being fully invested in the underlying index.

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Rebalancing

Adjusting an ETF's holdings to match changes in the underlying index.

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Liquidity Risk

The difficulty for ETFs to trade large amounts of illiquid bonds at a reasonable price.

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What is Low-Cost Diversification in ETFs?

Exchange-Traded Funds (ETFs) provide investors with exposure to a wide range of stocks, bonds, market segments, and manager styles in a single investment. This allows for diversification with less cost compared to traditional methods like mutual funds.

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How do ETFs democratize investing?

ETFs offer a cost-effective method for investors to gain exposure to various assets, making investment opportunities accessible to individuals previously only available to large institutions.

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What is a Standard (Index-Based) ETF?

Standard ETFs mirror or closely track a specific index, providing investors with a way to replicate the performance of that index.

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What is a Rules-Based ETF?

Rules-Based ETFs employ a specific set of rules to determine their investments, offering investors exposure to a predetermined strategy.

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What is an Active ETF?

Active ETFs employ a portfolio manager to actively select securities, aiming to outperform a specific benchmark or index.

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Taxation of ETF Distributions

Investors may be taxed on distributions from ETFs held in a non-registered account, which can include dividends, interest, and capital gains.

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Dividend and Interest Distributions from ETFs

Dividends and interest received by an ETF from its holdings are passed on to investors and are generally taxed as ordinary income.

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Capital Gains Distributions from ETFs

When an ETF sells securities to meet redemption requests, it might trigger capital gains that are distributed to investors.

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Non-Taxable Distributions from ETFs

Some ETF distributions are not subject to taxation, such as those related to administrative expenses or fund management fees.

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Study Notes

Exchange-Traded Funds (ETFs)

  • ETFs combine features of mutual funds and individual stocks.
  • They are structured as open-end mutual fund trusts and regulated like other mutual funds.
  • ETFs can be actively or passively managed, though most are passively managed.
  • ETF units trade on stock exchanges, like stocks.
  • They can be bought on margin and sold short.
  • Some ETFs have options trading.

Learning Objectives

  • Explain regulatory requirements and different legal structures of ETFs.
  • Describe key features of exchange-traded funds.
  • Differentiate among types of ETFs.
  • Identify risks specific to ETFs.
  • Compare ETFs and mutual funds.
  • Summarize taxation impacts of investing in ETFs.
  • Identify investment strategies involving ETFs.
  • Define mutual funds of ETFs and exchange-traded notes (ETNs).

Content Areas

  • Regulation and structure of Exchange-Traded Funds
  • Key features of ETFs
  • Various types of ETFs
  • Risks of investing in ETFs
  • Comparing ETFs and mutual funds
  • Taxation of investors in ETFs
  • Investment strategies using ETFs
  • Other related products

Key Terms

  • active ETFs
  • core holdings
  • commodity ETFs
  • covered call ETFs
  • designated broker
  • equity-based ETFs
  • exchange-traded funds
  • exchange-traded notes
  • full replication
  • futures-based ETFs
  • in-kind exchange
  • inverse ETFs
  • leveraged ETFs
  • physical-based ETFs
  • prescribed number of units
  • roll yield loss
  • rules-based ETFs
  • sampling
  • satellite holdings
  • spot price
  • synthetic ETFs
  • tracking error

Introduction

  • Exchange-traded funds (ETFs) are investment vehicles with characteristics from mutual funds and individual stocks.
  • ETFs are professionally managed, either actively or passively.
  • Passive management invests in securities tracking specific market indexes.
  • Unlike open-end funds, ETF units trade on exchanges.

Mutual Funds Trusts and Mutual Fund Corporations

  • ETFs are structured as mutual fund trusts or corporations.
  • These structures are regulated by National Instrument (NI) 81-102.
  • Individuals licensed as advisors can deal with ETFs under NI 81-102.
  • Some types of ETFs include index ETFs and active ETFs.
  • Leverage and derivatives use is generally limited.
  • Representatives may not be allowed to deal with certain types, such as synthetic, leveraged, inverse, or commodity ETFs.

General Disclosure Requirements

  • ETFs use client disclosure documents.
  • The general system is outlined in NI 41-101.
  • ETF Facts documents are summary documents, patterned after Fund Facts documents used for mutual funds.

Creation and Redemption Process

  • A designated broker (market maker or specialist) contracts with an ETF provider.
  • ETF units are created or redeemed in blocks from a prescribed number of units.
  • The broker buys (or borrows) the shares in the basket.
  • The shares are then exchanged for ETF units, and those units are sold as individual units in the open market.

Key Features of Exchange-Traded Funds

  • Low cost
  • Tradability, liquidity, and continuous price discovery
  • Low tracking error
  • Tax efficiency
  • Transparency
  • Low cost diversification
  • Targeted exposure

Tradability, Liquidity, and Continuous Price Discovery

  • ETFs trade on exchanges throughout the day, like stocks.
  • Their liquidity comes from the underlying securities.
  • Continuous and transparent pricing occurs.
  • This leads to minimizing tracking errors.

Low Tracking Error

  • ETF tracking error measures the return difference between the ETF and its underlying index.
  • ETFs are designed to closely match their benchmark index, reducing these discrepancies.
  • Administrative and trading factors affect tracking error.
  • ETF tracking errors are generally lower than mutual funds, due to in-kind creation and redemption process.

Tax Efficiency

  • Index-based ETFs typically reduce capital gains realizations.
  • Their in-kind creation and redemption minimizes taxable events.

Transparency

  • ETF providers are required to disclose holdings frequently, typically daily for broad indexes.
  • This transparency aids comparisons with underlying benchmarks.

Low Cost Diversification

  • ETFs provide widespread portfolio diversification (many stocks, bonds, and market segments).
  • This is achieved at lower costs than traditional mutual funds.
  • Low costs are attributed to exchange trading, which reduces record-keeping and other operational expenses.

Targeted Exposure

  • ETFs allow investors to access assets previously inaccessible.
  • These may include specific sectors or asset classes.
  • ETFs facilitate specialized investment strategies.

Types of Exchange-Traded Funds

  • Standard (index-based): replicate an index.
  • Rules-based (smart beta): follow alternative rules.
  • Active: managed by portfolio managers similar to mutual funds.
  • Synthetic: utilize derivatives.
  • Leveraged: aim for multiple returns against the reference.
  • Inverse: aim for multiple returns in the opposite direction.
  • Commodity: invest in physical or futures commodity contracts, or equity-based.
  • Covered call: employ covered call options strategies.

Risks of Investing in Exchange-Traded Funds

  • Tracking error risk: ETF returns may differ from underlying index returns.
  • Concentration risk: portfolios heavily weighted to a few securities.
  • Liquidity risk (especially with fixed income): availability for trading when needed.
  • Cash drag: ETFs that are not fully invested may experience performance lag due to not having all funds invested in holdings.
  • Composition of ETF Risk: the ETF may use differing weighting methodologies causing performance differences from a standard index
  • Risk related to securities lending: ETF issuer's credit risk affects security value (especially with synthetic ETFs).
  • Currency risk: ETFs holding non-Canadian investments are subjected to currency fluctuations.

Comparing ETFs and Mutual Funds

  • ETFs are typically passive and more transparent than mutual funds.
  • ETFs usually have lower costs and lower tracking errors than mutual funds.

Taxation of Investors in Exchange-Traded Funds

  • Investors in ETFs are taxed on realized gains.
  • Tax implications from distributions, including dividends, capital gains, and non-taxable distributions.
  • Mutual funds of ETFs: hold a portfolio of ETFs.
  • Exchange-traded notes (ETNs): debt obligations from institutions backing returns matching an index.

Investment Strategies Using Exchange-Traded Funds

  • Core and satellite portfolio construction.
  • Rebalancing.
  • Tactical asset allocation.
  • Cash management.
  • Exposure to hard-to-access markets.
  • Tax loss harvesting.

Tips for Trading Exchange-Traded Funds

  • Use limit orders.
  • For large trades, execute portions at a time.
  • Avoid trading during the closing of underlying market hours.
  • Be cautious regarding corporate actions and news impacting underlying assets, as this can impact returns

More Complex Roles of ETFs (Investment Strategies)

  • Core and satellite portfolio construction
  • Rebalancing portfolios
  • Tactical asset allocation
  • Cash management strategies
  • Targeted exposure to hard-to-access markets
  • Tax-loss harvesting

Exchange-Traded Notes (ETNs)

  • Debt instruments issued by banks, backing performance of an index or benchmark
  • May have credit risk
  • Subject to call or early redemption risk
  • Not considered investment funds

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