Exchange-Traded Funds Overview
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Questions and Answers

Which type of ETF is specifically designed to replicate a reference index closely?

  • Rules-based ETF
  • Active ETF
  • Inverse ETF
  • Standard ETF (correct)

    • What is a primary advantage of using ETFs for investors?

  • Higher fees than mutual funds
  • Limited transparency regarding holdings
  • Less diversification compared to traditional funds
  • Access to investments previously restricted to large investors (correct)

    • What challenge do ETFs face in maintaining transparency?

  • Inability to diversify effectively
  • Availability of only active management strategies
  • Difficulty in keeping costs low
  • Risk of revealing holdings to competitors (correct)

    • Which of the following ETF types is designed to provide a payout when the underlying assets decline in value?

    <p>Inverse ETF (D)</p> Signup and view all the answers

    How do ETFs compare to mutual funds in terms of cost and diversification?

    <p>ETFs provide low-cost diversification. (C)</p> Signup and view all the answers

    Which statement accurately describes a characteristic of exchange-traded funds (ETFs)?

    <p>Units of ETFs are typically listed and traded like individual stocks. (A)</p> Signup and view all the answers

    What distinguishes passive management of exchange-traded funds from active management?

    <p>Active management invests based on predictions and market timing. (B)</p> Signup and view all the answers

    Which of the following ETFs focus on a specific asset class, like stocks or bonds?

    <p>Equity-based ETFs (B)</p> Signup and view all the answers

    What is a potential advantage of investing in exchange-traded funds compared to open-end mutual funds?

    <p>ETFs offer the flexibility to be sold short and bought on margin. (D)</p> Signup and view all the answers

    Which type of ETF is structured to replicate the performance of a specific index?

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

    What primary characteristic distinguishes rules-based ETFs from traditional market-capitalization weighted ETFs?

    <p>They follow alternative weighting schemes based on specific criteria. (B)</p> Signup and view all the answers

    Which of the following is true about smart beta ETFs?

    <p>They may not follow a specific underlying index. (A)</p> Signup and view all the answers

    What is a common attribute of rules-based ETFs compared to traditional ETFs?

    <p>They often involve a more transparent construction methodology. (B)</p> Signup and view all the answers

    What objective do smart beta strategies aim to achieve that differs from conventional indexes?

    <p>To deliver unique performance outcomes using alternative criteria. (B)</p> Signup and view all the answers

    Which statement accurately reflects the operational approach of the BMO MSCI USA High Quality Index ETF?

    <p>It seeks to replicate the performance of the MSCI USA Quality Index while screening for specific financial metrics. (A)</p> Signup and view all the answers

    What is a significant characteristic of mutual funds regarding their disclosure of holdings?

    <p>They limit disclosure typically to their top 10 holdings once a month. (D)</p> Signup and view all the answers

    How do ETFs compare to mutual funds in terms of trading?

    <p>ETFs may trade at a premium or discount to the NAV. (A)</p> Signup and view all the answers

    What is the typical embedded fee structure in actively managed mutual funds?

    <p>They tend to have higher management and trading expenses. (A)</p> Signup and view all the answers

    What is a defining feature of the way mutual funds are bought and sold?

    <p>They are always purchased and redeemed directly from the mutual fund at the day's NAV. (B)</p> Signup and view all the answers

    What is the primary role of maintaining cash on hand for mutual funds?

    <p>To facilitate redemption requests and manage inflow and outflow of cash. (C)</p> Signup and view all the answers

    Flashcards

    Exchange-Traded Fund (ETF)

    An investment vehicle combining mutual fund and stock features. It's an open-end mutual fund trust, regulated like a mutual fund.

    Passive Management (ETF)

    An ETF management style that replicates an existing market index (like S&P/TSX 60).

    Active Management (ETF)

    An ETF management style where a fund manager actively selects securities.

    ETF Trading

    ETFs are traded on exchanges like stocks, allowing for buying, selling, margin, and short selling.

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    Regulation of ETFs

    ETFs are regulated by guidelines like NI 81-102 and possibly NI 81-104, similar to mutual funds.

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    ETF Diversification Benefit

    ETFs offer lower-cost diversification compared to mutual funds by allowing investors to access a broad range of assets in a single investment.

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    ETF Democratization

    ETFs have made investment opportunities previously available only to large investors accessible to everyone, including small investors.

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    ETF Targeted Exposure

    ETFs allow investors to target specific sectors, asset classes, or regions through various specialized funds.

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    Standard ETF Types

    Standard ETFs are based on a reference index, which can be either exactly replicated or approximately constructed.

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    ETF Trade-off Transparency vs. Competitiveness

    ETFs face the challenge of balancing transparency for investors with the need to protect competitive advantages by not revealing their holdings.

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    Rules-Based ETF

    An ETF that aims to achieve a specific objective by following a set of pre-defined rules instead of a traditional market-cap weighted index. These rules can be developed by the ETF provider or based on an existing index.

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    Smart Beta Strategy

    An investment approach used by rule-based ETFs that aims to outperform traditional market-cap weighted indexes. They achieve this by using alternative weighting schemes focused on factors like volatility, dividends, or revenue.

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    What is an example of a rule-based ETF?

    The BMO MSCI USA High Quality Index ETF is a smart beta ETF focused on US equity markets. It aims to replicate the MSCI USA Quality Index, prioritizing high return on equity, stable earnings growth, and low financial leverage.

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    Full Replication ETF

    A type of ETF where the fund manager attempts to hold all the securities in the underlying index in the same proportion.

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    Why are rules-based ETFs sometimes called smart beta ETFs?

    Because they use strategies that aim to generate a different outcome than conventional market-cap weighted indexes. They use alternative weighting schemes focused on specific factors like volatility, dividends, or revenue.

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    Cash Drag

    The performance loss a portfolio experiences when holding a large amount of cash.

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    How do Mutual Funds Handle Large Cash Inflows?

    Mutual funds can handle large cash inflows, but they need time to invest the money and may hold some cash on hand to meet redemption requests.

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    Embedded Fees (Mutual Funds)

    Mutual funds have hidden fees embedded in the management and trading expenses, often higher due to active management.

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    Embedded Fees (ETFs)

    ETFs usually have lower embedded fees due to passive management, with the exception of F-Class mutual funds.

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    Distribution (Mutual Funds)

    Mutual fund units are purchased and redeemed directly from the fund at the end-of-day's NAV per unit.

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    Study Notes

    Exchange-Traded Funds (ETFs)

    • ETFs are investment vehicles combining features of mutual funds and individual stocks
    • They are structured as open-ended mutual fund trusts
    • Regulated similarly to mutual funds (National Instrument 81-102)
    • Can also be subject to National Instrument 81-104 (commodities and derivatives)
    • Managed actively or passively
    • Passive ETFs track specific market indexes (e.g., S&P/TSX 60, S&P 500)
    • ETFs are traded on stock exchanges
    • Can be bought on margin or sold short
    • Some have options available

    Learning Objectives

    • Explain regulatory requirements and different legal structures of ETFs
    • Describe key features of exchange-traded funds
    • Differentiate among types of ETFs
    • Identify and explain risks specific to ETFs
    • Compare and contrast 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 exchange-traded funds
    • Various types of exchange-traded funds
    • Risks of investing in exchange-traded funds
    • Comparison of exchange-traded funds and mutual funds
    • Taxation of investors in exchange-traded funds
    • Investment strategies using exchange-traded funds
    • Other related products

    Key Terms

    • Active ETFs
    • Core holdings
    • Commodity ETFs
    • Covered call ETFs
    • Designated broker
    • Equity-based ETFs
    • ETF Facts
    • 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
    • Rule-based ETFs
    • Satellite holdings
    • Spot price
    • Synthetic ETFs
    • Tracking error

    Introduction

    • ETFs combine features of mutual funds and individual stocks
    • Structured as open-end mutual fund trusts, regulated like mutual funds
    • Professionally managed, actively or passively
    • Traded on exchanges like individual stocks
    • Can be bought on margin and sold short
    • Some have options available

    Mutual Funds Trusts and Mutual Fund Corporations

    • ETFs in Canada are structured as mutual fund trusts or corporations
    • Regulated by National Instrument (NI) 81-102
    • Can be bought/sold by SRO registered mutual fund dealers and investment dealers.
    • Include index and active ETFs

    General Disclosure Requirements

    • ETFs mostly use the client disclosure documents system (NI 41-101) to distribute ETFs.
    • An ETF Facts document, similar to a mutual fund's Fund Facts document, accompanies ETFs
    • This document addresses trading and pricing aspects, premiums/discounts, and more.

    ETF Facts Document

    • Includes essential information on ETF trading and pricing characteristics
    • Provides information about market price and bid-ask spreads, premiums & discounts, and more.

    Creation and Redemption Process

    • ETFs launched through a designated broker
    • The broker is a market maker or specialist.
    • ETFs are open-end funds with unlimited supply
    • Creation/redemption is in blocks (prescribed number of units) of units
    • Units are exchanged for underlying securities (via in-kind exchange)

    Key Features of ETFs

    • Low cost: Management expense ratio (MER) lower typically compared to other products
    • Tradability: Liquid, continuous price discovery
    • Low tracking error: Prices closely adhere to benchmark.
    • Tax efficiency: Lower portfolio turnover
    • Transparency: Daily holdings or monthly disclosures (or both)
    • Low cost diversification: Allows broader asset allocation
    • Targeted exposure: Access to specific market segments (like country or sector-specific ETFs).

    Tradability, Liquidity, and Continuous Price Discovery

    • ETFs trade on exchanges continuously, allowing continuous price discovery
    • Liquidity comes from underlying holdings, not ETF units themselves
    • ETFs can be held on margin/shorted

    Low Tracking Error

    • Tracking error: difference between ETF and underlying index returns
    • Lower costs of administration/trading in ETFs contribute to lower tracking errors

    Tax Efficiency

    • Index-based ETFs have low portfolio turnover, leading to fewer capital gains
    • In-kind creation/redemption reduces taxable events associated with mutual funds.

    Transparency

    • ETFs are required to have holdings published regularly (daily in the U.S., monthly/quarterly in Canada)
    • Improves investor visibility

    Low-Cost Diversification

    • ETFs offer broad exposure to stocks, bonds, and various managers (cost-effective)

    Targeted Exposure

    • Provide access to specialized asset classes or regions previously difficult or expensive for retail investors
    • Investment opportunities are expanded

    Types of ETFs

    • Standard (index-based): replicates the index closely
    • Rules-based: follow a particular methodology to achieve a specific objective, often using alternative weighting schemes
    • Active ETFs: actively managed, similar to typical mutual funds
    • Synthetic ETFs: derived from derivatives (e.g., swaps), not holding direct exposure to the index
    • Leveraged ETFs: attempt to achieve returns multiples of the benchmark
    • Inverse ETFs: aim for movements that are the inverse of the benchmark’s movements.
    • Commodity ETFs: invest in physical, futures-based, or equity-based commodity holdings

    Active Exchange-Traded Funds (ETFs)

    • Increasingly popular, actively managed like typical mutual funds
    • Trading timed differs, since it can change quicker

    Synthetic ETFs

    • Created using derivatives like swaps, but not holding direct index exposure
    • Exposure is notional, not real

    Leveraged ETFs

    • Use derivatives to leverage return effects of benchmark, sensitive to market fluctuations.
    • More volatile than ordinary ETFs

    Inverse ETFs

    • Mimic inverse (opposite) movements of benchmark
    • Highly complex; risky for holding periods beyond a single trading session

    Commodity ETFs

    • Physical-based ETFs: invest in physical commodities
    • Futures-based ETFs: utilize futures contracts, potentially involving roll-yield losses
    • Equity-based ETFs: invest in companies involved in commodity exploration or processing

    Covered Call Exchange-Traded Funds (ETFs)

    • Employ covered call strategies to enhance yield and reduce volatility (using options)
    • Similar to typical strategies, but applied via ETFs.

    Risks of Investing in ETFs

    • Tracking error: Difference between ETF and index performance/returns
    • Concentration risk: Over-reliance on a few holdings within the ETF
    • Composition risk: ETFs may have different weighting methodologies in comparison to benchmark
    • Securities lending risk: Risk of default by entities from which the ETFs lend assets

    Comparing ETFs and Mutual Funds

    • Compared to mutual funds, ETFs frequently have lower tracking errors, lower management expenses and higher transparency.

    Taxation of Investors in ETFs

    • Tax implications from distributions, dividends, interest, and capital gains
    • Distributions can be dividends/interests, capital gains, or non-taxable
    • Capital gains are generally 50% taxable

    Investment Strategies Using ETFs

    • Using ETFs for core/satellite portfolio construction
    • Asset rebalancing, tactical asset allocation, cash management, exposure to niche markets, tax loss harvesting
    • Mutual funds of ETFs
    • Exchange-traded notes (ETNs)

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    Exchange-Traded Funds PDF

    Description

    This quiz explores the key features, regulatory requirements, and different types of Exchange-Traded Funds (ETFs). You will learn to differentiate between ETFs and mutual funds, understand associated risks, and summarize taxation impacts. Gain insights into investment strategies involving ETFs and their legal structures.

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