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?

Inverse ETF Signup and view all the answers

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

ETFs provide low-cost diversification. Signup and view all the answers

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

Units of ETFs are typically listed and traded like individual stocks. Signup and view all the answers

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

Active management invests based on predictions and market timing. Signup and view all the answers

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

Equity-based ETFs Signup and view all the answers

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

ETFs offer the flexibility to be sold short and bought on margin. Signup and view all the answers

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

Full replication ETFs Signup and view all the answers

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

They follow alternative weighting schemes based on specific criteria. Signup and view all the answers

Which of the following is true about smart beta ETFs?

They may not follow a specific underlying index. Signup and view all the answers

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

They often involve a more transparent construction methodology. Signup and view all the answers

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

To deliver unique performance outcomes using alternative criteria. Signup and view all the answers

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

It seeks to replicate the performance of the MSCI USA Quality Index while screening for specific financial metrics. Signup and view all the answers

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

They limit disclosure typically to their top 10 holdings once a month. Signup and view all the answers

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

ETFs may trade at a premium or discount to the NAV. Signup and view all the answers

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

They tend to have higher management and trading expenses. Signup and view all the answers

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

They are always purchased and redeemed directly from the mutual fund at the day's NAV. Signup and view all the answers

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

To facilitate redemption requests and manage inflow and outflow of cash. Signup and view all the answers

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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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.