Exchange Traded Funds
Exchange Traded Funds (ETFs)
- Index-tracking funds that are listed and traded on major stock markets in the same way as the shares of publicly quoted companies.
- Similar to an index-tracking fund, as they reflect the diversification and performance of a chosen index, but traded like a single share through stockbrokers and their prices are updated throughout the day.
- Subject to broker fees in the same way as share transactions, but there is no stamp duty to pay on purchases. Typical management fees of less than 0.5%.
- Some ETFs use swaps to replicate the returns and so the investor is exposed to the risk that the counterparty may fail to meet their obligations. This is known as synthetic replication.
- Tracking an index by investing in just a subset of the index (rather than full replication) is known as sampling or optimisation.
Exchange Traded Commodities (ETCs)
- They work on the same principle as an ETF, tracking the performance of an underlying commodity or basket of commodities such as metals, natural energy resources, agricultural produce or livestock.
- The ETC may track an index that is designed to measure the value of that commodity.
Exchange Traded Notes (ETNs)
- An ETN is a type of bond issued by a bank. In the same way as other types of debt ETNs have a maturity date, but they do not pay any interest. Instead the returns are linked to the performance of a market index, less management fees.
- As ETNs are unsecured bonds, their value will be affected by the credit rating of the issuer. The value may drop even though there is no change in the underlying index if the issuing bank’s credit rating is downgraded, while repayment of the investment is dependent on the ability of the issuing bank to meet its commitments.
Questions - Use Your Note Taker To Jot Down Ideas / Calculations
1. Ross is invested in an Exchange Traded Fund (ETF) that his adviser has informed him is ‘synthetic’.
This indicates that:
a) the ETF holds stocks to replicate an index.
b) the ETF uses derivatives to match an index.
c) the ETF holds a representative sample of index stocks.
d) the ETF can be held on a platform if required.
B)
Synthetic replication is where replication is achieved through the use of derivatives rather than
purchasing the actual securities that make up an index.
2. Mohammad is interested in using Exchange Traded Funds to enhance the diversification of his
portfolio. He should be aware that:
a) some have additional risk via synthetic replication, but this type will always exclude any
tracking error.
b) they all fully replicate the index they are tracking and this means they will exclude any
tracking error.
c) some have additional risk via synthetic replication and they all are likely to experience a
degree of tracking error.
d) they all fully replicate the index they are tracking, but they are still likely to experience a
degree of tracking error.
C)
Synthetic replication is where an index is replicated through the use of derivatives which add
additional risk through the additional counter party (the bank issuing the derivative). It is unlikely
that ETFs will be able to completely mirror an index – there is likely to be some error.
3. An important difference between exchange traded funds (ETFs) and exchange traded notes (ETNs) is
that only:
a) ETFs are sensitive to changes in interest rates.
b) ETFs hold a portfolio of actual investments.
c) ETFs track an index.
d) ETNs give access to specialist market niches.
B)
ETNs do not hold a portfolio of investments, they are purely derivative based.
- Further study text reading: Pages 283 - 284