„Exchange-traded funds 101 for economists“ Lettau, Martin, and Ananth Madhavan

Question 1

What is the main idea?

Answer 1

Comparing ETFs to mutual funds, describing the benefits and concerns of ETFs, emphasizing the classification of ETFs.

Question 2

What is an ETF?

Answer 2

ETF – An investment vehicle that typically seeks to track the performance of a specific index

Early ETFs were almost exclusively seeking to track broad value-weighted equity indices (for example, the S&P 500) but ETFs today track a wide variety of equity and fixed-income indices

Question 3

What are the differences between ETFs and mutual funds regarding creation and trade of shares?

Answer 3

MUTUAL FUNDS:
Interact with capital markets directly

ETFs:
Don’t interact with capital markets directly;
Instead, the ETF manager is in contract with “Authorized Participants” (typically are large financial institutions), who access the capital markets and bring commodities to ETF.

Question 4

What is the interaction between ETF and the “Authorized Participant”?

Answer 4

 ETF managers contract authorized participants, who interact with the market
 ETFs issue or redeem their own shares, trade those for cash or other securities with authorized participants
* Creation – increasing supply of ETF shares
* Redemption – decreasing supply of ETF shares
 Authorized participants can buy or sell ETF shares in the secondary market, but they can also redeem or create shares directly from the ETF

Question 5

What are the differences between ETFs and mutual funds regarding determining share price?

Answer 5

MUTUAL FUNDS:
*Investors trade with the fund directly –> no counterparty needed
*Trades occur at the end of the day and at net asset value

ETFs:
*Investors mostly don’y trade the fund directly. Instead, they trade on an exchange or with APs
*Trades occur at a market determined price

Question 6

What are the differences between ETFs and mutual funds regarding transaction costs?

Answer 6

MUTUAL FUNDS:
*Remaining investors in the fund pay the transaction costs incurred by participants who remeed or subscribed

ETFs:
*Transaction costs in an ETF are “externalized” – ppl who sell the ETF shares are paying the transaction costs

Question 7

What are some other differences between mutual funds and ETFs?

Answer 7

o ETFs offer greater transparency, bc their investment strategies are specified in advance and their holdings are listed daily versus quarterly
o ETF structure enables lower fees than active mutual funds
 Mutual funds interact directly w investors – distribution and record-keeping costs
o Investors in ETF shares can short and lend shares, buy on margin (mutual can’t)
o ETFs can offer tax advantages (mutual can’t)
o ETFs can trade intraday – can hedge risks or gain exposure (mutual can’t)

Question 8

What are the main types of ETFs?

Answer 8

o Equity-based ETFs (dominating, 78% of exchange-traded product assets)

o Exchange-traded commodity funds – hold physical commodities (mostly buy futures contracts, don’t hold the commodities)

o Fixed income ETFs – invested in bonds or bank loans

o Exchange-traded notes – senior, unsecured debt securities, exposed to credit risk of the issuer

o Leveraged and inverse exchange-traded products – hold individual index stocks, have physical-backing

Question 9

How do equity-based ETFs divide?

Answer 9

 Market-cap-based ETFs (tracking biggest companies on the market)
 Sector ETFs (seek to track market-weighted capitalization benchmarks for each sector)
 Factor ETFs / “Smart beta” (focus on certain factors that are lined to stock returns)

Question 10

What are the benefits of fixed income ETFs against bonds?

Answer 10

Benefits against bonds:
* Traded on exchanges not OTC
* Higher degree of price transparency
* Higher liquidity
* Can keep constant duration easily

Question 11

What are potential issues of ETFs?

Answer 11

o Some investors may not have the financial sophistication to distinguish between the types of ETFs in the absence of a common classification scheme

o Intraday liquidity may induce “too much” trading (actively trading investors suffer lower returns)

o Some indices may do well in back testing but not going forward

Question 12

What are the concerns and misconceptions of ETFs? (Relating to closure, shorting, securities lending)

Answer 12

1. Fund closure and loss of all investment –> But assets can be returned to investors, as the closure doesn’t affect the asset price (When a company’s issued exchange-traded note goes bankrupt, then investor loses all the money)
2. If ETFs are shorted, long positions can exceed the total actual nr of outstanding ETF shares, ETF goes bankrupt –> Remote risk, bc many parties, which don’t have ETF shares to deliver won’t be able to settle the trade
3. Securities lending and counterparty risk –> Many safeguards tho, not a big threat

Question 13

What are the concerns and misconceptions of ETFs? (flash crash, liquidity, markets)

Answer 13

4. “Flash events” (sharp price movements and reversals in very short time), ETFs are heavily affected by them, but ETFs are not the cause –> no solution
5. Liquidity mismatch – difference in liquidity in the primary and secondary market
    Primary market: Risk that the AP stops doing his job in a crisis, reducing liquidity –> Highly likely that other APs will compensate the liquidity
    Secondary market: Trading shares of ETFs with higher liquidity than underlying assets (good thing), doesn’t reflect actual trade of assets, just trade of ETF ownership
6. Index investing may distort prices of underlying securities – liquidity in underlying stocks or bonds may decline (ppl buy them less), but indexes may also open up access for new liquidity investors who couldn’t invest in the market before –> Index investing is a small amount of total investments, so not a big threat