L2 Flashcards
(79 cards)
How are ETF shares created?
ETF creation/redemption happens in an OTC primary market.
2 groups exist in primary market -> ETF issuer (sponsor, manager) & Authorized participants (Special group of Institutional Investors)
Authorized participant then comes to the secondary market (can be an exchange or OTC) where the ETFs are available for retail investors and trade there.
Important points to remember about ETF shares creation?
AP creates new share by transacting in-kind with ETF issuer.
ETF issuer/sponsor publishes a creation basket daily.
Transactions are done in large blocks called creation units.
Redemption is like the opposite of creation process.
Describe why APs will indulge in creation/redemption in ETF?
Every ETF has underlying securities and the price of the ETF shares are usually in a tight gap around the intrinsic NAV of the underlying securities of the ETF.
This gap is called the Arbitrage gap. (costs and liquidity of underlying shares also need to be considered)
The AP then tries to take advantage of this gap and either creates more ETF shares (by buying from Issuer or Sponsor and selling in the secondary market) if the price of the ETF is higher than the price of the underlying security and vice versa if the price is lower.
What about costs incurred for transacting with underlying securities?
AP absorbs all the cost of transacting the securities for the fund’s portfolio.
These costs are passed to investors via the bid-ask spread in the secondary market.
Thus, frequent ETF traders bear the cost of their trading activity and buy-and-hold ETF shareholders don’t (unlike MFs where every party bears cost of trading activity in the fund).
Since creation & redemption happen in kind, ETFs lead to greater tax efficiency.
How does trading and settlement happen in the secondary market?
ETFs go through the same settlement and clearing process as other listed stocks.
US NSCC (National Security Clearing Corp) & DTC (Depository Trust Company) (who looks and tracks only at member level or APs) example.
Market makers are given up to 6 days to settle their accounts as they create liquidity in the ETF markets.
What is an expense ratio?
is a ratio which looks at the expense to run a fund to the AUM of the fund. Thus, lower the expenses = better management of the fund.
Which has higher fees among ETFs and MFs? Why?
ETFs charge lower fees as they don’t have to keep track of individual investor accounts, don’t bear the cost of communicating directly to the individual investors and Index-based folios don’t require extensive research.
How do we measure ETF performance? against what do we compare it to?
There are 2 broad ways to do this, one is Daily tracking error (not much efficient) and the most commonly used one is Periodic rolling tracking difference (shows if ETF is overperforming/underperforming)
Comparison should include a measure of central tendency and a measure of variation. (Periodic tracking difference fulfills both)
Why is their a tracking difference in ETFs?
some reasons are fees and expenses of ETF,
Representative sampling/optimization
Index changes
Regulatory and tax requirements
Tax benefits of Trading with ETFs?
A) Tax fairness (only frequent traders have to bear capital gains taxes and bid-ask spreads)
B) Tax efficiency (In-kind transactions result in low cost basis securities being exchanged to keep unrealized gains and taxes under control).
Imp points about ETF bid-ask spread?
Trade size matters (TS high then BAS low & vice versa)
Also, BAS are the tightest/narrowest for the shares that are very liquid having continuous two-way order flow.
If underlying securities are complex or have high spreads, then BAS spreads of ETF will also be high.
*ETF BAS are higher on Fixed Income relative to equity as underlying bonds trade in dealer markets and hedging is more difficult.
What are the ETF Risks?
A) Counterparty risks (use of ETNs, OTC derivatives like swaps and lending of securities creating counterparty risk)
B) Fund Closures (Creates unexpected tax liabilities, might be cos of regulation, competition and Corporate activity like merger and also soft closures like restricted creation halts and changes in investment strategy)
C) Investor related risk (ETFs have complex asset classes and strategies, makes it imp to understand underlying exposure. Examples can be leveraged and inverse funds)
What are ETF Strategies?
A) Portfolio Efficiency (applications include cash/liquidity management, rebalancing, portfolio completion and active manager transition management.
B) Asset class exposure management (which asset class to invest in based on strategy, style, country and many other factors)
C) Active or factor investing (Use ETFs to get exposure to one or more factors like Quality, dividend growth, value, momentum, low volatility etc allowing us to invest in a multi-asset-class strategy in single product)
Most ETF-related strategies have some component of active investing, either within ETF strategy or in a way the ETF is used.
What is Regression Analysis?
A statistical process where we infer the influence of one/more(independent) variables on a single(dependent) variable or we predict a dependent variable (Criterion) based on other independent variables (predictors).
Simple linear regression vs Multiple linear regression?
Simple is when we have one dependent variable and one independent variable and multiple linear regression is when we have a single dependent variable and two or more independent variables.
What should be an Analyst’s focus?
The heavy computational work is done by statistical software like Excel, Python, R, etc.
An analyst should focus on:
A) Specifying the model correctly,
B) Interpreting the output of the software.
Uses of Multiple Linear Regression?
A) to identify relationship between variables
B) to test existing theories
C) to forecast/predict a criterion
What is the general form of Regression Equation? What is the intercept co-efficient and what are slope co-efficients?
Yi = b0 + b1X1 + b2X2 + ei
b0 is the intercept co-efficient and it represents the expected value of Y(criterion) if all the predictors are zero.
b1, b2 etc are partial/regression slope co-efficients which measure how much the criterion changes when the independent variable changes by one unit, holding all other independent variables constant. We’ll always have k slope co-efficients where k = number of independent variables.
Assumptions under multiple linear regression?
There are 5 in total:
A) Linearity - The relationship between criterion and each of the predictors should be linear. (The regression line should fit through the entire data points graphs)
B) Homoskedasticity - The relation of criterion with the errors. (Criterion on the X-axis and errors on the Y-axis, where errors should be within a range)
C) Independence of Errors - The observations should be independent of one another. Regression residuals should be uncorrelated across observations.
D) Normality - The error terms should be normally distributed. (Deviations from the diagonal past +/-2 standard deviations indicate that the distribution is fat-tailed.
E) Independence of Independent variables - Independent variables are not random and there is no linear relationship between two or more of the independent variables or combination of the independent variables.
What is the term structure of interest rates?
is how the interest rate evolves with time or what the interest rates are across different time maturities.
What is a Spot rate in interest rate term structure?
A spot rate is the interest rate on a security that makes a single payment at a future point in time.
What is the discount factor?
The price or the present value of a risk-free single unit payment after N periods is called the discount factor.
How to calculate discount factor?
It’s the PV, so DF = 1 / (1 + Zn)^N where Zn = spot rate (YTM)
What is the Discount Function?
It’s a combination of Discount factors (PV) for a range of maturities.
