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CFA level 2 > pOFORLIO PART 3 > Flashcards

pOFORLIO PART 3 Flashcards

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1
Q

What is an Exchange-Traded Fund (ETF)?

A

Shares in an index-tracking portfolio that trades on secondary markets; similar to mutual funds but differ in costs and taxation.

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2
Q

What are the investment methods used by ETFs?

A

Direct investments in securities, derivatives, ADRs, or leverage.

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3
Q

Who manages the ETF portfolio?

A

The issuer (sponsor or manager) allocates the portfolio based on the stated index or style.

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4
Q

How do shareholders cash out of ETFs?

A

By selling shares on the secondary market; the ETF issuer is not involved.

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5
Q

Who are Authorized Participants (APs) in ETFs?

A

Large broker-dealers allowed to create or redeem ETF shares for a service fee.

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6
Q

What is the ETF creation/redemption process?

A

In-kind exchange where APs deliver a basket of securities to create ETF shares or receive securities upon redemption.

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7
Q

What is a creation basket?

A

The list of securities APs deliver to the ETF issuer to create ETF shares; disclosed daily.

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8
Q

What is a redemption basket?

A

The assortment of securities APs receive upon redeeming ETF shares.

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9
Q

What is a creation unit?

A

The lot size of ETF shares (commonly 50,000) used in creation/redemption.

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10
Q

List three purposes of the in-kind creation/redemption process.

A
  1. Lower cost 2. Tax efficiency 3. Keep market price in line with NAV.
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11
Q

What is the arbitrage gap in ETFs?

A

The price band within which ETFs trade around NAV due to APs’ transaction costs.

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12
Q

What causes a wider arbitrage gap?

A

Illiquid securities, timing differences in foreign markets, and market risk during trading.

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13
Q

How do APs cover their transaction costs?

A

By passing them on as bid-ask spreads to transacting shareholders.

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14
Q

Why are ETFs considered tax fair?

A

Because in-kind redemptions don’t affect nontransacting shareholders.

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15
Q

How are ETFs traded in the United States?

A

On secondary markets like stocks; NSCC guarantees trades; DTC settles trades after two days.

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16
Q

What are market makers’ settlement periods?

A

Up to six days to settle due to the creation/redemption process.

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17
Q

Describe ETF trading in European markets.

A

Fragmented exchanges, mostly institutional investors, OTC trading, multiple listings and classes, complex settlement.

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18
Q

What is tracking difference in ETFs?

A

The divergence between an ETF’s NAV return and the benchmark index return.

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19
Q

What is tracking error in ETFs?

A

Annualized standard deviation of daily tracking differences; measures consistency, not direction of deviation.

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20
Q

What does rolling holding period analysis show?

A

Cumulative effects of management and expenses over time; compared to expense ratio.

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21
Q

List sources of tracking error.

A
  1. Fees and expenses 2. Sampling and optimization 3. Depository receipts 4. Index changes 5. Regulatory and tax requirements 6. Fund accounting practices 7. Asset manager operations.
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22
Q

How do fees and expenses contribute to tracking error?

A

They reduce a fund’s return.

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23
Q

How does sampling and optimization affect tracking error?

A

Favor higher-liquidity securities, creating size bias relative to the benchmark.

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24
Q

How do depository receipts (DRs) impact tracking error?

A

Price differences between DRs and original securities cause tracking error.

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25
How do index changes contribute to tracking error?
Delays in portfolio rebalancing using creation/redemption process lead to tracking error.
26
How do regulatory and tax requirements affect ETFs?
Different tax treatments cause discrepancies in after-tax returns compared to the index.
27
How do fund accounting practices cause tracking error?
Differences in NAV calculation timing and currency rate capture times create return differences.
28
What are asset manager operations that impact ETF performance?
Share lending and foreign dividend capture to improve ETF performance relative to the benchmark.
29
What are the primary factors affecting ETF bid–ask spreads?
Liquidity and market structure of the underlying securities.
30
How do bid-ask spreads differ between fixed-income and large-cap equity ETFs?
Spreads are larger for fixed-income ETFs compared to large-cap equity ETFs.
31
When are ETF spreads narrower in different markets and time zones?
During the overlapping time period when both markets are open.
32
Which ETFs tend to have wider spreads?
Specialized ETFs like commodities, volatility futures, or small-cap stocks.
33
Do thinly-traded ETFs have higher spreads?
Yes, regardless of the liquidity of the underlying securities.
34
What factors determine quoted ETF spreads?
Ability to offset trades, transaction costs, and likelihood of secondary market offsets.
35
Formula for maximum ETF spread?
Creation/redemption fees + trading costs + spread of underlying securities + risk premium + AP's profit margin - discount based on probability of offsetting trade.
36
How are large ETF trades handled?
Via negotiation, not posted bid-ask spreads.
37
When do ETF spreads widen?
During volatile times or when new significant information is expected.
38
What is ETF premium/discount to NAV?
The percentage difference between ETF price and NAV per share.
39
Formula to calculate ETF premium/discount %?
(ETF price – NAV per share) / NAV per share.
40
Sources of ETF premiums/discounts?
1. Timing differences 2. Stale pricing.
41
What causes timing differences in ETF pricing?
ETFs on foreign securities or OTC bonds traded when underlying markets are closed.
42
What is stale pricing in ETFs?
When ETF trades do not reflect latest closing prices of underlying securities.
43
When can ETF prices be more informative than NAV or iNAV?
When the underlying market is closed, highly volatile, or illiquid, or pricing lags exist.
44
What are the costs of owning an ETF?
Management fees and trading costs (brokerage, bid-ask spreads, price impact, and premiums/discounts).
45
What happens to trading costs over longer holding periods?
They diminish when annualized over longer periods.
46
What are the key cost components for short-term ETF traders?
Spread and commission (trading costs).
47
What are the key cost components for long-term ETF investors?
Management fees.
48
Formula for total ETF cost?
Total cost = Round-trip trading cost + Management fees.
49
Formula for round-trip trading cost?
Round-trip commission + Spread.
50
Example: What is the round-trip trading cost if commission = 0.10% and spread = 0.15%?
0.35% (0.20% commission + 0.15% spread).
51
Example: What is the holding cost for 3 months with a management fee of 0.08%?
0.37% (0.35% trading cost + 0.02% management fee for 3 months).
52
Example: What is the holding cost for 1 year?
0.43% (0.35% trading cost + 0.08% management fee).
53
Example: What is the holding cost for 5 years?
0.75% (0.35% trading cost + 5×0.08% management fees).
54
Example: What is the average annual cost over 5 years?
0.15% (0.75% total cost / 5 years).
55
What is counterparty risk in ETFs?
Risk that a counterparty (e.g., issuing bank in ETNs) defaults, causing losses to investors.
56
What financial instrument has high counterparty risk?
Exchange-traded notes (ETNs).
57
How can investors estimate counterparty risk?
By examining the issuer’s credit default swap (CDS) spread; above 5% is considered very risky.
58
What is settlement risk in ETFs?
Risk from using OTC derivatives; mitigated by frequent settlements and collateral requirements.
59
What is security lending in ETFs?
ETFs lend securities to short sellers; overcollateralized, generates fees, but bears minimal default risk.
60
What is fund closure risk in ETFs?
Risk of liquidation or changes in investment strategy, leading to cash distributions and potential tax consequences.
61
What are creation/redemption halts in ETNs?
When issuers stop creating ETN shares, causing ETNs to trade at a premium to NAV.
62
What is expectation-related risk in ETFs?
Complex strategies like leveraged or inverse ETFs may produce outcomes different from investor expectations.
63
Why are leveraged ETFs unsuitable for long-term investors?
Daily compounding causes deviation from expected returns over periods longer than one month.
64
List types of ETF risks.
Counterparty risk, settlement risk, security lending risk, fund closure risk, expectation-related risk.
65
What are some portfolio uses of ETFs?
Efficient portfolio management, asset class exposure management, active investing, risk management, dynamic allocation.
66
How can ETFs be used for portfolio liquidity management?
Invest excess cash into ETFs to reduce cash drag and maintain market exposure.
67
How can ETFs be used for portfolio rebalancing?
Buy or short ETFs to adjust sector or asset class weights quickly and cost-effectively.
68
What is portfolio completion using ETFs?
Fill gaps in allocation due to manager turnover or investor-specific needs using targeted ETFs.
69
What is transition management with ETFs?
Use ETFs temporarily to maintain exposure during change of portfolio managers.
70
Why might large asset owners prefer SMAs over ETFs?
Lower costs, customization, and avoidance of public disclosure of holdings.
71
How can ETFs help manage asset class exposure?
Provide low-cost access to asset classes, subclasses, sectors, and facilitate tactical and strategic allocation.
72
What are core exposures in ETFs?
Long-term investments in broad or specific asset classes or sectors using passive index ETFs.
73
What are tactical strategies with ETFs?
Temporary rotation into/out of sectors or themes expected to outperform or underperform.
74
What are smart beta ETFs?
ETFs that use predefined rules (e.g., fundamentals) instead of market cap weighting; focus on factors like size and momentum.
75
What are multifactor ETFs?
ETFs that provide exposure to multiple factors and adjust weights based on market opportunities.
76
What is risk management with ETFs?
Using ETFs like low-volatility ETFs, currency-hedged ETFs, and duration-hedged bond ETFs to control specific risks.
77
What are alternatively weighted ETFs?
ETFs that use weighting methods other than market capitalization (e.g., equal weighting, fundamental weighting).
78
What are discretionary active ETFs?
Actively managed ETFs similar to closed-end mutual funds, often seen in fixed income markets.
79
What is dynamic asset allocation with ETFs?
ETFs that adjust allocations between asset classes based on risk/return forecasts dynamically.
80
What due diligence should investors perform when selecting alternative ETFs?
Review index construction methodology and performance history to determine suitability.

CFA level 2 (9 decks)

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