CSC II - Chapter 19: Questions

1) What is an ETF?

Exchange-traded funds (ETF) are regulated under either of two national instruments,
depending on their structure.

2) How are ETFs like mutual funds?

Much like the way mutual funds are structured, ETFs in Canada are structured as mutual
fund trusts or as mutual fund corporations. Both ETF classification structures are regulated
according to National Instrument (NI) 81-102 and can be bought and sold by SRO registered
mutual fund dealers and investment dealers.

3) How are ETFs like stocks?

ETFs are like stocks because they can be bought and sold on stock exchanges throughout
the trading day, just like individual stocks.

4) Who can sell ETFs?

ETFs can be sold by authorized brokerage firms and financial institutions that have the
necessary licenses and permissions to trade securities on behalf of investors.

5) What benefit does setting an ETF up as a Commodity Pool give the fund?

Individuals licensed as investment advisors can deal in any type of ETF that is registered
under NI 81-102.

6) What is the ETF Facts document?

This document is designed to look like the Fund Facts document that accompanies a mutual
fund.

7) When must the ETF facts document and the prospectus for the ETF be provided to the
investor?

The dealers must also make the prospectus available to investors, upon request, at no cost.

8) Why is it important for the ETF facts document to be provided?

It's important because the ETF facts document helps investors understand key information
about the ETF, such as its investment objectives, risks, fees, and past performance. This
helps investors make informed decisions before investing in an ETF.
9) What is a designated broker?

When an ETF provider wants to launch a new ETF, it does so through a designated broker
with whom it has entered into a contractual agreement. The designated broker may be a
market maker or a specialist representing a large investment dealer.

10) How are ETF shares issued and redeemed?

ETFs are created or redeemed in blocks of units known as a prescribed number of units –
typically consisting of 10,000, 25,000 or 50,000 ETF units.

11) Why do ETFs have low MERs?

The MER is lower because most ETFs are passively invested; therefore, they do not bear the
costs of active portfolio management.

12) The ETF Company and the designated broker are always exchanging shares for ETF units.
What is this process called?

In-kind exchange

13) Outline and briefly describe the 7 key features of ETFs.

• Low cost - ETFs generally have a significantly lower management expense ratio (MER)
compared to other managed products and mutual funds.

• Tradability, liquidity, and continuous price discovery - As with stocks, ETFs enable
investors to buy and sell throughout the day, if the respective exchanges are open. They can
be held on a margin or shorted, and options can trade on them.

• Low tracking error - For ETFs, tracking error is usually defined as the simple difference
between the return on the underlying index or reference asset and the return on the ETF.
Tracking error can be caused by several factors, including the cost to run the fund, cash
drag, and sampling methods.

• Tax efficiency - Index-based ETFs, which make up a large portion of the ETF market, tend
to have lower portfolio turnover.

• Transparency - In Canada, no such regulatory requirement is imposed on ETF providers.

The requirement is the same as it is for mutual funds: top holdings must be published
monthly and all holdings quarterly.
• Low-cost diversification - With a single ETF you can have exposure to a broad range of
stocks, bonds, market segments, and manager styles. You could also hold an ETF that
attempts to mimic the performance of a country or group of countries.

• Targeted exposure - ETFs allow small investors to access a broad range of assets that were
previously difficult and expensive to purchase. Investment opportunities that were once
realistically only available to institutional and other large investors have become open to
everyone.

14) ETFs can trade at a premium to or a discount from their NAV, why do they often not
deviate much from the NAV?

ETFs often don't deviate much from their NAV because of a mechanism called arbitrage.
Authorized participants can create or redeem ETF shares to keep the market price close to
the NAV. This process helps to keep the ETF's market price in line with its underlying assets.

15) List and briefly define the 8 types of ETFs.

• Standard (index-based) - With standard ETFs, the reference index on which the ETF is
based can be either exactly replicated or approximately constructed, depending on the
method used.

• Rules-based - Take a goal-oriented approach. Rather than following a traditional market-

capitalization weighted index, they follow an index focused on the areas of a market that
offer higher returns or lower risks than traditional indexes.

• Active - Construction techniques of the active ETF vary according to the sponsor and its
investment style (e.g., value or growth-based, top-down, or bottom-up, and quantitative or
qualitative). The active portion of a fund is constructed and managed no differently than
any other active mutual fund.

• Synthetic - Differ from other types because they do not hold the same underlying
exposure as the index they track. These ETFs are constructed with derivatives, such as
swaps, to achieve the return effect of the index.

• Leveraged - Use derivatives such as swaps to achieve the leveraged return. The portfolio
transparency of leveraged ETFs is like that displayed in synthetic ETFs.

• Inverse - Can be constructed with derivatives such as swaps to achieve an inverse return
effect. For example, an ETF could be based on a $300 million value swap referring to the
S&P 500.
 • Commodity - Often are not great proxies for the underlying commodity price because of
factors that affect corporate performance and the general movement of the stock market

• Covered call - employ strategies that have long been used by individual investors who
have direct access to the equity and option markets. These strategies enhance the yield and
reduce the volatility of owning the underlying stock or portfolio of stocks the options are
applied against.

16) What is roll yield loss?

It results when a near-term futures contract approaches expiration and is rolled over into a
more distant contract.

17) List and briefly describe the risks of investing in ETFs

• Risk related to tracking error - For ETFs, tracking error is usually defined as the simple
difference between the return on the underlying index or reference asset and the return on
the ETF. Tracking error can be positive or negative, but it is most often negative.

• Concentration risk – It occurs when a small number of holdings make up a

disproportionate amount of the overall ETF value. In such cases, the ETF and underlying
index on which it is based become more sensitive to moves in just a few stocks.

• Risk related to the composition of the ETF - Before recommending the purchase of ETFs to
your clients, you must clearly understand the funds. Otherwise, your clients’ expectations
can diverge significantly from the market performance.

• Risk related to securities lending - Securities lending refers to extending a loan of stocks
for a fee, with the aim of earning additional income for unitholders to partially offset fund
fees. Many equity ETFs are active in the securities lending business. These ETFs lend their
shareholdings to investors who wish to short sell certain equity issues.

18) Using the table below, compare ETFs and Mutual Funds.

ETF Mutual Fund

Management Style They consist mainly of passive funds, They consist of mainly active
with some active funds. funds, with some passive
funds.
Transparency of Holdings Most ETFs provide full transparency. Most mutual funds limit
disclosure of holdings to
once a month; typically
focusing on the top 10
holdings.
Cash Drag Flow Management They can handle large infusions of They need time to work new
 cash without suffering from cash money into the market and
drag. tend to keep some cash on hand
to fulfill redemption requests.
Embedded fees Management and trading expenses Management and trading
tend to be lower because most funds expenses tend to be higher
are passive. because most funds are active.
Advisor Compensation The client pays a commission to the In addition to load charges,
dealer. Most ETFs do not provide investors may have
trailer fees for the advisor. embedded compensation for
the advisors, which is part of
the MER. An exception is the
F Class version of mutual
funds.
Distributions They are bought and sold like stocks They are purchased and
in the secondary market during the redeemed directly from the
trading day. In some circumstances, mutual fund at the end-of-
ETFs can trade at a significant day’s NAV per unit. This is
premium or discount to the NAV. considered a primary market
transaction because units go
directly between the investor
and the mutual fund. Mutual
funds do not trade at a
premium or discount.
Tradability They can be held in a margin account They can be held in a margin
and sold short. ETFs trade throughout account. Mutual funds
the day and investors can use special cannot be sold short, do not
orders such as limit and stop loss trade during the trading day,
orders. and special trading rules do
not apply.
Minimum Investment ETFs can be purchased in single units Mutual funds can be
(though the spread may be slightly acquired for as little as $500.
higher).
Pre-Authorized Contributions Only a few ETFs offer PACs and SWPs. Most mutual funds offer
and Systematic Withdrawal Most ETFs allow only full units to be PACs and SWPs. Mutual
Plans purchased or redeemed, which funds can buy and sell partial
makes it harder to set the specific units, and so a regular dollar
dollar value for PACs and SWPs. value can be easily set.
Dividend Re-Investment Only some ETFs offer dividend Most mutual funds offer a
reinvestment plans. Where offered, dividend reinvestment plan.
the reinvestment must be made in The purchase of partial units
full units. is common.
Liquidity The volume traded on an ETF is not a Mutual funds simply trade at
measure of liquidity. ETFs are simply the end of the day at the
a basket of securities. If the NAVPU of the fund.
underlying securities are liquid, then
so is the ETF.
Tax Efficiency They are more tax efficient because They are less tax efficient
of the lower portfolio turnover. because of the higher
 portfolio turnover.
Redemption of units might
trigger capital gains if enough
investors redeem units,
forcing the manager to sell
off securities to raise cash.
Tracking Error There is a potential for tracking error, There is a potential for
but ETFs generally have a lower risk. tracking error, and mutual
funds generally have the
higher risk.
19) In what two ways can ETF investments in Non-registered accounts generate taxable
income?

On distributions from the ETF fund and on the proceeds of a sale of the ETF.

20) What are the three types of ETF distributions and how are they taxed?

• Dividend and interest distributions - For Canadian residents, distributions from Canadian
companies qualify for a lower effective tax rate than those of non-Canadian companies.

• Capital gains distributions - The CGRM is a formula devised to prevent double taxation of
capital gains in a mutual fund or ETF.

• Non-taxable distributions - In some cases, an ETF may distribute an amount that is not
taxable to the investors, such as a return on invested capital (ROC), for example. However,
such a distribution decreases the ACB of the investor’s units. If the investor were to sell the
ETF units, the lower ACB would increase the amount of any capital gain that would
otherwise be realized on the sale.

21) List and briefly describe the 6 ETF investing strategies.

Core and satellite portfolio construction Core holdings are typically passive ETF
holdings intended to provide most returns;
satellite holdings are more focused on
riskier sector ETF holdings. Satellite holdings
are used to boost returns above the core
asset returns.
Rebalancing ETFs can provide a simple and liquid way to
rebalance the asset allocation without
affecting the core portfolio holdings. A small
allocation to domestic and international
equity and fixed-income ETFs provides an
efficient way to rebalance the asset class
 when needed.
Tactical asset allocation Investment managers can use ETFs as a tool
to gain quick, diversified exposure to the
targeted asset class, while instantly exiting
the previous holding. With today’s vast
choice of ETFs, investors and advisors can
use them as the primary tool to implement
tactical shifts in a portfolio.
Cash management ETFs allow investors to temporarily park
their money in the stock market until they
make a long-term investment decision.
Exposure to once hard-to-access markets With ETFs having expanded into offering
hard-to-access classes, new levels of
portfolio optimization have become
available.
Tax loss harvesting ETFs are useful in harvesting tax losses on an
investment; they can be used to maintain
exposure to a sector while respecting
Canada Revenue Agency’s superficial loss
rules. If the ETF purchased is not identical to
an asset sold, the ETF can be used as a
substitute for the asset. (Superficial loss
rules are covered in a later chapter in this
course.)

22) List and briefly describe each of the newer variations of ETFs (pg. 19-23)

• Standard (index-based), whereby the reference index on which the ETF is based can be
either fully replicated or approximately constructed through sampling

• Rules-based, which are constructed based on a defined methodology to achieve a specific

objective

• Synthetic, which are constructed with derivatives such as swaps to achieve the return
effect of the index

• Leveraged, which use derivatives such as swaps to achieve the leveraged return