Etfs Course 02

8/3/2019 Etfs Course 02

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Course #: Title

Version 1 March 2011 1

Topic 1: ETF features ................................................................................................................. 3Index tracking ......................................................................................................................... 3

Trades at NAV ........................................................................................................................ 4Open-ended ............................................................................................................................ 4Exchange traded ..................................................................................................................... 4

Topic 2: How ETFs are created .................................................................................................. 5Primary and secondary market ............................................................................................... 5How are ETFs created? .......................................................................................................... 5What happens to the underlying securities? ............................................................................ 5ETF redemption process ......................................................................................................... 5ETFs are open-ended ............................................................................................................. 6

Topic 3: Understanding Net Asset Value (NAV).......................................................................... 7Market price vs. NAV .............................................................................................................. 7How is the NAV calculated? .................................................................................................... 7Where can I find the NAV?...................................................................................................... 7What keeps the market price in line with the NAV? ................................................................. 7Arbitrage ................................................................................................................................. 8Market price vs. index level ..................................................................................................... 8

Topic 4: ETFs - cost and tax efficient ........................................................................................ 10Low management costs ........................................................................................................ 10Tax efficient .......................................................................................................................... 10

Topic 5: ETF strategies ............................................................................................................ 12Instant diversification ............................................................................................................ 12Core plus satellite ................................................................................................................. 12Geared exposure .................................................................................................................. 13Adjust asset allocation .......................................................................................................... 13

Summary .................................................................................................................................. 15

Course 2

What are ETFs?


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Course 2: What are ETFs?


Information provided is for educational purposes and does not constitute financial product advice. Youshould obtain independent advice from an Australian financial services licensee before making anyfinancial decisions. Although ASX Limited ABN 98 008 624 691 and its related bodies corporate (ASX)has made every effort to ensure the accuracy of the information as at the date of publication, ASX doesnot give any warranty or representation as to the accuracy, reliability or completeness of the information.

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Topic 1: ETF features

An Exchange Traded Fund (ETF) is adiversified portfolio of securities that is tradedon ASX.

ETFs:

track a sharemarket index trade at or very close to the underlying

net asset value are open-ended are bought and sold on ASX.

Let's look at each of these features.

Index t racking

ETFs are index funds. Their price moves inline with the index they track.

Underlying indicesETFs are available over Australiansharemarket indices and internationalindices.

The underlying index could be a broadmarket index such as the S&P/ASX 200index in Australia, or the S&P500 index in theU.S.

It could be a sector index such as theS&P/ASX 200 Resource Index, which reflectsthe performance of listed resourcecompanies. Or it could be an index createdwith a specific aim such as achieving acertain income yield.

Exchange traded commodities (ETCs), which

are a variation of ETFs, give you exposure toprecious metals such as gold.

Accurate price trackingAn ETF's price tracks the underlying index.

ETFs are 'passively managed'. Their aim isto replicate the performance of the specifiedsharemarket index. The ETF manager's jobis to ensure the fund's holdings generallymatch the composition of the index.


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In contrast, actively managed funds aim tooutperform a specified benchmark. The fundmanager constructs a portfolio that variesfrom the composition of the index in anattempt to achieve outperformance.

Trades at NAV

The price of an ETF should be at or veryclose to its net asset value (NAV).

The NAV reflects the market value of theunderlying portfolio of shares, adjusted forthe fund's fees and expenses and expressedon a per unit basis.

Open-ended

ETFs are open-ended.

The number of units in the fund is not fixed.The ETF issuer can create or buy back(redeem) units in response to demand frominvestors.

The open-ended structure is one reason whyETFs track the NAV. (This is discussedfurther in Topic 3.)

In contrast the number of units on issue in aclosed-ended fund is fixed. Investor demandcan result in the unit price trading at asignificant premium or discount to NAV.

Exchange traded

ETFs are traded on ASX.

You buy and sell through your stockbroker atany time during ASX trading hours, just as

you buy and sell ordinary shares. You cannotbuy ETFs directly from the issuer.

Settlement of the trade takes place threebusiness days after the transaction (T+3).You receive a holding statement, just as youdo when you buy shares.


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Topic 2: How ETFs are created

Primary and secondary market

You cannot apply for ETFs in a float.

ETFs are issued on the primary market toauthorised participants. These participantscan create and redeem units in an ETF.

You can only buy ETFs on the secondarymarket (ASX).

How are ETFs created?

The authorised participant applies to theissuer for units in the ETF.

Instead of paying cash for these units, theauthorised participant delivers a basket ofsecurities equal to the value of the ETFs.

The basket of securities to be deliveredreflects the composition of the indexunderlying the ETF.

Once the issuer creates the new units, the

authorised participant is able to sell them tobuyers on ASX.

What happens to the underlying securities?

When ETFs are created, the underlyingsecurities are transferred to a custodian, whois responsible for holding them.

The custodian is appointed by the issuer ofthe ETF, but is independent from the issuer.

ETF redemption process

Authorised participants can also apply to theissuer to redeem ETFs.

The redemption process works in theopposite way to the creation process.

The authorised participant transfers ETFs tothe issuer, which in return delivers a basket

of the underlying securities to the authorisedparticipant. The issuer then cancels theETFs.


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The process of creating and redeeming ETFsin exchange for the underlying securities iscalled an 'in-specie' or 'in-kind' process.

ETFs are open-ended

In Topic 1 we said that ETFs are open-ended, meaning the number of units on issuecan be increased or decreased in responseto demand from investors.

If the existing supply of ETFs is insufficient tomeet investor demand, authorisedparticipants can apply to the issuer for newunits to be created, and then sell those unitson ASX.

If the supply of ETFs is more than is neededto meet investor demand, authorisedparticipants can redeem units, reducing thenumber on issue.

The open-ended structure of an ETF helpsensure that its market price stays at, or veryclose to the NAV. This is explained fully inTopic 3.


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Topic 3: Understanding Net Asset Value (NAV)

Market pr ice vs. NAV

The market price of an ETF and its net assetvalue (NAV) are two different things.

The market price is the price the ETF tradesat on ASX.

The NAV is the total value of the assets inthe ETF (adjusted for fees and expenses),divided by the number of issued units.

However, an ETF's market price should be at

or very close to the NAV. This ability toclosely track the NAV is a fundamentalfeature of ETFs.

How is the NAV calculated?

The NAV is the total value of the assets inthe ETF (adjusted for fees and expenses),divided by the number of issued units.

Where can I find the NAV?

The NAV of most ETFs is published daily.

Issuers generally publish the NAV of theirfund on their own website, or via CompanyAnnouncements on the ASX website.

A limited range of ETFs over Australianindices provide an indicative NAV (iNAV) thatis continually updated during the trading day.You can find this on your broker's website bytyping the letter 'Y' in front of the ASX code

for the ETF. For example, YSTW will returnthe iNAV for the ETF with the code STW.

What keeps the market price in line with theNAV?

The price of an ETF rarely deviates muchfrom its NAV.

If the price of an ETF moves out of line withthe NAV, this presents an arbitrage

opportunity to authorised participants andprofessional traders.


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Arbitrage is a technique used by professionaltraders to take advantage of perceivedmispricing and earn profits.

Let's look at how this works.

Arbitrage

Assume the price of an ETF drops below theNAV. This is because demand has droppedrelative to current supply.

An authorised participant can:

buy ETFs on ASX deliver them to the issuer in exchange for

the underlying securities, then

sell the securities on ASX.

The difference between the price paid for theETFs and the amount received for selling thesecurities on market is the arbitrageur'sprofit.

Buying the ETF will push up the price of theETF until it is again in line with the NAV.

What if the price of an ETF is significantly

higher than the NAV?

An authorised participant can:

buy the underlying securities on ASX deliver them to the issuer in exchange for

new ETFs, then sell the ETFs on ASX.

In this case the difference between the pricepaid for the securities and the amountreceived for selling the ETFs on market is thearbitrageur's profit.

Selling pressure will push down the price ofthe ETF until it is again in line with the NAV.

Market pr ice vs. index level

It's important to understand that an ETF'sprice is not necessarily 'equal to' the level ofthe underlying index.


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For example, on 14 October 2010 theS&P/ASX 200 index closed at 4699.1 points.The SPDR 200 ETF (ASX code: STW), anETF that tracks the S&P/ASX 200, closed at$44.64.

What matters is that in percentage terms, achange in the level of the index will result in asimilar percentage change in the price of theETF.


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Topic 4: ETFs - cost and tax efficient

ETFs offer cost and tax efficiencies, due tothe way they are structured.

Low management costs

Fund managers charge a fee to manage afund. This is sometimes called theManagement Expense Ratio (MER).

ETFs are passively managed index funds.The fund manager's sole task is to ensurethe fund's holdings match the composition ofthe index, so their MERs tend to be low.

For example, the SPDR S&P/ASX 200 Fund,which tracks the S&P/ASX 200 index, has anMER of around 0.29% per annum.

The Vanguard US Total Market Shares IndexETF, which tracks the MSCI US BroadMarket Index, has an MER of around 0.09%per annum.

Fees and costs are explained in detail inCourse 3.

Tax efficient

Low portfolio turnoverWhen an ETF issuer buys or sells shares, itmay make a capital gain or loss.

At the end of each tax year, these capitalgains/losses are passed on to you the ETFholder in distributions, and are thenassessable in your hands.

The fund manager usually only buys or sellssecurities to rebalance the portfolio in linewith changes to the composition of theunderlying index.

As a result, the fund realises few capitalgains or losses, minimising the tax impact oninvestors in the fund.

Capital gains/losses made by the fund areseparate from any capital gain or loss you

make when you sell your ETFs.


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On-market sales do not affect remaininginvestors.An investor disposes of their ETFs by sellingon ASX.

The sale has no impact on other ETF

holders.

Compare this with investments which areredeemed by the issuer, such as unlistedfunds. To pay out the investor, the fund mayhave to sell some of the fund's underlyingsecurities. This may crystallise capital gains,which can result in a capital gains tax liabilityfor remaining unitholders in the fund.


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Topic 5: ETF strategies

You can use ETFs in a number of ways,including:

instant diversification core plus satellite geared exposure adjust asset allocation.

Let's take a look at these applications indetail.

Instant diversification

An ETF provides exposure to all the stocks inthe underlying index, giving you instantdiversification, no matter how small yourinvestment.

Having your money spread across a range ofshares can decrease your overall risk, as itreduces the impact on your portfolio if one ortwo companies perform poorly.

Core plus satellite

The core plus satellite approach has twoelements:

a core portfolio that produces returns inline with the market, and

one or more investments the investorthinks will outperform the market(satellites).

The investor looks to the satellites to boostoverall returns by taking advantage of

opportunities, but relies on the core togenerate market returns.

An important consideration in this approachis that you achieve your core returns at lowcost - you don't want to pay high costs simplyto achieve market returns.

ETFs typically serve as the 'core' investment.


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For example, you could buy ETFs that trackthe performance of the S&P/ASX 200 indexas the core of your portfolio, producingmarket returns at low cost.

The satellites could be individual shares you

think will outperform the market, or activelymanaged funds.

You can also use ETFs as satellites.

If you think a particular sector will do well,you could buy ETFs that give you exposureto that sector.

Or you might have a view that an overseasmarket will perform strongly, and buy ETFs

that track the overseas market's index.

Geared exposure

You can use ETFs as part of a gearedinvesting strategy such as margin lending.

ETFs are generally on the list of 'approvedproducts' against which margin lenders willlend you money.

Using borrowed funds to invest in ETFs canincrease your returns if the ETF performswell. However, you will suffer increasedlosses if the ETF performs badly.

Adjust asset allocation

In Course 1 we looked at the importance ofasset allocation - the way you spread yourmoney between asset classes such as:

Australian shares international shares property bonds, and cash.

Your asset allocation has a significant impacton your investment returns.

From time to time you may want to adjustyour asset allocation - for example changingyour exposure to equities.


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ETFs enable you to easily adjust yourweighting to the sharemarket, or a sector ofit, in one transaction - buying ETFs toincrease your exposure, selling to decreaseit.


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Summary ETFs track a sharemarket index, either a

broad market index or a sector index.

They are created by the issuer, and thencan be traded on ASX.

ETFs are open-ended funds. The issuercan create or redeem units in response toinvestor demand.

An ETF generally trades at or close to thenet asset value, which is the value of thesecurities underlying the ETF. Arbitrageactivity ensures that the ETF price remainsin line with the NAV.

ETFs offer cost and tax efficiencies,due to the way they are structured.Because they are passively managed

index funds, management costs tendto be low.

You can use ETFs in a number ofways, including:

- to achieve instant diversification

- as part of a 'core plus satellite'approach

- as part of a geared investingstrategy

-

to adjust your asset allocation.

Documents

Etfs Course 02