CFA Series - ETF opportunities and risks

ETF opportunities and risks

One great thing about studying for the CFA is that you can tie the curriculum syllabus to real life examples and observe the motion in progress. I had a tendency to put in considerably more time and effort to studying certain topics like Real Estate (and REITS) , corporate finance, Equity investing and ETFs compared to the other topics combined.  As an enthusiast in ETF investing, I have significant holdings in STI ETF and is eager to gain knowledge and exposure to global ones.

One key limitation about the CFA is that it is only good at explaining historical examples and is backward looking. Elaborate discussions about macroeconomic models and DCF will not be able to explain the implications of QE and negative interest rates, and the appropriate discount rates to apply. Howard Marks Latest <Mysterious> Memo
explores the implications of negative I/R on risk seeking behavior, and inverted relationships whereby historical models may no longer predict future financial trends. Although I am nowhere as astute as the best investors, I will try to analyse the key points I will look out for in a ETF and how to avoid the lemons.

Image result for etf creation and redemption

ETF Arbitrage (
Redemption / Creation Process)
1) ETF issuer designates authorized participant (broker dealer as market maker). ETF issuer permits him to create new ETFs / Redeem new ETF for a fee. ETF issuers will disclose basket of securities daily. 

2) When the ETF is trading significantly over its NAV (beyond arbitrage gap)
Goldman will buy underlying basket of securities and go to the issuer to create new ETF shares. The ETF shares will be sold to the underlying client at a profit. 

3) When the ETF is trading significantly below its NAV (beyond arbitrage gap)
Goldman will buy the undervalued ETF shares and redeem for basket of securities. The underlying securities are worth more than the ETF wrapper.

Why ETF over managed funds
1) Lower transaction cost for ETF issuer. Compared to closed and managed funds, the ETF issuers need not buy / sell the ETF shares, only the AP will do so and profit from the bid offer spread.

2) Better tax efficiency. If there are less transactions, there is less capital gain taxes to be made. (Applicable to most countries outside Singapore)

3) Natural market mechanism to close arbitrage gap (Price band around NAV). Nonetheless for REITS and bonds-based ETF with underlying less liquid securities, the arbitrage gap will be greater.

4) Tax fairness. Only the transacting investors will incur the trading fees through the bid offer spread. Long term investors do not pay for those who frequent trade in and out.

How to choose a good ETF

Sources of Tracking difference

1) Find funds with minimal Rolling Holding Period (ETF Expense ratio)
=> Cumulative effect of portfolio management and expenses over time

2) Find funds with minimal tracking difference
=> Divergence between ETF return and return of tracked index (Vietnam ETF). Sampling vs Full replication methodology can bring about significant divergences

=> Illiquid and small cap have higher transaction cost and increase expense ratio. The more well-known ETFS will lead to a natural large cap and liquid security bias.

=> Certain ETF use other ETFs, Depository receipts as its constituents. Tracking error of micro components will be aggregated in the ETF wrapper.

3) Tracking error (Annualized standard deviation of daily tracking difference

4) Change in Index constituents
When index has changes in its constituents, there will be significant buying and selling of the underling companies to reflect the new constituents. There might be a momentum impact on underlying shares when the ETF is trading at a discount (Tencent and Hang Seng Index), or when new constituents are included (Ascendas REIT) or dropped out (Starhub) of the index. The recent proposed acquusition of Keppel by TH has noticable impact on the STI ETF. There might be a potential strategy of picking Mid Caps before they are included in the index.

5) Regulatory and tax requirements
Certain proficient ETF issuers will have special contracts to reduce the capital gain taxes and Dividend withholding taxes. (Irish domiciled S&P500)

6) Fund accounting practices
Fund accountants may have timing issues when accounting for the NAV of the ETF, in its timing of slightly dated securities values among different countries, and exchange rates.

7) Asset management operations
More larger fund managers will have securities lending programs or collateralized holdings with broker dealers to earn side income for its holdings.

Unfathomable risks (Not explored in conventional finance)
1) Counter-party risks in ETF / and failure of Broker-Dealers
Considering the interwoven relationships between ETF issuer and key market makers, if there is liquidity issue in financial markets, and failure of ETF issuer and key broker dealers, the survivability of the ETF (and subsequent liquidation) will be difficult to phantom.

2) Large and quick devaluation of large caps
Large cap companies which encounter a fast and immediate crisis, will immediately affect the valuation of the ETF. If the company is removed from the ETF, there will be significant volatility in financial markets and money flows due to this.

3) Size bias towards large caps neglecting small caps
Since the structure of ETFs favour large caps which are illiquid, there will be small caps and illiquid stocks that may be neglected by the market. Value investing may seemingly fail due to money flowing mindlessly into large caps regardless of its merits. There might be under-loved holdings that are neglected by the market if the investor is willing to play the long game.

4) ETFs with holdings of illiquid securities
Sector ETFS, flavor of the month ETF, leveraged and derivative based ETF, and crypto ETFs may have significant illiquid holdings. This will lead to liquidity issues when the market maker conducts the creation / redemption mechanism and transactions costs will be high. 

5) Political and regulatory changes in key countries
Country based ETFs will have significant issues with key political and regulatory changes to the government, especially if there are wars, financial restrictions, and severing of key relationships with global markets.


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