A Ten Step Guide To ETF | Exchange Traded Funds

A ten-step guide to Exchange Traded Funds

Understanding ETFs

Which market segments do ETFs cover?

What kinds of indices do ETFs track?

How to reduce interest rate and currency risks?

Since the first exchange traded funds (ETFs) were listed in North America over two decades ago, ETFs have become one of the most significant financial innovations of all time. ETFs combine the structure of a traditional savings vehicle—the mutual fund—with real-time pricing on stock exchanges, offering many different kinds of investors a powerful tool. The use of ETFs became widespread during the 2000s and has recently accelerated. During the summer of 2015, ETF assets under management worldwide surpassed USD 3 trillion for the first time.

The rising inflows into ETFs are a consequence of the key benefits of this type of fund structure: trans- parency, liquidity and low cost. Most ETFs have the objective of replicating the performance of an index, before fees and costs. This enables investors to buy the market, a market segment or strategy at the click of a button, creating instant exposure to a diversified portfolio of underlying securities.

As tradeable funds, ETFs are listed on exchanges around the world, enabling investors and traders to enter and exit positions at dealing prices set freely by the interaction of other market participants.

The fees for ETFs  are  often  significantly  lower than the annual management charges levied by traditional investment vehicles, making them a popular choice in an age of cost-consciousness and low returns.

ETFs have a wide range of uses, from acting as core holdings in long-term savings plans, serving as a useful tool for making tactical asset allocation changes and permitting investors to take short-term views on market movements.

Recent product enhancements have enabled investors to access many markets on an interest rate-hedged or currency-hedged basis via ETFs. Additionally certain ETFs offer exposure to markets on an inverse or leveraged basis, enabling investors to tailor their portfolio risk profiles more effectively.

Our objective in publishing this ten-step guide is to outline the key features of ETFs comprehensively, accurately and in plain language. We explain what ETFs are, how they work, which market segments they cover, how much they cost and how investors can use them to their best advantage.

For those seeking more detailed product information, please refer to the db X-trackers ETF website or speak to one of our specialists. As always, investors should consult an investment or tax advisor.

Step 1 ETFs – a rapidly growing market

Exchange Traded Funds
Exchange Traded Funds

Global ETF assets and ETFs’ share of the mutual fund market

During the last decade, the ETF market’s global growth has accelerated, with total ETF assets exceeding USD 500 billion in 2006, USD 1 trillion in 2009, USD 2 trillion in 2013 and USD 3 trillion in 2015. The compound annual growth rate of assets under management in ETFs between 2002 and June 2016 was over 25 percent per annum.

ETFs are a relatively recent innovation. The first ETF, the Toronto Index Participation Fund, was launched in Canada in 1989, followed by the first US ETF, the Standard and Poor‘s Depositary Receipts (SPDRs) on the S&P 500, in 1993. The first Asia-listed ETF, based on the Hong Kong Hang Seng index, followed in 1999, and the first European ETF, tracking the Euro STOXX 50 index, was listed in 2001.

As a result of the steady growth of interest amongst investors, ETFs have gained a steadily larger share of the global mutual fund market. Mutual funds are still the predominant form of collective savings vehicle, and their assets under management worldwide rose from USD 7.9 trillion in 2002 to USD 31.3 trillion at end-20151.

But ETFs’ faster growth rate meant that ETF assets have risen from a 2% share of global mutual fund assets in 2002 to over 9 percent at end-2015. (see Step 2 for a description of the key differences between ETFs and traditional mutual funds)

    ETFs by region

ETFs are listed on stock exchanges around the world, enabling investors in different regions to access a variety of asset class exposures. The US is the largest regional ETF market, measured by assets under management, with 1,655 locally listed ETFs and USD 2.2 trillion under management at the end of

June 2016. Europe is the world’s second largest ETF market, with 1,559 ETFs and USD 502 billion under management at the same date. The Asia-Pacific and Japanese ETF markets each have over USD 100 billion in assets, while Canada and Latin America also offer local investors a wide variety of ETF listings.

Global ETP assets by asset class/exposure

The first ETFs were equity market trackers, and equity ETFs remain the most popular form of exchange-traded product (ETP)2, representing 73.6 percent of the global market by assets under management in June 2016.

Fixed income ETFs have recently grown in popularity and totalled 17.9 percent of the global ETP market by assets at the same date. Commodity trackers, active ETFs, inverse (short) and leveraged ETFs and other asset classes (currencies, alternatives) represent the remaining 8.5 percent of the global ETP market.

European ETP assets by asset class/exposure

In Europe, fixed income ETFs have a larger market share, with 25.9 percent of regional ETP assets under management as of June 2016. With 8.3 percent of regional assets, Commodity ETPs also have a larger share of the European market than on a global basis.

Step 02 What are ETFs?

How a collective investment scheme NAV is calculate

An ETF is a type of mutual fund that is listed for trading on a stock exchange. A mutual fund is a legal structure designed for collective investment. Mutual funds are typically open-ended, meaning that their total number of shares in issue is variable. They create fund shares (or redeem them) to reflect demand and supply from investors. In this way, the price of a single share of a mutual fund reflects its net asset value (NAV). Traditionally, mutual funds have not been traded on stock exchanges. Instead, investors’ orders to transact in mutual fund shares are placed with the fund issuer at a set frequency, typically daily or weekly. Deals are struck on the basis of the fund’s NAV.

Another pooled investment scheme is an investment trust, a popular structure since the 19th century and now found mainly in the UK market. A typical investment trust has a fixed (rather than variable) number of shares in issue and is therefore referred to as closed-ended. Legally, investment trusts are companies and, like the shares of individual corporations, they are listed on stock exchanges, enabling investors to buy and sell them throughout the trading day.

ETFs combine the desirable features of mutual funds and investment trusts

Investment trusts cannot expand or contract their share capital to reflect investor demand. Therefore, new purchases of investment trust shares are likely to push up their market price. This can cause the price of an investment trust’s shares to exceed the trust’s NAV per share—a situation referred to as the trust’s shares trading at a premium to NAV. The opposite situation occurs when net selling pushes the invest- ment trust’s shares to a discount.

ETFs can be seen as a hybrid between an open-ended mutual fund and a share (see the table). ETFs’ intraday tradeability grants investors and traders significant extra flexibility by comparison with the fixed dealing window of a mutual fund. At the same time, ETFs’ unique creation and redemption mechanism.

As mutual funds, ETFs comply with the relevant regulations in the jurisdictions in which they are domiciled. Most US ETFs, for example, are compliant with the 1940 US Investment Company Act, the guiding rule for the US mutual fund market. The Investment Company Act sets minimum standards for funds’ liquidity, pricing, structure and governance. Similarly, in Europe, most ETFs comply with the EU-wide “Undertakings for Collective Investments in Transferable Securities” (or “UCITS”) rules. UCITS provides a secure, well-regulated framework for retail collective investment schemes by setting minimum standards for investable assets, liquidity, pricing and disclosure.

ETFs often offer greater transparency than the minimum standards set by regulators. While mutual funds and investment trusts may disclose their portfo- lio holdings only quarterly or half-yearly, most ETF issuers  voluntarily disclose their funds’ constituents daily via their websites.

Step 03 How do ETFs work?

How ETF shares are created and distributed

If a trade in an ETF takes place at a price that differs from the ETF’s net asset value, this could create an arbitrage opportunity from which professional traders may benefit. In other words, the market effectively ensures that an ETF’s price remains close to its under- lying net asset value.

The functioning of an ETF depends on a group of dealers authorised to transact directly with the ETF issuer in the so-called primary market. These dealers are called authorised participants (or “APs”).

Creations of fund shares occur when the AP supplies a specified basket of securities (called the creation basket) to the ETF issuer and receives ETF shares in return. These transactions may also occur as an exchange of cash for ETF shares.

In an ETF redemption, the reverse transaction occurs: the AP requests a redemption basket from the ETF issuer and supplies a set number of ETF shares to receive it and again may alternatively receive cash. The composition of the creation/redemption basket and the minimum basket size is set by the ETF issuer.

The secondary market of an ETF is where dealers and other market participants interact, whether on stock exchanges, other regulated trading venues or in the bilateral (“over the counter” or “OTC”) market. Investors can use different types of orders to trade in ETF shares (see Step 7), for example by transacting at the best available market price or by using a limit order.

The way ETF shares are distributed from the ETF issuer to investors via the primary market (which links the ETF issuer and APs) and the the secondary market (which links APs and investors) is illustrated in the diagram.

ETF price and the fair value band

The creation/redemption mechanism of an ETF plays another vital role. Since an ETF’s shares are freely traded in the secondary market, a prevalence of buyers over sellers could push the share price upwards, potentially exceeding the net asset value of each share. Similarly, an excess of sellers could push the ETF share price to a discount to its NAV.

If such a premium or discount occurs, it is likely to be ironed out quickly by arbitrageurs, as noted above.

If the ETF’s shares are trading at a premium to its NAV, the AP can buy the ETF’s underlying securities, supply them as a creation basket to the ETF issuer, receive ETF shares in return and sell them in the market for a risk-free profit. These transactions have the overall effect of bringing the ETF’s secondary market price back into line with its NAV.

Similarly, if an ETF’s shares are trading at a discount to its NAV, the AP can sell the ETF’s constituent securi- ties, buy ETF shares in the open market, exchange the ETF shares for the redemption basket and again end up with a risk-free profit. In turn, the ETF’s price is brought back into line with its NAV, this time from below.

ETF arbitrage is possible only when the fund’s price moves by more than a certain amount above or below its NAV. The width of this so-called no-arbitrage or fair value band reflects the costs of creating or redeeming the ETF, including the bid-offer spreads on the underlying securi- ties, any creation or redemption fees set by the issuer, transaction taxes (where applicable) and hedging and inventory costs. The ETF’s price in secondary market trading tends to move freely within this fair value band (see the diagram).

Any costs involved in creating or redeeming ETF units are therefore borne seamlessly and indirectly by those buying or selling ETFs in the secondary market. This design feature of ETFs represents an enhancement to the traditional mutual fund structure, since mutual fund issuers face the ongoing challenge of allocating portfolio transaction costs fairly between entering or departing investors and those remaining in a fund.

Step 04 Which market segments do ETFs cover?

Equity ETFs (73.6% of global ETP assets under management)

ETFs offer instant access to a wide range of markets, market segments, strategies and styles.

With nearly 6,000 ETFs and other exchange-traded products in existence worldwide at the end of September 20155, investors have a large selection of ETPs to choose from. These offer global, regional and country asset class exposure, as well as access to sectors, strategies and styles.

Most ETFs (and other ETPs) aim to track, before costs, the return on an index or a particular reference price (such as the price of a commodity or an exchange rate). A few ETFs, called active ETFs, representing 1.1% of global ETP assets under management, dispense with a benchmark and aim to outperform their rivals via manager skill.

Regulatory requirements ensure that the indices followed by index-tracking Exchange Traded Funds are subject to minimum diversification requirements. In many cases, particularly with broad market ETFs, the index underlying the fund may include thousands of shares or bonds.

ETFs‘ ability to provide low-cost, flexible, one-stop exposure to different asset classes makes them an increasingly popular tool in the construction of long- term portfolios and savings plans. ETFs’ tradeability also ensures their suitability for shorter-term, tactical asset allocation changes.

By asset class, the major categories of exchange- traded product are as follows.

 Step 05 What kinds of indices do ETFs track?

The types of indices tracked by ETFs vary in design, making index due diligence essential.

Almost all ETFs are index trackers, meaning that a fund’s performance objective is to replicate, as closely as possible (before product fees), the return on the index specified as the ETF’s benchmark.

Although there are many common features amongst indices, there is no such thing as a standard index construction methodology. Over time, indices’ uses have changed significantly. Early stock market indices, such as the Dow Jones Industrial Average, created in 1896, or the Financial Times 30 index, created in 1935, were intended primarily as informa- tion tools—measures of market sentiment.

From the 1970s onwards, some investment managers decided to track, rather than trying to outperform, market indices. Although indexing was initially viewed by many investment professionals as a gimmick, so-called passive (index-tracking) funds were offered at a significantly lower cost than traditional active funds, helping ensure index funds’ popularity. Passive investing has picked up momentum ever since, with steadily increasing inflows into tracker funds, including ETFs.

The standard type of benchmark tracked by index funds and ETFs is a capitalisation-weighted (also called market-weighted) index, in which the weigh- ting of each constituent is proportionate to its market capitalisation.

Several popular funds in the db X-trackers ETF range track capitalisation-weighted indices, such as the Euro STOXX 50, DAX, MSCI Europe and MSCI Japan equity indices.

Since the 2000s, there has been growing interest in alternative index construction methods. So-called strategic beta (also called “smart” or “alternative” beta) indices use different methods to select and weight their constituents. For this type of Exchange Traded Funds, the index can be seen as a pre-packaged, rules-based investment strategy, aiming to produce a different risk/return outcome to that of the capitalisation- weighted index.

As the index underlying an ETF represents the investment strategy of the fund, it is important that investors review the following questions when considering a fund purchase:

—         how does the index select its constituents?

—         how does the index weight its constituents?

The selection procedure used by the index provider may be straightforward (for example, the largest 50 eurozone stocks) or more complex (for example, if a quantitative strategy is used). The weighting methodo- logy may vary from capitalisation-weighting to weigh- ting equally, by yield, by factor exposure or risk model.

No index is entirely passive: index providers reconstitute their indices at regular intervals according to published rules. Capitalisation-weighted indices have minimal levels of turnover (often just a few percent a year), incurred when companies cross the size threshold for inclusion or exclusion. But some strategic beta indices can be more active, with potential implications for a tracker product’s cost and tracking ability.

To help investors perform their index due diligence, ETF issuers provide information about their funds’ underlying indices in documents such as the fund prospectus, factsheets, annual reports and (in Europe) Key Investor Information Documents. Index providers’ websites also offer educational materials.

Step 06 What do ETFs cost?

ETFs have a significant cost advantage over many traditional collective investment vehicles. For a full comparison with other products, investors should consider their total ETF holding costs.

The costs incurred by an investor in ETFs fall into two principal categories: recurring (ongoing),

deducted daily from the fund’s net assets and usually expressed on an annual basis6; and one-off transac- tion charges, incurred when buying and selling the Exchange Traded Funds.

For a long-term holder of an ETF, the annual charges levied by the ETF issuer are of primary importance. For more frequent traders, one-off transaction charges may be more relevant.

ETFs still have a considerable cost advantage over actively managed mutual funds, a key reason for ETFs’ growing market share.

At the end of 2014, the asset-weighted average total expense ratio for US index-tracking equity ETFs was around a third that of equity mutual funds, while the asset-weighted average total expense ratio for US index-tracking fixed income ETFs was less than a half that of fixed income mutual funds.

In Europe, the cost differential in favour of ETFs is even starker. Based on end-2014 data, the asset- weighted average total expense ratio for index- tracking equity ETFs was 22% that of equity mutual funds, while the asset-weighted average total expense ratio for index-tracking fixed income ETFs was 32% that of fixed income mutual funds.

In many countries, mutual fund issuers also levy an initial charge (called a front-end load or sales fee) on purchasers, and sometimes a redemption fee on fund sellers. This represents an additional cost headwind for mutual fund holders.

Investors in ETFs face transaction costs when buying and selling fund shares. Transaction costs include the bid-offer spread on the ETF and (where applicable) brokerage commissions and transaction taxes.

The bid-offer spread on an Exchange Traded Funds reflects the liquidity of the underlying securities held by the fund. For example, the secondary market spread on an ETF tracking a popular equity index is likely to be lower than the spread on an ETF tracking an index of emerging market equities or corporate bonds.

For the most liquid ETFs and in normal market conditions, bid-offer spreads can often be a fraction of the average bid-offer spread on the underlying securities held by the fund. This is because popular ETFs attract a great deal of trading activity in their own right.

Example: total cost of ownership

Investors should consider the total cost of ownership over their likely holding period when assessing an ETF purchase. The total cost includes the tracking difference created by the ETF’s total expense ratio, the efficiency of the portfolio management and tax considerations, returns from securities lending or swap enhancements, as well as the bid-offer spread on the units. The tracking error is best understood as the consistency of the fund’s tracking of the benchmark index.

In the example below we assume that an investor buys an ETF with a TER of 15 basis points (bps) and holds it for a year, paying 5bps dealing commission on purchase and 5bps commission on sale. The bid-offer spread is 10bps, half of which is incurred at purchase and half at sale. The total cost of ownership is therefore 35bps.

Step 07 How can I buy and sell ETFs?

Investors can gain exposure to a wide range of asset classes and strategies via ETFs listed on stock exchanges.

Investors in many markets have access to a wide variety of ETFs on their regional exchanges. For example, as of June 2016, the US and European ETF markets had over 1,500 listings each.

An ETF may be cross-listed, enabling greater access and liquidity. A cross-listed ETF has listings on multiple exchanges, often with share classes denominated in different currencies. For example, db x-trackers Euro STOXX 50® UCITS ETF (DR) is listed on the Borsa Italiana and German Xetra exchanges in euros, the SIX-Swiss exchange in Swiss francs and the London Stock Exchange in pounds sterling.

The fundamental source of liquidity for an ETF is the creation/redemption mechanism described in Step 3. The ETF’s Authorised Participants are able to create and redeem ETF shares if a fund’s price moves out of line with its underlying value.

As well as APs, designated market makers (or “designated sponsors”) have contractual obligations to help support ETFs’ secondary market liquidity.

Stock exchanges place obligations on designated market makers in an ETF to ensure the fund’s liquidity (see the table for an example). The Exchange Traded Funds issuer also helps ensure the performance of the market makers by requiring them to meet minimum trading volume and maximum bid-offer spread requirements for its funds.

Step 08 Creating ETF portfolios

ETFs can be considered a powerful tool for use in portfolio construction. A single ETF enables inves- tors to buy the entire market, a market segment or strategy with only one trade, allowing for instant exposure to a diversified portfolio of underlying securities.

While ETFs have a wide range of uses, including serving as a tool for tactical asset allocation changes and permitting sophisticated investors to take short-term views on market movements, they are often used core holdings in long-term savings plans, where they function as low-cost building blocks in the portfolio construction process.

For example, three ETFs in the db X-trackers range collectively provide comprehensive coverage of global equity and bond markets (see table below). The MSCI World and MSCI Emerging market indices include, between them, nearly 2,500 companies from 58 developed and developing markets. The Barclays Global Aggregate Bond index includes nearly 17,000 fixed rate bonds from investment-grade issuers in 72 countries.

At a more granular level, ETFs offer access to common types of securities within individual asset classes. In the table at the top of page 21 we show three ETFs offering exposure to popular segments of the global fixed income market: global sovereign bonds, higher-yielding Eurozone sovereign bonds and liquid euro-denominated corporate bonds.

Step 09 Short and leveraged ETFs

Short and leveraged ETFs offer inverse or geared (leveraged) exposure to an underlying index by tracking a daily short or daily leveraged version of the index.

A daily short index provides the inverse daily performance of the corresponding long index (with dividends reinvested), subject to an adjustment for interest rates to mirror the effect of cash movements. This interest adjustment reflects both the interest earned on uninvested cash and proceeds from the short sale, and the cost of borrowing the index constituents to provide the short exposure.

A daily leveraged long (or leveraged short) index provides two times the daily performance (or two times the inverse daily performance) of the corres- ponding long index, also subject to an interest adjustment to mirror the effect of the cash movements involved in creating the leveraged long or leveraged short exposure.

Short and leveraged Exchange Traded Funds are a type of exchan- ge-traded fund designed for use by experienced and financially sophisticated investors. Short ETFs can be used by investors as a way to profit from, or to hedge their exposure to, falling markets. Levera- ged ETFs can be used by investors to amplify exposure (or inverse exposure) to an index, whether for return or risk management purposes.

A key thing to remember about short and leveraged ETFs is that they typically reset their exposure daily. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the inverse or leveraged multiple of the underlying index’s return. The example below shows how this divergence occurs.

In this example, the reference index falls 5% on day 1 (from 100 to 95) and rises 5.26% on day 2 (from 95 back to 100). The short ETF’s performance is the inverse of the daily performance of the reference index (i.e., +5% on day 1 and -5.26% on day 2). The 2* leveraged ETF’s performance is double the daily performance of the reference index (i.e., -10% on day 1 and +10.52% on day 2).

Step 10 How to reduce interest rate and currency risks?

Interest rate-hedged and currency-hedged ETFs enable investors to receive the return from an underlying index net of interest rate or currency risk, respectively.

Interest rate-hedged ETFs allow investors to reduce the interest rate risk of their fixed income investments, hedging during a rising rate environment and leaving exposure mainly to the credit component of the ETF’s underlying fixed income exposure. Currency-hedged ETFs give investors access to international equity and bond market returns while minimising foreign currency risk.

The diagram below, and on page 25 illustrate how the exposure of an interest rate-hedged index, anc currency-hedged index differs to that of an unhedged index. The aim is to mitigate interest rate or currency risk respectively.

Interest rate-hedged ETFs combine long holdings of fixed income securities with short positions in interest rate forwards or futures contracts. The short positions in forwards or futures act to hedge (offset) the interest rate risk arising from the fixed income portfolio.

Each month, in a physically replicating Exchange Traded Funds, the portfolio manager sells contracts in the government bond or interest rate forward and futures markets, matching the interest rate exposures of the ETF’s underlying bond holdings. This has the effect of largely neutralising the portfolio’s interest rate risk by reducing its duration to zero at month-end.

If interest rates rise during the course of the month, causing a loss in the value of the bonds held by the ETF, the short position in bond and interest rate forwards/ futures should provide a similar equal and offsetting gain.

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