Question

QUESTION #4 /8 (2 marks each) Answer the following questions regarding Exchange-Traded Funds (ETFs), in your own words:

a. How are ETFs typically structured?

b. Please describe how an in-kind exchange works?

c. What are the risks related to the composition of an ETF?

d. Why is “securities lending” a risk for ETFs?

Answer 1

a) . An ETF (Exchange Traded Fund) is typically structured as a combination of a mutual fund or unit investment trust. It can be bought or sold at the end of each trading day at its net asset value. It trades throughout the trading day, with the feature of closed-end fund at prices that may be more or less than its net asset value (NAV).

b).  In-kind redemptions of an ETFs is a fundamental feature of the asset class, which refers to offer the investors exit from the fund without payment of cash, by offering them other securities or other forms of properties on proportionate basis.Ex. Payment of dividend stock by companied instead of cash to the investors. When an investor wishes to redeem ETFs, the distributor usually exchanges the shares to be redeemed for a portfolio of securities held by the ETF.

c). Composition risk refers to the indices that the ETFs tracks, are not interchangeable. Even though, the ETFs track the same index or Industry sector, their performance may not be the same due to volume of holdings in the underlying portfolio. For example, two ETFs may track the Automobile industry, but rely on a different parametres of companies or segments.

d). Securities lending is a risk for ETFs due to following reasons:

• Credit worthiness and Financial stability of a short seller
• Defaulting borrowers with insufficient collateral security
• Lesser amount of interests from the investments of colateral into money market securitites.