Browse Analysis of Managed and Structured Products

19.2.2 General Disclosure Requirements For Exchange-traded Funds

A comprehensive guide on the general disclosure requirements for exchange-traded funds (ETFs) as set out in NI 41-101, including detailed insights into the ETF Facts document, the creation and redemption process, and various ETF types and risks.

19.2.2 General Disclosure Requirements For Exchange-traded Funds

Overview

ETFs predominantly use the client disclosure documents system to qualify the distribution of ETFs to the public. The actual requirements of this system are set out in NI 41-101 (National Instrument 41-101).

ETF Facts Document

ETFs must produce and file a summary disclosure document called ETF Facts. This document is designed much like the Fund Facts document used for mutual funds but addresses specific characteristics of ETFs, such as market price, bid-ask spread, and the premium or discount of the market price to the net asset value (NAV).

An amendment to NI 41-101, effective December 10, 2018, introduced a new disclosure delivery regime. Given that ETFs are exchange-traded, the delivery mechanism differs from mutual funds. The ETF Facts document is distributed through the dealer where the ETF is purchased, and the dealers must deliver the ETF Facts document to investors within two business days of the purchase. If an investor does not receive the ETF Facts document, they have the right to seek damages or rescind the purchase.

Disclosure Requirements: Long Form Prospectus

As part of the ETF disclosure requirements, an Annual Long Form Prospectus must be filed with the securities commission. Although this document does not need to be updated annually unless there are changes in the ETF’s affairs, it must be written in plain language and set up in an easily understood format. The prospectus must be delivered to purchasers upon request and is not required to be provided for subsequent purchases unless there have been amendments.

ETF providers also need to comply with continuous disclosure requirements, including providing annual audited financial statements and management reports.

Creation and Redemption Process of a Standard ETF

When an ETF provider launches a new ETF, a designated broker, which could be a market maker or a specialist representing a large investment dealer, plays a crucial role. ETFs are created or redeemed in blocks of units known as a prescribed number of units, typically 10,000, 25,000, or 50,000 units.

Example Creation Process:

Here’s an example of creating a block of 50,000 ETF units:

Common Share Issuer Basket of Shares Current Price Total Value
ABC Corp. 1,500 $59.62 $89,430
DEF Corp. 1,785 $71.50 $127,628
JKL Corp. 2,312 $47.38 $109,543
MNO Corp. 1,482 $25.93 $38,428
QRS Corp. 2,112 $15.01 $31,701
Total Value $396,730

The designated broker delivers the basket of shares valued at $396,730 to the ETF provider, which in turn delivers 50,000 ETF units worth $7.93 per unit ($396,730 ÷ 50,000). The designated broker can then sell these ETF units in the open market. The process can work in reverse when the broker wishes to remove ETF units from the market.

Key in-Kind Exchange Diagrams:

    flowchart LR
	    A[ETF Company] -- Basket of Stocks --> B[(Designated Broker)]
	    B -- Prescribed Number of ETF Units --> A
	    B -- ETFs Shares --> C[Stock Exchange]
	    subgraph Market
	        C
	    end
	    subgraph Designated Brokers
	        B
	    end
	    subgraph ETF Company
	        A
	    end

Key Features of Exchange-traded Funds

Here are the primary features of ETFs:

  • Low Cost: ETFs generally have lower Management Expense Ratios (MER) compared to mutual funds due to passive management and less administrative overhead.

  • Tradable and Liquid: ETFs can be traded on exchanges anytime during trading hours, held on margin, sold short, and have various order types placed on them.

  • Continuous Price Discovery: The underlying asset prices provide efficient and transparent pricing for ETFs, benefitting liquidity and price discovery.

  • Low Tracking Error: Tracking errors are minimal due to arbitrage opportunities available through the in-kind creation and redemption process.

  • Tax Efficiency: Reduced turnover due to index tracking often results in fewer taxable events, allowing capital to compound more efficiently.

  • Transparency: ETFs, especially those tracking indices, are typically transparent with holdings often published daily.

  • Low-Cost Diversification: ETFs offer diversification across various securities with minimal costs.

  • Targeted Exposure: Access to a broad range of assets through ETFs that were previously difficult and expensive to purchase.

Types of Exchange-traded Funds

  1. Standard (Index-based) ETFs: These can use full replication or a sampling method to track an index.

  2. Rules-based ETFs: These follow specific methodologies to achieve targeted objectives, also known as smart beta ETFs.

  3. Active ETFs: Managed like other active funds but with potential restrictions related to the in-kind creation and redemption process.

  4. Synthetic ETFs: These use derivatives such as swaps for exposure, instead of holding the underlying assets directly.

  5. Leveraged ETFs: Designed to achieve multiples of the index they track, using derivatives.

  6. Inverse ETFs: Constructed to achieve an inverse return of the underlying index, either leveraged or unleveraged.

  7. Commodity ETFs: These can be physical-based, futures-based, or equity-based, providing exposure to commodities directly or indirectly.

  8. Covered-call ETFs: Use options strategies like writing covered calls to enhance yield and reduce volatility.

Risks of Investing in ETFs

While providing multiple benefits, ETFs are also associated with specific risks:

  • Tracking Error: The simple difference between the return of the ETF and the return of the underlying index or asset.

  • Concentration Risk: When a small number of stocks make up a significant portion of the ETF.

  • Risk Related to ETF Composition: Varied composition of ETFs can cause performance differences.

  • Securities Lending Risk: Dependence on creditworthiness in securities lending can cause problems.

Comparing ETFs and Mutual Funds

Feature Exchange-traded Funds Mutual Funds
Management Style Mainly passive; some active Mainly active, some passive
Transparency Full transparency Limited to monthly (top holdings)
Cash Flow Management Handle large cash flows well Cash drag can occur
Embedded Fees Lower management, trading fees Higher due to active management
Advisor Compensation Client pays commission; no trailer fees Load charges; embedded advisor fees
Distribution Bought/sold in secondary market Purchased/redeemed from fund at NAV
Tradability Held on margin, sold short, trades any time Held on margin, no short selling, trades end of day
Minimum Investment Can buy in single units As little as $500
PACs/SWPs Limited offering Common offering
Dividend Reinvestment Some offer plans Most offer plans
Liquidity Based on underlying securities End of the day based on NAV
Tax Efficiency More tax-efficient due to lower turnover Less efficient, higher turnover
Tracking Error Lower risk Higher risk

Taxation of ETF Investors

Investors holding an ETF in a non-registered, taxable account may be taxed on distributions and sales proceeds:

  • Distributions can include dividend and interest income, capital gains, and non-taxable items like return of capital.

  • Capital Gain/Loss occur on the sale of ETF, with 50% of gains being taxable.

Investment Strategies Using ETFs

ETFs can play complex roles in investment portfolios beyond general uses. Strategies include core and satellite allocations, rebalancing, tactical asset shifts, cash management, and tax loss harvesting.

Trading Tips for ETFs:

  1. Use limit orders for price protection.
  2. Execute large trades in bulk for easy creation/redemption by brokers.
  3. Avoid trading ETFs when markets for underlying securities are closed.
  4. Be cautious if major underlying holdings are on a halt.

There are variations of ETFs like mutual funds of ETFs and Exchange-traded notes (ETNs), each with unique characteristics:

  • Mutual Funds of ETFs: Multiple ETFs in one vehicle offering automated rebalancing and PACs/SWPs, albeit with higher advisor compensation costs.

  • ETNs: Debt obligations promising returns based on an index, with no tracking error but additional credit and early redemption risks.

Key Takeaways

  1. Disclosure Delivery Regime: Post-2018 amendments set standard practices for delivering ETF facts documents.
  2. Cost Efficiency & Transparency: ETFs feature low costs, comprehensive transparency, and enhanced tax efficiency.
  3. Diverse Types & Strategies: Understanding types (standard, rules-based, active, etc.) and investment strategies involving ETFs can help optimize portfolios.

Review Questions and FAQs are available online for each chapter.

Frequently Asked Questions on ETF Investments:

  1. What constitutes as a reasonable MER for an ETF?
  2. Can ETFs generate tracking errors in volatile markets?
  3. What is the impact of ETF liquidity on pricing?
  4. How can synthetic ETFs mitigate counterparty risks?
  5. Are leveraged ETFs suitable for long-term investments?

For any further clarifications, the Chapter 19 online FAQ section will be able to assist.


📚✨ CSC Exam Bank ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## What is the primary document known as that ETFs must produce and file for summary disclosure? - [ ] Fund Facts - [ ] Long Form Prospectus - [x] ETF Facts - [ ] Simplified Prospectus > **Explanation:** ETFs must produce and file a summary disclosure document called ETF Facts, which is designed to provide an overview similar to the Fund Facts document for mutual funds but tailored to the unique characteristics of ETFs. ## According to NI 41-101 amendments effective December 10, 2018, when must the dealer deliver the ETF Facts document to investors? - [ ] At the time of purchase - [x] Within two business days of the purchase - [ ] Upon request by the investor only - [ ] Before the transaction is completed > **Explanation:** According to the amendment to NI 41-101, dealers receiving a purchase order for ETF securities must deliver the ETF Facts document to investors within two business days of the purchase. ## Which of the following is an essential feature of the creation and redemption process of ETFs? - [x] In-kind exchange - [ ] High transaction costs - [ ] Exclusive to cash transactions - [ ] Limited market impact > **Explanation:** The creation and redemption process involves an in-kind exchange where the designated broker exchanges a basket of underlying stocks with the ETF provider for a prescribed number of ETF units and vice versa. ## How is the value per ETF unit determined? - [x] By dividing the total value of the underlying basket of stocks by the number of ETF units - [ ] Based on an arbitrary price set by the ETF provider - [ ] By market supply and demand exclusively - [ ] Through complex financial derivatives > **Explanation:** The value per ETF unit is determined by dividing the total value of the underlying basket of stocks by the prescribed number of ETF units to be sold in the marketplace. ## Why are ETFs typically lower in cost compared to mutual funds? - [ ] Higher management fees - [x] Lower management expense ratios (MER) - [ ] More complex strategies - [ ] Higher trading volumes > **Explanation:** ETFs generally have lower management expense ratios (MER) compared to mutual funds due to their passive investment approach and the lower administrative and trading costs associated with their structure. ## What type of disclosure document must ETFs file annually and deliver upon investor request? - [ ] ETF Facts - [ ] Fund Facts - [x] Long Form Prospectus - [ ] Summary Prospectus > **Explanation:** As part of ETF disclosure requirements, a Long Form Prospectus must be filed annually with the securities commission and delivered to investors upon request. ## What aspect of ETFs ensures they stay closely aligned with their NAV? - [ ] High trading frequency - [x] Arbitrage by designated brokers - [ ] Manual adjustment by fund managers - [ ] Restricted trading hours > **Explanation:** The in-kind creation and redemption process allows designated brokers to perform arbitrage, ensuring that the ETF's market price stays close to its NAV by buying the underlying securities when the ETF is undervalued and vice versa. ## Which key ETF feature refers to the minimal deviation from the performance of the underlying index? - [ ] Tax efficiency - [x] Low tracking error - [ ] Targeted exposure - [ ] Transparency > **Explanation:** Low tracking error is an essential feature of ETFs, ensuring minimal deviation from the performance of the underlying index due to efficient management and arbitrage mechanisms. ## How does the ETF issuance mechanism provide tax efficiency? - [ ] Through regular large dividend distributions - [ ] Always keeping cash reserves for redemptions - [ ] Frequent rebalancing of the portfolio - [x] Fewer realizations of capital gains and the in-kind creation/redemption process > **Explanation:** ETFs are tax-efficient because their in-kind creation and redemption mechanisms and lower portfolio turnover result in fewer taxable events compared to actively managed investment vehicles. ## Which ETF type involves holding derivatives rather than the underlying assets to replicate performance? - [ ] Standard ETF - [ ] Active ETF - [ ] Leveraged ETF - [x] Synthetic ETF > **Explanation:** Synthetic ETFs are constructed using derivatives, such as swaps, to achieve the return effect of an index without holding the same underlying assets. I hope these quizzes help your students effectively prepare for their Canadian Securities Course (CSC) exams! If you need more examples or specific areas of focus, feel free to ask.

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Tuesday, July 23, 2024