Lexicon

AP or Authorised Participants

Authorised Participants or APs as they are more usually known are the large financial institutions, such as investment banks or market makers, which are involved in the creation and redemption of ETF shares.

Basket

The grouping of securities within an ETF is sometimes referred to as a basket.

Bid and ask spreads

There is usually a difference – a spread – between the bid price – the highest price a buyer is willing to pay – and the ask price – the lowest price a seller is willing to accept. Spreads vary from one ETF to another and tends to be higher for ETFs with lower trading volumes. Bid/ask spreads are a key part of the overall cost of investing and should be consider when evaluating whether to buy an ETF.

Closed-end fund

Closed-end funds issue a fixed number of shares through an initial public offering and often use leverage to magnify their performance. Closed-end funds are bought and sold like stocks and their share price often trades at a noticeable discount or premium to the fund’s net asset value.

Closet index fund

An actively managed fund that closely mimics the performance of an index fund.

Counterparty risk

Counterparty risk is the risk that an institution defaults and fails to pay on a trade or another financial transaction. ETFs that use swaps or derivatives may be exposed to counterparty risk. ETNs are also subject to counterparty risk because they rely on the creditworthiness of the issuing financial institution.

Creation and redemption

To create an ETF unit or share, a market maker buys a basket of stocks (or other assets) that match the composition of the ETF. That basket of assets is then exchanged with an ETF custodian for a set number of ETF units or shares (creation). The market maker than has an inventory of ETFs to meet the demand for buy and sell orders.

Redemption is the creation process in reverse. A market maker will swap a number of ETF shares with the ETF custodian for the underlying basket of assets which can then be sold for cash in the secondary market.

Creation unit

The smallest block of shares in an exchange-traded fund that can be purchased or redeemed directly from the fund company at net asset value. Creation units are usually transacted in 50,000 share increments, making them large transactions limited to institutions and other authorised participants. Instead of receiving cash, the seller of a creation unit receives a basket of securities that corresponds to the portfolio holdings in a particular ETF. This is known as “in-kind” transfer, a process which is unique to ETF’s and does not create tax consequences for the seller.

Discount to NAV

An ETF, mutual fund or closed end fund whose share price is lower than the fund’s net asset value (NAV). The occurrence of significant NAV premiums or discounts with ETFs is rare.

ETF or Exchange traded fund

ETFs or exchange traded funds are low cost open ended funds that can be bought or sold on regulated stock exchanges through ordinary brokerage accounts. ETFs cover a broad range of assets including equities, equity indices, bonds, currencies, real estate and commodities. They offer intraday liquidity so they can be bought or sold when the stock market is open for trading. In general, ETFs have lower expenses than closed end funds and mutual funds.

ETC

An ETC could refer to either an exchange traded commodity or an exchange traded currency. These enable investors to gain exposure to commodities and currencies without trading futures or taking physical delivery.

Exchange traded commodities

Investment vehicles (usually undated, zero coupon notes) that usually track the total return from an underlying commodity index, based either on a single commodity or on a broader basket of commodities.

Exchange traded currencies

Investment vehicles (usually undated, zero coupon notes) which allow investors to gain exposure to foreign exchange movements. Currency ETCs aim to reflect movements in exchange rates between two currencies, plus any exposure to local interest rates.

ETN or Exchange traded note

ETNs or exchange traded notes are unsecured debt securities that pay a return linked to the performance of a single security or index. ETNs are subject to counterparty risk, meaning that the creditworthiness of the issuer can have an impact the note’s final return and value.

ETP or Exchange traded product

ETP is a ‘catch-all’ term that is used to include exchange traded funds, exchange traded notes, exchange traded commodities and exchange traded currencies.

TER – total expense ratio

The TER represents the percentage of the fund assets that is taken out each year to cover the cost of investment management, legal, administrative and marketing fees and other associated expenses. If an investor had £10,000 in an ETF with a TER of 0.25 per cent, they would pay £25 a year in expenses. However, the expense ratio does not include the cost of acquiring or selling an ETF, such as commissions or any sales charges.

Gold ETF

A popular type of ETF which is designed to give exposure to physical gold or to gold related securities such as mining companies. ETFs that track the price of gold itself generally acquire and store physical gold or gold derivatives. Gold funds are often used to hedge against inflation and currency risks.

Inverse or short ETFs

The object of an inverse or short ETFs is to deliver the opposite performance to a particular benchmark. So an inverse FTSE 100 ETF would rise 10 per cent if the FTSE 100 fell 10 per cent and vice versa.

Leveraged ETFs

Leveraged ETFs aim to deliver a magnified performance of a particular index. Most leveraged ETFs attempt to multiply daily index returns by two or three times. Short leveraged ETFs aim to deliver a multiple of the daily index but in the opposite direction to the underling benchmark.

NAV or net asset value

Net asset value is calculated as the total value of a fund (stocks plus cash and accruals minus fees) divided by the number of shares in issue. ETFs and ETPs usually trade close to their NAVs which provides investor with the knowledge that the market price closely reflect the value of the underlying assets. The activity of market makers and other traders normally ensures that the price of an ETFs does not substantially deviate from the NAV.

Open end index fund

This type of fund structure reinvests dividends on the date of receipt and pays them out via a quarterly cash distribution. This ETF structure is also permitted to use derivatives, loan securities and is registered under the SEC Investment Company Act of 1940.

OTC – over the counter

Usually refers to a transaction or trade agreed directly between two parties. Around half of all ETF trading in the US is done OTC as many institutions find it easier to trade large orders in this way rather than on an exchange.

Passive management

Many ETFs are described as passive management investment tools as they are designed explicitly to track an index but not to outperform that benchmark. Active management, on the other hand, does seek to beat a benchmark. Actively managed ETFs are becoming increasingly popular with some providers.

Replication

ETFs can use different methods to track (replicate) their underlying benchmark.

Full replication – replicating an index by buying all of the constituents in exactly the same weightings as they are present in a benchmark. Full replication would also involve re-balancing the ETF whenever the index is rebalanced.

While relatively straightforward to fully replicate the FTSE 100 in an ETF, it would be more difficult and expensive to fully replicate the FTSE All Share as it has more than 600 constituents

Optimisation – or partial relication – seeking to track a benchmark by investing in a subset of the index constituents whose returns are judged likely to match those of the index as a whole.

Synthetic replication – buying assets that may or may not be index constituents and entering into a “swap” transaction with the ETF’s sponsoring investment bank to swap the return on these investments for the return of the index.

Swap based ETFs

Swap based ETFs aim to deliver precise index returns (before any management fees). In a swap based ETF, the investors’ cash is used to purchase a basket of assets, usually known as the “substitute” basket. (Note that the constituents of the substitute basket do not have to correspond to the assets which make up the benchmark index that is being tracked.) The ETF swaps the performance of the substitute basket with a counterparty who is frequently the parent bank of the ETF issuer. The swap counterparty guarantees to pay the performance (daily returns) of an index or benchmark to the ETF. So the responsibility of tracking the index performance are effectively passed on to the provider of the index swap. However, the investor in the swap based ETF must bear some counterparty risk exposure to the bank writing the swap.

Short ETFs

The main objective of short ETFs is to deliver the inverse or opposite performance to a particular benchmark. So an inverse FTSE 100 ETF would rise 10 per cent if the FTSE 100 fell 10 per cent and vice versa.

Target date fund

A type of ETF or mutual fund that adjusts its holdings of stocks, bonds and other assets to deliver returns in a specified year or range of years.

Tracking error

A crucial measure of how closely ETF follows the index to which it is benchmarked. As Authorised Participants can create or redeem ETFs at their net asset value, this helps to ensure that the price of the ETF trades close to the NAV.

Potential sources of tracking error include (i) transactions costs as each trade within an ETF involves a set of costs, including the spread between the bid and ask prices.

(ii) Annual fees – ETFs charge an annual fee that includes the cost of portfolio management and custody of the securities in the funds.

(iii) Rebalancing costs – index providers, such as FTSE or S&P, regularly rebalance their indices to reflect securities that enter or leave. In rebalancing, index providers do not take into account the costs and timing considerations of buying and selling securities.

(iv) Dividends – the taxation of dividends and the timing of dividend payments can also contribute to tracking error. If dividends are sourced from a wide range of countries, then the timing and extent of any withholding tax rebates can affect the performance of an ETF.

(v) Variations in stock lending revenue – some ETFs generate additional revenue by lending out some of their investments. Stock lending began as a way of facilitating the prompt settlement of trades but it has now developed into a profitable business for some ETFs and other asset managers. Hedge funds frequently borrow stock to sell it short as part of their overall trading strategy. Although stock lending can provide an important source of revenues to an ETF provider, it also introduces an element of counterparty risk.

Unit investment trust

Some ETFs are structured as unit investment trusts. These do not reinvest dividends in the fund but pay them out via a quarterly cash distribution. To comply with diversification rules, this ETF structure will sometimes deviate from the exact composition of a benchmark index. This type of fund is registered under the SEC Investment Company Act of 1940. The Dow DIAMONDS, PowerShares QQQ and the SPDR S&P 500 are examples of this product format.