The use of other structures including unsecured debt, grantor trusts, partnerships, and commodity pools by ETPs can, in addition to a significantly different risk profile, create different tax and regulatory implications for investors when compared to ETFs, which are funds.
Smart beta wave
Over the past few years the finance industry realised most traditional investment managers were either using a value-based approach to stock selection (picking extremely low valued stocks) or momentum-based (recent winners that continue to perform better), charging high management fees for these simple strategies.
Numerous academic studies and practitioners showed these simple strategies, or in more technical terms gaining exposure to factors like value and momentum, can outperform the market capitalisation based stock market indices in the long run.
Index providers like S&P 500, FTSE Russell and NASDAQ created factor indices, which are simple rules based indices, to benchmark performance for such style-based managers.
This helped to determine if an investment manager truly had skill or was just implementing a simple value/momentum strategy to deliver returns and charging high fees.
Since these indices were rules based, ETF issuers saw this as an opportunity and created low-cost ETFs that tracked these factor indices. These ETFs typically have returns similar to those style-based investment managers but at much lower costs. These new ETFs that tracked a rules-based index are now known as “Smart Beta” ETFs.
With a low cost alternative to investing, most sophisticated asset owners started moving away from high cost managers and have now started using these smart beta products.
In definition, a “Smart Beta” index is a rules-based index that weights its constituents using factors/characteristics other than market capitalisation.
Typically factors or characteristics are used to derive weights are:
• Value
• Momentum
• Dividend yield
• Low volatility
• Quality
Smart Beta ETFs now make up over $400bn (£281.3bn) in assets under management, as of December 2015.
ETF creation/redemption process
The below flowchart shows how ETFs are traded on the exchanges
ETF creation process
1. Buyer issues a buy order handing over cash to an authorised participant (AP) to purchase shares of an ETF.
2. If the AP has an inventory (spare shares on hand), the ETF shares are sold directly to the buyer.
3. If there is no inventory with the AP, the AP would buy the underlying stocks the ETF is supposed to hold from the exchange with that cash.
4. These underlying stocks are then handed over to the ETF provider in exchange of ETF shares which can then be handed over to the buyer.
ETF Redemption Process works exactly the same way but the flow of cash and stocks is reversed.
Differences between ETFs and Oeics/UTs –
