Week 9 Tut Answers. PDF

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Tut answers for Week 9 Equities and Investment Analysis....

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Topic 8 Week 9 Tutorial – Investment Vehicles I (ETFs) Q1. Describe the differences and similarities between active and passive portfolios. Answer: Similarities:  Both passive and active portfolios are indirect investments o They pool the money of investors (individuals or companies) to invest them in a set of assets  Both portfolios are managed by professional fund managers  Both portfolios charge (management) fees  Both portfolios periodically distribute obtained income and capital gains to their investors  (Both active and passive portfolios are created for the purpose of making money from investments) Differences:  Active portfolios are designed with the goal of outperforming a certain index or benchmark. Passive portfolios are designed with the goal of mimicking the performance of a certain index or benchmark  Active portfolios are actively managed, i.e., holdings are frequently rebalanced. Passive portfolios are rarely rebalanced.  Active portfolios charge higher management fees vs. passive portfolios  Active portfolios are associate with higher capital gain taxes vs. passive portfolios

Q2. What passive portfolios are available to investors? Briefly describe the key features of each of them. Answer: There are four types of passive portfolios available to investors: unit investment trusts (UITs), passive mutual funds, real estate investment trusts (REITs), and exchange-traded funds (ETFs). UIT: typically a portfolio of income-generating securities, such as dividend stocks and bonds. The initial set of assets is fixed at inception, and the securities held within a portfolio are known to the investor. The portfolio has a termination date, at which all investors get back their money and all the capital proceeds generated during the life of the UIT. Units of UIT can be bought/sold through the investment company, which creates and redeems units at the end of each day. Passive mutual fund: a portfolio of assets tracking a known index or benchmark. The index/benchmark holdings are known, but the portfolio holdings are generally not. As the index/benchmark changes its holdings, so does the passive mutual fund tracking the index/benchmark. Shares in passive mutual funds can be bought/sold through the investment company, which creates and redeems shares at the end of each day. REIT: a portfolio of real estate assets owned and/or managed by the investment company. Types of real estate assets in the portfolio are known (retail, residential, healthcare, office, or mortgage), while the exact assets may not be known. REITs may change their holdings, but due to the nature of the real

estate business, these changes occur relatively rarely. Shares in REITs can be bought/sold through the investment company or on exchanges as many REITs are listed on exchanges. ETF: a portfolio of assets tracking a known index or benchmark. The index/benchmark holdings are known, but the portfolio holdings may not be known (except for APs). As the index/benchmark changes its holdings, so does the passive mutual fund tracking the index/benchmark. Shares in ETFs can be bought/sold through exchanges during trading hours.

Q3. Usually, John Dow puts the spare money left at the end of each month into a savings account. He considers whether he should put all the saved money so far into ASX 200 stocks as they seem to offer more profits than what he gets from his savings account. He found that there is an open-end mutual fund and an ETF that track the ASX 200 index. He asks your opinion on where he should invest. a) What would you recommend to John and why? Explain the difference between the available investment options. b) John is also asking whether he should invest the spare money left at the end of each month into ASX 200 stocks through an option you recommended to him. What would you say? Answer: a) The recommendation may be different depending on John’s liquidity preferences and the amount of money he has saved so far. Mutual funds typically require a minimum of initial investments to be more than $5,000-$10,000. If John has less than the minimum required amount, the passive mutual fund option is not available to him. If he has more than that, the recommendation should depend on John’s liquidity preferences, management fees charged by the mutual fund vs. ETF, and dividend yields. Lower management fees and higher dividend yields are preferable. In terms of liquidity preferences, it is faster to redeem money from ETFs (by simply selling them on exchanges), while redeeming money from mutual funds would generally require a bit more time. If John is concerned about the time to get cash back on hand, he might be better off choosing the ETF. b) Depending on how much money John saves every month, the mutual fund option may now be available to him (subsequent investments also have a minimum requirement, but this requirement is lower than the initial investment requirement). He should also consider commission fees if he decides to invest each month. If his savings are small, his commissions will eat a lot of his potential profits. For example, if he saves $100 each month and decides to invest this money through CommBank Pocket, he would pay a min commission of $2 on each trade. That’s a total of $4 as a roundtrip cost = 4% of his $100 investment.

Q4. You are an authorized participant (AP) for the SPY ETF (track S&P 500 index). The current SPY bid and ask prices are $450.37 and $450.44, respectively. You can buy the holdings underlying the SPY ETF on the exchange for a total price of $450.30. a) How much money can you make from the discrepancy of prices observed in the ETF and the underlying stock markets for the 300,000 units of ETFs? Assume that you use market orders for your trades, that there is enough quantity of stocks offered at the bid and ask priced to accommodate your demands, and that you can make all transactions instantly. b) Describe the transactions you are making and their timing.

c) How much money can you make if the price of stock holdings underlying SPY is $450.50? d) Describe the transactions you are making and their timing.

Answer: a) ($450.37 - $450.30)*300,000 = $21,000 b) First, buy underlying holdings of the SPY ETF worth 300,000 ETF units ($450.30*300,000). Then, deliver 300,000 creation baskets to the investment company in the primary market to get 300,000 SPY ETFs. Finally, sell all ETFs in the secondary market at the best available bid price and get $450.37*300,000. c) ($450.50 - $450.44)*300,000 = $18,000 d) First, buy 300,000 SPY ETFs on the secondary market at the best available ask price ($450.44*300,000). Then, redeem 300,000 ETFs through the investment company in the primary market to get the baskets of securities underlying the ETFs. Finally, sell these securities on the secondary market for $450.50 per 1 basket to get $450.50*300,000.

Q5. Skylight Health Group Inc. (SLHG) owns and operates a proprietary electronic health record system that supports the delivery of care to patients through telemedicine and other remote monitoring system integrations in the US, Canada, and the UK. In addition, it offers a disruptive subscription-based telemedicine service for the un/under-insured population. Your analysis shows that the company is increasing its customer base quicker than its competitors. You expect SLHG to generate higher profits than what is currently expected by the market. However, your concern is that when lockdown eases, people may start to go back to face-to-face consultations, and the company’s profits would start to deteriorate. Describe a trading strategy that uses ETFs and may help you to trade on your expectations while taking your concerns into account. For simplicity, consider only these ETFs for your strategy: SPY, QQQ, IXJ, EDOC. Answer: You want to trade on your positive information on SLHG, but your concern is that the industry risk may adversely affect the company prospects. You can buy SLHG stock and simultaneously short sell a telemedicine ETF, EDOC. If your expectations about SLHG realize, you will get profits from your long bet, and these profits are likely going to be higher than potential losses from your short bet since SLHG prospects seem to be better than that of other competitors in the same industry. However, if your concern is realized, you may get losses on your long bet, but your losses can be compensated by the short bet on the industry. Other ETFs are less appropriate for the strategy because they are not tracking the telemedicine industry. SPY is a market-wide ETF, QQQ tracks tech stocks listed on Nasdaq, IXJ track all healthcare stocks (mostly mature pharma companies).

Q6. Read the FT article about active ETFs. Summarize the recent trends in ETFs: which ETFs are becoming more popular, the barriers to launching new ETFs

Answer: Active ETFs are becoming more and more popular. Although initially, most ETFs were designed to track a known index or benchmark, now many new ETFs are launched with an active investment

strategy in mind. Active strategies under an ETF umbrella became possible after the US legislation allowed ETFs not to disclose their holdings to keep their strategies secret. At the same time, the barriers to launch ETFs are really low as there exist providers who can essentially construct an ETF for your trading strategy. Thus, you don’t need to worry about institutional details of launching new ETFs as these providers take care of all the aspects. In addition, operational costs of managing ETFs (e.g., clearinghouse and dealing costs) seem to be pretty low compared to traditional mutual funds. Another trend is the popularity of thematic ETFs, investing in securities with a nice sellable story for investors (e.g., cyber security, ESG).

Q7. Read the FT article about ETFs & fees. Do active funds charge higher fees than ETFs? How has the competition from ETFs affected the fees in active management? Do you think that the fees of active funds and ETFs would eventually become the same?

Answer: Active funds charge higher fees than ETFs. However, the fierce competition from ETFs for investor money has prompted active funds to reduce their fees as well. In recent years, investors have withdrawn funds from more expensive active funds and put them in cheaper active funds or ETFs. This tendency may encourage active funds to reconsider their current trading strategies and build new ones that would be cheaper. Generally, since active funds rebalance their positions more frequently, one may expect them always to have larger fees than ETFs. It is important to understand that while ETFs that track indexes deliver the performance of the index, active funds are supposed to outperform the index/benchmark and therefore are able to charge higher fees for potentially better performance. From an investor’s perspective, they should look at the performance of funds vs. ETFs after fees....