Exchange-Traded Funds: Structure and Tracking
What the exam tests
This domain tests how an ETF is created, priced and traded, and whether you can tell an ETF apart from an ETN. Expect NAV versus market price, tracking difference, fees, and the JSE listing and reporting requirements.
Core rules
- An ETF is an open-ended fund whose units are listed and traded intraday. Authorised participants create and redeem units in large baskets, usually in specie, against the underlying portfolio. That arbitrage is what keeps the market price close to NAV.
- NAV is calculated from the closing prices of the underlying assets. The indicative NAV (iNAV) is published during the day so traders can see the fair value of a unit against its market price.
- Tracking difference is the cumulative gap between fund return and index return, largely explained by the total expense ratio plus transaction and withholding-tax drag. Tracking error is the volatility of that gap.
- Physical ETFs hold the underlying securities; synthetic ETFs gain exposure through swaps and carry counterparty risk. ETNs are debt instruments issued by a bank, so the investor takes the issuer's credit risk.
- Distributions received by the fund are passed to unit holders; a price-only comparison against a total return index understates performance.
Worked example: tracking and pricing
An ETF tracks an index that returned 12.0% over a year. The fund returned 11.4%.
- Tracking difference = 11.4% - 12.0% = -0.6%
- If the TER is 0.45%, the remaining -0.15% is transaction costs, cash drag and dividend withholding tax
Now suppose the ETF trades at R10.20 while the published iNAV is R10.00. The unit is at a 2% premium, and an authorised participant can create units at NAV and sell them, which should pull the price back toward fair value.
Traps that cost marks
- Treating an ETN as a fund; it is a note with issuer credit risk.
- Comparing the ETF's price return with a total return index and calling the gap pure fee drag.
- Assuming the market price always equals NAV in illiquid underlyings.
- Ignoring securities lending or swap exposure when assessing counterparty risk.