Exchange Traded Funds And The UCITS Framework

Author:Mr Brian Kelliher
Profession:Dillon Eustace
 
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Introduction

An Exchange Traded Fund ("ETF") is an investment

vehicle that, in its typical form, is designed to enable investors

to track a particular index through a single liquid instrument that

can be purchased or sold on a stock exchange.

An ETF offers characteristics of an investment fund (such as low

costs and broad diversification) but also characteristics more

commonly associated with equities (such as access to real time

pricing and trading).

ETFs have seen dramatic growth in recent years, in terms of

assets invested and the number of products available, in contrast

with the net outflows being currently experienced by many

traditional investment funds. The scope of the products on offer

has also widened with ETFs covering a broad range of asset classes

as well as specific sectors.

Set out below is a summary of some of the main advantages that

ETFs offer to investors, a brief overview of how an ETF is

structured as well as how ETFs can be established in Ireland within

the UCITS framework.

What is an ETF?

An ETF is a particular type of investment fund structured to

facilitate trading of its shares on an exchange. ETFs generally

function as index tracking funds, i.e. they provide their investors

with an exposure to the securities in an index. The listing on an

exchange means the ETF shares can be bought and sold by investors -

on an intra-day basis and using realtime pricing - much like an

equity security.

Advantages of an ETF

Some of the particular aspects of ETFs that make them an

attractive investment for a broad range of investors are outlined

below.

Low costs

In almost all circumstances, an ETF will not be required to sell

securities within its portfolio, nor will it typically be required

to purchase such securities directly on the open market, due to the

in kind subscription and redemption arrangements regarding creation

units, discussed further under "ETF construction",

below.

The decreased level of portfolio transactions means that the ETF

is subject to lower transaction costs than a traditional index

tracking fund, in addition to the generally lower management costs

of pursuing an index tracking strategy when compared with an

actively managed fund.

As a result, ETFs offer a lower cost alternative to other

investment funds where the average expense ratio of an ETF might be

0.25 per cent for an ETF compared to 1.5 per cent for an actively

managed fund. However, transactions in ETF shares by investors in

the secondary market may be subject to brokerage commissions and/or

transfer taxes associated with the trading and settlement through

an exchange.

Diversification and choice

Investment in an index tracking product will automatically

provide diversification across the sector covered by the index, the

actual level of diversification being determined by the specific

index.

Available ETFs cover indices on most major equity markets as

well as regional, industry specific and country-specific sectors.

ETFs also cover other asset classes such as fixed income securities

with the range of available ETFs continuing to increase. This means

that with an ETF, an investor can gain a broad exposure to any

number of markets/sectors through the purchase of a single

security.

Transparency

As the components of the basket for the purchase or sale of

creation units are published on each dealing day, an ETF provides

greater portfolio transparency than a traditional investment fund

which would not publish portfolio holding information on a daily

basis and, if published, would generally be made on a lagged

periodic basis only.

Real-time pricing and intra-day trading

Intra-day trading enables investors to buy and sell their shares

at any time throughout the day, unlike traditional investment funds

which would generally deal only once a day (or less frequently).

ETFs therefore offer greater liquidity and opportunities to avail

of intra-day pricing changes.

In addition, by virtue of being listed on an exchange, investors

purchase ETF shares with real-time prices. This differs from

traditional investment funds, the shares/units in which are

purchased at forward prices. Shorting and margin As an ETF

share is an exchange traded security, it can be treated by

investors similar to an equity security and so can be sold short or

purchased on margin, subject to regulatory restrictions that may

apply.

Flexibility and range of investors

As ETFs can be openly purchased on an exchange there is normally

no requirement to open a specific account or provide any particular

documentation specifically for the ETF, although an account with a

broker/clearing system will generally be required to trade listed

securities.

ETFs are generally available to both retail and institutional

investors. They attract both active traders and long-term

investors. Investment managers may utilise ETFs where they find it

difficult to achieve out-performance of a market in a certain

sector or region.

How is an ETF constructed?

ETFs are typically established as index tracking funds where

they aim to track an index by holding a portfolio of securities

that represents or replicates the index, to the extent possible. As

a passive investment vehicle, the only trading activity conducted

by the ETF itself would be to reflect changes made to the index at

a rebalancing interval by making a corresponding change to its own

portfolio.

The ETF will be structured to offer shares to investors on the

secondary market, facilitated by...

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