CFA® Level II Portfolio Management - Understanding ETFs: Creation, Redemption, and Market Dynamics

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Welcome to our lecture on Exchange Traded Funds (ETFs), tailored for CFA Level II candidates. In this session, you’ll learn about the mechanics of ETFs and how they compare to index mutual funds, focusing on the creation and redemption processes, and the role of authorized participants (APs).

What You’ll Learn:

1. ETF Basics and Benchmarking:
• Understand how ETFs aim to replicate the returns of benchmark indexes and the primary differences between ETFs and mutual funds.

2. Creation and Redemption of ETF Shares:
• Learn about the role of authorized participants in creating and redeeming ETF shares to maintain market liquidity and price stability.
• Explore the concepts of creation baskets, creation units, and redemption baskets.

3. Market Price vs. NAV:
• Discover how APs use arbitrage opportunities to keep ETF market prices close to their net asset value (NAV).
• Understand the arbitrage process and how it ensures that ETF prices remain within a narrow band around the NAV, known as the arbitrage gap.

4. Cost and Tax Efficiency:
• See how the involvement of APs reduces transaction costs for ETF issuers and enhances tax efficiency by targeting low-basis stocks for redemption.

5. Impact on Shareholders:
• Learn why ETF transaction costs are borne by transacting shareholders through the bid-ask spread, making it fairer compared to mutual funds where all shareholders share these costs.

By the end of this lecture, you’ll have a comprehensive understanding of how ETFs operate, their advantages over mutual funds, and the critical role of authorized participants in maintaining ETF market integrity. This knowledge is crucial for your CFA Level II exams and your career in finance.