AI for Trading Series №8: Exchange Traded Funds (ETFs)

Learn about ETFs and how they are used by investors.

Photo by William Iven on Unsplash

Drawbacks of Mutual Funds

Drawbacks of Open-ended Mutual Funds

  1. An open-ended mutual funds may need to maintain parts of their assets under management (AUM) in cash to let investors withdraw their shares on any given day. This dilutes the fund’s overall performance.
  2. Open-ended mutual fund limits the number of times you can invest/withdraw within a time frame.
  3. Fund share price is determined when the market closes.

Drawbacks of Close-ended Mutual Funds

Exchange Traded Funds (ETFs)

  • ETFs make it easier to invest in commodities (oil and natural gas, gold and silver, corn and cows) and international stocks.
  • ETFs are also used for hedging.

Commodity Futures

Entering a Futures Contract. (Source: AI for Trading nano degree course on Udacity)
Futures Contract Complete. (Source: AI for Trading nano degree course on Udacity)
Closing the Futures Position — I. (Source: AI for Trading nano degree course on Udacity)
Closing the Futures Position — II

Commodity ETFs

  • Investors who wish to gain exposure to commodities may buy futures contracts, but this requires them to roll over their positions regularly.
  • Rolling over a futures contracts involves closing out the existing position before its due date and then taking a new position that is due at a later date.
  • Commodity ETFs handle this, so investors could more easily buy and hold shares in a commodity ETF and not worry about rolling over individual futures contracts.

International ETFs

  • If investors wish to trade international stocks, these stocks would be listed on a stock exchange of another country, and may be in a different time zone.
  • This means that trading is done during the stock exchange’s open hours, which may not be as convenient for the investor.
  • International ETFs are traded on a local stock exchange, while they are still linked to the stocks that are listed abroad

Hedging with ETFs

ETF Sponsors

Authorized Participants (APs)

Create Process

  1. The Authorized Participant buys stocks and bundles them in the same proportions as defined by the ETF Sponsor.
  2. The AP makes a trade with the ETF Sponsor.
  3. The ETF Sponsor creates ETF shares and gives these to the AP, in exchange for a bundle of stocks.
  4. The APs go to the stock market and sell their ETF shares on the open market. The investors can buy these shares and now have investments linked to all of the stocks that are in the ETF portfolio.

Redeem Process

  1. The AP buys ETF shares from investors in the stock market.
  2. The AP trades these ETF shares with the ETF Sponsor in exchange for the original stocks.
  3. The AP sells these stocks on the stock exchange.

Arbitrage

Misaligned ETF prices and Arbitrage Opportunity

References

  1. AI for Trading nano degree course on Udacity.
  2. AI for Trading: GitHub

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Purva Singh

Purva Singh

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Hi! I am a tech enthusiast currently working on leveraging language technologies to solve financial use-cases! View my work here: https://purvasingh96.github.io