ETFs

Q&A for Investors

Update : Apr. 22, 2011

Q&A on ETFs & ETNs

Q&A

About ETFs

• Q1 What is an ETF?
• Q2 How does the ETF market work?
• Q3 How do ETFs differ from ordinary investment trusts?
• Q4 How do ETFs differ from Nikkei 300 trusts?
• Q5 How can I subscribe to an ETF?
• Q6 How do I redeem an ETF?
• Q7 How are ETFs priced?
• Q8 What risks are involved in trading ETFs?

Listing and Disclosure

• Q9 What are the listing criteria for ETFs?
• Q10 What are the disclosure requirements for ETFs?

TSE-listed ETFs

• Q11 What are the contract specifications for these ETFs?

Benefits offered by ETFs

• Q12 What benefits do ETFs offer investors?
• Q13 What kind of investors will benefit from ETFs?

Trading, Settlement & Market Information

• Q14 What differences are there between trading stocks and ETFs?
• Q15 What ETF market information is available?
• Q16 Is margin trading available, and if so what benefits does it offer?
• Q17 How are ETFs traded on the day they are listed?
• Q18 Can ETFs be traded on TSE's ToSTNeT?
• Q19 Are there any short-selling restrictions?
• Q20 How do arbitrage transactions work?
• Q21 Are ETFs eligible for dividends like stocks are?
• Q22 How are ETF transactions be settled?

Costs & Taxation

• Q23 What costs are involved for ETF transactions?
• Q24 How are ETF transactions taxed?

TSeTF Website

• Q25 What is ETFs on TSE?

ETFs in the US

• Q26 What is the ETF market like in the United States?

Answers

Q1 What is an ETF?

An ETF is an 'exchange traded fund'. It is an index-tracking investment trust which is listed and traded on a stock exchange market.

For example, TOPIX-based ETFs are made up of shares in the same proportion as the TOPIX index. Thus an investor buying a TOPIX ETF is essentially buying shares in the TOPIX index. The price reflects this correlation. Thus, at current levels the price of one TOPIX ETF would be 1,300 yen. As the trading unit for TOPIX ETFs is 100 units (or shares), this means that an investor can trade shares in the whole of the TSE First Section (=TOPIX) for just 130,000 yen.

One key characteristic of ETFs is that investors holding over a certain number of ETFs can exchange (redeem) these for a basket of shares. Conversely, investors with a basket of shares can use these to subscribe to an ETF. However, the minimum value needed for such redemptions and subscriptions is so high that only institutional investors and securities companies can afford to do so.

Q2 How does the ETF market work?

1. As an index-tracking investment fund, the assets of an ETF are basically the stocks which make up the index.
2. Fund administrators adjust subscription and redemption conditions in line with changes to the underlying index so as to maintain tracking between their ETF and the index.
3. Investors can subscribe and redeem ETFs, based on the publicised conditions, via authorised participants. In addition to handling subscriptions and redemptions, authorised participants also undertake arbitrage transactions to maintain tracking between ETFs and the underlying indices.
4. Unlike ordinary investment trusts, investors can trade ETFs on the TSE market just like stocks.
5. Since ETF prices track those of the underlying indices, ETFs can be used for active arbitrage between the ETF market and the stock and index futures market.

Q3 How do ETFs differ from ordinary investment trusts?

The main differences between ETFs and ordinary investment trusts are as follows:

1. ETFs are listed on TSE and can be traded at any time during trading hours, using both limit and market orders. Ordinary investment trusts can only be traded at specific times and at the base price.
2. ETFs can be used for margin trading.
3. ETFs offer in-kind subscription and redemption.
4. Like stocks, ETF trading can be done via any securities company.
5. In-kind subscription and redemption mean that costs for fund administrators are radically reduced.

Q4 How do ETFs differ from the Nikkei 300 trust?

The Nikkei 300 Trust is an investment trust which tracks the Nikkei 300, a weighted average index of 300 TSE-listed stocks. This trust was listed in 1995 on all Japanese stock exchanges. While both ETFs and the Nikkei 300 trust is similar in that they both track an index and can be traded on the TSE market at any time. The greatest difference is that, unlike ETFs, the Nikkei 300 trust only offers in-kind redemption, not in-kind subscription.

Q5 How can I subscribe to an ETF?

A defining characteristic of ETFs is that subscription is not cash-based, but instead investors deliver a basket of shares which accurately track the underlying index, as prescribed by the fund administrators. As the investors have already bought the stocks, there is no need for the fund administrators to take investors money to the market to buy stocks, thus considerably reducing operating costs. To take account of changes to the composition of the underlying indices, fund administrators publish daily lists of the basket of shares (which stocks and how many of each) necessary for subscription. An example of how this works is given below, using a Nikkei 225 ETF.

beneficiary		Nikkei 225 basket of shares + cash portion		fund
		beneficiary certificates

Subscription for TSE-listed ETFs is performed by authorised participants. The participants subscribe their baskets of shares, and then sell the resulting ETFs on the TSE market.

If securities companies or investors other than the authorised participants wish to subscribe to an ETF, they must do so through an authorised participant. However, as the huge costs involved (several hundred million yen) are prohibitive, most chose to buy ETFs on the TSE market, in the same way as trading stocks. For details of additional subscriptions, please see the individual ETF contracts.

Q6 How do I redeem an ETF?

Redemption is the reverse of subscription. In other words, investors receive a basket of shares in return for their ETFs. Unlike ordinary investment trusts which require the sale of assets on the market in order to return investors their money, ETFs return the assets (units of stocks mirroring the index) to the investor directly. Thus reducing costs. An example of how this works is given below, using a Nikkei 225 ETF.

beneficiary		beneficiary certificates		fund
		basket of Nikkei 225 shares

If securities companies or investors other than the authorised participants wish to redeem an ETF, they must do so through an authorised participant. However, as the huge costs involved (several hundred million yen) are prohibitive, most chose to sell ETFs on the TSE market, in the same way as trading stocks. For details of redemption procedures, please see the individual ETF contracts.

Q7 How are ETFs priced?

As ETFs track the performance of a particular index, their base price is basically equivalent to the value of the index. An example of how this works is given below, using a Nikkei 225 ETF.

Nikkei 225 14,067.70 yen		market increases by 1%		14,208.38 yen
base price 14,068 yen				14,208 yen

Arbitrage trading taking advantage of the index-tracking nature of the ETF, as well as using subscriptions and redemptions, mean that ETFs offer a performance very similar to the underlying index.

Q8 What risks are involved in trading ETFs?

Given their nature as stock investment trusts, and as stock exchange traded products, investors should bear the following points in mind when trading ETFs.

1. Neither the capital nor the dividends are guaranteed.
2. As the assets under management are stocks they are vulnerable to stock price fluctuations.
3. Close tracking of the underlying indices can be difficult during periods of market volatility.
4. Pricing of ETFs is subject to market demand and other variables.
   

Q9 What are the listing criteria for ETFs?

The main listing requirements for ETFs are sufficient liquidity and close tracking of the underlying index. The minimum number of trading units that must be listed is 10,000, which is 2.5 times the requirement for ordinary stocks. In terms of distribution, at least 1,000 beneficiaries must be recruited within a year of listing. An average monthly trading volume of at least 10 trading units must also be maintained. With regard to index tracking, ETFs must include at least 95% (by market capitalisation) of the index's composite stocks, and the net asset value (NAV) must be maintained at a ratio of at least 0.9 of the underlying index.

Q10 What are the disclosure requirements for ETFs?

In the interests of transparency and user-friendliness, the following information must be disclosed.

1. Daily composition of stock basket (for subscription purposes).
2. Daily net asset value (NAV) per unit.
3. Daily divergence between NAV per unit and the closing price of the underlying index.
4. Financial reports etc. for the fund on a regular basis.
   This information will shortly be available on the TSeTF Square website at:
   ETF on the TSE

Q11 What are the contract specifications for these ETFs?

Please see the following page to access a regularly updated list of TSE-listed ETFs.

• Listed ETFs

Q12 What benefits do ETFs offer investors?

1.Comprehensible & Easy to Use

• As ETFs track indices which can readily be accessed in newspapers and on television, their prices are easy to understand.
• Thus, for example, if on a news programme they announce that TOPIX rose 15.25 points today to reach 1,315.25 points, you will know that the price of TOPIX ETFs will have mirrored this increase.
• As ETFs mirror the market as a whole there is no need to investigate individual companies' financial and business results, thus simplifying investment decisions.

2.Low Risk

• Unlike investing in individual stocks, ETFs offer the benefits of a diversified portfolio covering the underlying index's component stocks.
• In other words, the risks involved are reduced by spreading them across a wide portfolio.

3.Inexpensive

• Institutional investors are able to minimise risk and maintain stable returns over the long term by investing directly in a wide-range of stocks mirror benchmark indices.
• ETFs allow ordinary investors to mimic the index management strategies of fund managers but at a greatly reduced price. For example, investors can buy 1 TOPIX-based ETF for 130,000 yen, which gives them the same market coverage and index-management ability as a major fund management company.

4.Constant Trading during Auction Hours

• Ordinary investment trusts can only be bought and redeemed at the daily base price.
• In contrast, ETFs can be traded at any time during auction hours. So investors can check prices (using 4-figure identifying code) and place orders just like for stocks.
• As ETF prices mirror the underlying index, they can move both up and down. Investors can follow and exploit these movements allowing them to plan their transactions on a real time basis.

5.Margin Trading

• Margin transactions are also available for ETFs. Thus, investors can anticipate and exploit market trends, allowing further opportunities to make a profit. For example, by selling on margin in the expectation that the market will decline and they'll be able to buy back equivalent ETFs at a lower price, in order to return them to the securities company that lent them in the first place. Thus making a profit from the price difference between the sale and the subsequent purchase.
• As profits are achieved on the basis of the increase/decrease in value of deposited collateral, this offers leverage - as well as risk. Using ETFs for margin transactions is equivalent to trading bull and bear index funds. Bull funds are those where the increase in value is greater than the rise in the index; and bear funds are those where the decrease in value is greater than the fall in the index. The ability to trade throughout auction hours is an added convenience.

6.Readily Available

• Unlike, ordinary investment trusts can only be traded at specific retail shops, ETFs are readily available at any securities company.

7.Low Costs

• As there is no need for fund administrators to produce prospectuses, nor any need to buy and sell assets at subscription and redemption, management costs are minimised.

Q13 What kind of investors will benefit from ETFs?

ETFs are attractive products with a range of uses making them suitable for a wide range of investors.

1. Individual Investors

(a) Novice

• ETFs are ideal for those with no previous investment experience, as they are based on indices which can easily be followed in newspapers and in radio and television news programmes. Prices are basically the same as the index value which again make it easy for investors to make investment decisions. Exposure to risk is reduced by the wide market coverage offered by ETF portfolios.

(b) Amateur

ETFs are also ideal for those with experience of investment trusts, but who have not dabbled in individual stocks. As mentioned above, ETFs are easy to monitor as they track readily available indices. ETFs have the added benefit of being available for trading at any time during auction hours, unlike investment trusts, and fees and other costs are reduced.

(c) Experienced

• ETFs also have something to offer to those with more experience of the stock market, those who have already tried their hands at individual stocks. As a readily tradable product, ETFs make a welcome addition to investors' existing portfolios and give wider exposure to the market as a whole.

(d) Semi-professional

For those with experience of margin trading, ETFs are a welcome new margin trading tool, offering investors the chance to take greater advantage of market prospects. The leverage (and associated risk) mean that investors will be able to mimic bull and bear index fund trading. ETFs offer the added benefit that they can be traded through out market hours.

2. Institutional Investors

• ETFs give institutional investors the same benefits as a portfolio of stocks tracking a benchmark index, namely spreading risk and maintaining stable returns over the long term, whilst removing the need for re-balancing the portfolio and other administrative tasks.

3. Securities Companies

• In addition to the index-tracking benefits, ETFs also offer securities companies the opportunity to arbitrage between the ETF market and the stock and index futures markets. For example, by selling an ETF on margin at a high price, then buying a basket of shares at a lower price and using those shares to subscribe to an ETF, which is then returned.

Q14 What differences are there between trading stocks and ETFs?

Basically ETFs are traded in exactly the same way as stocks, there are no special rules. A brief outline of ETF trading on the TSE market is given below.

1.Trading Rules

• Both market and limit orders are allowed.
• Tick sizes (the minimum increment in which prices are quoted) are based on the price of the ETF, the same as for stocks. For example, if TOPIX is at 1,300 points, a TOPIX ETF will be priced at about 1,300 yen. So it is treated the same as a stock priced at 1,300 yen. At this price level (up to 2,000 yen), the tick size is 1 yen, in other words prices are quoted in 1 yen increments: 1,299 yen, 1,300 yen, 1,301 yen, etc.

2.Trading Units

• Trading units (the minimum number of 'shares/units' (in this case beneficiary certificates) that may be traded) vary from product to product.
• The standard trading unit for TOPIX ETFs is 100 units. Thus at a price of 1,300 yen, the minimum investment needed is 130,000 yen.

3.Placing Orders

• Placing an order to buy or sell an ETF is as simple as placing an order for ordinary stocks.
• Investors can either visit the office of a securities company directly, or place their order over the internet.

4.Settlement

Settlement is the exchange of cash and securities to complete a transaction. Depending on the class of transaction, settlement is either same day or on the third day after the transaction (T+3), the same as for stocks.

5.Dividends

• ETF holders are entitled to dividend payments (a share of profits) in the same as for ordinary stocks and investment trusts.

Q15 What ETF market information is available?

The same kind of market information is available (from information vendors and securities companies) as for ordinary stocks, including prices, trading volume and value, best 3 quotes (both buy and sell) and pre-opening quotes.

Q16 Is margin trading available, and if so what benefits does it offer?

Yes, margin trading is available for ETFs. In principle all ETFs are designated as margin issues upon listing, and where possible they will also be designated as loan issues.

Margin trading means trading using borrowed securities or cash in the hopes of making a profit by exploiting the upward or downward movement of the market before re-paying the loan. So for example, investors who think that the market will continue to decline will sell (using borrowed securities) on margin and then buy back at a lower price to replace those sold. Thus profiting from the price differential. Conversely, investors who think that the market will continue to rise will buy (using borrowed cash) on margin, then re-sell at a profit later. Margin transactions also allow investors to take advantage of the leveraging offered by the price fluctuations of deposited collateral - although this is balanced by the consequent risks. Basically, margin trading of ETFs is equivalent to bull and bear (see 13.5 for an explanation) index fund trading. However, unlike ordinary bull and bear fund trading, which require daily leveraging on the futures market and are thus more expensive and less cost-efficient, ETF margin trading does not incur any additional transaction costs as investors can enjoy the profits arising from the market price fluctuations of deposited collateral.

Q17 How are ETFs traded on the day they are listed?

Unlike shares which are not subject to daily price limits on their first day of trading, it is easy to establish a base price from which to set daily price limits for ETFs even on their first trading day, as they are based on index. The base price for ETFs is the last value of the underlying index on the day before listing. This price will be published on the TSE website after the close of trading on the day before the ETF is due to list. Thus for example, for a TOPIX ETF which is listed the day after TOPIX is at 1,300 points, the daily price limits for the first day of trading will be 1,100 yen ~ 1,500 yen, in other words ± 200 yen. Subsequent daily price limits will be set on the basis of the preceding day's closing price (including closing quotes), the same as for ordinary stocks.

As mentioned above, ETFs are eligible for margin trading from the day they are listed.

Q18 Can ETFs be traded on TSE's ToSTNeT?

Yes, ETFs can be traded on TSE's off-hours trading system, ToSTNeT. ToSTNeT offers investors a variety of benefits.

1.Individual Investors

• ToSTNeT trading allows investors to trade on the basis of that day's closing price. This is in contrast to ordinary index investment trusts, which require investors to place their orders before the base price is even finalised.

2.Institutional Investors

• ToSTNeT allows institutional investors and securities companies to 'exchange futures for physicals' (EFP), in other words to exchange a futures position for a cash market (stock) position. In this respect, ETFs are equivalent to baskets of shares. EFPs using ETFs are already common in the US, and ToSTNeT provides investors with access to this function. ToSTNeT allows users to minimise the market impact of large-scale ETF transactions (basket transactions).

ToSTNeT Trading :

• ToSTNeT - 1 (single issue trading)
  Trading hours : 08:20∼09:00, 11:00∼12:30 & 15:00∼16:30
  Pricing : ± 7% of the auction closing price
  Method : cross-trading
• ToSTNeT - 2 (closing price trading)
  Trading hours : 08:45, 12:15 & 16:00 (orders accepted from 08:20)
  Pricing : auction closing price & VWAP
  Method : time-priority execution at each specific time

Q19 Are there any short-selling restrictions?

Short-selling is the sale of security that the investor does not possess, or which the investor has borrowed. Short-selling restrictions apply to ETFs. These restrictions apply to prices and the manner in which orders are displayed. However, given the nature of ETFs the following exemptions are planned.
(As for stocks, short-selling restrictions do not apply to margin transactions.)

• Short sales of shares when redeeming ETFs for those shares.
• Short sales of ETFs when making additional subscriptions for those ETFs.

Additionally, the following transactions are exempt from short-selling price restrictions.

• Short sales of ETFs to arbitrage/hedge between ETF and index futures transactions.
• Short sales of ETFs to arbitrage/hedge between ETF and stock transactions.
• Short sales of ETFs when the price of the ETFs exceeds the value of the index.

Q20 How do arbitrage transactions work?

ETF arbitrage trading offers investors the opportunity to exploit the price relationship between ETFs and the underlying index (stock prices), and as well as the ability to make in-kind subscriptions and redemptions. An example of an arbitrage transaction taking advantage of the fact that an ETF is priced above the underlying stocks. The investor profits from the net difference between the cash received for the ETF sold and the cash paid for the stocks (excluding loan fees, etc.)

ETFs can also be used to arbitrage index futures positions. Thus allowing investors to choose between stocks and ETF arbitrage transactions on the basis of price.

Q21 Are ETFs eligible for dividends like stocks are?

ETF-holders are eligible for dividend payments on the basis of the dividends paid by the stocks held as assets. Thus, for transactions to be settled after the dividend payment day, the base price is adjusted accordingly - just like for stocks. The adjustment to ETF base prices does not take place until payment of the ETF dividends.

Q22 How are ETF transactions settled?

Settlement of ETF transactions takes place via the Japan Securities Depository Center (JASDEC) book-entry system. Just as JASDEC notifies issuers of the beneficial stockholders facilitating the payment of dividends to shareholders via trust banks, so it fulfils the same role for ETF-holders.

Q23 What costs are involved for ETF transactions?

ETF transactions are subject to the same fees as stock transactions. These fees are determined by individual securities companies. Sales are also subject to taxation, basically the same as for stocks. Equally, just like ordinary investment trusts a certain proportion of the income from the assets held in trust are payable to the fund administrator. (These are indirect payments, not levied on individual transactions or dividend payments.)

Q24 How are ETF transactions taxed?

The tax system of Exchange Traded Funds is the same as that of stocks.

• What taxes will I have to pay? (FAQ)

Q25 What is ETFs on TSE?

ETFs on TSE is an area of the TSE website dedicated to the TSE ETF market. It features educational and PR materials. Explanations are given as to what an ETF is, how the market works and trading rules. Other information gives details oft listed ETFs and their daily disclosure updates showing the correlation between the net asset value (NAV) of the ETFs and the value of the underlying index, as well as portfolio composite files, giving details of the baskets of shares needed to subscribe to an ETF.

ETFs on TSE is a work in progress and we will continue working to provide as much information as is possible. ETFs on TSE can be found at the following web address:

• ETFs on TSE

Q26 What is the ETF market like in the United States?

Some of the key ETFs listed in the United States are SPDRs based on the S&P 500, Diamonds based on the Dow Jones Industrial 30, and Nasdaq-10, all listed by the American Stock Exchange (AMEX) in 1993, 1998 and 1999 respectively. There are now currently over 84 listed ETFs, in a variety of industrial sector and globally based indices. Since 1997, this market has grown significantly as a result of the stock market boom and the growing interest in index-based investment trusts shown by individuals, institutional investors and securities companies alike. AMEX is currently the world's leading ETF market.

Earlier this year, TSE signed a strategic alliance with AMEX, and looks forward to working with AMEX to promote the global ETF market.

• Indices