Exchange-Traded Funds: Mechanics and Applications - Full Guide

Why Exchange-Traded Funds (ETFs) are Important:
ETFs have become increasingly popular investment vehicles due to their liquidity, diversification, and cost-effectiveness. Understanding the mechanics and applications of ETFs is crucial for CFA Level 2 candidates, as they are frequently tested on the exam.

What are Exchange-Traded Funds?
ETFs are investment funds that are traded on stock exchanges, much like individual stocks. They typically track an index, sector, commodity, or other asset class, and aim to provide investors with exposure to a diversified portfolio in a single security.

How Exchange-Traded Funds Work:
ETFs are created and redeemed through a process called creation/redemption. Authorized participants (APs) buy the underlying securities and exchange them with the ETF provider for ETF shares, which are then sold to investors on the secondary market. This process helps keep the ETF's price in line with its net asset value (NAV).

Exam Tips: Answering Questions on Exchange-Traded Funds
1. Understand the differences between ETFs and mutual funds, such as intraday trading, transparency, and tax efficiency.
2. Know the creation/redemption process and the role of authorized participants.
3. Be familiar with the types of ETFs, such as equity, fixed income, commodity, and leveraged ETFs.
4. Understand the risks associated with ETFs, including tracking error, liquidity risk, and counterparty risk.
5. Practice calculating the net asset value (NAV) and the premium/discount of an ETF.
6. Be prepared to analyze the impact of market events on ETF pricing and trading.

By understanding the mechanics and applications of ETFs, and following these exam tips, CFA Level 2 candidates can improve their performance on questions related to this important topic.