Final answer:
ETFs tracking narrow-based stocks are subject to a haircut against capital to account for volatility and risk.
Step-by-step explanation:
ETFs tracking narrow-based stocks are subject to a haircut against capital. A haircut is a reduction in the value assigned to an asset for the purpose of calculating its collateral value. In the context of ETFs, a haircut is imposed to account for the potential volatility and risk associated with the underlying stocks.
For example, if an ETF tracks a basket of stocks that are deemed to be volatile or illiquid, the issuer may apply a 10% haircut. This means that the collateral value of the ETF is reduced by 10% when calculating its value for lending or borrowing purposes.
Overall, haircuts are meant to protect investors and ensure that ETFs accurately reflect the risks associated with their underlying assets.