Don Chance John Neumann Robert Waid and Kelly Haughton · 2016-04-21 · The following best describes my primary business activity ... Do you personally sell, ... work in the index

Indexes On My MindDon Chance

Arbing ETFsJohn Neumann

ETF Trading Industry Roundtable

Small Cap Indexes—With A Russell RebuttalRobert Waid and Kelly Haughton

Plus Coleman on the ETF/Index Boom, Haslem, Bogle, Blitzer, and Indexing Africa

1May/June 2008 www.journalofindexes.com

POSTMASTER: Send all address changes to Charter Financial Publishing Network, Inc., P.O. Box 7550, Shrewsbury, N.J. 07702. Reproduction, photocopying or incorporation into any information-retrieval system for external or internal use is prohibited unless permission is obtained in writing beforehand from the Journal Of

Indexes in each case for a specific article. The subscription fee entitles the subscriber to one copy only. Unauthorized copying is considered theft.

34

16

42

V o l . 1 1 N o . 3

w w w . j o u r n a l o f i n d e x e s . c o m

Six One Way, Half-A-Dozen The Otherby Don M. Chance . . . . . . . . . . . . . . . . . . . . . . . . 10 A fresh perspective on the indexing debate.

The ETF-Index Pricing Relationshipby John J. Neumann . . . . . . . . . . . . . . . . . . . . . . . . 16The Diamonds, the Dow and the business of arbitrage.

The State Of The ETF Marketwith Cliff Weber, Gary Gastineau, Gus Sauter, John Jacobs, Jim Ross and Lisa Dallmer. . . . . . . . . . . . . 22Specialists, seed capital and the future of ETFs.

Examining Small-Cap Manager Investable Universesby Robert J. Waid. . . . . . . . . . . . . . . . . . . . . . . . . . 30The flaw with the Russell 2000. Plus, Russell responds!

Boom Time For Indexers?by Murray Coleman . . . . . . . . . . . . . . . . . . . . . . . . 34What the ETF boom means for indexing start-ups.

Bogle’s Corner . . . . . . . . . . . . . . . . . . . . . . . . . . 38The gap between fund and shareholder returns.

An Idea Whose Time Has Comeby John A. Haslem . . . . . . . . . . . . . . . . . . . . . . . . . . 42Why the SEC should kill the 12(1)b fee.

Talking Indexes: David Blitzer . . . . . . . . . . . . . 46Will it be inflation? Or recession? Or both?

The Final Wordwith Benedict Okoh. . . . . . . . . . . . . . . . . . . . . . . . 64Developing indexes for the developing world.

f e a t u r e s

NYSE To Acquire Amex . . . . . . . . . . . . . . . . . . . . . . . . . .48Claymore Liquidates Eleven ETFs . . . . . . . . . . . . . . . . . .48IRS ETN Tax Decision . . . . . . . . . . . . . . . . . . . . . . . . . . .48Indexing Developments . . . . . . . . . . . . . . . . . . . . . . . . . .48Around The World Of ETFs . . . . . . . . . . . . . . . . . . . . . . .51Know Your Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55Into The Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56On The Move . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56

Selected Major Indexes . . . . . . . . . . . . . . . . . . . . . . . . . 59Returns Of Largest U.S. Index Mutual Funds . . . . . . . . . 60U.S. Market Overview In Style . . . . . . . . . . . . . . . . . . . . 61 U.S. Economic Sector Review. . . . . . . . . . . . . . . . . . . . . 62Exchange-Traded Funds Corner . . . . . . . . . . . . . . . . . . . 63

d a t a

n e w s

2 May/June 2008

Contributors

David Blitzer is the chairman of the S&P 500 Index Committee and a member of Standard & Poor’s Investment Policy Committee and Economic Forecast Council. He previously served as corporate economist at McGraw-Hill and as senior economic analyst with National Economic Research Associates. Mr. Blitzer is often quoted in the national business press and is the author of Outpacing the Pros: Using Indexes to Beat Wall Street’s Savviest Money Managers, McGraw-Hill, 2001.

John Bogle is the founder and former CEO of The Vanguard Group, Inc., and president of the Bogle Financial Markets Research Center. He created Vanguard in 1974 and had been associated with a predecessor company since 1951, following his graduation from Princeton University magna cum laude in economics. Mr. Bogle founded the Vanguard 500 Index Fund, the first index mutual fund, in 1975. Vanguard now comprises some 130 mutual funds with $1.3 trillion in assets.

Don Chance holds the William H. Wright, Jr. Endowed Chair for Financial Services at Louisiana State University. He was formerly First Union Professor of Financial Risk Management at Virginia Tech and prior to his academic career, he worked for a large southeastern bank. Professor Chance has authored three books, including co-authoring An Introduction to Derivatives and Risk Management, now in its 7th edition. He frequently speaks at conferences on indexing and ETFs.

Murray Coleman is the managing editor of IndexUniverse.com and the director of research for Index Publications LLC, the publisher of the Journal of Indexes. Prior to joining Index Publications, Mr. Coleman was a mutual funds reporter for Dow Jones’ Marketwatch.com, and earlier, for Investor’s Business Daily. His experience reporting on the financial industry stretches back more than two decades.

John Haslem is professor emeritus of finance at the Robert H. Smith School of Business, University of Maryland, College Park. He served the Smith School as founding academic affairs dean and as founding chair of the finance depart-ment. His mutual funds analysis course was the first of its kind. Mr. Haslem has authored five books, including Mutual Funds: Risk and Performance Analysis for Decision Making, Oxford: Blackwell Publishing, 2003.

John Neumann is the assistant professor of economics and finance, and direc-tor of the Financial Information Lab, at the Peter J. Tobin College of Business at St. John’s University. Professor Neumann completed his doctorate in business administration from Boston University’s School of Management during the summer of 2003. In between receiving his DBA and a B.S. in economics from the Wharton School in 1986, Dr. Neumann built information systems over 10 years for Arthur Andersen & Co. (now Accenture), Robert A. Stanger & Co. and AT&T.

Robert Waid is the head of index research for Wilshire Equity Analytics. Mr. Waid has two decades of index-related experience at Wilshire Associates and is now closely involved with the Dow Jones Wilshire indexes. His prior respon-sibilities included overseeing Wilshire’s Proprietary Investment department and Proprietary Research, where he was responsible for the development, implementation and management of domestic long/short programs. Before taking on his money management role, Mr. Waid oversaw Wilshire’s Database Systems Group.

John

Bog

le

Don

0Ch

ance

Mur

ray

Cole

man

John

Has

lem

Dav

id B

litze

r

John

Neu

man

n

Robe

rt W

aid

May/June 20084

Copyright © 2008 by Index Publications LLC and Charter Financial Publishing Network Inc. All rights reserved.

Jim WiandtEditor

[email protected]

Dorothy HinchcliffManaging Editor

[email protected]

Matt HouganSenior Editor

[email protected]

Heather BellContributing Editor

Lisa BarrCopy Editor

Laura ZavetzCreative Director

Jodie BattagliaArt Director

Merri ChapinGraphics Manager

Andres FonsecaOnline Art Director

Aimee PalumboProduction Manager

Editorial Board:David Blitzer: Standard & Poor’s

Lisa Dallmer: NYSEJames Ross: State Street Global Advisors

Deborah Fuhr: Morgan StanleyGary Gastineau: ETF Consultants

Kelly Haughton: Frank Russell CompanyJohn Jacobs: The Nasdaq Stock Market

Joanne Hill: Goldman SachsLee Kranefuss: Barclays Global Investors

Kathleen Moriarty: Katten Muchin Rosenman Jerry Moskowitz: FTSE

Don Phillips: MorningstarJohn Prestbo: Dow Jones IndexesGus Sauter: The Vanguard Group

Steven Schoenfeld: Northern TrustCliff Weber: The American Stock Exchange

Review Board:Jan Altmann, Sanjay Arya, Jay Baker, Heather Bell, William Bernstein, Herb Blank, Srikant Dash, Fred Delva, Gary Eisenreich, Richard

Evans, Jeffrey Feltman, Gus Fleites, Bill Fouse, Christian Gast, Thomas Jardine, Paul Kaplan, Joe Keenan, Steve Kim, David Krein, Ananth Madhaven, Brian Mattes, Dan McCabe, Kris

Monaco, Matthew Moran, Ranga Nathan, Jim Novakoff, Rick Redding, Anthony

Scamardella, Larry Swedroe, Jason Toussaint, Jeff Troutner, Mike Traynor, Peter Vann, Wayne Wagner, Peter Wall, Brad Zigler

The Journal of Indexes is the premier source for financial index research, news and data. Written by and for industry experts and

financial practioners, it is the book of record for the index industry.To order your FREE subscription, complete and fax this form

to (732) 450-8877 or subscribe online at www.journalofindexes/subscriptions.

All questions must be answered to qualify for free subscription. Publisher reserves the right to reject unqualified applications.

qYes! Send me a free subscription to Journal of Indexes magazine

qNo, thank you

Name

Company

Address

City State Zip

Phone Fax

E-mail

Signature Date

Title

The following best describes my primary business activity (check one): (1) qPlan Sponsor (2) qFinancial Advisor(3) qInvestment Management (4) qMutual Fund Management(5) qPension Fund Consulting (6) qPension Fund Management(7) qBrokerage (8) qAcademic(9) qOrdinary Investor (10) qOther:__________________

Do you personally sell, recommend or manage investments, work in the index industry or advise clients on investment and/or asset management?qYes qNo

If you advise clients as to their investments, how do you charge them?qCommission only qFee only qFee and commission

If you manage investments, what are your total assets under management? (1) qOver $500 million (2) q$100 million - $500 million (3) q$50 million - $99.9 million (4) q$25 million - $49.9 million (5) q$10 million - $24.9 million (6) qUnder $10 million

free subscription offer!

May/June 20086

David SmithPublisher

[email protected] ext. 26

Jim WiandtDirector of Operations

[email protected] • Fax: 212.208.4318

Fernando RiveraAdvertising Coordinator


Don FriedmanDirector of Business Development


Caren Paradise KohlNew England Advertising Director


Diane RogalaEast Region Advertising Director


Dawn ZarcaroAdvertising Manager


Steve KimballReprint Sales Manager732.450.8866 ext. 29

Susanna MarraCirculation Manager

732.450.8866 ext. 24

Charter Financial Publishing Network, Inc.

499 Broad StreetShrewsbury, NJ 07702

732.450.8866 • Fax 732.450.8877Charlie Stroller, President/CEO/CFO

[email protected]

Index Publications LLC419 Lafayette St., 3rd Floor

New York, NY 100031.877.6INDEX6 • Fax 646.706.7051

Jim Wiandt, [email protected]

Charter Financial Publishing Network Inc. also publishes: Financial Advisor magazine, Private Wealth magazine, Nick Murray Interactive, Exchange-Traded Funds Report and Risk-Controlled Investing.

For a free subscription to the Journal of Indexes, IndexUniverse.com or Financial Advisor magazine,

or a paid subscription to ETFR, please visit www.journalofindexes.com/subscriptions.

May/June 20088

Editor’s Note

eading off our early summer offering are two outstanding submis-sions from academia. We normally backload the magazine with our more academic offerings to give you a chance to get warmed up at the front of the publication. But this issue, we open with an outstanding ramble through the current state of the indexing world by Professor Don Chance of Louisiana State University, who is always a good read.

Next up is the closest look I’ve seen at the process of how and why the arbitrage process works for ETFs from Professor John Neumann of St. John’s University. If you didn’t already have confidence in the tight

pricing of ETFs to the underlying net asset value (NAV), this should help you find some.The Neumann piece is a perfect lead in to our ETF trading roundtable. These features

are among my favorites that we do, and this one is stellar. We’ve brought in the key figures around ETF trading and asked them the same questions side-by-side to compare and contrast their responses. The result is extraordinarily interesting and informative.

While we’re in the debating spirit, we have a submission from Bob Waid (father of the DJ Wilshire indexes) that takes a direct shot at the Russell 2000. Kelly Haughton (father of the Russell indexes) provides a rebuttal. The poor (index) kids, as always, are caught in the middle.

Also out of the middle of the index business is David Blitzer of S&P with his column, which takes a reflective look at current market turbulence and its place in history.

Our own Murray Coleman weighs in with an index-focused piece of his own … this one examining the rough-and-tumble world of the smaller, innovative index provid-ers. Murray’s piece has some choice quotes, including this one from Kevin Carter at AlphaShares: “If you’re providing an index to a $50 million [in assets] ETF, then you’d better find a night job.”

Then we get into the “old school” material. John Bogle returns to his Corner with a biting look at the yawning gap between fund and shareholder returns, while Professor Haslem provides a clarion call for the banishment of 12b-1 fees.

Rounding out the issue is a nifty little profile with one of those innovative indexers Murray was talking about, Benedict Okoh from AfriFinance, which has African indexes that have been launched into incipient demand from investors increasingly looking toward frontier markets. We’ve got it all here this issue from the new school to old school. We hope you enjoy it.

Jim WiandtEditor

The State Of The Index World

Jim WiandtEditor

L

May/June 200810

by Don M. Chance

A fresh perspective on the indexing debate

Six One Way, Half-A-Dozen The Other

May/June 2008www.journalofindexes.com 11

Ah indexing. What a fascinating and contentious subject. At the almost innumerable indexing conferences and on the pages of this journal and elsewhere, we hear

nearly endless debate on the critical issues of the times in the riveting world of indexing. As an observer of this industry, I find these issues fascinating, not always for what we hear, but oftentimes for what we don’t hear. I think it is worthwhile on occasion to take an objective look at this debate. So in this article, I intend to visit six of the key issues in indexing. I will outline each issue and tell you what I think is really going on.

Issue 1: Modern Portfolio Theory And The Roots Of Indexing

Thanks to its origins in modern portfolio theory (MPT), indexing has become the gold standard in investment strat-egy. Anyone who claims to be indexing is automatically deemed to be following a wise and well-tested strategy with its origins in the modern portfolio theory of Markowitz, Sharpe and the usual cast of characters. The imprimatur of academic support for indexing is surely responsible for much of the strategy’s popularity and the belief that indexing is a sound strategy. But things are not really what they seem.

As most indexers know, modern portfolio theory was devel-oped in the early 1950s by Harry Markowitz, who went on to share the Nobel Prize in Economics in 1990. What Markowitz did was to propose that investment strategy should be based on the notion of a portfolio of assets whose interrelationships should be considered. Markowitz defined the concept of diversification in mathematical terms, as reflected by the cor-relations among the assets in the portfolio. He proposed that investors who wanted to achieve the maximum ex ante satis-faction from their investments should attempt to hold only efficient portfolios, which are those that maximize expected return for a given level of risk.1 Markowitz also provided the algorithms that would identify these portfolios. Yes, I know he did a lot more, but those are the essential ideas. These results were published in his 1952 article and 1959 book.2

Shortly thereafter, three economists, William Sharpe, John Lintner and Jan Mossin, began working on the notion of what happens to markets when people behave in the manner of maximizing expected return for a given level of risk. Almost simultaneously, these three pioneers of finance found two important results. The first is that every investor would hold a portfolio that consists of all risky assets in the market, which has come to be known as the market portfolio. The second is that the expected return on an asset is given by the risk-free rate plus a premium that reflects the asset’s contribution to the risk of a diversified portfolio.

The appropriate measure of risk for an asset was found to be its covariance with the market portfolio, a concept that has since been dubbed beta. Of course, this model became known as the capital asset pricing model (CAPM). Sharpe published his results in 1964, Lintner in 1965 and Mossin in 1966.3 Lintner died in 1983 and Mossin in 1987. Sharpe shared the Nobel Prize in 1990 with Markowitz and Merton Miller, another well-known financial economist, though not a contributor to modern portfolio theory.

As noted, an important result from CAPM is that everyone

should hold the so-called market portfolio. Trying to identify over- and underpriced securities and sectors of the market would be a wasted effort. It took around 10 years for this concept to make it into practice, but John Bogle, who had written a thesis in 1951 at Princeton on the idea of a fund that would replicate a market index, created the first index fund in 1976, which came to be known as the Vanguard S&P 500 Index Fund. The fund was not too popular at the start, new and unconventional ideas nearly always being initially rejected by the masses, but the idea slowly began to take hold and the rest is, as they say, history.

It is important to understand that there is nothing in the CAPM or MPT that dictates that investors should hold an index fund. The theory says that investors should buy and hold a portfolio consisting of all risky assets. That such a portfolio is represented by an index is a stretch. For one, no index can truly represent the entire universe of assets. Even if stocks and bonds were contained in an index, there would still be gold, commodities, vintage automobiles, real estate, baseball cards, comic books, fine wines, and Angelina Jolie autographs for starters. In fact, anything that one might possess that can fluctuate in value would be part of the market portfolio.4

The omission of assets from the market portfolio is often recognized as an important consideration. In his classic 1977 critique of the empirical tests of the CAPM, Richard Roll demon-strated that omitting even one asset from the empirical proxy for the market portfolio could greatly skew the results. In practice, this notion has led to the creation of indexes comprised of more and more assets. But of course, we’ll never capture everything.

Well, it is asking a bit much for mankind to lump all risky assets together into a single portfolio, so we’ll have to let the indexers off the hook on this one. Bill Sharpe has also advanced the notion that maybe it does not really matter. The idea of a truly global market portfolio might matter to some investors but perhaps not to most. So maybe a more limited definition of the market is acceptable.5 And even if we could put all assets into a portfolio, there is no assurance that inves-tors would buy that portfolio and hold it. In fact, I am quite confident they and their advisors would not. Trading is way too much fun and watching a static portfolio can be about as much fun as watching reruns of “The Weather Channel.”

But it is reasonable to ask whether an index is sufficiently broad to reflect a collection of risky assets that the average investor could hold. And it is reasonable to ask whether an index that itself is dynamic in composition or is actively traded by an investor is a strategy befitting its status as a descendent of MPT and the CAPM.

My point? The indexing industry has benefited from the endorsement of its products by an academic lineage going back to Markowitz’s MPT. Of course, it can easily argue that academic theory is no longer needed to support an industry that has stood quite nicely on its own for many years. But by association, indexing is oftentimes treated as synonymous with the buy-and-hold-the-market portfolio strategy.

We need to remember what indexing is and what it isn’t. What indexing is, is a strategy for investing in a collec-

tion of assets designed by a group of human beings who have defined what assets will be contained in the index and

May/June 200812

how these assets will be weighted or combined. What index-ing isn’t is a strategy that assures investors that they are maximizing expected return per unit of risk. We can never be assured that we are doing just that. Markowitz, Sharpe, et al., never addressed the question of whether we can 1) measure expected returns, volatilities and correlations, and 2) measure our feelings (called preferences) about risk. While there has been much research on these subjects since that time, I am not sure we have really made much progress.6

Issue 2: Market Value WeightingsWhile we know that we cannot truly measure the market

portfolio, we do know from MPT and the CAPM that the port-folio’s composition is market-value weighted. That means that all assets are held in proportion to their market values. Consider a market consisting of two stocks, A and B. A has 100 shares outstanding at $40 a share, and B has 200 shares

outstanding at $30 a share. Thus, company A is worth $4,000 and company B is worth $6,000 for a total value of the market of $10,000. The market value weight of A is 40 percent and that of B is 60 percent. Any investor who wants to hold the market portfolio, or an indexer who wants to replicate the market portfolio would, therefore, hold a portfolio consisting of 40 percent of his money in A and 60 percent in B.

Recent debates have questioned whether market value weighting, or cap weighting as it is often called, is a good strategy. Let’s see where that idea comes from. Assume that stock A goes up by 10 percent to $44 and stock B goes down by 5 percent to $28.50. Then company A is worth $4,400 and company B is worth $5,700. Thus, the stocks are now worth $10,100. The weight of A is now 43.56 percent and the weight of B is now 56.44 percent. A is now more weighted than before and B is less weighted.

While some may disagree, the essential argument against market value weighting is this: A is now more expensive than before and B is now less expensive than before. Therefore, investing according to market value weights means to com-mit relatively more money (than previously) to more-expen-sive stocks and relatively less money (than previously) to less-expensive stocks. Some have even referred to market value weighting as essentially buying high and selling low. But the basic idea is that stocks that have gone up are “expensive” and stocks that have gone down are “cheap.” Therefore, such a strategy presumably makes little sense.

That is absurd. Investing according to market value weighting is nothing

more than going along with what other investors believe. In our example, A has become relatively more expensive than B because investors increased the price of A and decreased the price of B and did so for a reason. A is now worth more

because investors are more optimistic about the future pros-pects of A and less so about the future prospects of B.

To disagree with the beliefs of the majority of investors is not necessarily an unreasonable strategy. But to do so arbi-trarily, mechanically and as an ongoing strategy is equivalent to following a continuous contrarian strategy. While we are all contrarians on occasion, outright rejection of market value weighting is simply saying, “Sell what everyone else is buying and buy what everyone else is selling.”

I believe that history has proven time and again that in financial markets, the majority tends to be right more often than wrong. And even when it’s not right, there is at least some comfort in being collectively wrong.7

Issue 3: Fundamental IndexingConcern by opponents of market value weighting has

led to the development of a new form of investing called

fundamental indexing.8 “Fundamental” is a nice word. Getting back to fundamentals is usually thought of as a good thing. Let us remember what the word “fundamental” means in an investment context. Going back to Benjamin Graham, David Dodd and their modern-day disciple Warren Buffett, we find the notion of fundamental value of a company. Fundamental investors try to determine what a company is worth. Sure, a stock may be selling for $50 a share, but could it be worth more or less than $50? Trying to find out what a company is worth is often called fundamental analysis, which is usually considered a virtuous activity in the investment profession. In fact, much of the basis for the prestigious Chartered Financial Analyst (CFA) program is fundamental analysis.

Fundamental analysis has some elements of a science. Financial analysts compute ratios, forecast dividends and growth rates, plug them in to formulas and come up with pre-cise numbers. Then they go on CNBC and tell Maria Bartiromo things like, “I see that stock hitting $75, maybe $80 a share in the next 12 months.”

Realistically, no one really has a clue. Fundamental analysis is as much of an art as it is a science. The ability to judge the quality of a company’s management, surely an art form, is as important as the analyst’s shot-in-the-dark estimate of future growth. But it’s all fuzzy. No one can really identify the fundamental value of a company. But those who do well, such as Warren Buffett, will likely be good at identifying the overpriced and underpriced stocks. Buffett may not be able to tell you the true value of the company, but he seems able to often identify whether that value is higher or lower than the current price.

That leads us to the notion of fundamental indexing.The fundamental indexers are basically telling us that they

can identify overvalued and undervalued stocks and sectors.

I believe that history has proven time and again that in financial markets, the majority tends to be right more often than wrong.


Their rules are often simple and sometimes easily replicated. They might pick high-dividend-paying stocks, or they might pick those stocks with the strongest earnings growth in the last year. Value and growth stock indexes are elements of fundamental indexing. Their compositions change based on the notion of whether a stock’s price is high (growth) or low (value) relative to fundamental value.

Fundamental indexers will often tell you that market value weightings are biased toward growth stocks. They reason that market value weightings, which tilt a portfolio toward higher-valued companies, therefore favor growth stocks and disfavor value stocks. But this notion is correct only if by defi-nition value stocks are ones with lower market values. That might sometimes be the case, but surely not always. Investing cannot be as simple as preferring stocks with relatively low weights and eschewing stocks with relatively high weights.9

Fundamental indexing is a form of active trading in which the index creator pronounces that it will create and actively manage an index. Change “an index” to “a portfolio” and you have precisely the same thing. Of course, calling this “indexing” gives it a certain blessing; one whose origins are in MPT, CAPM, Markowitz and all that good stuff as I previously discussed.

I have no problem with fundamental indexing—or, call it what it is, active trading—a point I will discuss in the next section. And I really have no problem with calling it “index-ing,” because I can tell the difference between that and a strategy of buying and holding a broadly diversified portfolio. I’m not so sure, however, that everyone notices that difference.

Issue 4: Active TradingLet’s create a simple market consisting of only two sectors:

technology and health care. Let the firms in each sector have values that add up to $1,000. Thus, the market as a whole is worth $2,000. Assume an index fund is available that truly replicates the market.

Now let us assume that through countless conferences, innumerable books, and the tireless classroom and research efforts of business school professors like myself, the next generation is firmly convinced that indexing and by that I mean buying and holding a broadly diversified portfolio is the way to go. Let’s think about what would happen.

With everyone solidly committed to indexing, there would be no technology and health care analysts.10 Information about the relative worth of the technology and health care sectors would be of little use because everyone indexes. Thus, the overvalua-tion of one sector is offset by the undervaluation of the other. Who cares if technology is overpriced and health care under-priced? We all buy and hold a proxy for the market portfolio.

I’ll tell you who ought to care. We all ought to care a lot!The firms in overpriced sectors will have relatively lower

costs of capital, while the firms in underpriced sectors will have relatively higher costs of capital. This means that overpriced firms will be able to invest in more projects, while underpriced firms will be unable to invest in some otherwise attractive proj-ects. Thus, capital is being allocated inefficiently.

We can even carry the argument a degree further. Suppose the advocates of indexing notice that the sectors are frequently mispriced. Seeing an opportunity, they cre-

ate indexes on the sectors. Now there is a whole new, or at least revived, profession of sector analysts processing infor-mation. Then we are likely to get more accurately priced sectors, but what about the component stocks? No one is following stocks, because everyone either holds the over-all market index or the sector indexes. So now individual stocks become mispriced. Microsoft might then have access to inordinately cheap capital with which it can continue to grind out infinitesimally “improved” versions of Windows, while Eli Lilly, on the verge of curing ALS, has a cost of capital so high that it cannot sink any more money into R&D unless the disease becomes sufficiently widespread that it can sell enough of the drug to justify the investment.

That’s great. Our PC’s still turn into the infamous “blue screen of death” and we have to hope more people get ALS. How depressing.

Thus, with regard to active trading, I will just quote Martha Stewart, usually talking about something she made out of pine cones, “It’s a good thing.”11 This justifiable pursuit of alpha by large, sophisticated and low-cost investors who can afford it benefits us all. But most investors do not have the kinds of resources required to actively trade at a low enough cost with a reasonable expectation of generating alpha, so they ought to be content to index, knowing that they reap the benefits of efficient capital allocation in the economy.

Issue 5: AlphaI find it somewhat surprising that in the indexing world,

we hear the term alpha used quite a lot. I suspect there are some misunderstandings about alpha, so let me either clear them up or muddy the waters further.

First, it is extremely important to understand that alpha is not a measure of market- or sector-timing ability. It is a mea-sure of selectivity that indicates the performance of a stock or sector relative to its benchmark or expected performance. Consider two investors, one an optimist who invests 100 per-cent of his money in an index fund and the other a pessimist who invests 100 percent of her money in cash, which earns 4 percent. In accordance with MPT, the index fund has a beta of 1.0, so the optimist has a beta of 1.0 and the pessimist has a beta of 0.0. Let’s say the index earns 10 percent.

The benchmark return of the optimist is: Optimist: 4% + (10% - 4%)1.0 = 10%.

The benchmark return of the pessimist is: Pessimist: 4% + (10% - 4%)0.0 = 4%.

The alpha of the optimist is: Alpha (optimist): 10% - 10% = 0%

The alpha of the pessimist is: Alpha (pessimist): 4% - 4% = 0%.

Thus, both optimist and pessimist have alphas of zero. But the market outperformed cash and the optimist was in the market. The optimist made the right call, and the pessimist made the wrong call. What gives?

Well, what gives is that alpha does not measure timing; that is, the act of being in or out of a market or sector at the right time. In the example above, you can change the return on the index to anything you want and you will get the same result. Alpha will not distinguish two investors, one of whom

May/June 200814

makes the right market or sector call and the other of whom makes the wrong one.

But to fully appreciate this issue, we need to distinguish timing from selectivity. Isn’t one just a form of the other? For example, let’s go back to our market with two sectors, technology and health care. Assume there are no individual stocks, just sectors. These could be two enormous holding companies that have bought up all of the component stocks so you can only buy the sectors through buying the holding companies. Let us assume one sector is undervalued and one is overvalued. The objective should be to buy the underval-

ued sector and sell the overvalued sector. If the investor does so successfully, it generates an alpha. But we have to be very careful in recognizing what alpha is.

Alpha is the excess return earned from taking on risk that is not rewarded.

In the MPT-CAPM world, an investor cannot expect a premium from investing in sectors and individual assets. That risk is diversifiable, and diversifiable risk does not qualify for a risk premium.12 Alpha is earned from tak-ing on a degree of this type of risk that goes beyond the market value weightings. In practice, whether alpha can be earned from identifying mispriced sectors depends on whether there is a risk premium from investing in a sector, knowing that sector risk can be eliminated by diversifying across sectors. The CAPM says that there is no sector risk premium, but there are some who believe otherwise.

Thus, in a loose sense, timing and selectivity can be viewed as similar, but there is a clear difference. Timing is buying an asset class that commands a risk premium before that asset class outperforms a different asset class, and selling the asset class before it is outperformed by a different asset class. Because that asset class commands a risk premium, quality timing is not reflected in alpha. Measuring timing performance requires something other than alpha, a topic we do not get in to here. Investing in an asset class that does not command a risk premium, on the other hand, can generate alpha. Hence, one can view an individual stock as a tiny asset class. Buying it in such a weight that more is held than dic-tated by a benchmark can lead to alpha, if you’re good. Thus, we have to be clear on what an alpha is: earning a return from an asset that does not command a risk premium.

Of course, using alpha assumes that we can adequately measure alpha, and that is an even more important ques-tion. But the editors would kill me if I got started on that issue. Maybe another time.

Issue 6: Stocks, Bonds And Long-Term InvestingIn Jeremy Siegel’s latest book, he states that stocks have

earned a long-term compound return of 8.3 percent from 1802–2006, while bonds have earned 4.8 percent over that

time period.13 In spite of the higher risk, but in light of infla-tion and taxes, Siegel argues that stocks are the best long-run investment. The indexing industry has benefited from that view, because it is a pretty strong argument for buying and holding a stock index for most of your life and hoping from the hereafter that your heirs keep doing so.

I have no problem with this argument. Stocks have indeed been the best long-term investment in the past. But some people mistake that notion for the idea that stocks are best for the long run because they diver-sify your risk across time. And they believe that because

stocks have been the best long-term historical investment in the past, the same will carry over to the future. Let us take a look at what these views mean.

The first idea is the notion of time diversification, which must be contrasted sharply with portfolio diversification. In the latter case, assets are combined in such a manner that their relative behaviors provided something of a canceling or offsetting effect. If well diversified, an inves-tor will be unlikely to find that all assets will go down at once. Likewise, all assets will rarely go up at once. This is the notion of diversification that is the basis for buying and holding the market portfolio. Time diversification, on the other hand, is the idea that if you remain invested for a long enough period of time, bad performance in some periods will be more than offset by good performance in other periods. In contrast, if you are invested for only a short period and that period happens to have bad perfor-mance, you have no opportunity to recover in later peri-ods. So the argument goes: Be in it for the long haul.

This is a misleading view and arises from thinking of long-term market history as a large number of short subhistories rather than just a single period of long history.

Consider Siegel’s annual return data from 1802–2006, a period of 204 years. How do you view it? Is it one period of 204 years, or 204 periods of one year? If it’s the latter, why not view it as 408 periods of six months, or 2,448 twelve-month periods, or so on? The finer we divide time, the more it appears that we have more experience than we really have. In fact, what we have is one period of 204 years, a time over which stocks outperformed bonds and earned a compound annual return of 8.3 percent. The next 204 years could be different.

That market history is not an agglomeration of subhisto-ries is easy to verify with a market simulator. While I will not take you through the details, consider a computer program generating random numbers indexed to have the character-istic of the same average return, 9.7 percent, and standard deviation, 17.5 percent, as stocks did over the 1802–2006 period. Each time you run the simulation, it generates a series of prices that represent a possible long-term history of the market. Each series will have come from a process with

What will investing be like? I will venture a prediction that

indexing will go in and out in waves.


the correct annual return and standard deviation, but some realizations of that process will go up and some will go down. This means that it is quite possible that investing in the stock market for the 204 years since 1802 would have been a losing proposition. We have lived through only one 204-year period since 1802, and it happened to be a good one.14

Whether stocks will be a good long-term investment in the future is not really much related to the fact that they have been a good long-term investment in the past. But the two important issues are whether stocks will outperform cash; that is, whether there is a positive return to bearing the risk that stocks have, and whether stocks will deliver a compound return of 8–10 percent as they have in the past over the long run.

Should stocks beat cash in the long run? They should. Except for inflation, stocks have risk that cash does not. If investors do not perceive that stocks will beat cash, they will sell stocks. In fact, that is pretty much what makes stocks go down as inves-tors take money out of the stock market and put it into cash and other markets. The loss in stock prices makes stocks have higher expected returns, as investors pay less for stocks. This process continues until stocks have prices that are sufficiently low to imply high enough expected returns so that there is a premium expected for bearing risk. Therefore, it is extremely unlikely that stocks will not outperform cash and all other investment avenues that bear less risk in the long run.

But it is unclear exactly how far into the future one must look to define the long run. Clearly stocks are sometimes out-performed by cash. In fact, there have been two four- and two five-year periods in the history of U.S. markets in which cash outperformed stocks. I don’t know about you, but I would probably be getting impatient had I been around at that time.

So I am just not quite sure how long the long run is. As the Eagles sing,

We’ll find out. In the long run.

Well, we won’t find out. But maybe our children’s children will. Keep reading for more on this.

Some Final ThoughtsIt’s fun to speculate on what the distant future could be

like, knowing none of us will be around to witness it, nor will anyone remember how bad our predictions were. Perhaps in 100 years, if the network news is still around, the talk-ing heads will be earning $1 million a broadcast, while their viewers have already gotten their news through other media. Perhaps “American Idol” (Version 107 but probably renamed) will still be popular and maybe Jack Bauer V, or someone like him, will be torturing lots of terrorists in a 24-hour period. Hopefully New Orleans will not have slid into the Gulf. The fixed-income portion of Harvard’s endowment might be suf-ficient to fund the entire national debt. For sure, Yankees and Red Sox fans will still hate each other, and hopefully the Cubs will have broken their curse.

What will investing be like? I will venture a prediction that indexing will go in and out in waves. At times, the industry will market indexing as a new invention and people will see indexes on everything from the latest hot stocks to the latest cold stocks to stocks predicted by Nostradamus to outper-form in the 22nd century. At other times, indexing will be outré, and individual stocks possibly even poorly diversified portfolios will be touted as the only reasonable means of achieving true long-run wealth. Doctoral dissertations will be written on the good, the bad and the ugly of indexing and other forms of investing. There will be 1 million mutual funds but, because of mergers and failures, only a few more publicly traded companies than there are today.

But one thing is for sure: People will still expect to earn a higher return for taking more risk in the long run. And they’ll still be wondering just how long this long run really is.

Endnotes*The author acknowledges helpful comments from Al Neubert.1Note that I emphasize the Latin words ex ante. Markowitz said nothing about whether investors would realize ex post satisfaction. In other words, he did not collect any data and

examine whether the ex ante measures of risk and return proved to be good measures of ex post results. That’s another story, a part of which I take up as the 6th issue.2Harry Markowitz, “Portfolio Selection,” The Journal of Finance, Vol. 7, 1952, pp. 77-91 and Portfolio Selection: Efficient Diversification of Investments, 1959, New Haven: Yale University Press.3William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” The Journal of Finance, Vol. 19, 1964, pp. 425-442; John Lintner, “The Valuation

of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics, Vol. 47, 1965, pp. 13-37; Jan Mossin, “Equilibrium

in a Capital Asset Market,” Econometrica, Vol. 34, 1966, pp. 768-783. Interestingly, Sharpe and Mossin used the term “capital asset” followed by either “prices” or “markets,” while

Lintner did not use the term at all. None used the term “Capital Asset Pricing Model.” Eugene Fama, another of the pioneers of the model, was not noted for using the term, seeming

to prefer “two-parameter model.” Frankly, it is not clear who gave the model the name it is so commonly referred to, though the term was used in 1972 by Fischer Black, Michael

C. Jensen, and Myron Scholes in their article, “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in the Theory of Capital Markets, ed. Michael C. Jensen, 1972, New

York: Praeger Press.4The remarkable success of online auctions further complicates the issue of identifying the market portfolio. Thanks to eBay, we now know that people possess an incredible

amount of marketable junk that may well constitute its own asset class, what with rates of return, standard deviations, etc.5http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm6Just to show you how little we know about risk preferences, take note that economists believe they have learned a great deal about this subject by studying game shows, as if

people act normally on national television risking money that wasn’t theirs when the show started.7Unless, of course, you are a politician or CEO, where you are expected to be correct and in agreement with your constituents 100 percent of the time.8See Robert D. Arnott, Jason C. Hsu, and Philip Moore, “Fundamental Indexation,” Financial Analysts Journal, Vol. 61, March/April 2005, pp. 83–89.9If my explanation isn’t good enough for you, see André F. Perold, “Fundamentally Flawed Indexing,” Financial Analysts Journal, Vol. 63, November/December 2007, pp. 31-37.

continued on page 57

May/June 200816

by John J. Neumann

The Diamonds, the Dow and the business of arbitrage

The ETF-Index Pricing Relationship


n the more than a decade since the first exchange-traded products were introduced, these securities have become progressively more popular investment vehicles among pro-

fessional and individual investors alike. As of March 2008, there were more than 600 exchange-traded fund portfolios being actively traded and several hundred more in registration.

Not only has the number of ETF offerings increased, but the size of the individual ETF issues has grown. At year-end 2007, the S&P 500 index-tracking ETF (SPY, or the SPDR) had 25 times more shares outstanding than in 1998, and its aver-age daily trading volume grew at an average annual rate of 40.5 percent over that time. DIA, or “Diamonds,” which was introduced in 1998 to track the portfolio of 30 stocks in the Dow Jones Industrial Average (“DJIA”) and is the focus of this article, has seen its daily average volume grow by 41 percent per year on average over that same period.

ETFs in general allow investors to gain from intraday moves of an index since they trade as individual company stocks do, with continuously updated bid/ask quotes. They support inves-tors’ pursuit of passive investment strategies with more direct control of tax events (and generally lower expense ratios) than mutual funds. Thus, if investors believe that large, blue-chip- type companies are going to have a good (bad) day on average, but are unable to pinpoint exactly which of the 30 stocks in the DJIA might experience the most significant price increases (declines), Diamonds now provide a vehicle with which they can try to profit from their expectation. This is not possible with a traditional index mutual fund, since these funds calcu-late their net asset value once a day, after the markets have closed, so buyers and sellers of shares do so at the same price. Additionally, unlike mutual funds, ETFs can be sold short to gain if the index is expected to decline.

If the individual stocks in the DJIA index are all subject to their own buying and selling pressures throughout the day, DIA, as a stand-alone security, must also be subject to buying and selling pressures. One can envision a piece of news being released which motivates investors to transact in the ETF —but not the individual companies—perhaps because the news is so fundamental a systematic news event, in modern portfolio theory terms, that it is expected to have an on average effect on “the market.” Conversely, and perhaps more clearly, news released about individual companies in the index might attract

investor attention to these individual stocks more so than to the portfolio as a whole, especially during earnings reporting periods. What, then, is the mechanism that assures that the share price of an independent ETF security does not become disconnected from the underlying portfolio of stocks to which it is tied and consistently fulfills its objective of tracking the underlying index portfolio? In a word, arbitrage.

Arbitrage And The ETFsStrictly speaking, an arbitrage is a mispricing between two

(or more) assets or bundles of assets which are identical in some way and related via a well-defined pricing relationship. The mispricing may exist because one asset (or bundle) is overpriced for a period of time, because the other asset (or bundle) is underpriced for a period of time or because both assets (bundles) are mispriced. An arbitrage strategy attempts to lock in a risk-free profit by exploiting the mispricing with a virtually costless portfolio that calls for short positions in the overpriced asset(s) and long positions in the under-priced asset(s), the latter financed using the short proceeds. Implemented on a large scale, the net selling pressure of the short positions causes the price(s) of the overpriced asset(s) to decline, while the net buying pressure forces the price(s) of underpriced asset(s) to rise. The expectation is that when prices return to levels at which the well-defined relationship once again holds, this portfolio can be unwound to leave a net cash amount as the investor’s arbitrage profit.

The Diamonds prospectus reads: “[T]he Sponsor’s aim in designing DIAMONDS was to provide investors with a security whose initial market value would approximate one-hundredth (1/100th) the value of the DJIA.” Figure 1 reveals that from January 20, 1998, the day the Diamonds ETF started trading, until December 31, 2005, the ratio of the closing val-ues of the Dow Jones Industrial Average to the per-share price of Diamonds ranged from 98.4526 to 102.4855. The mean ratio was 99.8978, with a standard deviation of 0.2204, indi-cating that roughly 95 percent of the time, this ratio has been between 99.457 and 100.3386. Interestingly, the standard deviation of this ratio was highest in the years immediately after the introduction of this price-weighted ETF, perhaps reflecting a learning curve among the financial markets.

Once the ratio between these two “baskets of securities” was

I

Figure 1

Historical Ratios Between DJIA 30 Index And DIA

Minimum

1998 – 2005 99.8978 0.2204 102.4855 98.4526

2005 100.0102 0.1197 100.4722 99.6885

2004 99.8373 0.1559 100.2977 99.3565

2003 99.7889 0.1676 100.3701 99.3318

2002 99.8430 0.2176 100.4599 99.1101

2001 99.8923 0.2087 100.5997 99.4663

2000 99.9356 0.3036 102.4855 98.4526

1999 99.9591 0.2104 100.5599 99.3561

1998 99.9165 0.2438 100.7562 98.9492

Source: Values are taken at the close. Index values from Yahoo Finance and DIA prices from CRSP. Data from January 20, 1998 through December 31, 2005.

MaximumPeriod AverageO

May/June 200818

pegged at 100:1, a pricing relationship was established the viola-tion of which presents opportunities for arbitrage trading. When a significant enough violation occurs, astute (or well-positioned) investors can swoop in, capture profits and force prices back in line. Thus, the price pressures unleashed by arbitrage activity help to maintain the integrity of the relationship between an ETF security and its underlying index portfolio. I note here that this activity originates in two possible ways. The first is the ability of well-capitalized, professional investors to take long positions in the underpriced security and short positions in the overpriced security, and then unwind those positions by interacting with the ETF-issuing trust to make exchanges of ETF shares and the underlying stocks (Mehta, 2002 and Venkatesh, 2002). This is the primary mechanism by which the ETF and underlying index remain closely tied together. The second sees individual arbitra-geurs unwind the positions with offsetting sell and buy-to-cover transactions in the financial markets. I’ll start with the latter. I use Diamonds in this demonstration because it is much easier to envision simultaneous buy or sell trades of 30 stocks than of 500 stocks (using the S&P 500 and SPY) or even 100 stocks (using the NASDAQ-100 Index and QQQQ). In addition, as a price-weighted index, the DJIA is calculated in a way that is distinct among indexes so that implementing an arbitrage strategy with the DJIA stocks and Diamonds calls for a straightforward rule of starting

with one share of each component, and then scaling it up to the limit of available investable funds.

Example 1 —DJIA:DIA Ratio Less Than 100:1The examples use market data from April 11, 2006, when

the closing price of Diamonds was $110.93 per share and the closing level of the DJIA was 11089.63, calculated by dividing the $1,385.44 sum of the prices of the 30 component stocks by the index divisor, then at 0.12493117. On this day, the DJIA:DIA ratio was 99.96962:1.

Suppose, however, that this ratio was observed to be 96.049:1 at some point during the day, significantly below the lower end of the range in which roughly 95 percent of the actual daily values have historically fallen. This would occur if the DJIA were at its proper level but the Diamonds price was $115.458 per share instead of $110.93. Or, it would be observed if Diamonds were properly priced at $110.93 but the DJIA was too low at 10,654.69. It could also happen with combinations of DJIA values above 10654.69 and Diamonds prices below $115.458. The critical insight is that it does not matter which of these scenarios has caused the ratio to fall below 100:1. With it on the low side of 100:1, the ETF is over-valued relative to the index, or the index is net undervalued relative to the ETF, and so a knowledgeable investor could

Figure 2

Perfect And Imperfect Unwinding

Diamonds too high at $113.49; DJIA too low at 10900.58




Market Change

Unwind At 100:1 Ratio Unwind At 99:1 Ratio

Portfolio Short sell 12 DIA shares and use these funds to buy 1 share each of the 30 component stocks

DJIA rises to 11089.63; sum of 30 prices is now $1,385.44. Diamonds falls to $110.93 from $113.49

DJIA rises to 11089.63; sum of 30 prices is now $1,385.44. Diamonds falls from $115 to $110.93

DJIA rises to 10989.00; sum of 30 prices is now $1,372.87.Diamonds falls to $111 from $113.4910989:111 = 99:1

DJIA rises to 11059.29; sum of 30 prices is now $1,381.65. Diamonds falls to $111.71 from $11511059.29:111.71 = 99:1

Unwinding

Buy-to-cover 12 shares of Diamonds at $110.93, cost: $1,331.16. Sell the index component shares for a total of $1,385.44

Buy-to-cover 12 shares of Diamonds at $111, cost: $1,332.Sell the index compo-nent shares for a total of $1,372.87

Buy-to-cover 12 shares of Diamonds at $111.71, cost: $1,340.52.Sell the index compo-nent shares for a total of $1,381.65

Arbitrage Profit

$1,385.44 – $1,331.16 = $54.28 (net $54.34 with the initial $0.06)

$1,372.87 – $1,332 = $40.87 (net $40.93 with the initial $0.06)

$1,381.65 – $1,340.52 = $41.13 (net $41.19, with the initial $0.06)

Expectation

(11089.63 – 10900.58) *.12493117 +(113.49 – 110.93)*12 = $54.34

(11089.63 – 11045.61) *.12493117 +(115.00 – 110.93)*12 = $54.34

(10989 – 10900.58) *.12493117 +(113.49 – 111)*12 = $40.93

(11059.29 – 11045.61) *.12493117 +(115.00 – 111.71)*12 = $41.19


exploit the mispricing by short-selling DIA and buying shares of the 30 index stocks.

Columns 2 and 3 of Figure 2 outline two distinct cases where the price of the ETF is above its correct $110.93 value and the DJIA index is below the 11089.63 level where it should be. Case 1 has the price of Diamonds at $113.49 per share with the DJIA at 10900.58. Case 2 sets the ETF price at $115 per share and the index at 11045.61. In both cases, the ratio of DJIA level to DIA price is 96.049:1. I present two scenarios to reinforce the idea that the arbitrage strategy and payoff is the same for any given value of the DJIA:DIA ratio, regardless of what specific prices and values the ETF and index take to produce that ratio.

Since the DJIA index effectively includes one share of each component stock, and the total cost of one share of each stock is the sum of the 30 stock prices, the investor needs $1,361.82 (=10900.58*0.12493117) to purchase one share of each index component as part of the arbitrage strategy to exploit the mispricing depicted in Case 1 and $1,379.94 (=11045.61* 0.12493117) to purchase the shares in Case 2. A short sale of 12 ETF shares raises the required funds in each case so that, as expected, the cash flows of the arbitrage portfolio net to virtu-ally $0, ignoring commissions for the moment.

Case 1:Short sell Diamonds 12 shares*$113.49 = +$1,361.88Buy 1 share of each DJIA stock - $1,361.82 ——————— $ 0.06

Case 2:Short sell Diamonds 12 shares*$115.00 = +$1,380.00Buy 1 share of each DJIA stock - $1,379.94 ——————— $ 0.06

These two cases illustrate how the selling pressure on the ETF forces its price down while the buying pressure on the index component stocks forces their prices up, until both the ETF and DJIA reach levels where arbitrage exploitation is no longer profitable. Once that happens and the ratio resettles at 100:1, each portfolio can be unwound to lock in the identical $54.28 arbitrage profit. When the index returns to its correct value of 11089.63, the sum of the prices of the 30 component stocks is $1,385.44. This amount is received when the shares are sold, and these funds are used to cover the short posi-

Figure 3

Unwinding With High Ratios

Diamonds too low at $108.00; DJIA too high at 11238.26




Market Change

Unwind At 100:1 Ratio Unwind At 101:1 Ratio

Portfolio Short sell 1 share each of the 30 index component stocks and buy 13 DIA shares

DJIA falls to 11089.63; sum of 30 component prices is $1,385.44. Diamonds share price rises to $110.93 from $108

DJIA falls to 11089.63; sum of 30 prices returns to $1,385.44. Price of Diamonds shares rises to $110.93 from $109.08

DJIA falls to 11150.40; sum of 30 component prices is $1,393.03. Price of Diamonds shares rises to $110.40 from $108.11150.40:110.40 = 101:1

DJIA falls to 11224.13; sum of 30 component prices is $1,402.24. Price of Diamonds shares rises to $111.13 from $109.08. 11224.13:111.13 = 101:1

Unwinding

Sell the Diamonds shares for $110.93*13 = $1,442.09; use these funds to buy the index components for $1,385.44 to cover the short.



Arbitrage Profit$1,442.09 – $1,385.44 = $56.65 (net $56.66, with the initial $0.01)



Expectation

(11238.26 - 11089.63) *.12493117 +(110.93 – 108.00)*13 = $56.66

(11350.65 – 11089.63) *.12493117 +(110.93 – 109.08)*13 = $56.66

(11238.26 – 11150.40) *.12493117 +(110.40 – 108.00)*13 = $42.18

(11350.65 – 11224.13) *.12493117 +(111.13 – 109.08)*13 = $42.46

May/June 200820

tions in the Diamonds, which cost a total of $1,331.16 at the true per-share price of $110.93. This activity leaves a cash balance of $1,385.44 - $1,331.16 = $54.28, again ignoring commissions, with no positions in any securities or liabilities remaining. The initial 6 cents retained from establishing the portfolio brings the total arbitrage profit to $54.34. As shown in the “Expectation” row of Figure 2, this amount is exactly the difference between the respective posited prices of Diamonds and their correct price ($110.93) scaled by the 12 shares, plus the difference between the posited levels of the index and its 11089.63 true value scaled by the index divisor.

ETF was $113.49 or $115Sell shares of component stocks +1,385.44Buy DIA to cover short position -12*110.93 = -1,331.16 ________

Arbitrage Profit $54.28Net $54.34

The $54.34 is the maximum profit to be reaped from arbitrage exploitation when the DJIA:DIA ratio is 96.049. If an investor unwinds the arbitrage portfolio early, prior to the ratio resettling at 100:1, smaller arbitrage profits are realized. The fourth and fifth columns of Figure 2 revisit Cases 1 and 2 with the change that the investor unwinds the arbitrage port-folio when the ratio has risen from 96.049:1 to 99:1 instead of all the way back to 100:1.

Example 2—Ratio Greater Than 100:1An inflated DJIA:DIA ratio signals a situation where the

ETF is undervalued relative to the index, or, alternatively, the stocks of the index are net overvalued relative to the ETF. Figure 3 summarizes two scenarios where the index:ETF ratio is well above its 100:1 peg at 104.058:1. These scenarios capture the realistic cases where both assets are mispriced in producing the 104.058:1 ratio. In Case 1, the DJIA is 11238.26 and higher than its actual April 11, 2006 value of 11089.63, while the price of Diamonds at $108 per share is lower than the $110.93 price on April 11. Case 2 depicts the DJIA at 11350.65 and the ETF price at $109.08. The arbitrage strategy to exploit such a severe deviation from the peg ratio in this direction is to short sell the 30 component stocks in the index and use those proceeds to buy the relatively undervalued shares of the ETF. Columns 2 and 3 of Figure 3 outline the trades and maximum net arbitrage profit that can be earned by unwinding the arbitrage portfolio when the ratio falls back to exactly 100:1, while columns 4 and 5 illus-trate what happens if the unwinding occurs prematurely at a DJIA:DIA ratio of 101:1.

Professional Investors And Restrictions On Individuals

Each strategy, whether exploiting the high or low ratio mispricing, involves 31 trades to set up the portfolio: 30 buys or sells for the component stocks and one for the ETF―and 31 trades to unravel it. Therefore, transactions costs are key. For an individual investor using the oft-advertised price of

$14.95/trade from an online broker, the total cost is $926.90. Thus, an investor needs to scale up the 96.049:1 position by at least 18 times to cover these costs and realize profits. That calls for short selling 216 shares of the ETF and buying 18 shares of each component stock to produce an arbitrage prof-it of 18*$54.34 = $978.12 - $926.90 = $51.22. The 104.058:1 position would likewise need to be scaled up 17 times to pro-duce a net profit of 17*$56.66 = $963.22 - $926.90 = $36.32. Of course, with risk-free profits on the menu, an investor is motivated to scale it up to as much as he/she can afford!

Unfortunately, individual investors face obstacles in imple-menting these strategies. For one, they are generally required to keep short sale proceeds in their brokerage accounts and would not be able to use them to cover the required purchases. Further, with the average online brokerage account, it would be virtually impossible to execute all 31 trades simultaneously as required by this strategy. That is a must, as any delay or frac-ture in establishing the arbitrage positions puts the success of the strategy at great risk while other investors quickly squeeze out the arbitrage profits. Thus, professional traders are usually best-positioned to take advantage of these short-lived oppor-tunities because of their full-time attention to the financial markets, available technology, collateral at their disposal and fewer restrictions on the use of short sale proceeds. It can be shown how a trader employs futures contracts in the DJIA index along with positions in the ETF to capitalize on oppor-tunities when the index:ETF ratio deviates substantially from 100:1. When it is below 100:1, the portfolio consists of a short position in Diamonds and a long position in the index futures contract. Above 100:1, the strategy entails a long position in the ETF and a short index futures position. These cases would demonstrate that while a profit is certain to be captured, for a given DJIA:DIA ratio value, the amount of that profit depends on the extent of the index mispricing.

Authorized Participants (“APs”) have an additional option by which they can exploit an index:ETF mispricing by virtue of the fact that they have contracted with the ETF issuer and are able to “create” or “redeem” shares. So, when the DJIA:DIA ratio is sufficiently higher than 100:1, an AP might start with the steps I outlined earlier, but instead of selling DIA shares to purchase index components shares when the ratio resettles at 100:1, they swap their DIA shares with the ETF issuer in exchange for index component shares which are surrendered to cover the short positions. Excess components are the source of the arbitrage profit here. If the DJIA:DIA ratio is profitably below 100:1, an AP could begin with the steps I outlined earlier, but unwind the portfolio when prices adjust and the ratio returns to 100:1 by swapping index com-ponents shares to the ETF issuer (rather than selling them) in exchange for new DIA shares, use these to cover the short positions and sell leftover components shares to lock in the profit. I illustrate this case in the next section by returning to the two cases from Figure 2.

Authorized Participants When DJIA:DIA Ratio Is 96.049:1

The key distinction in transacting with the ETF issuer is that all exchanges must be done in 50,000-lot creation units.

May/June 200821

Thus, sufficient quantity of the component stock shares must be surrendered to receive 50,000 shares of Diamonds, or a minimum of 50,000 shares of Diamonds must be surrendered in exchanges for component shares.

When the price of the ETF is $113.49 ($115) per share, 50,000 shares have a value of $5.6745M ($5.75M). When the DJIA index is 10900.58 (11045.61), the sum of the prices of the 30 component stocks is $1361.82 ($1379.94). In both cases, short sales of 50,000 shares of the ETF on the secondary market are enough to finance the purchase of exactly 4,167 shares of each index component stock. Once the selling-and-buying pressure unleashed by these trades moves prices so that the ratio resettles at 100:1, 50,000 shares of Diamonds are worth $5,546,500 ($110.93 per share) and are equivalent to $5,546,500/$1,385.44 = 4,004 shares of each component. The AP at that point swaps 4,004 of his/her 4,167 shares of each component for 50,000 ETF shares, uses these shares to cover the original short positions and sells the remaining 4167 - 4004 = 163 shares of each component for 163*$1,385.44 = $225,826.72 (sum of the 30 prices at the reestablished index level of 11089.63 is $1,385.44). This amount represents the captured arbitrage profit, as shown below.

ConclusionThe fundamental lesson from these analyses is that it does

not matter, in the first case, how the DJIA:DIA ratio came to be low at 96.049:1. Recognition that this signals a relative ETF overvaluation (or index component net undervaluation) calls for a strategy of short selling the ETF shares and using the pro-ceeds to buy shares of each index component stock, which pro-duces a maximum unscaled arbitrage profit of $54.34 for the individual investor and 163 excess component shares for the AP. In the second case, where the ratio is 104.058:1, how the ratio became inflated is irrelevant. An investor merely needs to recognize this as the signal of a relative ETF undervaluation (or index component net overvaluation) and act accordingly. The strategy to short sell shares of the index component stocks and buy the ETF produces a maximum unscaled arbitrage profit of $56.66 in the individual case. This is the essence of the risk-free arbitrage profit. The establishment of a (virtually) zero-cost portfolio results in the same, sure profit outcome when the portfolio positions are closed out, and the price pressures exerted by investors attempting to exploit even the slightest mispricings are what maintain the peg ratio between an ETF and its underlying index.

REFERENCESBodie, Z., Kane, A., and Marcus, A., Investments (Boston, 2005), 6th Edition, Irwin.

Mehta, N. “Getting Saved on Wall Street: ETFs: A New Religion is Ten Years Old,” Traders Magazine, 15 (Dec. 1, 2002), 32-34.

PDR Services, LLC. Diamonds Trust, Series 1 Prospectus. (New York, February 2006), American Stock Exchange LLC.

Venkatesh, B. “NAV discount and ETFs,” Businessline (July 14, 2002).

ETF was $113.49; Both ETF was $115; DJIA 10900.58 DJIA 11045.61

Short sell 50,000 ETF shares +$5,674,500 +5,750,000Total Cost of 1 share of each component $1,361.82 $1,379.94Cost of 4,167 shares of each component -$5,674,703.94 -$5,750,209.98Net Cost -$203.94 -$209.98

Value of 50,000 ETF shares at $110.93 $5,546,500Cost of 1 share of each component when DJIA Index is 11089.63 $1,385.44

Component shares to receive 50,000 ETF 4,004 shares from trust

Proceeds from sale of excess components 163 x $1,385.44 = $225,826.72

Net Profit $225,622.78 $225,616.74

May/June 200822

A virtual roundtable discussion with Cliff Weber, Gary Gastineau,

Gus Sauter, John Jacobs, Jim Ross and Lisa Dallmer

The State Of The ETF Market


The ETF market is changing … fast. More than 300 ETFs launched last year in the U.S. alone, and an additional 450+ are in registration. Assets are growing at a 40+ percent annual clip, and the types of investors using ETFs are evolving as well.

Meanwhile, the traditional specialist-driven market maker system—a system that has supported the growth of ETFs since the first one launched in 1993—is rapidly disappearing. And two of the biggest ETF listing venues in the world—the New York Stock Exchange and the American Stock Exchange—are merging.

Against this backdrop, Matt Hougan, senior editor of the Journal of Indexes, spoke with six leaders of the ETF industry to see how and where this fast-moving industry is evolving.

Cliff Weber, executive vice president of development and strategy, American Stock Exchange

Journal of Indexes (JoI): Do specialists have a role in the future of ETFs?

Cliff Weber, American Stock Exchange (Weber): I think there certainly will be a role for liquidity providers. What we are seeing in the markets, and what has been happen-ing for some time, is a convergence of the traditional spe-cialist role and the traditional market maker role towards a “designated liquidity provider” model. In this model, the liquidity provider is directly compensated for liquidity provision at an enhanced rate in return for commitments on continuity and quality of markets. This is driven, at least in part, by the deterioration in the value of being a specialist post-Reg NMS [National Market System] and by the desire of the issuers to have someone committed to supporting their fund in the secondary market.

JoI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Weber: Since ETFs can be created and redeemed each day at NAV [net asset value], there really shouldn’t be a material impact on the market quality or attractiveness of an ETF as a result of the amount of seed capital. To the extent that a specialist or market maker is sitting on more inventory than desired, he or she may be willing to be a more aggressive seller, but that isn’t likely to continue for too long. I think at the end of the day, the real issue is that many of the more recently listed ETFs are based on more narrowly focused mar-ket segments or strategies, so they naturally have a smaller universe of interested investors. Also, it is becoming harder for the newer ETFs to get attention as the number of new ETFs continues to grow so dramatically.

JoI: Should investors worry about spreads for active ETFs when they launch?

Weber: Investors always should worry about spreads in any investment, including index-based ETFs, as spreads directly impact return on their investment. There are a number of ways investors can manage that cost, including the use of limit

orders inside the bid and offer instead of market orders. In this context, though, I think the real question is wheth-

er or not one can expect spreads systematically to be wider in actively managed ETFs than in index-based ETFs. A lot of this depends on the specifics of the funds you are comparing, but all things being equal, to the extent there is less certainty in the exact holdings of the fund, the spread is likely to be wider. Therefore, the more the fund manager is willing to dis-close about his holdings, the narrower the spread is likely to be. However, our experience has been that most traditional active managers don’t want to reveal much, if any, informa-tion beyond their current practices.

To compensate for this, we have developed an approach where additional information is provided to the marketplace to serve as a proxy for the fund holdings and performance without revealing the actual fund holdings. This information will help narrow the spread. How much the spread narrows will have to be seen in the market once trading begins, but we have done a lot of testing on this with many funds and our results have been very encouraging.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Weber: ETF listings provide a number of benefits. Issuers pay listing fees, but these tend to be rather minimal in ETFs. Also, the exchange may provide some services in connection with the listing, but again, these fees tend to be modest. The real benefit for an exchange is that the primary listing venue tends to have a material market share edge in trading versus products listed on other markets and traded UTP [unlisted trading privileges]. This advantage translates into more opportunity to earn transaction-based fees and fees from the sale of market data.

JoI: What will the ETF market look like five years from now?

Weber: Over the past five years, the ETF universe has explod-ed. The number of ETFs in the U.S. has grown from 130 to 646; the number of domestic issuers has increased from five to 23; assets under management have increased from $101.6 billion to $620.5 billion. [These numbers compare the end of 2002 with the end of 2007.] This growth has been fueled by the increasing awareness and acceptance of the ETF struc-ture, the expansion of the product category to include new asset classes like commodities, and the extension of the prod-uct into narrower subsegments of the market and into more strategy-based and theme-based indexes.

I think the next significant trend that will drive ETF growth will be the introduction of true active management into the ETF structure. ETFs ultimately are a very flexible and effi-cient distribution platform. The successful extension of this platform to truly actively managed portfolios will open the category up to the many, many investment managers that cur-rently do not issue ETF shares because they don’t run index funds and don’t want to disclose their funds’ holdings. The net result will be a much broader base of issuers. And while I don’t expect that many of these new funds will be very active traders, I’m quite sure that once these funds are available,

May/June 200824

smart investors will create new and innovative ways to use them for alpha capture strategies, etc.

Gary Gastineau, managing director, ETF Consultants

JoI: Do specialists have a role in the future of ETFs?

Gary Gastineau, ETF Consultants (Gastineau): I think market mak-ers in new, less actively traded ETFs will be supported by fund issu-

ers. Issuers will find that they must subsidize market makers, at least in the period immediately after the launch of a fund. There are a number of mechanisms for doing this, and additional ones will probably be developed over time.

The role of the specialist or any other market maker is usually less significant for ETF investors (or traders in any security) when a security trades more than a million shares a day than when it trades a few thousand shares a day. The structure and eco-nomics of the NMS make it inevitable that computerized trading engines attempting to capture tape revenue by trading in size for little or no net transaction profit will continue to increase the disparity in trading volume between more actively and less actively traded ETFs.

It is interesting to note that ETF trading volume in the U.S. has been running over 1 billion shares a day. The volume has been very concentrated: ETFs trading over a million shares a day account for 95 percent of total volume. The average assets of these actively traded ETFs is about 10 times the average assets of the less actively traded funds, but the average trading volume of the most actively traded funds is more than 100 times the volume of the less actively traded ETFs. There is a good chance that the four most actively traded “stocks” for 2008 could all be ETFs.


Gastineau: Willingness of market makers to contribute seed capital is a function of the amount they expect to make by trading an ETF. The growing disparity between trading volumes in the most and least actively traded ETFs is partly a function of a crowded marketplace, where getting attention is difficult. As in the case of subsidiz-ing market makers, issuers of new ETFs will have to be more creative in looking for seed capital.

It is interesting that very little attention has ever been paid to the modest size of small mutual funds as a cause for concern, but a great deal of attention is paid to the assets of small ETFs. As long as expenses are capped, small fund size is not very important. A fund that has grown too large is much more likely to face performance problems than a fund that remains small is to face viability problems. The performance problems may be easier to hide, but they are more costly to investors.


Gastineau: Trading spreads will be narrower for less actively traded funds with a more investor-oriented trading mechanism. Trading spreads will stop being an issue. JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Gastineau: Frankly, I have never understood this phenomenon.


Gastineau: Actively managed ETFs will be well on their way to surpassing transparent index ETFs in terms of assets under management. Benchmark index ETFs will continue to dominate trading activity for as long as I can imagine. The evaluation of funds will

A Better Way to Index

www.researchaffiliates.com

Take a Closer Look

50 years ago, S&P popularized cap-weighting as the optimal approach to measuring the market. This is no longer the case. RAFI® indexes have picked up where cap-weighting left off by creating the first suite of products providing an Efficient Index for an Inefficient Market™. RAFI® solves the problem of cap-weighting by cutting through market noise and breaking the link between a stock’s price and its portfolio weight.

Fundamental Index ®


be much more sophisticated and the nature and quality of fund information will be greatly improved. Within five years it should be clear to everyone that the ETF structure can be vastly supe-rior to the mutual fund structure for all investors—including participants in defined contribution plans and other investors who make small periodic investments in funds.

Gus Sauter, chief investment officer, Vanguard


Gus Sauter, Vanguard (Sauter): I certainly think they do. Whether it’s under the name “spe-

cialist” or “lead market maker” or just “market maker,” I think they will certainly have a role in creating liquidity for ETFs … as they have historically. Of course, as certain ETFs become more liquid, a lot of the market is made by the investors themselves, and that reduces the role of specialists in those funds. But I do think that they will have a role in creating a market for ETFs.


Sauter: I think it certainly has. I also think there will be a lot of ETFs that will not even make it to market because they won’t be able raise seed capital. These are ETFs that are pretty narrow in scope and don’t have much investor appeal. So, yes, there will be and has been an impact.


Sauter: Certainly they should be concerned about spreads. They represent a cost of investing; it’s a form of transaction costs. In an index ETF, you should typically have reasonably small spreads. In an active ETF, they will undoubtedly be much wider, reflecting the risk of uncertainty to the market maker or specialist. They don’t have the same degree of certainty or knowledge of the portfolio, so they are going to widen the spreads. I think many people under-estimate transaction costs, and spreads are a key component—they can wipe out any expected return from the investment.

JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Sauter: Certainly, the exchanges benefit from fees paid on any securities that list there. There’s also a transaction fee that they receive for trading, so the exchanges love to have products that have a lot of volume—they receive a small transaction fee for every single trade. That is one of the pri-mary sources of their revenues.

JoI: What do you consider when deciding where to list funds?

Sauter: We look for three things, not necessarily in this order: 1) we consider the exchange’s commitment to the ETF marketplace, 2) we look at the reliability of the exchange, and 3) we look at the amount of liquidity that the exchange is able

9 Ways to Bring Clarity to Your Portfolio

An investor should consider our funds’ investment objectives, risks, charges and expenses carefully before investing. For this and more complete information about our funds call 800.983.0903 or visit the website www.powershares.com for a prospectus. Please read the prospectus carefully before investing.A I M Distributors, Inc. is the distributor of the PowerShares Global Exchange-Traded Fund Trust.© 2008 PowerShares Capital Management LLC www.powershares.com | 800.983.0903

Fundamentals Weighted Sector Members of the PowerShares Family

Compare sector indexes at www.powershares.com/rafi

May/June 200826

to attract. That is a very significant factor, which is related to the structure of the exchange. Do they provide a robust electronic trading platform? Do they have a market-making system that also assures liquidity and tight spreads? What particular specialist firms work on the different exchanges? Some specialists are particularly good at working on ETFs, and they may not be working on every exchange.

JoI: How will the NYSE/Amex merger impact the industry?

Sauter: I think the merger itself will be positive. We’re excited about it. We think it combines the Amex’s commitment to ETFs with the NYSE’s platform and capital. The other advantage is that it brings together volume that has been fragmented across exchanges. I think we’ll see liquidity increase.

I think the NASDAQ is really ramping up their commitment to ETFs, and there will be healthy competition across the combined NYSE/Amex and the new NASDAQ effort.


Sauter: I think there will be consolidation. I think the margin-al products that are narrowly focused and that don’t provide good long-term investment opportunities will consolidate, be removed or close down. We’ve seen a little of that so far. I think we’ll see ETFs continue to grow in terms of assets. But I also think most of the assets and trading volume will be concentrated in the 50 largest ETFs, which not coincidentally, will be the most broadly based ETFs and represent the best investment opportunities for a long-term investor.

John Jacobs, executive vice president, NASDAQ


John Jacobs, NASDAQ (Jacobs): No. Since the NYSE moved ETFs to Arca and the NYSE

is buying the Amex, all ETFs will be on electronic markets like the ones NASDAQ OMX has been providing for the past 37 years.

JOI: Has the shrinking size of seed capital had an impact on newly listed ETFs?

Jacobs: Yes. We are seeing some ETFs delayed in coming to the public markets because attracting seed capital has become more challenging recently. However, for some of the larger ETF providers that have a strong track record of developing liquid ETFs, seed capital is not an issue.


Jacobs: Investors should always take account of spreads, as they will affect the cost of their transactions.

JoI: Why do exchanges compete so vigorously for ETF listings?

What do they gain from it? Jacobs: ETF listings are a service to exchange custom-ers—bragging rights, in a sense—and produce very little revenue in and of themselves. The trading activ-ity is where the real competition is and trading activity tends to stick to the primary listing venue during the initial incubation period of new ETFs. As ETFs grow and become more liquid, trading volume is less tied to the listing market and gravitates more to the fastest and most efficient trading venue. The NASDAQ stock market is the most liquid market for ETFs in the United States, and executes over 50 percent of all ETF trading volumes, regardless of where the ETFs are listed.


Jacobs: Very different. Assets under management will have grown significantly (to multiple trillions of dollars). The large mutual fund companies will probably have emerged as ETF providers, and investors all over the globe will know what the acronym ETF actually stands for. You may even see stand-alone ETF exchanges.

Jim Ross, senior managing director, State Street Global Advisors


Jim Ross, SSgA (Ross): Probably not … although I say that carefully, because mar-

ket makers have a significant role to play in the future of ETFs. A lead market maker is almost equivalent to a specialist these days.

Really, I think the role of the specialist has been rede-fined in the electronic exchange world. Some of their responsibilities have been lessened, and some of the benefits you got as a specialist in the past from an order flow perspective have changed.

I think a lead market maker role will be critical going forward, especially for the newer ETFs. SPY doesn’t need a specialist, or even a lead market maker, since the real mar-ket for that ETF is so liquid. But for a newer ETF, you need some type of commitment from someone to ensure that a tight market is being made.


Ross: From a State Street perspective, we haven’t seen an impact for our ETFs. We’ve been able to get a fair amount of seed capital for our funds. I’m not sure how it works for other funds. I think a lack of seed capital probably stops some ETFs from coming to market, or at least slows them down significantly. [Getting seed capital] is not as easy as a phone call anymore … you can’t just call someone up and get $50 million or $100 million anymore.

May/June 200828

JoI: Why is seed capital important?

Ross: It helps establish a fund and shows that there are shares out there that are trading. It shows that there is a decent liquidity pool for the fund.

If you look at the parallel with mutual funds, there are not a lot of investors buying new funds with a couple of million dollars in them.

The whole answer, though, isn’t getting the seed capital up and going. It’s getting the fund running and some real interest and real demand there.


Ross: Yes. Active ETFs have the potential of having wider spreads. Spreads are always important, but they have the potential of becoming more important with active ETFs. A fully transparent portfolio will come pretty close to letting you know how big the spreads are, but if we start to see portfolios that are not fully transparent, I’m not exactly sure how that will work.

JoI: What impact will the NYSE/Amex merger have on ETF product issuers?

Ross: I’ll take a philosophical approach. I think the ETF listing market was changing whether or not this merger happened. I’m not sure the merger will have a major impact. I think ETF product issuers have seen changes in how listings work and how the specialist system works for years.

I think the bigger change happened last year when the NYSE moved everything to its Arca platform. They decided to move away from the specialist system as it existed then.

The merger means one less listing venue, but I anticipate that other very viable listing venues will emerge.

Lisa Dallmer, senior vice president, ETF & Index Services, NYSE


Lisa Dallmer, NYSE (Dallmer): Yes, abso-lutely. Specialists perform a very neces-

sary function for ETFs. In the NYSE Arca marketplace, we actually call them “lead market makers.” The function, however, is the same: to be a liquidity provider and facili-tate price discovery for the products they trade. The lead market makers have obligations to maintain a continuous quote, manage the opening and closing auction, provide price discovery and drive the inside quote a certain per-centage of time throughout the day. There is still an ongo-ing role for these professional traders who know how to price the basket of securities and therefore know how to provide price discovery in the marketplace.


Dallmer: I would actually suggest that the question be rephrased: “Has the wave of newly listed ETFs had an effect on seed capital?” As we’ve seen more and more products come to market, I think we’re seeing a supply-and-demand issue where the product sponsors have a lot of great ideas … some of which are third-to-market, fourth-to-market or even fifth-to-market … and that’s having an effect on the marketplace with respect to the supply of that initial seed capital. There’s an investor appetite that changes when you get a fifth-to-market product. So for those parties providing the initial seed capital, understanding how a sponsor intends to differentiate and distribute the product in a crowded dis-tribution channel is important. Overall, I believe sponsors are more thoughtfully designing their product sets with more emphasis on innovation and investor demand.


Dallmer: I think investors should understand the products they’re investing in, whether they’re passively managed index ETFs, mutual funds or the new construct of what we’re call-ing actively managed ETFs, which are essentially the actively managed ETFs that are coming out shortly with fully transpar-ent portfolios.

In traditional open-ended mutual funds, of course, there is no bid/ask spread when an investor gets in and out of the fund. However, there are still costs of managing the fund that come in the form of expense ratios, fees you might pay in the form of front-end loads, etc. Those fees represent themselves differently in an ETF. Instead of a commission to your financial advisor, you might see that there is a fee to pay to purchase the security through your broker—a standard transaction fee.

To the extent that there are spreads around the bid/ask of the ETF, it is going to be reflective of what the portfolio is holding, the fund’s disclosure of that portfolio—which will be publicly available—and the management process imple-mented by the fund advisor. The spread of any ETF is based on its underlying holdings. JoI: Why do exchanges compete so vigorously for ETF listings? What do they gain from it?

Dallmer: ETFs are part of the broader listing strategy of exchanges. Exchanges compete vigorously for public com-pany listings; we compete vigorously for closed-end fund listings; we compete vigorously for ETF listings. It’s in part because there’s an order flow benefit that, I would say, oftentimes benefits the primary exchange in the sense that opening and closing auctions are done on the primary exchange. Also, the largest price discovery and liquidity providers are working on the primary exchange. As we’re able to win listings, articulate our position and offer valu-able services to our ETF issuers, we gain a more dominant position in the growing marketplace.

As a quick example, I’m looking at a statistic we have from the month of February. There was an issuer that had some primary listings with NYSE Arca and some primary list-

May/June 2008www.journalofindexes.com

ings on another exchange. For the listings that were primarily listed on NYSE Arca, our liquidity providers drove the inside price 91 percent of the time. If our liquidity providers are driving the inside price in our primary listings, we are more likely to be at the best price with respect to other exchanges interacting with our quotes in the national market system, so we are more likely to attract market share. Our market model, which features designated liquidity providers for every primary listing, is a core component of our value propo-sition to investors and issuers.


Dallmer: That’s a hard question. I think it’s certainly going to grow in its offerings to investors. Volume growth is another important element of that question. We han-dled 285 million shares a day in 2007. That’s a 65 percent increase from 2006. We’ve seen significant growth in the types of assets we are placing in the ETF wrapper. We’ve seen growth in the product approval process in that we no longer need to have an index per se, and instead we can have a portfolio with an investment objective and a set of securities that is constantly disclosed.

I think we are going to continue to see incremental chang-es in the marketplace over the course of the next five years,

and I think we’re going to see assets grow. As a packaging mechanism, the ETF wrapper is very efficient at delivering investors some value-added services like tax efficiency, ease of access and an open architecture.

That packaging mechanism, right now, works very well on transparent portfolios, as we’re about to experience with the actively managed products. There are changes that will have to occur in that packaging mechanism if some of them wanted to run a portfolio and not disclose the holdings.

[Regardless of what happens with nontransparent active funds,] I think we’re going to see more assets under management, and see the ETF industry continue to grow worldwide. I think we’re going to see more refinement of the distribution model. I think 2007 has been a valuable year for issuers to gain experience on the distribution models and understand what really works for them and how their products map fits into financial advisors’ needs. I think we’re going to see refinement of the existing matu-rity level of the investor and we’re going to see incremen-tal opportunity in the product set over the course of the next three years or so.

Overall, I think ETFs will continue to grow and be a com-petitive alternative to mutual funds or structured products. The business is growing substantially and NYSE Euronext has leadership positions in the U.S. and Europe.

29

reprintsjoi.qxd 4/1/08 10:22 AM Page 1

May/June 200830

by Robert J. Waid

Why the Russell 2000 missed the mark

Examining Small-Cap Manager Investable Universes


Russell Size Indexes

Russell Microcap

Russell 2500

Russell 3000

Market-Cap Ranks - Large to Small

0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000

Source: Wilshire Associates

Large- and small-cap managers existed long before the creation of size indexes and the confirmation of the size effect. Goals for an index provider such as the Rus-

sell Investment Group (formerly the Frank Russell Company) include creating an investment style benchmark, an asset allocation tool and an implementation methodology for pas-sive investing purposes.1 By not recognizing the transition from large- to small-cap and small- to micro-cap, and by back-ing into a default definition of small-cap, the Russell 2000 Index has missed the mark for each of these goals.

Investment Style Benchmark One benchmark goal articulated by the Chartered Finan-

cial Analyst (CFA) Institute is that the index benchmark be appropriate given a manager’s investment style. Appropri-ateness is more than matching the style name. Ideally, it is matching the neutral position or passive return of the mea-sured investment strategy. The CFA Institute Subcommittee on Benchmarks and Performance Attribution emphasized the point that “Choosing a bad or inappropriate benchmark can undermine the effectiveness of an investment strategy and lead to dissatisfaction between client and manager.”2

In the mid-1980s, Russell research of manager data showed that, “Investment managers select not from hun-dreds of stocks but between 3,000 and 3,200 issues.”3 Fur-ther surveys showed that managers who viewed themselves as large-cap managers purchased stocks down to a market-cap rank of about 1,000.

This led Russell to create the Russell Indexes that were “as simple as 1, 2, 3” with the top 1,000 stocks

labeled as large-cap, the next 2,000 stocks labeled as small-cap and the combined 3,000 defined as the invest-able universe (see Figure 1).

Conceptually reasonable but logically flawed, Russell treat-ed the 2,000 small-cap as the difference between its large-cap 1,000 and its investable universe 3,000. What Russell missed was that while large-cap managers stopped buying near the 1,000th market-cap-ranked company, going the other direc-tion, small-cap managers stopped buying near the 500th mar-ket-cap-ranked company. Micro-cap managers stopped buying near the 2,000th market-cap-ranked company. This is a critical evaluation issue for how small-cap managers actually invest.

In the early 1980s, Wilshire Associates’ related stud-ies with variance analysis and performance attribution led to the observation that the performance differences between large-cap and small-cap shifted between the 500th and 1,000th market-cap-ranked stock. Years of style metric testing, along with affirmation from institu-tional holdings and money managers, confirmed these attribution-driven results. These results led to Wilshire’s 1986 release of style indexes that divided the Wilshire 5000 (now the Dow Jones Wilshire 5000) into large-, small- and micro-cap indexes divided at the 750th and 2,500th market-cap-ranked stocks, respectively.4

Years later, Russell research showed “that many small-cap growth managers tend to let their winners run.”5 Active money managers are reluctant to sell their “winners.” This led Russell to create the Russell 2500 Index in 1993 to cover the stocks ranked 501 to 3,000. The release of the Russell 2500 supported the argument that the Russell 2000 Index

Russell Indexes: 1000, 2000 And 3000

Russell


0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000


Large Small

Figure 1

Figure 2

May/June 200832

started too low in the market-cap range for a true represen-tation of small-cap managers.

In June 2005, Russell launched the Russell Microcap Index. This index covered the market-cap stocks ranked from 2,001 to 4,000, extending Russell’s coverage, but it did not extend the coverage of their core indexes. The Rus-sell Microcap Index’s overlap with the Russell 2000 and Rus-sell 2500 Indexes raised questions about Russell’s definition of small-cap. Russell admits to receiving a fair amount of academic criticism because of the overlap with its existing small-cap indexes (see Figure 2). Russell defends this over-lap by saying that it covers the micro-cap opportunity set and that small-cap managers invest down to 3,000.6

According to Russell, its analysts noticed that, “the Rus-sell 2000 Index did not fit all of the small-cap investment products available in the marketplace. Many managers drew on somewhat large-cap stocks, while a new (and growing) class of managers focused almost exclusively on the small-est end of the spectrum.”7 Russell further points out that, while use of the Russell 2500 and style indexes continue to grow, use of the “Russell 2000 has remained mostly flat.”8

Russell’s staff seems comfortable with index overlaps as shown by its style index methodology. Russell’s error is that, “[t]he Russell indexes do not attempt to refine the market by excluding companies in the opportunity set.”9

Wilshire believes that the DJ Wilshire 5000 Index10 includes all companies in the opportunity set. By definition, divid-ing the market into subsets requires excluding companies. Wilshire’s equity research recognized that large-cap com-

panies ranked beyond 500 began the transition to small-cap and stopped having large-cap attributes near 1,000, whereas the reverse was true for small-caps. (Wilshire defines this transition-overlap range as mid-cap stocks.) The same type of size transition was recognized between stocks ranked 2,000 and 3,000 for small-cap and micro-cap. Russell did not acknowledge this transition until the release of their 2,500 small-cap and micro-cap indexes. For more than 20 years, Wilshire research has continued to support the 750 and 2,500 break points.11 Figure 3 shows Russell’s combined index representation of the U.S. equity market supports the size break points at 750 and 2,500.

Note that independent of each other and years before Russell’s 2500 and Micro-cap indexes, Wilshire size indexes perfectly bisect the Russell defined overlap space.

Holdings coverage research has continued to show results similar to those of Figure 4. Small-cap style money manager investments not included in the 750–2,500 small-cap market-cap range are balanced above and below these size breaks.

With smaller security counts (1,750 versus 2,000), higher portfolio percentage covered, and balanced outliers, mar-ket-cap breaks at 750 and 2,500 hit the bull’s eye for small-cap and small-cap style benchmarks. The evidence indicates that Russell’s break points are too low.

Asset Allocation ToolAnother benchmark goal articulated by the CFA Institute

is that the index be “representative of the asset class or mandate.”12 This is important for risk budgeting, asset allo-cation, and attribution. According to William Sharpe:

The usefulness of an asset class factor model depends on the asset classes chosen for its implementation. While not strictly necessary, it is desirable that such asset classes be 1) mutu-ally exclusive, 2) exhaustive and 3) have returns that ‘differ.’

Russell And DJ Wilshire Index Size Definitions

DJ Wilshire

Russell


0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000


Large Small Micro

Large Small Micro

Figure 3

Small-Cap Style Managers’ Size Coverage11

June 2005

100%90%80%70%60%50%40%30%20%10%

0%

Russell Value DJ Wilshire Value Russell Growth DJ Wilshire Growth


■ Large ■ Small ■ Micro

Percen

t of P

ortfo

lio

71.6%

75.7%

67.4%

82.0%

Figure 4


Figure 5

Ten-Year Annualized Returns For Small-Cap Indexes As Of December 2006

RussellDJ

Wilshire S&P Lipper

9.44 10.76 11.58 10.32 — 1.32 2.14 0.88

Ten-year Annualized Outperformance

www.journalofindexes.com May/June 2008 33

Pragmatically, each should represent a market-capitalization weighted portfolio of securities; no security should be included in more than one asset class; as many securities as possible should be included in the chosen asset class…13

The Russell 2500 and Russell Microcap Indexes are

eliminated as tools for asset allocation because they are not mutually exclusive. This leads to a dilemma for Rus-sell index users. On the one hand, they can restrict their asset allocation research to only the top 3,000 stocks at the cost of not being exhaustive. (This would allow users to differentiate large-cap from small-cap by ignor-ing the additional 1,000 Russell and 2,000 additional DJ Wilshire stocks.) On the other hand, users could select the nearly 4,000-stock Russell 3000E Index14 but would have to use it as a single asset class.

Method For Passive InvestmentPassive investments compared with active money man-

agement are supposed to represent the neutral investment style at little or no cost. Cost is comprised of not just man-agement fees but transaction and implementation costs as well. It has been estimated that due to arbitrage around index changes, “investors in Russell 2000-linked funds [annu-

ally] lose between 1.30% and 1.84%.”15 This arbitrage cost amounts to more than the fees of most active managers.

This Russell 2000 performance lag is supported by the 10-year performance shown in Figure 5 as well as the sig-nificant number of negative one-standard-deviation events that occur after Russell’s annual rebalance versus those of other small-cap indexes shown in Figure 6.

ConclusionThe Russell 2000 Index was created with a fundamental

misinterpretation of how small-cap money managers invest. Russell did not recognize the overlap or transition between the sizes. If Russell did, it perhaps would have chosen a value in the transition area when it created the large- and small-cap indexes. Russell should have corrected this error by moving the market-cap cutoff from 1,000 and 3,000 to numbers closer to 750 and 2,500. Instead Russell created new indexes extending the reach with an overlap of its existing indexes. This has led the Russell 2000 Index to be a flawed small-cap index as a performance standard for active managers, a questionable tool for asset allocation purposes and an expensive implementation method for passively cap-turing small-cap performance.[Editor’s Note: For a response from Russell, please turn to page 57.]

Endnotes1Russell’s three main index purposes: russell_us_indexes_methodology.asp, www.russell.com, November 13, 2007.2“Benchmarks and Performance Attribution Subcommittee Report,” CFA Institute Benchmarks and Performance Attribution Subcommittee, Chairman John C. Stannard, CFA Frank

Russell Company, August 1998. 3“Objective Benchmarking,” Kelly Haughton, www.russell.com, Sept. 21, 2004.4The size splits at 750 and 2,500 have been constants for all Wilshire-affiliated size index families including the current Dow Jones Wilshire Large-Cap Index, the Dow Jones Wilshire

Small-Cap Index and the Dow Jones Wilshire Micro-Cap Index.5Haughton, Kelly, Mahesh Pritamani, Russell Research Commentary, US Equity Style Methodology, August 2005. 6Haughton, Kelly, The Russell Index Philosophy, Journal of Indexes, September/October 2006.


Figure 6

Performance Differences For Small-Cap Indexes Versus The Russell 2000Monthly Number Of One-Standard-Deviation Events – January 1997 To December 2006


DJ WilshireNegative

S&PLipper DJ Wilshire

Positive S&P

Lipper

January 0 2 1 1 3 4

February 1 1 0 2 1 1

March 1 1 1 1 0 1

April 2 3 1 2 1 2

May 2 1 2 0 1 2

June 3 0 2 2 1 1

July 6 3 5 0 0 1

August 1 0 1 0 0 0

September 0 0 0 2 1 1

October 3 1 1 0 0 0

November 2 0 0 2 2 1

December 0 2 1 0 1 2

Total 21 14 15 12 11 16

May/June 200834

by Murray Coleman

Why the ETF rush is … and is not … great news for indexing start-ups.

Boom Time For Indexers?


The backlog of filings for new exchange-traded funds is growing at a pace that rivals the number already on the market. With such a booming product pipeline,

demand for increasingly exotic indexes is following suit. Does that translate into boom times for indexers?

Maybe, maybe not.Several unique challenges face smaller index providers.

For one, the path to profitability for a new index provider is a long one: First, you have to develop the index, which can take years; then you have to license it to a product issuer, fighting with other index providers for limited slots; then the product must actually launch and attract assets, which is a big hurdle (currently, more than 100 U.S.-listed ETFs have less than $10 million in assets).

As more active ETFs come onto the scene, indexers face new challenges, as the need for indexes may be outstripped by the high-profile nature of popular managers.

Still, against these odds, some upstart index providers have done their homework and say they like what they’ve found.

One is Jim Huguet, chief executive at Great Companies, a Tampa, Fla.-based investment management and research shop. At first, he and his colleagues set out to create a mutual fund around his firm’s expertise. But they decided to enter the ETF fray instead. “It came down to more than just that ETFs were a faster-growth area,” Huguet said. “The ETF mar-ket also offers much lower entry costs for new providers.”

With a mutual fund, he says, start-up expenses for his firm would come to anywhere from $150,000 to $200,000. And that doesn’t count costs of marketing the new prod-uct. “It can take a huge amount of money to get a mutual fund to a profitable level of assets. Our estimate was that, just to break even on a mutual fund, we’d need around $200 million,” Huguet said.

That figure was based on a very limited marketing cam-paign. Huguet says ETF providers should be prepared to spend much more when trying to introduce new indexed products into the ETF field.

Since mutual funds are dominated by active managers, Huguet says most advisors won’t recommend new funds to their clients without at least three years’ worth of performance data.

“The ETF marketplace is largely indexed, which makes it more straightforward in presenting information indicating how a new index performs in different markets,” he said. “Advisors will accept backtested data with ETFs. But they generally ignore backtested data with mutual funds.”

In a more structured environment, Huguet found that test-ing model indexes was more a matter of selecting appropri-ate software and finding the right people to do the research. Since Great Companies already had many of those capabili-ties in-house, he estimates the firm spent around $25,000 to equip itself to do historical tests on its indexes.

Index developers in conjunction with their sponsors also need to pay someone like The American Stock Exchange or Standard & Poor’s to maintain and calculate the index on a regular basis. Huguet says that probably costs his firm in the neighborhood of $25,000 per year.

On the plus side, the close relationship between index developer and ETF provider firms translated into

a lot of resource sharing, he says. That can be espe-cially helpful in further reducing marketing and other non-research expenses.

Nearly a year ago, a product based on Huguet’s index launched: the Claymore/Great Companies Large-Cap ETF (AMEX:XGC).

As of March 2008, however, the fund had little in the way of assets. Still, Huguet says that going the ETF route makes sense.

“One of the big problems with starting a new mutual fund is that you face a lot more barriers to entry than with ETFs,” he said.

Searching For New AnglesKevin Carter, chief executive of AlphaShares, also sees

ETFs as the best platform to apply the firm’s research and investing expertise. But he warns that rising competition leaves few truly unique openings for new indexes. That’s driving rivals to move into more niche markets, Carter says, where it could prove difficult to attract enough assets over longer periods.

“Finding a new way to index the market is tough enough,” he said. “But you’ve also got to make sure there’s enough demand to attract assets over the long-term.”

He and his partner Burton Malkiel saw limited oppor-tunities for U.S. investors to target small-cap and real estate stocks in China.

“The only indexes with accompanying ETFs were for mega-cap stocks in China,” Carter said.

Malkiel, of course, has an extensive history with index mutual funds. He was a long-time Vanguard Group board member and also chaired the new products committee at the American Stock Exchange when the first ETF was launched in 1993.

“Our primary business isn’t indexing,” Carter said. “But we were looking around to find the best way to pursue our research and investment strategies.”

The result was the creation of benchmarks for the Claymore/AlphaShares China Real Estate ETF (NYSE Arca: TAO) and the Claymore/AlphaShares China Small-Cap ETF (AMEX: HAO). AlphaShares has also created separate all-cap indexes for value-oriented and growth-focused stocks in China.

While it might be easier to get started, however, Carter emphasized that making sustainable and lucrative profits in ETFs isn’t a walk in the park.

Indexing as a business requires scale to make real money, Carter said. As a result, he says, unless you’re an established name in the industry such as Standard & Poor’s or Dow Jones, it can be tough to focus solely on providing indexes.

“The problem is that to get scale, you’ve got to find an index with real demand,” Carter said. “If you’re providing an index to a $50 million [in assets] ETF, then you’d better find a night job.”

How Big, How Fast?How big is the ETF market opportunity? Currently, some

450 different prospectuses for ETFs and exchange-traded notes are in some form of review by the SEC. Those funds would join 648 ETFs that were already trading on the market through last year, representing over $600 billion in assets.

As Figure 1 shows, the growth of the industry has been astounding … both in the number of ETFs and the assets linked to them.

May/June 200836

The new crop of funds is much different, however. Traditional market-cap sized benchmarks are giving way to more fundamen-tally based and quantitative methodologies. A very significant number of the new ETFs are alpha-seeking mechanisms.

“They’re quasi-active or active management using some sort of judgment for putting securities in portfolios,” said Jeffrey Ptak, a Morningstar analyst.

As next-generation types of indexes come out, “they rep-resent a stark break from more traditional market-cap-based methodologies,” he added.

Niche products are also growing in numbers, as are bond ETFs. “Index providers keep an ear to the ground for interesting

twists in the market. They’re not going to mint and license new indexes if they don’t think they’re going to draw interest from investors,” Ptak said. “But sponsors are very cognizant

that there are certain names in the market such as S&P, MSCI, Russell, Dow Jones and FTSE [with established brands].”

As a result, he says, there’s probably always going to be a nat-ural tendency by ETF sponsors to look first “to align themselves with the more marquee players in the indexing business.”

A Focus On QualityWith close to 80 percent of the industry’s assets held by

the top four ETF providers, Thomas Mench says he wonders how worthwhile it is for investors and advisors to keep up with all of the smaller benchmarking firms.

“The rest are just trying to survive,” said the Cincinnati-based pioneer in using ETFs within strategically managed accounts for institutional investors. “The smaller players tend to come out with more of the indexes we think are less reli-able and court tracking error problems. We also don’t want to consider investing our clients’ assets in something that might face liquidation down the line.”

He pointed out that Claymore had to shutter 11 ETFs recently. “With the number of ETFs coming on the market, we’re going to

see more consolidation in this industry,” Mench said. “And larger ETF providers are going to start gobbling up smaller ones to a greater extent than we’ve seen in the past.”

As competition grows in the market, ETF providers tap-ping into outside indexing researchers and index provid-ers are going to need to make sure they’ve got tight rules and procedures in place to maintain product quality, says Christian Magoon, the new president and chief executive officer at Claymore Investments.

Although his firm became the first major U.S. provider to close a number of ETFs recently, Magoon says Claymore took such action as a precaution ahead of a looming glut of funds. He believes the shuttering was the responsible action to take for investors rather than waiting until later.

“All firms have to assess if it’s the best thing for shareholders to keep so many products out there,” said Magoon, who before his recent promotion headed up Claymore’s ETF business in the U.S. “We’re constantly reviewing each fund’s performance as well as changing asset levels relative to their peers.”

Picking index providers involves a combination of factors, Magoon says. Selecting an area of the market that shows increasing demand is only one part of the equation, he adds.

“As more ETFs come out, it’s becoming even more impor-tant to select index providers with strong backgrounds. You’ve got to look at expertise and make sure to do your due diligence,” Magoon said.

Claymore’s 29 ETFs track indices from more than a dozen different index providers. That’s similar to the number that PowerShares Capital Management uses to support more than 120 ETFs.

“We’ve got two camps of indexers. One is the more glob-

ally well-known providers who aren’t very open to changes to their indexes,” said Ben Fulton, executive vice president of product development at PowerShares. “Those can be well-established providers like the FTSE, S&P and Dow Jones, which have set models and demonstrated research.”

On the flip side are smaller index shops such as WilderShares, Dorsey Wright, Lux Research and Mergent.

In many cases, PowerShares finds that with less widely-known indexers, “we can work with them to turn their theo-retical research models into working indexes,” Fulton said.

For example, Dorsey Wright has been providing technical analysis for decades to Wall Street. “I knew them well and knew they had created rankings for each company in terms of relative strength in the market,” Fulton said.

Once someone has some sort of ranking system, then it can be fairly straightforward to create an index, he added.

“But we also like to see providers with brand-name aware-ness. If they don’t have that or some sort of ranking system, we might as well go to an established benchmark like S&P or FTSE,” Fulton said. “Without some sort of value-add, turning

Source: Morningstar Inc. Data as of 12/31/07.

“If you’re providing an index to a $50 million [in assets] ETF, then you’d better find a night job.”

—Kevin Carter, AlphShares

Figure 1

ETF Industry Asset Growth: 2000-2007

Year Number Of ETFsTotal Assets

($USD Millions)

2007 648 $613,029.9

2006 328 $418,696.3

2005 194 $300,461.7

2004 152 $222,432.2

2003 101 $148,316.4

2002 103 $109,297.5

2001 101 $78,930.7

2000 83 $69,202.1


research into an index doesn’t make much sense.”The indexes used by PowerShares are almost exclusively designed

for ETFs. “Most other ETF providers start the other way. They’ll put out a request for proposal of all the indexes you have at a specific time,” Fulton said. “What you end up getting is all the indexes that haven’t been licensed yet to your competitors. We really try to sit in an advisor’s seat and consider what they really need.”

The key is to make sure an idea is investible. An example the firm cites is its recently launched PowerShares India Portfolio (NYSE: PIN). “We looked at the existing indexes, which included the SENSEX, the S&P Nifty Fifty and the MSCI India. But those were all developed for people inside India to track,” Fulton said.

Once you move outside of the country, he added, there are all sorts of regulatory issues regarding foreign ownership restric-tions. “So we were concerned about the tracking error. We want to make sure we can manage a fund in a realistic manner. It’s more a matter of common sense than anything,” Fulton said.

With his 20-plus years of industry contacts, he started talking to smaller research groups focused on India. One that stood out was Indus. “Their specific focus is around India-based indexes for the U.S. marketplace,” Fulton said. “And they were willing to devote the time to create a customized index just for an ETF. And then we hooked them up with Standard & Poor’s to maintain and

calculate the index’s performance on a daily basis.”But the India ETF’s launch was one of the rare times

when an idea moves to full fruition. Only about 4 percent of the ideas originally pursued wind up as an index that PowerShares picks for an ETF, he added. His team main-tains that many concepts for new products are on the drawing board despite years of research.

“The bottom line is that we need to have confidence in an index and index provider,” Fulton said. “They’ve got to go through a gauntlet of criteria we impose. We do heavy due diligence for everything before even considering actually put-ting it out on the market.”

He added: “We’ve had hundreds of research groups and existing index providers come to us and talk about creating ETFs. But we only work with a very select few. The lion’s share don’t make the cut.”

In fact, Fulton says, many of PowerShares’ competitors’ new products came to him first. “I’m sure at least one pro-spective index provider a day contacts us,” he added. “And we get them from all over the world.”

He says that the index monitoring isn’t a one-time gig, either.“We continue to monitor the portfolios and index con-

stituents. We also think it’s important to keep track of what the index providers are doing with their businesses.”

“They’ve got to go through a gauntlet of criteria we impose. … The lion’s share don’t make the cut.”

—Ben Fulton, PowerShares

May/June 200838

When we were an industry that sold what we made, the returns earned by shareholders closely paral-leled the returns reported by the funds them-

selves. But when we became an industry that focused on making what would sell, those two returns sharply diverged. This departure began in the “go-go” era of the mid-1960s, when we created scores of risky funds, seeking high returns by rapid trading, investing in small and often risky compa-nies, and following new “investment concepts.”

Many of these funds reported past returns that were achieved by dubious means, including buying “letter stocks” from insiders at substantial price discounts and marking up their prices to the higher market price. The investment records of many of these “incubation funds” that were later taken public were little short of fraudulent. These funds were “hot.” The money flowed in, and then they turned cold. Fund investors paid a high price for our folly.

In the recent era, while the conditions were different, the outcome was the same. In the late 1990s, fund inves-tors again paid a high price for our focus on the promise of the technology-driven information age, and on the promised land of the great bull market. The price they paid can be measured by the errors that fund investors made in the timing of their fund purchases and the selec-tion of the funds they chose.

The first two charts reflect those destructive patterns. The timing penalty (Figure 1) was evidenced by the fact that fund investors placed little money into equity funds during the cheap markets of the late-1980s and early-1990s (less

than $10 billion per year), but invested more than $500 bil-lion at the peak market levels of 1998–2000.

The selection penalty (Figure 2) made a bad situation worse. Investors poured the lion’s share of that $500 bil-lion into those “new economy” growth funds, technology funds, telecommunication funds and even Internet funds. It was these funds that led the market upward, and then led the market downward, with late-to-the-party fund investors paying an awful price. Ironically, at the height of the bubble, investors were actually liquidating their stodgy old value funds, which would provide excellent downside protection during the bear market that followed.

The Yawning Gap Between Fund Returns And Shareholder Returns

[Adapted from comments made to the Financial Industry Regulatory Authority in Washington, D.C., on October 15, 2007.]

The Timing PenaltyEquity Fund Cash Flow Follows The Stock Market

1600

1400

1200

1000

800

600

400

200

0

$130,000

Millions

$110,000

$90,000

$70,000

$50,000

$30,000

$10,000

-$10,000

-$30,000

-$50,000Q185

Q187

Q189

Q191

Q193

Q195

Q197

Q199

Q101

Q103

Q105

Q107

Source: Bogle Financial Markets Center

Net New Cash Flow

S&P 500

Figure 1

Bogle’s Corner

by John Bogle


We are only now beginning to calculate the devastation that these two patterns dealt to the wealth of mutual fund investors. But the data showing investor returns—resisted by the industry ever since I first mentioned it in a speech to financial writers in Chicago 11 years ago—can no longer be hidden. We can now readily compare the returns earned by the fund itself—as reported in its shareholder reports and prospectus—to the returns actually earned by its investors. The technical distinction is between time-weighted and dollar-weighted (or asset-weighted) returns. The results are not pretty.

Begin with the fact that during the 25-year period 1980–2005, when the S&P 500 Index rose at a 12.3 percent annual rate, the return of the average fund aver-aged 10.0 percent annually, or 2.3 percentage points less. But the returns earned by fund investors fell far short of that 10.0 percent return. We can’t be sure of exactly how far short, but an analysis of the past decade suggests that the gap was huge (Figure 3).

For example, the 200 funds with the largest cash inflows during the five-year period 1996–2000—essentially the duration of the late, great bull market—reported an aver-age return of 8.9 percent for the 10 years from 1996 to 2005. But the dollar-weighted return of those 200 funds—the return actually earned by their shareholders—was just 2.4 percent, only 25 percent of the annual returns reported by the funds themselves.

The consistency of this pattern is remarkable. Among those 200 funds, the shareholders of 198 funds actually earned less money than the funds reported. In only two cases did the shareholders do better. In the best case, by just 0.5 percent per year; in the other case, by a minuscule 0.05 percent per year. When we compound these shortfalls, the results are little short of astounding (Figure 4). For fully 76 of the 200 funds, the cumulative shortfall ranged from minus 50 percent to minus 95 percent!

Unsurprisingly, given the marketing ethos of today’s mutual fund business, the funds that reported the highest returns dur-ing the bull market experienced the largest gap between fund returns and shareholder returns, and vice versa. Figure 5, show-ing the relationship between the various quartiles of reported performance and the actual shareholder performance, makes it clear that the higher the performance quartile in the bull mar-ket, the lower the returns earned by investors. As it might be said in biblical terms, “and the first (in reported returns) shall be the last (in shareholder returns).”

The fund industry, naturally, argues that it bears little responsibility for this state of affairs. Rather, it is the fool-ishness of the investing public that is to blame for these disastrous results. But the industry surely bears a heavy responsibility—I would argue, the largest share—for the harm that has been done. Consider these facts:

• It was we in the fund industry who created those new funds that were to create such havoc for investors. As the market soared ever higher, we introduced those

494 brand-new “new economy” funds. Only a precious few of the major fund marketers had the courage to stand firm against the market madness, and forbear from creating and offering such funds.

The Selection Penalty:Quarterly Flow Into Growth And Value Funds,

And The NASDAQ’s Close

Nasdaq5000

4500

4000

3500

3000

2500

2000

1500

1000

500

0

$160

$140

$120

$100

$80

$60

$40

$20

$0

-$20

-$40

-$60

Net Flow (bil)

Q1‘98

Q4‘98

Q3‘99

Q2‘00

Q1‘01

Q4‘01

Q3‘02

Q2‘03

Q1‘04

Q4‘04

Q3‘05

Q2‘06

Q1‘07

Source: Strategic Insight

Growth

Value

Nasdaq Close

Figure 2

The Gap Between Annual Time-Wtd. And Dollar-Wtd. Returns

1996 - 2005

20%

0%

-20%

-40%

-60%

-80%

-100%

Covers the 200 funds with largest cash flows during 1996-2000.


Figure 3

Figure 4

The Amazing Gap Between Cumulative Time-Wtd. And Dollar-Wtd. Returns

1996 - 2005

20%

0%

-20%

-40%

-60%

-80%

-100%

Covers the 200 funds with largest cash flows during 1996-2000.


May/June 200840

• When we had funds whose performance turned “hot, we marketed them aggressively. Our public relations departments were willing co-conspirators with the press

in establishing interviews with our “star” portfolio manag-ers, many of whom, inevitably, turned out to be comets.

• The higher a fund’s performance soared, the more we advertised our returns. Example: In March 2000, the month the market hit its high, there were 44 equity funds that advertised their performance in MONEY maga-zine. The average advertised annual return was +86 per-cent. Imagine! (During the next three years, these funds were to plummet by 39 percent.) Unsurprisingly, after the fall, in the October 2002 issue of Money, there were only four funds that advertised their performance.

I believe that the mandatory and prominent disclosure of shareholder returns alongside fund returns would alert fund investors to the true returns that managers have actually achieved for their shareholders. Such disclosure, I suspect, would also discourage fund managers—and brokers and financial advisors, too—from following “the fund of the week” syndrome; remind them of the perils of aggressive marketing; and give them some self-discipline regarding the creation and promotion of high-risk funds.

Figure 5

High Fund Performance ProducesLow Shareholder Returns


Q1 149% -8.5% 50.8% 0.03% -50.7%

Q2 106% -5.8% 39.3% 0.05% -.39.3%

Q3 92% 2.5% 40.3% 0..18% -40.1%

Q4 70% 2.3% 31.6% 0.13% -31.5%

Avg. 103% -2.4% 40.4% 0.10% -40.3%

1996 to 2000

2001 to 2005

1996 to 2005

1996 to 2005

Time-Wtd. Returns $-Wtd

Cumulative Returns

Dollar-wtd minus Time-wtd

May/June 200842

by John A. Haslem

Should the SEC rid mutual fund investors of 12b-1 fees?

An Idea Whose Time Has Come


The principal reason for the differences in rates charged open-end companies and other clients appears to be that with the latter group a normal procedure in negotiating a fee is to arrive at a fixed fee which is mutually acceptable. In the case of the fees charged open-end companies, they are typically fixed by essen-tially the same persons who receive the fees, although in theory the fees are established by negotiations between independent representatives of separate legal entities, and approved by demo-cratic vote of the shareholders.

Wharton School of Finance and Commerce (1962)

hairman Christopher Cox’s essential message at the Security and Exchange Commission’s (2007) annual forum for mutual fund directors was very clear: “It is

high time for a thorough re-evaluation . . .” of 12b-1 plans. He further stated that it is also time for fund independent direc-tors to review fund 12b-1 plans, which require their initial and annual approval.

Rule 12b-1 fees pay for fund advertising and distribution services provided by broker-dealers and other intermediar-ies. The original justification for Rule 12b-1 (approved in 1980) was that it would enable mutual funds to attract new shareholders through advertising and financial incentives to brokers. The fees were promoted as a means of slowing the large net outflows that were seen as threatening the survival of many funds. It was argued that fund asset growth would benefit shareholders through increased economies of scale and reduced flow volatility. These increased scale economies were supposed to provide shareholders with expense reduc-tions sooner than they would in the absence of 12b-1 fees. Haslem (2003) also provides background on 12b-1 fees.

The “bottom line” for shareholders of mutual funds with 12b-1 plans is whether the cost reductions from economies of scale are large enough to pay the fees, and, if so, whether the reductions are passed on to shareholders.

Over time, 12b-1 fees began to be used to substitute for front-end loads. In this regard, Cox noted that the transfor-mation from distribution subsidy to sales load now totals $11 billion in broker compensation.

12b-1 Plans Pro And ConThe SEC’s June 2007 roundtable also focused on regulation

of mutual fund 12b-1 plans. The law firm of Willkie Farr & Gallagher (2007) was represented on the panel and prepared a memorandum. The panelists generally agreed that 12b-1 plans should continue, but with improved disclosure and increased board ability to exercise supervisory authority.

But the real panel debate was over which party should pay the 12b-1 fees. The pro and con summations follow in order:

. . . Rule 12b-1 contributes to investor choice in paying for costs associated with the purchase of mutual fund shares. . . . [M]any investors dislike paying loads. Rule 12b-1 fees are used to pay broker-dealers and other intermediaries for distri-bution costs, the provision of investor services, and other costs . . . so that investors can purchase shares without loads.

. . . Rule 12b-1 fees depress mutual fund returns. . . . [U]sing fund

assets to compensate intermediaries increases a fund’s expense ratio . . . [C]osts associated with distribution of shares should be borne by the investor directly out of their own assets.

However, the pro 12b-1 fees side of the argument says nothing to justify the use of mutual fund (shareholder) assets to pay for advertising and distribution costs to attract new shareholders.

Earlier, Mahoney’s (2004) study of mutual funds also pro-vides a summation of the pros and cons (in order) of the use of 12b-1 fees:

The mutual fund industry argues that these fees are a means by which investors who purchase through brokers can spread out the broker’s compensation over time rather than bear it all at once in the form of a sales load.

Critics of 12b-1 fees note that they, unlike sales loads, are not paid directly by the investor in connection with a transaction, but deducted from the fund’s assets. Thus, in effect, current shareholders bear the cost of attracting new shareholders. Because the manager has a greater interest in maximizing the size of the fund than do investors, the manager may spend more on marketing than the shareholders would prefer.

This pro 12b-1 fees position does nothing to justify using mutual fund assets to pay sales loads.

Freeman (2007) recalls that when Rule 12b-1 was adopted it was argued that mutual fund shareholders would benefit from the scale economies generated when new investors buy shares. The source of this asset growth was to be the diversion of fund assets to stimulate new sales. However, the results have not proven to be in the best interests of fund shareholders, which thereby provides a general response to the pro and con summations of the 12b-1 fees controversy:

The idea that sales to new investors financed out of fund assets are beneficial to existing fund shareholders is dubious and not sup-ported by the literature. No credible evidence exists demonstrating shareholders receive a pecuniary benefit from 12b-1 fees.

Cuthbertson, Nitzsche, and O’Sullivan (2004) explicitly add

mutual funds sold by direct distribution to Freeman’s conclu-sion. Direct distribution funds with 12b-1 plans use these monies to pay for advertising or shelf space at fund supermar-kets. The authors conclude: “To the extent that the 12b-1 fee is used for advertising, this implies that current shareholders bear the cost of attracting new shareholders [bold added].”

So why has the mutual fund industry gone to such lengths to protect the basics of current regulation of 12b-1 plans? Mahoney (2004) provides a realistic answer to this question. In 2003, fund investors paid some $9.5 billion in 12b-1 fees (63 percent to brokers) and $12.3 billion in broker marketing, distribution and account services. Writing in The Wall Street Journal, Anand (2007) reports that the payment of 12b-1 fees has risen further to $12 billion.

Any argument supporting 12b-1 plans must explain why mutual funds that are closed to new shareholders increasingly continue to charge 12b-1 fees. This behavior perhaps more than anything shows the hypocrisy in arguing that 12b-1

C

May/June 200844

plans benefit shareholders. The reality is that fund advisors benefit greatly from this practice.

The hypocrisy of the mutual fund industrys support for 12b-1 fees is perhaps best stated by Gogerty (2007) in his Morningstar “memo” to the SEC:

The fact that closed funds continue to charge 12b-1 fees clearly illustrates that the fees are no longer primarily used for their intended purpose—to market and promote a fund. A 2005 survey conducted by the Investment Company Institute revealed that less than 5% of the esti-mated $10.9 billion collected in 12b-1 fees that year were used for promotion and advertising…

Haslem’s (2004) summation of the implications of 12b-1 fees concludes this section:

. . . Rule 12b-1 fees . . . allow fund managers to use fund assets to pay distribution expenses, including sales fees and commis-sions, customer servicing fees, administrative expenses, adver-tising and promotion. However, fund managers have not used 12b-1 fees to provide shareholders with the promised reductions in expenses due to economies of scale . . . . The irony in this is that it is the fund managers who have reaped the bonanza from larger funds,―larger amounts of investment advisory fees, larger amounts of 12b-1 fees, and larger expense savings from scale economies. In fact, stock and bond funds with 12b-1 fees have lower returns, higher expenses, and more risk. Further, the jus-tification for the use of multiple share classes rests on the weak foundation of 12b-1 fees [bold added].

Empirical Research: Various Issues Siggelkow’s (1999) empirical analysis identifies 12b-1

plans as representing abusive conflicts of interest. But, first, he presents the mutual fund characteristics that should reduce these conflicts:

(1) The ease of investor exit from funds at net asset value. (2) The huge amounts invested in funds provide incentives

for investors to monitor agency conflicts.(3) The availability of many choices of funds in each

investment category. (4) The importance of investor trust and fund reputation to

the success of funds helps deter agency conflicts.(5) The ready access of investors to fund performance (but

not to agency costs).

Siggelkow next identifies two major conflicts of interest: the shifting of mutual fund marketing expenses (12b-1 fees) and research expenses (“soft dollar” commissions) to share-holders. He suggests that fund managers are exploiting retail shareholders’ ignorance of these abusive practices.

Even if mutual fund shareholders were aware of these abuses, they lack the market power to correct them. The ability of shareholders to achieve solutions to these abuses through effective monitoring is limited due to wide dispersal of share ownership among large numbers of small investors. Thus, shareholders would have to rely on fund directors to monitor abuses. But, so far, this would be a “weak reed” to rely upon.

Ultimately, however, effective monitoring is essential to the

self-interest of mutual funds, if they hope to maintain the investor trust upon which they have grown and prospered greatly. Tufano and Sevick (1997) examine the relationship between fund board structure and the size of advisory contracts. Fund directors are legal fiduciaries, and independent directors have clearly defined legal responsibilities, including, most importantly, approval of advisory contracts. The directors most likely to be effective in approving lower-cost advisory contracts are found to be those who serve on (1) smaller boards, (2) boards with larger percent-ages of independent directors, and (3) many boards for the same fund sponsor. The opposite appears true for those independent directors who receive overly generous compensation packages.

Mutual fund directors are less likely to approve lower advi-sory contracts when they are selected or influenced by fund management. In these cases, fund managers must take respon-sibility for effective monitoring of abuses to have the best chance of retaining investor trust. Thus far, they have not seen their own long-term self-interest bound up in so doing.

The issue of 12b-1 plans also comes into play in Elton, Gruber and Busse’s (2004) research on index mutual funds. They find that investor returns from S&P 500 mutual funds are much lower than expected by the rational behavior paradigm of financial economics. The expectation that these investors would be among the most knowledgeable is found to be false. These investors violate the rationality paradigm and, at a mini-mum, ignore the indicators that predict fund returns.

What then are the nature of and implications for index mutual fund shareholders who act inconsistently with the rationality par-adigm? These unsophisticated shareholders are more influenced by fund salesmanship and marketing than by their own financial analysis. The funds they hold have higher 12b-1 fees, loads and expenses, less management fees, than the “best” funds.

Index mutual funds pay brokers and financial advisors for fund flow, but 12b-1 fees, loads and expenses less manage-ment fees do not explain all of the flow. The residual flow reflects the actions of brokers and financial advisors who are often motivated by compensation systems that are not in the best interests of shareholders.

Unsophisticated mutual fund shareholders pay higher 12b-1 fees (and other expenses and loads) than do sophis-ticated shareholders whose behavior is consistent with the rationality paradigm.

In such a market, all that is necessary for inferior funds to exist and grow is a set of uninformed investors and a set of distributors who have an economic incentive to sell inferior products.

Hogue and Wellman’s (2006) research complements that by Elton et al. (2004). They note that mutual funds aggressively advertise performance, but rarely compete on expenses. The industry has become very adept at segmenting investors by level of sophistication, which allows fund advisors to sell high-cost funds to unsophisticated investors. The use of 12b-1 fees allows funds to reduce front-end loads, and places them in the expense ratio where they are less likely to be noticed by investors.

But, in addition, they conclude that there is another seri-ous implication of mutual fund market segmentation: “Market segmentation to extract higher fees from less-knowledgeable investors raises ethical concerns.”


Thus, the issue of 12b-1 fees involves more than just mutual fund expenses.

The SEC’s View In Chairman Cox’s message at the forum for mutual fund

directors, he took care to point out the developments that make “. . . the original premises of Rule 12b-1 seem highly suspect in today’s world.” These developments include:

(1) Fund growth is no longer in question and large size can create shareholder problems as funds lose flexibility and produce lower returns.

(2) “ Collecting an annual fee from mutual fund investors that is supposed to be used for marketing is no more consumer friendly than forcing cable TV sub-scribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers.”

(3) Independent director decisions to approve 12b-1 fee plans has to be decided “no” unless existing share-holders will benefit.

(4) There is need for a broad review of all investor disclosures.

Finally, Cox concludes that the current regulation of 12b-1 plans falls “tragically short” of meeting the needs of mutual fund shareholders:

To far too great a degree, and in substantial part because of a regulatory cumbersomeness . . . our financial services industries are able to skim off much more of the assets they handle than would be the case in a well-functioning market. Nonetheless, the SEC’s past failures to eliminate 12b-1 plans

indicate the mutual fund industry’s strength in Washington. Wall Street recently opposed any significant changes in Rule 12b-1, which allows fund managers to pay marketing and distribution costs out of fund assets. The Wall Street Journal’s Hughes (2007) reports the financial industry’s Securities Industry and Financial Markets Association as stating that “such fees support legitimate and necessary administrative and investment services for fund shareholders.” One must wonder how these fees represent “legitimate” services to current fund shareholders.

SEC staff economist Walsh’s (2004) empirical analysis of 12b-1 plans derives from the question of whether mutual fund shareholders benefit from the assumed increase in fund assets and reduced flow volatility. She states:

The use of fund assets to market the fund leads to an inherent conflict of interest between fund advisers and shareholders. Fund advisers earn fees based on assets under management. Asset growth increases the fees collected by

the adviser. Thus, while current shareholders incur the costs to grow the fund, it may be that the adviser is the primary beneficiary of the resulting growth.

If 12b-1 plans did provide a net benefit, mutual fund shareholders should recover their fee payments through higher fund net returns, and these returns would derive from either lower expense ratios due to scale economies or higher gross returns. Higher gross returns would come from less volatile fund flows, which would require smaller cash reserves and permit investing a larger proportion of assets in higher returning assets at lower transactions costs.

However, Walsh’s (2004) analysis finds that 12b-1 fees are inconsistent with increased net mutual fund returns to shareholders, and also may not provide higher gross returns to funds:

12b-1 plans do seem to be successful in growing fund assets, but with no apparent benefits accruing to the shareholders of the fund. Although it is hypothetically possible for most types of funds to generate sufficient scale economies to offset the 12b-1 fee, it is not an efficient use of shareholder assets. No share-holder will be better off investing in a small 12b-1 fund in hopes of helping the fund grow to attain these scale economies.

Furthermore, these higher expenses do not translate into higher gross returns. Indeed, fund flows may be more volatile and gross returns may be lower for funds with lower 12b-1 plans. Fund advisers use shareholder assets to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees.

For a contrary view on 12b-1 fees, see the Appendix. Comments on this statement are welcome.

ConclusionThe stated and objective empirical findings in this study

(and others) are generally consistent. There is no evidence that mutual fund shareholders benefit from Rule 12b-1 plans, which provide a serious conflict of interest.

The promise that 12b-1 fees would be used to increase mutual fund assets and thereby lower fund shareholder expenses appears to have been a cynical industry effort to gain SEC approval, while the intended beneficiary was (and is) fund management—and what a bonanza it has been.

The opportunity to prohibit 12b-1 fees, as both abusive and costly conflicts of interest to mutual fund shareholders, will never be better than now. The major question is not whether Chairman Cox is determined to prohibit or drasti-cally change 12b-1 fees for the better, but, rather, if he will be able to prevail over the opposition of the industry and its Washington supporters.

ReferencesAnand, Shefali, “Review of 12b-1 Fees May Be Far-Reaching,” Wall Street Journal, June 19, 2007, p. C13.

Cox, Christopher. Speech by SEC Chairman: Address to the Mutual Fund Directors Forum, Seventh Annual Policy Conference. U.S. Securities and Exchange Commission, Washington,

D.C., April 13, 2007.

Cuthbertson, Keith; Dirk Nitzsche; and Niall O’Sullivan, Mutual Fund Performance, Working paper, SSRN, December 12, 2006.

Elton, Edwin J.; Martin J. Gruber; and Jeffrey A. Busse. “Are Investors Rational? Choices Among Index Funds,” Journal of Finance, Vol. 59, No. 1, (February 2004), pp. 261–288.


May/June 200846

The financial markets remain mired in a series of credit crunches and disruptions that began about a year ago when it became clear home prices wouldn’t rise for-

ever and that some mortgage lenders and borrowers were a bit too optimistic about how soon (formerly) rising prices would bail them out.

The spreading credit difficulties seem to puzzle a lot of market participants, as though it were unprecedented. But it has happened before, although in slightly different disguises each time.

Maybe the best evidence that we’ve all been through this are the titles of those books we now wish we’d actually read. These might begin with Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds from 1841, recounting, among other events, the Dutch tulip craze of 1637. For those who missed that crisis, dealing in futures on tulip bulbs got a bit out of hand as prize bulbs sold for more than houses. Then the market col-lapsed as the delusions and madness became clear. Holland suffered a recession. Tulip bulbs were only the most infamous example Mackay chronicled; there was also John Law’s banking games in France and Britain’s South Sea Bubble.

More recent and more analytical is Charles Kindleberger’s Manias, Panics, and Crashes, now in its fifth edition. Kindleberger, a well-known economic historian, passed away in 2003. He recognized that there is a regular pat-tern to financial mania beginning with some shift or event that leads to a seemingly unprecedented boom. For the current boom, it was the Fed’s long-running effort to stave off recession after the dot-bomb bust. The Fed’s extended period of very low interest rates succeeded at that goal, but it set the stage for the housing boom and current bust.

As the housing boom got going, everyone had a reason why

home prices would not fall, and even why a doubling of home prices since 2000 made perfect sense. Few cared to look back to 1990–91 when home prices, also spurred by cheap money (in the aftermath of the S&L bailout), fell.

By the time things were really rolling along—late 2006 and the early beginnings of 2007—one could point to what Robert Shiller titled the second edition of his famous book, Irrational Exuberance, about buying a home. (Or, in some cases, buying several homes as an investment.)

As Kindleberger and others remind us, after the mania comes the panic and crash. Indeed, that’s about where we are now. As the market turmoil has spread from market to market, many still seem puzzled. Why, as a new market is struck, do people still rush for cash? This pattern was also seen before. When a credit crunch starts, would-be borrowers ask themselves whether they would like to hold on to the bank’s commitment to lend or if they would prefer cold cash. It doesn’t take much to prefer cash, espe-cially when the sky is falling. As the crunch begins, anyone with a line of credit or a commercial paper program promptly draws it down. In a crisis, cash is king. But this leaves the lenders without cash—the borrowers have it all. In response, the lenders raise interest rates and tighten credit standards and the crunch wors-ens. While solvency is enough to assure a loan in good times, liquidity is the only thing that matters in times like these.

There is another shift as credit tightens and markets slide—risk becomes a four-letter word. In good times, everyone will-ingly takes on risk. In very good times, no one even believes in risk—higher volatility is seen as a sure path to much higher returns. But when the crunch comes, everyone runs from risk and the markets can find no takers, even as prices fall. The economy rapidly moves from a high-growth/high-investment posture where risk-taking is widespread, to a deep funk where

Déjà Vu All Over Again

by David Blitzer

Gauging the current credit crisis

Talking Indexes


the only thing anyone will hold is cash. If this pattern is not interrupted, recession and slumping investment are the result. The shifts in attitudes toward risk are of much greater mag-nitude than the shifts in economic growth, employment or profits. The changed appetite for risk magnifies the damage from the crash. To a large extent, the goal of Fed rate cuts is to reawaken risk-taking, not to trim the cost of money.

However, at times the Fed does too good a job at reawaken-ing risk-taking. The aftermath of the dot-bomb bust may have been one of those times. Hyman Minsky, an economist of the second half of the 20th century who studied these concerns, pointed out that stability is, itself, destabilizing. In long periods of stability, the market comes to believe that there are few dan-gers, that markets will always rebound and that we will always come out ahead and profitable. Many who experienced the markets of the 1980s and 1990s enjoyed such a period of stabil-ity. Yes, there was a crash in 1987 and there were falling home prices in 1990-–91, but we survived and prospered through all of that and much more. We can smile and tell tales of the S&L Crisis, of Long-Term Capital Management, of The Asian Crisis and Russia’s Debt Default. Most of all, we can all tell tales of the Age of Greenspan when the Fed seemed capable of fixing anything.

Many of us forgot that the opening of the period of stability actually came before the Age of Greenspan. In 1979, President Carter appointed a little-known banker, Paul Volcker, to run the Fed. Volcker looked around and saw double-digit inflation threatening the economy. He set out to vanquish inflation, no

matter what. He did, but at the cost of two back-to-back reces-sions with double-digit unemployment and interest rates twice as high as the 10-percent-plus unemployment rate. The pain was terrible but the cure was worth it—two decades of rising markets and booming economies in the Age of Greenspan.

There are two questions facing the markets now, one par-tially academic and one far more serious. The academic one is whether this is a “Minsky Moment” when the past stability bred excess and collapse. Maybe the question is not if, but how bad.

The second is the question that faces the Fed—is recession or inflation the more likely and more pressing problem? If the answer is recession, that’s almost good for our economy as a whole. Usually, fighting recession is ultimately successful: It means lower interest rates and markets tend to rebound early in the battle. At this writing, the Fed is fighting recession and is cutting interest rates. However, not quite everyone is convinced, and that old love of risk is not yet back in style. If the enemy is inflation, things are less attractive. Volcker’s cure was high inter-est rates and a nasty recession to wring out inflation. It’s no fun and markets fall further before any discussion of recovery. If inflation is the enemy, the Fed will need to reverse course.

Is fighting inflation worth it? The successful economic policy of the 1980s and 1990s—for both political parties—could be summed up as follows: The Fed takes care of controlling inflation and the economy takes care of itself and just about everything else. Time will tell which battle—inflation or recession—will be the battle of 2008.

Appendix A Statement On 12b-1 Fees As Valuable Services

“. . . [C]oncerns regarding the cost to investors can be raised regarding the proposed elimination of 12b-1 fees in the Mutual Fund Act of 2004. These fees are not hidden actions by the advisory firm; they are

observed implicitly in the net performance earned on fund shares and reported explicitly as part of the expense ratio and in shareholder reports. Many academics have argued that these fees are a deadweight

loss for investors but this misses the point that 12b-1 fees are largely deferred payment for brokerage services. These brokerage services package together investment advice, information, convenience, and other

intangibles, like reputation, that are of value to investors. The elimination of 12b-1 fees would impose costs on investors via an impact on the market for these services. Put succinctly, these valuable services

will continue to be demanded and thus provided, and ultimately investors will bear the cost. Two obvious possibilities that might follow from the elimination of 12b-1 fees are increases in management fees to

advisory firms and a shift to more fee-based broker-investor arrangements. It is not possible to eliminate 12b-1 fees and leave investors enjoying the same bundle of services at a lower price [italics added].”

Source: Paula A. Tkac. “Mutual Funds: Temporary Problem or Permanent Morass?” A paper presented at the Financial Markets Conference, Federal Reserve Bank of

Atlanta, Sea Island, Ga., April 2004.

Freeman, John. John Freeman’s Working Paper Responding to the Advisory Fee Analysis in AEI Working Paper #127, June 2006, “Competition and Shareholder Fees in the Mutual

Fund Industry: Evidence and Implications for Policy,” by John C. Coates, IV, and R. Glenn Hubbard. Working paper, SSRN, 2007.

Gogerty, Andrew, “Memo to SEC: 12b-1 Fees Must Go,” Morningstar.com, April 19, 2007.

Haslem, John A., Mutual Funds: Risk and Performance Analysis for Decision Making. Oxford: Blackwell Publishing, 2003.

Haslem, John A., “Are Mutual Fund Expenses Too High? A Commentary,” Journal of Investing, Vol. 13, No. 3 (Fall 2004), pp. 8–12.

Houge, Todd, and Jay Wellman. “The Use and Abuse of Mutual Fund Expenses,” Journal of Business Ethics, Vol. 70, No. 1 (January 2007), pp. 23–32.

Hughes, Siobhan, “Wall Street Resists Efforts to End Fund Fees,” Wall Street Journal, July 20, 2007, p. C11.

Mahoney, Paul G., “Manager-Investor Conflicts in Mutual Funds,” Journal of Economic Perspectives, Vol. 18, No. 2 (Spring 2004), pp. 161–182.

Siggelkow, Nicolaj, Expense Shifting: An Empirical Study of Agency Costs in the Mutual Fund Industry. Working paper, Wharton School Center for Financial Institutions, University

of Pennsylvania, Jan. 4, 1999.

Tkac, Paula A. “Mutual Funds: Temporary Problem or Permanent Morass?” A paper presented at the Financial Markets Conference, Federal Reserve Bank of Atlanta, Sea Island, Ga., April 2004.

Tufano, Peter, and Matthew Sevick, “Board Structure and Fee-Setting in the U.S. Mutual Fund Industry,” Journal of Financial Economics, Vol. 46 (1997), pp. 321–355.

Walsh, Lori, “The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns. U.S. Securities and Exchange Commission,” Office

of Economic Analysis, Washington, D.C., 2004.

Wharton School of Finance and Commerce. “A Study of Mutual Funds.” Prepared for the U.S. Securities and Exchange Commission. Report of the Committee on Interstate and Foreign

Commerce, 87th Congress, Washington, D.C.: GPO, 1962, p. 493.

Willkie Farr & Gallagher. SEC Holds Roundtable on Rule 12b-1. Client memorandum, Washington, D.C., June 22, 2007.

Haslem continued from page 45

May/June 200848

NYSE To Acquire AmexIn January, NYSE Euronext

announced it would shell out $260 million for the American Stock Exchange, payable to Amex seat-holders in shares of NYSE Euronext stock. In addition, NYSE will be sell-ing the Amex headquarters at Trinity Place, with the proceeds going to Amex seat-holders as well.

The NYSE and the Amex are the two leading venues for ETF listings in the U.S.: The Amex has nearly 400 listings while the NYSE has roughly 250. The two exchanges have differ-ent strengths with regard to their ETF listings: The Amex is known for offer-ing strong support and services to its ETF-listing clients, including dedicat-ed floor specialists that help maintain tight markets in the early days of ETF trading; the NYSE brings power and prestige, along with its ultrafast NYSE Arca electronic trading system.

Claymore LiquidationsIn a surprising move, Claymore

Securities liquidated 11 of its least-popular ETFs in February, in one of the largest ETF fund closings in recent memory. In fact, the Clay-more announcement marked the first ETF liquidation since 2006, when the SPDR O-Strip (AMEX:000) ETF was eliminated due to low assets.

The last day of trading for the funds was February 19. On February 28, shareholders of record received cash payments for the full value of the funds. Any capital gains or losses from the portfolio were distributed as well. The funds being liquidated were:

• Claymore/BIR Leaders 50 • Claymore/BIR Leaders

Mid-Cap Value • Claymore/BIR Leaders

Small-Cap Core

• Claymore/Robeco Boston Partners Large-Cap Value

• Claymore/LGA Green • Claymore/KLD Sudan

Free Large-Cap Core • Claymore/Clear Mid-Cap

Growth Index • Claymore/Zacks Growth

& Income Index • Claymore/IndexIQ

Small-Cap Value • Claymore/Robeco Developed

World Equity • Claymore/Clear Global

Vaccine Index The 11 funds were not the 11

smallest funds in the Claymore fam-ily; instead they were selected based on such factors as their performance against competing funds and their acceptance in the marketplace.

“We’re always monitoring our funds to see what is being accepted by the marketplace,” said Christian Magoon, who heads up the ETF group at Clay-more. “For some reason, these prod-ucts just didn’t get traction. We view it as, ‘the marketplace has spoken.’”

Many wonder if Claymore’s deci-sion could lead other ETF providers to liquidate funds as well. There are currently more than 100 ETFs with less than $10 million in assets.

IRS ETN Tax DecisionThe Internal Revenue Service

has issued a ruling that ends the tax advantage that currency-based exchange-traded notes have had over competing currency products, including exchange-traded funds. In fact, the new ruling puts the first generation of ETNs at a slight disad-vantage for most investors.

When the first ETNs launched, their prospectuses suggested that all gains in the funds (both interest income and gains from currency

appreciation) could be taxed at the long-term capital gains rate of 15% (provided that the ETNs were held for a year or longer). That contrasted with the negative tax treatment assigned to most cur-rency products, where all gains are taxed as regular income (with rates up to 35%), regardless of how long the positions are held.

But on December 7, 2007, the IRS announced that all financial instru-ments linked to a single currency (including ETNs) were to be treated as “debt” for federal tax purposes. This means that all gains—interest and otherwise—are taxable as ordi-nary income, with rates up to 35%.

The IRS also said that shareholders will owe taxes each year on interest income. That’s a problem for holders of the original ETNs, as those notes do not pay out interest income to share-holders; instead, the interest is incor-porated into the value of the note, and is not realized by the shareholder until the note is sold. As a result, ETN holders will have to pay taxes out of pocket.

Since the announcement, new ETNs have been launched that do pay interest income.

Importantly, this ruling does not apply to noncurrency-based ETNs. The IRS has issued a request for comment on how taxes should be handled for these and other ”prepaid forward contracts.”

INDEXING DEVELOPMENTSS&P Doppelganger

Standard & Poor’s recently launched the S&P 500 Inverse Index.

The index tracks the returns of a short position in the S&P 500 Index, or rather, the inverse of the S&P 500’s total return. Although borrow-ing costs are not included in the index, it does incorporate the effect

News


of interest earned on collateral and on the profits from the short selling of the components of the S&P 500.

The index is designed to be a benchmark and to underlie investable products, particularly in Europe and parts of Asia, where S&P says that companies require an actual index tracking inverse performance in order to launch inverse tracking funds.

S&P says more inverse indexes are on the way, as well as leveraged indexes.

DJ Wilshire Adds MarketsDow Jones Indexes and Wilshire

Associates announced that three new countries will be added to the Dow Jones Wilshire Global Index family, bringing the total number of countries covered by the Dow Jones Wilshire Global Index family to 61, and the total number of emerging markets to 33.

Bahrain, Kuwait and Sri Lanka start-ed being included in the global index series March 24, following the index’s first quarter review. All three are clas-sified as emerging markets. In addition to the creation of new individual coun-try indexes, the change will affect the Dow Jones Wilshire Global Total Mar-ket Index, Dow Jones Wilshire Global ex-US Index and Dow Jones Wilshire Emerging Markets Index. Bahrain and Kuwait will also be incorporated into the Dow Jones Wilshire Middle East & Africa Index, while Sri Lanka will enter the Dow Jones Wilshire Asia-Pacific Index. Dow Jones projected that the change would ultimately result in the addition of eight Bahraini, 69 Kuwaiti and 18 Sri Lankan companies to the Dow Jones Wilshire Global Total Mar-ket Index last March.

Russell Launching Global Style New indexes to slice and dice

global stock markets are due out from Russell Investments on April 1.

Russell says the Russell Global Large Cap Growth Index and Russell Global Large Cap Value Index will represent segments of the Russell Global Index. The indexes will approach style at a global level rather than country by country. They are designed to include float-adjusted market capi-talization, annual reconstitution and multifactor style analysis.

ESG India IndexStandard & Poor’s recently

launched a socially responsible index covering India’s stock market in coop-eration with KLD Research & Analyt-ics, a socially responsible investing research firm, and CRISIL, a leading research firm in India.

The S&P ESG India Index, which is governed by environmental, social and governance (ESG) standards, is the result of a competition sponsored by the International Finance Corporation, a member of the World Bank Group.

IFC sold S&P its original emerging and frontier markets family of indexes.

The S&P ESG India Index draws its 50 components from the 500 largest stocks listed on the National Stock Exchange of India Ltd. They are cho-sen based on their quantitative and qualitative scores in the areas of ESG transparency and disclosure. The S&P ESG India Index rose 65.09% in 2007, outperforming the S&P CNX Nifty Index, which was up 56.80%.

DJ Launches Dharma IndexesIn January, Dow Jones unveiled

an index family designed to meet the investing needs of more than 1 billion people—roughly one-fifth of the world’s population.

The Dow Jones Dharma Indexes was developed with Dharma Invest-ments, target members of the Dhar-mic religions—Hinduism, Buddhism, Jainism and Sikhism—and reflect the values held in common by them.

The S&P ESG India Index draws its 50 components from the 500 largest stocks listed on the National Stock Exchange of India Ltd.

May/June 200850

The family includes five index-es—a global benchmark and four country indexes covering the United States, the United Kingdom, Japan and India. The indexes are moni-tored continuously and reviewed on a quarterly basis. Components are determined through a series of industry, environmental, corporate governance and qualitative screens established and maintained by a group of committees and advisory groups that are made up of experts in finance and Dharmic religions.

FTSE EnvirotechFTSE recently launched the

FTSE ET50 Index, which covers the world’s top environmental technol-ogy companies. It was developed jointly by FTSE and Impax Asset Management, an investment man-agement firm specializing in the environmental sector.

The 50 components are select-ed from a universe of 500 stocks determined by Impax. All of the selected components are pure-play environmental technology companies representing catego-ries such as alternative ener-gy and energy efficiency, water

technology and pollution con-trols, and waste technologies and resource management.

The FTSE ET50 Index is part of a trend. Indexes focused on ecology themes, many with ETFs based on them, have been cropping up fairly steadily in the last couple of years. WilderShares, KLD, HSBC and Standard & Poor’s have all recently launched ecologically oriented indexes.

According to FTSE, the FTSE ET50 Index is just the first in what will be a series of indexes that FTSE will develop with Impax.

S&P Launches International Dividend Indexes

In February, Standard & Poor’s launched the S&P Dividend Oppor-tunities Indexes. The new series provides exposure to high-yielding stocks for income-oriented inves-tors. It currently includes a global index and a global ex-U.S. index called the S&P Global Dividend Opportunities Index and the S&P International Dividend Opportu-nities Index, respectively.

The investable universe for the indexes includes all listed dividend-paying stocks and American Deposi-

tory Receipts (ADRs), with certain restrictions on components regard-ing volume, primary exchange, val-ue-traded and market capitaliza-tion. Components meet profitability and earnings growth requirements. Eligible stocks are ranked according to their dividend yields, with the top 100 selected for inclusion. Com-ponents are weighted to achieve maximum yield while still comply-ing with cap-weighting limits.

Shortly after the launch of the indexes, the SPDR S&P International Dividend ETF (AMEX: DWX) began trading on the American Stock Exchange. The new fund charges 0.45% in annual expenses.

Schwab Adds To RAFI LineupCharles Schwab & Co. launched

two new index mutual funds based on Rob Arnott’s fundamental bench-marking system. The funds com-pete against ETFs offered by Pow-erShares that use the same indexes, and for the most part offer lower expense ratios.

The Schwab Fundamental Inter-national Small-Mid Company Index Fund (SFIVX) has an investor share class expense ratio of 0.79% per year, but it’s not so cheap. The fund mirrors the same benchmark as the PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (AMEX: PDN), which charges 0.75%.

The investor share class of the Schwab Fundamental Emerging Markets Index Fund (SFEMX) actu-ally features a lower expense ratio. It charges 0.84%, while its rival, the FTSE RAFI Emerging Markets Port-folio (AMEX: PXH), charges 0.85%.

The cost differences become more pronounced when comparing Schwab’s two other share class-es. For a minimum purchase of $50,000, “select” shares are avail-able for each fundamental mutual fund in Schwab’s fund family. At those levels, costs drop 15 basis points (0.15%), meaning both of the new funds are cheaper than the cor-

News

FTSE recently launched the FTSE ET50 Index, which covers the world’s top environmental technology companies.


Newsresponding PowerShares ETFs.

An initial purchase of $500,000 or more costs even less: 0.55% per year for the emerging markets fund, and 0.60% for the developed mar-kets fund.

The new funds join three others launched in April 2007: the Schwab Fundamental U.S. Large Company Index Fund (SFLVX), Schwab Fun-damental U.S. Small-Mid Company Index Fund (SFSVX) and Schwab Fundamental International Large Company Index Fund (SFNVX). Simi-lar PowerShares ETFs can be found for each, and all the Schwab funds sport lower expense ratios in their various share classes.

ProShares Launches Mutual Funds

Here’s something a little different: ProFunds has launched a mutual fund.

After building a lineup of some 58 mutual funds over nearly a decade, the firm slowed to just two new mutual fund launches last year, even as its sister unit, ProShares Advi-sors, released a barrage of ETFs.

The new mutual funds track China’s once-booming stock mar-ket. The UltraShort China ProFund (UHPIX) seeks daily results that cor-respond to twice, or 200%, the inverse of the daily performance of the Bank of New York China Select ADR Index. The UltraChina ProFund (AMEX: UGPIX) seeks to gain twice as much, or 200%, of the same Bank of New York benchmark.

AROUND THE WORLD OF ETFSA Different Kind Of Total Market

The new Claymore U.S.-1 Capi-tal Markets Index ETF (AMEX: UEM) seeks to cover most invest-able stocks traded in America and almost every investment-grade bond traded in the U.S. The port-folio provides access to Treasur-ies, investment-grade corporates as well as federal mortgage-spon-sored assets and agency issues. The ETF’s expense ratio is capped

at 0.37% annually through 2010. UEM’s bond segment is also

captured by the Claymore U.S. Capital Markets Bond ETF (AMEX: UBD), which represents about 80% of investable US bonds.

A third ETF, the Claymore U.S. Capi-tal Markets Micro-Term Fixed Income ETF (AMEX: ULQ), includes investment-grade issues with maturities of one year or less. The portfolio will also hold investment-grade commercial paper and certificates of deposits.

The expense ratios on UBD and ULQ are listed at 0.27%.

PowerShares Launches Multiple Funds

PowerShares launched a number of funds in the past few months. One of the most notable is the Power-Shares S&P BuyWrite Portfolio based on the CBOE S&P 500 BuyWrite Index, which tracks the performance of a covered call strategy as applied to the S&P 500 Index. The strategy tends to outperform in down mar-kets, but sacrifices some upside per-formance when the market is rising. It is often used to reduce volatility in a portfolio. The new ETF trades under the symbol “PBP” on the NYSE Arca exchange and is the first ETF available to investors using the Buy-Write strategy. It charges 0.75%.

PowerShares also launched the PowerShares DWA Developed Mar-ket Technical Leaders (NYSE Arca: PIZ) and PowerShares DWA Emerg-ing Markets Technical Leaders (NYSE Arca: PIE). The funds rely on the technical strategies of Dors-ey Wright Associates. PIZ charges 0.80%, while PIE charges 0.90%.

The PowerShares FTSE RAFI International Real Estate Portfolio’s (Amex: PRY) underlying index tracks real estate companies from devel-oped markets excluding the United States. It charges 0.75%.

Claymore And AlphaShares Target China

AlphaShares, the index provid-

er that claims Dr. Burton Malk-iel as one of its executives, and Claymore Securities, the ETF pro-vider, have collaborated to launch two ETFs in the past few months that address previously uncharted areas of the Chinese market.

The Claymore/AlphaShares China Real Estate ETF launched on the NYSE Arca platform under the symbol ”TAO.” The fund is the first to combine two very hot areas of investment under one umbrella: China and real estate. TAO’s under-lying index, the AlphaShares China Real Estate Index, tracks roughly 50 publicly traded companies and REITs that engage primarily in the development, management or ownership of real estate proper-ties in mainland China, Hong Kong and Macau. It includes only shares available to foreign ownership, and eligible companies must have total market capitalizations of at least $500 million to be included in the index. TAO has an expense ratio of 0.65%.

Another fund, the Claymore/Alpha-Shares China Small Cap Index ETF (AMEX: HAO), tracks an index that covers 120 companies between

May/June 200852

$200 million and $1.5 billion in market capitalization. Individual companies are capped at 5% of the index. According to AlphaShares, the small size of the companies means that it contains fewer banks and government-owned entities. Claymore’s HAO comes with a price tag of 0.70%.

AlphaShares Sells Stake

Private equity firm Northern Lights Ventures has bought a share of an index provider with Burton Malkiel as its chief investment officer.

AlphaShares, which is based in the San Francisco Bay Area, said it has sold an undisclosed stake in its start-up business to the Tacoma, Wash.-based Northern Lights.

The indexing company is headed by the founder and ex-chief executive officer of Active Investment Advisors, Kevin Carter. Its research director, Mark Adams, also came from the firm. AIA was bought by IXIS Asset Manage-ment in 2004.

The firm has two ETFs based on its benchmarks: The Claymore/AlphaShares China Real Estate ETF (NYSE: TAO) launched in Decem-ber and the Claymore/AlphaShares China Small Cap ETF (AMEX: HAO) opened at the end of January.

The managing director of North-ern Lights, Paul Greenwood, will join AlphaShares’ board of directors.

Also, AlphaShares board member Julian Rainero has stepped down and the company has converted to an LLC structure.

Vanguard MegaCap Funds

Vanguard launched three index funds covering the “mega-cap” seg-ment of the U.S. stock market; the funds are available as ETF and institu-tional shares, but not regular investor shares. The ETF shares—the Vanguard Mega Cap 300 (MGC), Vanguard Mega Cap 300 Value (MGV) and Vanguard Mega Cap 300 Growth (MGK) funds—all began trading on the NYSE Arca upon their launch.

While the institutional shares charge an expense ratio of just 0.08%, the ETF shares charge 0.13%. The three funds track the MSCI U.S. Large-Cap 300 Index and its growth and value subindexes.

BGI ETF Covers Emerging Market Debt

Barclays Global Investors added the iShares JPMorgan USD Emerging Markets Bond Index Fund (NYSE Arca: EMB) to its lineup in December; the new fund tracks the JPMorgan EMBI Global Core Index covering sovereign and quasi-sovereign emerging-market debt issued in U.S. dollars.

Previously, PowerShares was the only firm offering an ETF for that particular asset class, with its Power-Shares Emerging Markets Sovereign Debt Portfolio (AMEX: PCY) tracking the DB Emerging Market USD Liquid Balanced Index. PCY was launched in October, and currently has about $35 million in assets.

EMB is more expensive than PCY. The iShares fund charges 60 basis points versus the PowerShares fund’s 50-basis-point expense ratio.

Van Eck Continues Muni Bond Blitz

While the pace of municipal bond ETF launches has largely subsided, Van Eck has continued to build its family after entering the market late.

In January, the firm launched its second muni bond ETF. The Market Vectors-Lehman Brothers AMT-Free Long Municipal Index ETF (AMEX: MLN) tracks the Lehman Brothers AMT-Free Long Continuous Munici-pal Index. The index is weighted by market value and includes fixed-rate, investment-grade municipal bonds with durations of at least 17 years. As implied by the index’s name, its components are all exempt from the alternative minimum tax. MLN carries a net expense ratio of 0.24%.

In February, Van Eck launched the Market Vectors-Lehman Broth-ers AMT-Free Short Municipal ETF

(AMEX: SMB), which tracks the Leh-man Brothers AMT-Free Short Con-tinuous Municipal Index. The index covers investment-grade municipal bonds with a nominal maturity of one to six years. SMB charges a net expense ratio of 0.16%.

The new ETFs join the Market Vec-tors-Lehman Brothers AMT-Free Inter-mediate Municipal Index ETF (AMEX: ITM), which was launched December 6 and tracks the Lehman Brothers AMT-Free Intermediate Municipal Index. Van Eck has another three muni bond ETFs in registration.

New Currency iPathsBarclays Capital has filed for

three new currency-based ETNs. Interestingly, two of the notes

will make cash payments to note-holders on a quarterly basis to reflect interest income earned by the note. This stands in contrast to earlier ETNs, which incorporate the value of the interest into the share price of the note. The change comes in response to an IRS tax ruling requiring all ETN holders to pay taxes on interest income on an annual basis. The new notes will incorporate the implied interest over the course of the quarter and then go ”ex-dividend” once the interest is paid. Both will charge 0.89% in expenses.

The first ETN filing with this interest income payout is for the Barclays Asian and Gulf Curren-cy Revaluation Notes, which are designed to provide exposure to five Middle Eastern and Asian mar-ket currencies that are officially tied to the value of the U.S. dollar.

Barclays will also make interest payments on the new Barclays GEMS Strategy ETN, where GEMS stands for Global Emerging Markets Strat-egy. The ETN offers exposure to a 15-currency money market account, incorporating both local currency movements and local interest rates into the value of the note.

The third ETN—and one that

News


NewsBarclays will not make interest pay-ments for—is the Barclays Intel-ligent Carry ETN, which intends to offer exposure to the carry trade. The carry trade is an institutional strategy that seeks to profit by bor-rowing money in low-yielding cur-rencies and investing that money in high-yielding currencies. This index uses long and short forward posi-tions in G10 currencies to execute the trade. Interestingly, the ETN charges investors for the bid/ask spread required to buy and sell the various currencies; it levies a fee of 0.007% for each index component.

The note charges 0.65%.

Taiwan: The Next ETF Hot Spot?The Taiwan Stock Exchange has

said that deals are in the works to list a wide array of ETFs within the next six months, according to The Financial Times. The exchange cur-rently lists just seven ETFs covering mainly the Taiwan stock market. But the exchange is pursuing addi-tional listings in many ways.

For starters, it is in talks with the Tokyo Stock Exchange about cross-listing both exchanges’ ETFs, and has signed an agreement with the Abu Dhabi Securities Market (ADSM) to jointly develop and list ETFs as well.

Société Générale, which already offers a number of ETFs on the Euronext Paris exchange, has detailed 10 different possible ETFs to list on the Taiwan Stock Exchange, while two more Taiwan firms are looking to list ETFs on their home exchange.

ETFs could provide the Taiwan Stock Exchange with a way to respond to and capitalize on domestic investors’ increasing interest in foreign invest-ment opportunities, rather than losing business to foreign stock exchanges. According to the FT article, Taiwan’s capital outflows have increased in the past few years as a result of pension reform and deregulation in the asset management industry.

Van Eck Offers Pure-Play Gambling ETF

Van Eck Global launched the first gambling-only ETF: The Market Vec-tors-Gaming ETF (AMEX: BJK) is the only pure-play ETF for that particu-lar industry. Its cap-weighted index divides those companies into five different areas: casinos and related resorts is the biggest, followed by tech, sports and race books, horse racing and online gaming. Although the U.S. is the most heavily repre-sented country, the index takes a global approach. The expense ratio for BJK is 0.65%.

Old CRB Underlies New ETFGreenHaven Commodity Services

launched an ETF tied to an old itera-tion of the popular CRB Commodity Index. The GreenHaven Continuous Commodity Index ETF (AMEX: GCC) is charging 0.85% in annual fees.

The ETF tracks the Continuous Commodity Total Return Index. That’s an equal-weighted portfo-lio with 17 commodities ranging from cotton to gold.

The CRB was the first and is still one of the best-known commodity indexes. The fund tracks the CRB Index as it existed prior to a 2005 reformulation, when the bench-mark was rebranded the Reuters/Jeffer-ies CRB Index and underwent

a major design overhaul. The GreenHaven ETF, like all

commodity ETFs, will invest its col-lateral cash in Treasuries. Its returns will incorporate changes in the spot prices, income (or losses) from the roll yield on the various contracts and interest income from the col-lateral Treasuries investments.

Canada Gets First Money Market ETF

Canada has gotten North America’s first money market ETF. Claymore Investments, the second-largest ETF issuer in Canada, has launched the Claymore Premium Money Market ETF (CMR) on the Toronto Stock Exchange. Interestingly, the fund does not track an index.

Money market funds typical-ly hold high-quality, short-term debt, and are mostly used for capital preservation or as cash reserves. They typically pay sub-stantially higher interest than standard savings or brokerage accounts, with a small risk of default. CMR carries an expense ratio of 0.25%. Regular and advi-sor shares are available.

May/June 200854

KOL Tracks Alternative Energy Source

Van Eck’s new Market Vec-tors - Coal ETF (NYSE Arca: KOL) tracks the coal industry, a nice spot to be in as coal comes into vogue and oil prices continue to rise. According to the World Coal Institute, coal meets roughly a quarter of the world’s energy demand and is the source of 40% of the world’s electricity.

KOL mimics the performance of the recently released Stowe Coal Index, which covers 60 compa-nies from around the world that are involved in the coal indus-try. The index is weighted by float-adjusted market capitaliza-tion and includes stocks from 12 countries. It was up over 103% in 2007 and has a three-year annual-ized return of 43.81%.

Components are involved in five areas of the coal industry: mining and production, which is the largest subset; mining equipment; transportation; technology; and power genera-tion. KOL charges an expense ratio of 0.65%.

WisdomTree Launches First-Ever India ETF

WisdomTree won the race to get the first ETF to cover India to market in February with the listing of the WisdomTree India Earnings Fund (NYSE Arca: EPI). Roughly one million shares changed hands on the first day of trading.

EPI’s index is weighted by earn-ings rather than dividends because fewer companies in India pay dividends. Most importantly, the underlying index was constructed with India’s newest foreign capital restrictions in mind; the methodol-ogy includes an investable weight-ing factor that reflects both avail-able float and the government’s foreign investment limits. The WisdomTree India Earnings Index includes approximately 150 stocks.

EPI charges an annual expense ratio of 0.88%.

ProShares Files For 130/30 ETF

ProShares has filed papers with the Securities and Exchange Com-mission for a new “130/30” ETF.

The new fund will use a pro-prietary, quantitative analytical

system to rank all of the large-cap stocks in the U.S. market. It will then take a 130% long position in the high-ranked stocks and a 30% short position in the low-ranked stocks. The goal is to capture additional alpha and generate excess returns while retaining a net 100% exposure to the market.

This kind of ”130/30” strategy is one of the fastest-growing segments of the financial industry. According to Morgan Stanley, there is now more than $100 billion invested in 130/30 funds worldwide. Most of that money is run by hedge funds and other high-cost products tar-geted at institutions and ultra-high-net-worth investors, and nearly all of it by active managers. The new ProShares fund, in contrast, will make the strategy available to all investors at relatively low cost using an index-based approach. The index has not been announced.

SSgA Active Target Date ETFsState Street Global Advisors

filed an exemptive relief request with the SEC for the right to launch a family of nine actively managed target date ETFs. According to SSgA, the ETFs will be funds of funds holding other ETFs, and the active management will be in terms of asset allocation. Funds will be available with target dates of 2010, 2015, 2020, 2025, 2030, 2035, 2040, 2045 and ”Retire-ment Income.” They will not track an index, so there is no intraday indicative value. However, SSgA will publish a NAV on a 15-second basis based on the values of the underlying funds and securities.

The new funds will rebalance annu-ally. Should they launch, they would be the first funds to package other ETFs into a tradable ETF package.

WisdomTree Teams With Dreyfus On Cash, Fixed-Income ETFs

WisdomTree Investments announced a new partnership agreement with

News

Van Eck’s new Market Vectors - Coal ETF (NYSE Arca: KOL) tracks the coal industry; a nice spot to be in as coal comes into vogue and oil prices continue to rise


Dreyfus Corp. to help market its new line of cash and fixed-income ETFs. Under the deal, all WisdomTree cash and fixed-income ETFs will be co-branded and co-marketed by Drey-fus, which is a division of The Bank of New York Mellon.

WisdomTree filed papers with the SEC to launch 12 foreign cur-rency money market funds. The funds will act like traditional money market funds except they will be denominated in foreign currencies and pay local currency rates. The fil-ing includes funds tied to developed market currencies like the British pound, the euro and the Japanese yen, but also emerging markets currencies like the Chinese yuan, Indian rupee and Brazilian real.

WisdomTree ETFs Available In Chile

WisdomTree Investments has expanded into Latin America. The New York-based ETF company says that its filing with the Comisión Clas-ificadora de Riesgo, which regulates pension funds in Chile, has been approved. As a result, some 34 Wis-domTree ETFs from the WisdomTree Trust are now available for invest-ment by Chilean pension funds.

Currently, WisdomTree esti-mates the country’s pension funds hold about $114 billion in assets. Chile has been very aggressive about encouraging its workers to invest for retirement, and ETFs are already being used by investors, with both iShares and SPDRs funds registered in the country.

The pension plans have also recently seen their restrictions on foreign holdings eased to 40%. WisdomTree didn’t register some of its smaller ETFs in Chile, as the country had set a thresh-old requirement of at least $20 million in assets.

Frontier ETFs Launch OverseasAs part of its recently formed

db x-trackers platform, Deutsche

Bank has issued two ETFs focused on so-called frontier markets. Fron-tier markets are essentially pre-emerging markets, and they have been undergoing hyper-growth in the past several years.

The db x-trackers ETFs are listed on multiple stock exchanges across Europe. Those include Euronext Paris, Borsa Italiana, Frankfurt Xetra, London Stock Exchange and SWX Swiss Exchange. The funds are sup-ported by a number of market mak-ers providing liquidity in the ETFs, according to DB in a statement.

One fund tracks the FTSE Viet-nam Index, which includes about 20 companies, and the other fol-lows the S&P Select Frontiers Index. The latter tracks the S&P Frontiers Index, and offers exposure to 30 companies in markets like the Unit-ed Arab Emirates, Pakistan, Panama, Cambodia and Bulgaria.

Lehman Enters ETN MarketLehman Brothers entered the

ETN market in February with the launch of three products under the “Opta” name.

The Opta S&P Listed Private Equi-ty Index Net Return ETN (NYSE Arca: PPE) includes the stocks of 30 listed companies whose primary business is private equity investing. It will come with an expense ratio of 0.75%.

The Opta Lehman Brothers Com-modity Index Pure Beta Total Return ETN (AMEX: RAW) covers energy, metals, agriculture and livestock. It will have an expense ratio of 0.85%.

The Opta Lehman Brothers Commodity Index Pure Beta Agri-culture Total Return ETN (AMEX: EOH) tracks an underlying index that includes eight futures contracts broken down into grains (corn, soy-bean meal, soybean oil, soybeans, and wheat) and softs (coffee, cot-ton, and sugar). It will charge an expense ratio of 0.85%.

Both of the commodities products use sophisticated and unusual weighting systems in an

attempt to outperform standard commodity benchmarks.

Revenue-Weighted ETF Offer S&P Alternative

Three ETFs from RevenueShares Investor Services were recently launched tracking modified ver-sions of popular S&P benchmarks. The funds weight names by revenue rather than market-cap sizes.

The RevenueShares Large Cap Fund (NYSE: RWL) tracks a reve-nue-weighted version of the S&P 500, while the RevenueShares Mid Cap Fund (NYSE: RWK) is designed to complement the S&P 400. The RevenueShares Small Cap Fund (NYSE: RWJ) holds the components of the S&P 600.

The idea for a revenue-weight-ed index was developed by Vince Lowry and his company, VTL Asso-ciates. RevenueShares was hired to do sales and marketing and S&P will maintain the new indexes.

The revenue-based ETFs will start out charging 0.49% in annual fees.

KNOW YOUR OPTIONSETF Options Top Index Options At CBOE

Since early last year, options trading using ETFs has been soar-ing. In fact, at least in the open-ing months of 2008, ETF options have surpassed those of more established index options in cer-tain markets. According to CBOE data, January and February trad-ing of the 25-year-old options on indexes averaged about 992,000 in daily volume. At the same time, ETF options averaged 1.3 million a day. That represented a 124% jump from the same two months of 2007.

“We’ve seen big growth every year in ETF options,” said Matt Moran, vice president of business development at the CBOE. “But all options have been growing. So it’s part of a larger pattern we’re seeing.”

News

May/June 200856

NewsHe says growth in ETF options

is tied into a few different fac-tors. For one, more education about how to use options as insurance and a means to miti-gate risks coincides with retail investors discovering ETFs as diversification tools.

“As ETF assets have grown, a lot of the ETF providers are becoming big believers in options,” Moran said. “They’ve come to us and asked for options to be listed on their new ETFs.”

But the recent surge in ETF options trading is still somewhat confined. Three ETFs have domi-nated that activity. The latest CBOE figures show that in January and February:

• The iShares Russell 2000 Index Fund (NYSE: IWM) has averaged 395,383 daily options volume, a 97% increase from the same peri-od a year ago.

• PowerShares QQQ (NASDAQ: QQQQ) averaged 268,000 in options trading per day, up 61% compared with the same time last year.

• The SPDRs (AMEX: SPY) aver-aged 337,000 daily options trades, up 242%.

The next biggest was Financial Select Sector SPDR (AMEX: XLF), which saw a 1,200% leap com-pared with a year earlier. But it represented a much lower level, about 71,000 trades per day.

Perhaps just as interesting, some of the more popular names aren’t always the biggest draws in

terms of options trading. “More diversified ETFs that lend them-selves to being more of buy-and-hold vehicles may have huge asset size, but aren’t usually going to be found at the top,” noted Moran.

An example he gives is iShares MSCI EAFE Index fund (NYSE: EFA).

INTO THE FUTURESVIX Sees Record Volumes

January was a pretty good month for VIX futures contracts trading on the CBOE Futures Exchange (CFE), despite the decline in the stock markets: The contract vol-ume was up 91% from January 2007, with 85,731 contracts trad-ing hands for the month. That’s about 89% of the CFE’s total con-tract volume for January.

VIX futures contracts, not sur-prisingly, have been doing well in the increasingly volatile mar-ket environment. January wasn’t even the highest-volume month in recent history. In November 2007, one of the more volatile months of the year, a total of 173,864 VIX futures contracts were traded, a 303% increase over November 2006. August 2007 was another fairly vola-tile month that saw a dramatic increase in the number of VIX futures contracts traded.

The CBOE says hedge funds account for much of the vol-ume, as hedge fund managers use the futures to hedge against spikes in implied volatility. VIX futures contracts were launched in March 2004.

ON THE MOVEMcNabb To Fill Brennan’sShoes At Vanguard

Vanguard’s Jack Brennan recently announced that he would step down as chief executive offi-cer. He is only the second person to hold that title at the company, having taken over the reins at Vanguard in 1996 from its found-er, John Bogle, the pioneer of retail index mutual funds.

Vanguard says Brennan will be succeeded by F. William McNabb III, who previously served as a managing director overseeing the firm’s growing institutional and international operations.

Brennan joined Vanguard in 1982. He was elected president in 1989 and later became its chair-man in 1998 (to go along with his CEO duties). Brennan will remain as chairman of Vanguard’s board, the company said.

McNabb has been with Van-guard since 1986, serving in sev-eral key senior management roles. He became Vanguard’s president and director effective March 1.

Under Brennan, Vanguard’s assets under management have grown to $1.25 trillion in U.S. mutual fund assets, including $43 billion in ETF assets.

Claymore’s Magoon Promoted

Claymore has named Christian Magoon, the managing director in charge of its ETF business, as presi-dent. He is responsible for product development, marketing and distri-bution for the company’s ETF and unit investment trust businesses.

7Haughton, Kelly, The Russell Index Philosophy.8Haughton, Kelly, The Russell Index Philosophy.9“Objective Benchmarking,” Lori Richards, www.russell.com; Sept. 21, 2004.10 The Dow Jones Wilshire 5000 contains all U.S. stocks with readily available prices. The membership count has ranged from 3,069 on Feb. 28, 1971 to 7,562 on July 31, 1998.

The membership count on June 30, 2007 was 4,919.11Waid, Robert, “A More Stylish Fit,” Journal of Indexes, September/October 2006.12“Benchmarks and Performance Attribution Subcommittee Report”13 Sharpe, William F., “ASSET ALLOCATION: MANAGEMENT STYLE AND PERFORMANCE MEASUREMENT: An asset class factor model can help make order out of chaos,” Journal of

Portfolio Management, Winter 1992, pp. 7-19.14The Russell 3000E Index is the Russell 3000 Index extended to include the missing Russell Microcap companies.15 Singal, Vijay, with Honghui Chen and Greg Noronha, “Index Changes and Losses to Investors in S&P 500 and Russell 2000 index funds,” Financial Analysts Journal, July/August

2006, pp. 31-47.

Some people seem to want to put all small-cap investment managers into one box. But when it comes to indexes, investment managers like a variety of different boxes. Our observation of the benchmarks they have chosen for their investment products backs this up.

As assets benchmarked against one or another of the indexes in the family of Russell Indexes have increased, we have managed our methodology to improve index representation and transitions. In just the past five years, Russell has made significant pro-cedural changes to our indexes (for documentation, see www.russell.com), which have resulted in even-more-effective benchmarks. Some people ignore the impact of these changes in their analysis.

Our size, popularity, hallmark transparency and focus on letting the market determine the indexes leave us open to critiques, which we welcome from the Russell Index Client Advisory Board as well as the marketplace as a whole. But don’t box Russell clients into just one bench-mark. They like the family!

Kelly HaughtonStrategic Director, Russell IndexesRussell Investments

Small-Cap And Mid-Cap Benchmark Usage

Source: Nelson MarketPlace

AUM$ billions$66.5 $7.8

$51.3

$54.6

$128.2

$116.3$169.4

$122.8 $291.4

■ Russell 2000®

■ Russell 2000 Growth

■ S&P SmallCap 600

■ Russell 2000 Value

■ Russell 2500™

■ Russell Midcap® Value

■ S&P Midcap

■ Russell Midcap Growth

■ Russell Midcap®

Don’t Box Me In

RESPONSE

Waid continued from page 33

May/June 2008 57

Chance continued from page 15

10And we could say goodbye to those all-star analyst awards, which, in my opinion, would be good riddance. Giving ego-stuffed actors their Oscars makes more sense than

all-star analyst awards. At least an actor can be evaluated for a short-term effort in a specific movie. Awarding an analyst for having a lucky year is like giving someone an

award for having won the lottery.11Yes, I know she probably isn’t the best choice for a quote I can link to active trading.12Let us be careful here as well. Just because a risk can be eliminated does not mean that there is no risk premium associated with that risk. One can easily eliminate market risk

by selling futures contracts on the market. For that matter, one can eliminate market risk by investing all of one’s funds in the cash. Risk for which one cannot expect to earn a

risk premium is risk that can be completely eliminated from the market as a whole. One can diversify across stocks to eliminate that risk. One can diversify across industries and

sectors to eliminate that risk. Indeed, holding the market portfolio eliminates all of that risk. But of course, investors as a whole cannot eliminate the entire market risk.

13Jeremy Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 4th ed., 2008, New York: McGraw-Hill.

14It is tempting to shorten the period and look at something like 100-year periods, starting with 1802–1902, 1803–1903, etc. From that we would have quite a few 100-year periods

to examine. But the problem with that approach is that the periods are not independent. The results from 1802–1902 will likely be very similar to those of 1803–1903. This is like

measuring a person’s weight on two consecutive days and expecting to see much of a difference. Over time, of course, there will be small differences that could accumulate, but

the results are hardly independent from day to day. So overlapping periods do not really give us more information, just the appearance of more information.

59May/June 2008www.journalofindexes.com

Global Index Data

Dow Jones - AIG Commodity Goldman Sachs CommodityMSCI Indonesia MSCI World/Metals&Mining MSCI Thailand LB US Treasury US TIPSLB Global AggregateDJ Transportation AverageGoldman Sachs Natural ResourcesCSFB Credit Suisse HYLB MunicipalAMEX CompositeMSCI Japan DJ Wilshire REIT FTSE NAREIT Equity REITsMSCI Pacific DJ Composite AverageJSE Gold South AfricaMSCI EAFE Small Cap DJ Wilshire REITMSCI EM MSCI EAFE Growth Dow Jones IndustrialDJ US Health CareMSCI World Ex US S&P SmallCap 600/Citi ValueS&P MidCap 400/Citi GrowthS&P Smallcap 600 S&P Midcap 400 Russell 2000 Value MSCI EAFE NYSE CompositeRussell 3000 Value Russell 1000 Value MSCI AC Far East Ex Japan S&P MidCap 400/Citi ValueMSCI World S&P SmallCap 600/Citi GrowthDJ Wilshire 4500Morningstar Dividend Leaders S&P 500/Citi ValueMSCI Pacific Ex Japan DJ Wilshire US Small Cap Russell 1000 DJ Small Cap GrowthDJ Wilshire 5000Russell 3000 MSCI Europe S&P 500 MSCI EAFE Value S&P 500/Citi GrowthDJ Utilities Average Russell 3000 Growth MSCI World LCLRussell 2000 DJ US FinancialMSCI EAFE LCLRussell 2000 Growth BSE SENSEX LCL IndiaNASDAQ Composite

16.2332.6750.8140.0640.9411.64

9.481.43

34.432.663.36

17.18-4.23

-17.56-15.69

5.308.88

-18.001.45

-36.4816.45

8.898.36

12.44-5.5413.50-0.307.98

-9.7811.17

6.58-1.01-0.1733.38

2.659.045.605.77

-10.341.99

30.731.905.77

12.385.735.14

13.865.495.969.13

20.1111.40

2.83-1.57

-17.661.177.05

47.159.81

17.0311.23

6.395.965.755.244.50

-0.21-1.33-2.67-3.38-3.45-3.91-4.23-4.55-5.47-5.64-5.67-5.93-6.19-6.26-6.73-7.11-7.12-7.37-7.42-7.64-7.82-7.91-7.92-7.94-7.99-8.02-8.03-8.11-8.15-8.18-8.22-8.24-8.25-8.52-8.54-8.62-8.87-8.89-8.91-8.98-9.00-9.05-9.16-9.56-9.77-9.85

-10.19-10.27-10.88-11.76-12.32-13.35-14.36

2.07-15.0969.6134.56

6.760.416.649.81

16.8211.93

4.8416.90

6.2435.9735.0612.2015.71

5.5419.3136.1529.1822.3319.05

6.8825.7119.57

5.8115.1210.3223.4826.3417.8622.3422.2528.4714.6220.0710.5416.0725.6420.8032.0216.9815.46

9.0715.8815.7233.7215.7930.3811.0116.63

9.4613.5218.3719.4213.8113.3546.70

9.52

23.9320.7269.9764.33

134.268.40

12.5131.8434.0127.93

5.3142.3635.9136.1837.1338.4829.4011.4761.3536.1851.5931.9928.2819.4339.4239.2037.3238.7935.6246.0338.5929.2831.1430.0340.7733.8033.1138.5043.9527.5330.3645.7749.0329.8948.4831.6431.0638.5428.6945.3027.0829.3930.9722.7647.2532.2317.4148.5472.8950.01

-19.51-31.93

-9.921.104.557.901.58

-9.30-15.59

5.785.13

-5.59-29.4012.3513.93

-25.40-11.7829.65

-12.35-4.69

-24.58-5.44

-12.84-21.40

9.52-2.556.54

-0.6114.02

-21.44-10.21

-4.33-5.59-4.141.43

-16.823.00

-9.385.03

-8.18-9.883.13

-12.45-8.50

-10.97-11.46-19.90-11.89-18.52-16.12-26.27-19.63-15.25

2.49-6.38

-17.54-9.23

-17.87-21.05

15.9211.5342.1933.7113.99

6.805.548.08

22.604.122.52

15.517.179.098.91

10.738.925.89

10.6522.2925.6513.99

6.905.39

13.544.257.834.267.033.09

12.766.985.565.79

20.456.109.284.318.052.566.64

19.915.965.876.846.095.71

13.735.37

11.444.11

14.275.805.603.90

-1.257.344.61

37.833.45

15.4112.7652.6238.3929.25

6.416.94

18.6528.93

9.463.35

22.2914.9017.5217.3818.3215.90

1.4925.4019.2632.9319.9211.74

8.3021.6815.4116.2115.7215.5315.3521.1813.7013.9813.8925.4114.7416.1116.0917.3310.5014.2027.5717.0712.2416.7512.9212.4422.4711.6422.31

9.1723.4610.8011.1315.10

7.9112.3414.7239.8711.17

11.1511.4419.4416.06

7.757.976.394.25

11.475.554.71

12.663.14

10.9310.22

5.306.357.45

-13.9310.79

-5.785.097.037.34

12.077.429.627.736.624.536.306.247.637.265.117.316.329.305.17

11.416.864.424.544.564.447.274.07

-2.289.741.752.255.344.241.812.23

17.112.52

10.268.484.88

--1.38

-6.719.02

-7.455.33

12.332.36

11.6611.82

4.2810.74

0.38-

14.848.99

-11.3412.32

9.06---

12.7511.45

8.758.65

10.9610.97

5.40-

8.90-

10.16--

10.1410.73

9.788.319.699.67

11.899.64

--

9.337.766.369.24

10.935.046.43

-8.47

0.760.411.401.250.490.480.260.300.92

-0.04-0.480.810.280.350.340.560.550.210.491.121.030.860.320.150.810.050.340.050.28

-0.030.760.320.170.200.850.200.540.060.36

-0.120.280.940.180.200.240.220.180.800.150.640.020.790.18

-0.03

-0.39-

0.091.250.00

Index Name YTD 2007 200621.3625.5512.5633.66

4.852.84

-4.4911.6536.48

2.263.51

22.6425.5213.8212.1622.64

9.4943.3426.1913.9930.3113.28

1.728.32

14.478.36

14.427.68

12.564.71

13.546.956.857.05

17.8610.77

9.497.07

10.283.168.71

13.827.376.278.796.326.129.424.91

13.801.14

25.145.17

13.744.556.46

25.964.15

42.341.37

9.1517.2844.5413.88-4.048.469.27

27.7324.5711.96

4.4822.2215.8633.1631.5818.9815.58

-27.7530.7833.1822.4516.12

5.314.55

20.3821.0915.7822.6516.4822.2520.2512.1616.9416.4914.2317.1814.7224.2918.5113.8015.0328.4619.4611.4115.4712.6211.9520.8810.8824.33

6.9730.24

6.939.49

18.3313.3910.1814.3113.08

8.59

2005 2004 200325.9132.0738.11-4.2824.3216.5716.52

-11.48-13.26

3.119.61

-2.74-10.28

3.583.82

-9.29-15.94130.33

-7.823.58

-7.97-16.02-15.01-20.81-15.80-12.93-19.67-14.63-14.53-11.43-15.94-19.83-15.18-15.52-11.05

-9.43-19.89-16.57-17.85

-7.29-16.59

-6.42-18.98-21.65-38.89-20.86-21.54-18.38-22.10-15.91-28.10-23.38-28.04-25.20-20.48-12.35-27.45-30.26

3.52-31.53

2002 2001 3-Yr 5-Yr 10-Yr 15-Yr Sharpe15.1922.1624.6521.8823.42

4.984.66

15.4719.81

4.513.72

13.7412.0316.7816.2011.83

8.4039.1514.0615.6720.1311.06

8.708.82

11.2413.0911.5712.8311.1013.0211.06

9.169.028.82

19.0710.96

9.3812.8511.4410.66

9.0016.2312.75

8.8412.82

9.219.14

11.678.76

11.359.23

12.5110.14

9.6013.9512.3311.6015.4122.7213.82

Std DevTotal Return % Annualized Return %

Selected Major Indexes Sorted By Year-To-Date Returns May/June 2008

*Source: Morningstar. Data as of 2/29/08. All returns are in dollars, unless noted. YTD is year-to-date. 3-, 5-, 10- and 15-year returns are annualized. Sharpe is Sharpe Ratio. Std Dev is three-year standard deviation.

May/June 200860

Vanguard 500 IndexVanguard Tot StkVanguard Inst IdxVanguard 500 Idx AdmVanguard Total Bd IdxVanguard Total Intl StkVanguard Tot Stk AdmVanguard Inst Idx InstPlVanguard Eur Stk IdxFidelity Spar US EqIxVanguard 500 Index SignalVanguard Em Mkt IdxVanguard Tot Stk InstVanguard Total Bd Idx AdVanguard Total Bd Idx InVanguard Pac Stk IdxT. Rowe Price Eq Idx 500Fidelity Spar 500 AdvFidelity U.S. Bond IndexDimensional Intl SmCpValVanguard Tot Stk InstPlsVanguard Inst Tot Bd IdxDimensional US LgCpValFidelity Spar 500 IdxVanguard Mid Cap IdxFidelity 100 IndexDimensional EmergMrktsValVanguard Gr IdxFidelity Spar US Eq AdvVanguard TotBdMkt Idx SigDimensional Intl ValVanguard Mid Cap Idx InsDimensional Intl Small CoVanguard SmCp IdxDimensional US Micro CpVanguard ExtMktIdxFidelity Spar Intl IndexFidelity Spar Tot Mkt IxVanguard Inst DevMktsIdxVALIC I StockVanguard TotStMkt Idx SigGatewayVanguard Eur Stk Idx InsVanguard REIT IndexVanguard Val IdxSchwab S&P 500 In SelVanguard Dev Mkts IdxFidelity Spar Tot Mkt AdvVanguard Bal IdxDimensional US Sm CpVanguard EmgMkts Idx AdmrVanguard SmCp Idx InsVanguard SmCp Vl IdxSchwab 1000 In InvSchwab S&P 500 In InvDimensional TaxMgUSSmCpVlDimensional USLgCoVanguard Intm Bd IdxDimensional One-Year F/IDimensional FiveYrGlbF/I

VFINXVTSMXVINIXVFIAX

VBMFXVGTSXVTSAXVIIIX

VEURXFUSEXVIFSXVEIEXVITSXVBTLXVBTIXVPACXPREIX

FSMAXFBIDXDISVXVITPXVITBXDFLVXFSMKXVIMSXFOHIXDFEVXVIGRXFUSVXVBTSXDFIVXVMCIXDFISXNAESXDFSCXVEXMX

FSIIXFSTMXVIDMXVSTIXVTSSXGATEXVESIXVGSIXVIVAX

SWPPXVDMIXFSTVXVBINXDFSTXVEMAXVSCIXVISVXSNXFXSWPIXDTMVXDFLCXVBIIXDFIHXDFGBX

0.180.190.050.090.200.320.090.030.270.100.090.450.060.110.070.320.350.070.320.750.030.050.300.100.220.200.700.220.070.110.480.080.640.230.550.250.100.100.120.360.090.950.120.210.210.190.270.070.200.400.300.080.230.500.370.550.150.180.190.33

57,096.4 48,000.5 42,257.7 33,773.6 30,592.6 27,068.4 25,976.6 24,380.2 23,436.3 20,074.9 19,604.8 12,684.5 12,593.6 11,225.1 10,264.1 10,259.5

9,801.9 9,007.3 8,846.9 8,642.4 8,141.4 7,756.8 7,704.5 7,240.7 7,224.1 6,808.1 6,800.0 6,365.0 6,302.1 5,816.5 5,805.9 5,729.2 5,663.0 5,563.1 4,938.2 4,729.4 4,509.6 4,457.9 4,397.6 4,370.0 4,296.4 4,225.7 4,127.5 3,908.6 3,882.9 3,696.0 3,592.8 3,561.2 3,510.9 3,395.4 3,357.8 3,353.0 3,326.7 3,318.1 3,315.4 3,290.6 3,199.1 3,160.3 3,151.5 3,104.5

-9.71-9.51-9.69-9.702.20

-10.34-9.50-9.69

-11.16-9.70-9.70-7.30-9.492.232.23

-10.81-9.75-9.701.981.22

-9.482.11

-3.95-9.70-8.71

-10.8615.89-9.07-9.702.23

-0.21-8.681.92

-9.37-3.88-8.98

-10.97-9.46

-11.00-9.77-9.48-2.72

-11.11-8.96

-10.00-9.72

-11.02-9.47-4.94-3.54-7.27-9.33-7.97-9.48-9.79-5.19-9.673.301.281.09

5.255.785.365.345.16

14.655.875.39

13.465.325.29

26.655.915.255.29

10.105.065.334.59

30.205.975.21

16.075.317.57

-48.63

6.075.345.20

27.687.71

27.565.22

13.486.90

12.455.97

12.545.025.825.92

13.628.765.715.30

12.385.995.69

13.7126.74

5.363.665.775.12

15.085.325.623.573.64

3.994.474.114.055.787.464.524.147.313.944.00

13.914.595.845.914.943.783.965.89

14.45--

9.493.95

---

3.073.955.80

11.51-

12.156.18

11.736.006.594.46

-3.724.485.647.42

10.105.063.93

-4.475.379.93

13.936.34

-4.263.75

-3.946.504.165.16

9.549.519.679.586.15

-9.559.69

11.999.469.55

-9.606.196.254.099.329.446.22

----

9.43---

9.149.476.16

---

10.1014.8710.10

---

9.299.526.95

12.06-

9.98---

8.4312.80

-10.21

-9.45

--

9.47-

4.496.12

56,041 31,031 56,030 56,041

- 32,809 31,031 56,030 50,382 52,009 56,041 18,735 31,031

- -

19,645 56,007 52,078

- 944

30,898 -

18,911 52,078

6,702 109,789

3,269 39,587 52,009

- 26,887

6,702 914

1,549 431

2,347 40,506 28,943 38,070 55,997 31,031 36,979 50,382

4,860 57,302 60,514 38,068 28,943 31,091

833 18,735

1,549 1,456

45,447 60,514

861 56,022

- - -

16.516.716.516.5

-15.116.716.513.815.516.518.016.7

--

16.316.515.6

-14.116.6

-13.615.617.015.211.421.015.5

-13.417.017.217.819.217.412.815.714.516.516.716.613.825.613.617.014.515.716.719.218.017.815.117.117.015.916.6

---

8.759.178.768.752.91

11.909.178.76

11.378.758.75

20.009.172.912.91

11.878.758.762.72

10.019.182.929.648.75

10.92-

16.779.768.752.919.75

10.949.89

12.7613.7611.7810.88

9.1710.80

8.749.173.57

11.3816.33

8.928.72

10.829.175.35

13.5420.0112.7711.61

8.788.73

13.628.733.920.621.97

2.031.872.102.114.882.861.952.133.372.052.101.901.984.964.992.551.822.054.932.161.904.971.362.021.41

-1.630.902.094.963.071.571.971.391.981.252.731.733.221.761.951.933.495.152.882.023.121.773.141.822.021.572.441.571.840.802.074.734.680.78

Fund Name Ticker Assets ER 3-Mo -9.07-8.97-9.06-9.061.88

-8.25-8.94-9.06-9.40-9.06-9.07-6.94-8.911.901.90

-6.53-9.10-9.061.78

13.67-8.911.862.14

-9.06-8.65

-10.1934.41-9.24-9.061.90

10.08-8.6713.87-8.72-0.81-8.55-8.61-8.92-8.48-9.11-8.94-3.21-9.39-4.06-8.67-9.08-8.55-8.92-4.630.24

-6.93-8.68-6.65-8.85-9.15-0.67-9.043.173.072.73

5.395.495.485.476.92

15.525.575.50

13.825.435.47

38.905.567.027.054.785.185.465.40

-5.627.01

-5.436.02

--

12.575.467.02

-6.22

-1.16

-4.33

10.725.57

11.045.135.557.94

13.96-16.46

0.095.50

10.995.606.16

-39.09

1.29-7.075.765.34

-5.447.61

--

YTD 2007 3-Yr 11.5012.6411.6211.59

4.4422.8812.7411.6522.2811.5411.5235.4512.79

4.534.57

17.8611.3011.55

4.2730.9612.87

4.5115.5811.5316.39

-41.8210.2211.55

4.4725.1716.5527.6316.2517.9816.5420.7212.7221.0711.2512.67

8.0822.4716.7714.0311.5220.8912.73

9.4516.9535.5116.4315.0211.8711.3118.5311.54

5.062.813.77

5-Yr 10-Yr 15-Yr Mkt Cap P/E Std Dev Yield Total Return % $US Millions Annualized Return %

Largest U.S. Index Mutual Funds Sorted By Total Net Assets In $US Millions May/June 2008

Source: Morningstar. Data as of 2/29/08. ER is expense ratio. YTD is year-to-date. Mkt Cap is geometric average. PE is price-to-earnings ratio. Std Dev is 3-year standard deviation. Yield is 12-month.

Global Index Data

www.journalofindexes.com

Morningstar U.S. Style Overview: January 1 - February 29, 2008

Trailing Returns %3-Month YTD 1-Yr 3-Yr 5-Yr 10-Yr

Morningstar Indexes

US Market –8.86 –8.97 –3.83 6.06 12.69 4.37

Large Cap –9.10 –9.13 –2.33 5.76 11.29 3.28Mid Cap –7.79 –8.25 –6.85 7.51 16.39 7.10Small Cap –9.23 –9.34 –11.07 4.32 15.91 6.39

US Value –7.24 –8.07 –9.44 5.70 14.23 6.40US Core –8.05 –7.57 –1.74 6.52 13.37 5.59US Growth –11.24 –11.32 –0.26 5.70 10.17 0.25

Large Value –7.22 –8.46 –7.53 6.04 13.48 5.68Large Core –8.26 –7.79 1.11 6.70 12.46 4.68Large Growth –11.83 –11.29 –0.63 4.18 7.50 –1.50

Mid Value –7.72 –7.15 –14.91 4.80 15.69 8.13Mid Core –7.04 –6.74 –8.56 6.40 15.63 7.53Mid Growth –8.70 –10.65 2.93 11.03 17.45 4.94

Small Value –5.98 –6.39 –14.66 3.62 16.48 8.50Small Core –8.66 –7.43 –13.29 4.15 16.09 9.20Small Growth –12.69 –13.65 –6.08 4.78 14.88 1.76

Morningstar Market Barometer YTD Return %

US Market–8.97

–8.07

Value

–7.57

Core

–11.32

Growth

–9.13Larg

e Ca

p

–8.25Mid

Cap

–9.34Smal

l Cap

–8.46 –7.79 –11.29

–7.15 –6.74 –10.65

–6.39 –7.43 –13.65

–8.00 –4.00 0.00 +4.00 +8.00

Sector Index YTD Return %

–2.91 Media

–3.85 Energy

–6.20 Consumer Services

–6.53 Industrial Materials

–6.59 Consumer Goods

–7.10 Healthcare

–10.83 Business Services

–10.86 Financial Services

–11.21 Utilities

–14.73 Hardware

–17.24 Software

–17.82 Telecommunications

Industry Leaders & Laggards YTD Return %

Insurance (Title) 11.91

Broadcast TV 7.31

Home Building 6.15

Gold & Silver 4.80

Land Transport 4.43

Agrochemical 3.52

–21.42 Education

–23.28 Photography & Imaging

–23.83 Online Retail

–27.86 Wireless Service

–27.89 Business/Online Services

–28.05 Audio/Video Equipment

Biggest Influence on Style Index Performance YTD

Return %Constituent

Weight %Best Performing Index

Small Value –6.39

MoneyGram International Inc. –76.19 0.42PNM Resources Inc. –44.11 0.49MGIC Investment Corp. –33.86 0.60Ikon Office Solutions Inc. –45.04 0.45Deluxe Corp. –35.98 0.55

Worst Performing Index

Small Growth –13.65

Onyx Pharmaceuticals Inc. –50.88 0.87SiRF Technology Holdings Inc. –74.25 0.40Healthways Inc. –41.22 0.60Tessera Technologies Inc. –43.37 0.56FormFactor Inc. –45.83 0.46

1-Year

–7.53

Value

Larg

e Ca

p

1.11

Core

–0.63

Growth

–14.91

Mid

Cap –8.56 2.93

–14.66

Smal

l Cap –13.29 –6.08

–20 –10 0 +10 +20

3-Year

6.04

Value

Larg

e Ca

p

6.70

Core

4.18

Growth

4.80

Mid

Cap 6.40 11.03

3.62

Smal

l Cap 4.15 4.78

–20 –10 0 +10 +20

5-Year

13.48

Value

Larg

e Ca

p

12.46

Core

7.50

Growth

15.69

Mid

Cap 15.63 17.45

16.48

Smal

l Cap 16.09 14.88

–20 –10 0 +10 +20

Notes and Disclaimer: ©2006 Morningstar, Inc. All Rights Reserved. Unless otherwise noted, all data is as of most recent month end. Multi-year returns are annualized. NA: Not Available. Biggest Influence on Index Performance listsare calculated by multiplying stock returns for the period by their respective weights in the index as of the start of the period. Sector and Industry Indexes are based on Morningstar's proprietary sector classifications. The informationcontained herein is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

?

Morningstar U.S. Style Overview Jan. 1 – Feb. 29, 2008

Source: Morningstar. Data as of 2/29/08

61May/June 2008

May/June 200862

DOW JONES INDEXES | QUARTERLY U.S. SUMMARY | QUARTER 4, 2007

Page 9

DOW JONES U.S. INDUSTRY INDEXES

Basic Materials 561.39 3.70%

Consumer Goods 1,387.07 9.15%

Consumer Services 1,611.86 10.64%

Financials 2,625.93 17.33%

Health Care 1,761.27 11.62%

Industrials 2,040.30 13.46%

Oil & Gas 1,763.55 11.64%

Technology 2,282.10 15.06%

Telecommunications 493.79 3.26%

Utilities 625.52 4.13%

DOW JONES U.S. INDUSTRY REPRESENTATION

Market Cap Weight inIndustry (USD Billions) DJ U.S. Index

Financials17.33%

Health Care11.62%

Industrials13.46%

Oil & Gas11.64%

Consumer Services10.64%

Basic Materials3.70%

Consumer Goods9.15%Technology

15.06%

Utilities4.13%Telecom.

3.26%

HISTORICAL DOW JONES U.S. INDUSTRY REPRESENTATIONS (%)

Basic Materials 371.36 3.20% 145.17 5.49% 44.85 4.93% 561.39

Consumer Goods 1,077.36 9.29% 245.34 9.28% 64.37 7.07% 1,387.07

Consumer Services 1,198.75 10.33% 292.05 11.05% 121.06 13.31% 1,611.86

Financials 2,025.71 17.46% 444.33 16.81% 155.89 17.13% 2,625.93

Health Care 1,433.31 12.36% 213.00 8.06% 114.96 12.64% 1,761.27

Industrials 1,303.03 11.23% 543.16 20.55% 194.10 21.33% 2,040.30

Oil & Gas 1,463.14 12.61% 242.03 9.15% 58.37 6.42% 1,763.55

Technology 1,889.24 16.29% 276.78 10.47% 116.08 12.76% 2,282.10

Telecommunications 426.93 3.68% 64.72 2.45% 2.13 0.23% 493.79

Utilities 410.35 3.54% 177.14 6.70% 38.03 4.18% 625.52

Total 11,599.20 76.55% 2,643.72 17.45% 909.85 6.00% 15,152.78

DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S.Large-Cap Large-Cap Mid-Cap Mid-Cap Small-Cap Small-Cap Index

Industry Market Cap Weight Market Cap Weight Market Cap Weight Market Cap

DOW JONES U.S. INDUSTRY REPRESENTATION BY SIZE (IN BILLIONS USD)

Industry 2007 Q4 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

Basic Materials 3.70 3.02 2.95 2.74 2.67 2.28 1.98 2.47 2.34 3.53 4.31 5.02 6.28

Consumer Goods 9.15 8.63 9.17 9.40 10.22 8.44 8.14 8.34 11.63 13.79 14.72 15.09 15.62

Consumer Services 10.64 12.32 13.99 13.43 12.97 12.84 10.45 14.49 12.57 10.51 9.59 10.09 11.45

Financials 17.33 22.12 21.25 21.01 21.08 19.04 18.02 14.11 16.92 19.31 16.89 15.11 13.51

Health Care 11.62 11.43 12.17 13.33 14.56 14.28 14.23 9.21 12.44 11.35 11.08 11.11 9.90

Industrials 13.46 12.62 12.64 11.87 11.68 12.07 12.54 11.98 11.89 13.47 14.35 14.39 14.50

Oil & Gas 11.64 9.29 7.10 6.05 6.32 5.88 6.00 4.51 5.46 7.17 7.88 7.45 7.91

Technology 15.06 13.58 14.50 16.10 13.53 17.12 19.89 25.59 16.43 11.78 12.25 9.99 8.76

Telecommunications 3.26 3.21 3.00 3.09 3.81 5.03 5.19 6.96 7.20 5.67 5.36 7.29 7.24

Utilities 4.13 3.76 3.24 2.98 3.15 3.02 3.56 2.34 3.12 3.43 3.57 4.45 4.82

Data based on market-cap information as of December 31, 2007.


Page 8

Basic Materials 3.47 4.41 32.86 17.63 32.86 17.94 20.27 8.71 9.83

Consumer Goods -1.68 0.70 9.69 14.91 9.69 8.75 12.56 5.87 9.62

Consumer Services -4.02 -8.04 -7.18 14.36 -7.18 1.35 8.77 5.13 8.76

Financials -4.91 -13.23 -17.66 19.43 -17.66 1.54 9.43 5.96 12.93

Health Care -2.58 0.23 8.36 6.88 8.36 7.85 9.39 7.12 9.91

Industrials -0.30 -3.42 13.57 13.87 13.57 10.67 16.19 6.11 9.95

Oil & Gas 7.32 4.36 34.84 22.77 34.84 30.45 29.88 15.07 15.51

Technology 1.24 -0.29 15.70 10.10 15.70 9.59 15.13 5.77 12.94

Telecommunications 3.01 -6.69 10.04 36.83 10.04 13.07 12.99 1.22 6.80

Utilities 0.52 6.72 17.76 21.28 17.76 18.10 20.61 8.59 9.45

Total Return (%) Annualized Total Return (%)

Industry 1-Month 3-Month YTD 2006 1-Year 3-Year 5-Year 10-Year Since Inception

HISTORICAL PERFORMANCE RETURNS


CORRELATION COEFFICIENTS

CORRELATION COEFFICIENTS: U.S. INDUSTRY INDEXES VS. U.S. INDEX AND SIZE INDEXES

Data based on total-return index values as of December 31, 2007. Inception date December 31, 1991. Correlation data based on monthly total-return index values fromDecember 31, 2004 to December 31, 2007.

Industry 1000 3000 5000 8000 4000 2000 0001 9000 6000 7000

Basic Materials 1.0000

Consumer Goods 0.4883 1.0000

Consumer Services 0.5100 0.6824 1.0000

Financials 0.3716 0.6341 0.7188 1.0000

Health Care 0.1589 0.7166 0.4071 0.5388 1.0000

Industrials 0.7291 0.5678 0.7805 0.5717 0.2747 1.0000

Oil & Gas 0.6300 0.2268 0.0456 0.0816 0.0842 0.2394 1.0000

Technology 0.6383 0.6365 0.7114 0.5280 0.3772 0.7740 0.2961 1.0000

Telecommunications 0.4165 0.3874 0.5717 0.6082 0.3824 0.5736 0.1816 0.4923 1.0000

Utilities 0.1993 0.4564 0.1036 0.2214 0.4454 -0.0063 0.3480 0.1320 0.1416 1.0000

Industry DJ U.S. Index DJ U.S. Large-Cap Index DJ U.S. Mid-Cap Index DJ U.S. Small-Cap Index

Basic Materials 0.7296 0.6802 0.7688 0.7555

Consumer Goods 0.8087 0.8316 0.6985 0.6480

Consumer Services 0.8165 0.7854 0.8108 0.7899

Financials 0.7915 0.8151 0.6767 0.6524

Health Care 0.5937 0.6321 0.4764 0.4065

Industrials 0.8181 0.7899 0.8152 0.7740

Oil & Gas 0.4441 0.3974 0.4984 0.4883

Technology 0.8490 0.8286 0.8039 0.8291

Telecommunications 0.6646 0.6729 0.5763 0.6025

Utilities 0.3426 0.3352 0.3306 0.3154


Page 9


Basic Materials 561.39 3.70%

Consumer Goods 1,387.07 9.15%

Consumer Services 1,611.86 10.64%

Financials 2,625.93 17.33%

Health Care 1,761.27 11.62%

Industrials 2,040.30 13.46%

Oil & Gas 1,763.55 11.64%

Technology 2,282.10 15.06%

Telecommunications 493.79 3.26%

Utilities 625.52 4.13%

DOW JONES U.S. INDUSTRY REPRESENTATION

Market Cap Weight inIndustry (USD Billions) DJ U.S. Index

Financials17.33%

Health Care11.62%

Industrials13.46%

Oil & Gas11.64%

Consumer Services10.64%

Basic Materials3.70%

Consumer Goods9.15%Technology

15.06%

Utilities4.13%Telecom.

3.26%

HISTORICAL DOW JONES U.S. INDUSTRY REPRESENTATIONS (%)

Basic Materials 371.36 3.20% 145.17 5.49% 44.85 4.93% 561.39

Consumer Goods 1,077.36 9.29% 245.34 9.28% 64.37 7.07% 1,387.07

Consumer Services 1,198.75 10.33% 292.05 11.05% 121.06 13.31% 1,611.86

Financials 2,025.71 17.46% 444.33 16.81% 155.89 17.13% 2,625.93

Health Care 1,433.31 12.36% 213.00 8.06% 114.96 12.64% 1,761.27

Industrials 1,303.03 11.23% 543.16 20.55% 194.10 21.33% 2,040.30

Oil & Gas 1,463.14 12.61% 242.03 9.15% 58.37 6.42% 1,763.55

Technology 1,889.24 16.29% 276.78 10.47% 116.08 12.76% 2,282.10

Telecommunications 426.93 3.68% 64.72 2.45% 2.13 0.23% 493.79

Utilities 410.35 3.54% 177.14 6.70% 38.03 4.18% 625.52

Total 11,599.20 76.55% 2,643.72 17.45% 909.85 6.00% 15,152.78

DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S. DJ U.S.Large-Cap Large-Cap Mid-Cap Mid-Cap Small-Cap Small-Cap Index

Industry Market Cap Weight Market Cap Weight Market Cap Weight Market Cap

DOW JONES U.S. INDUSTRY REPRESENTATION BY SIZE (IN BILLIONS USD)

Industry 2007 Q4 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

Basic Materials 3.70 3.02 2.95 2.74 2.67 2.28 1.98 2.47 2.34 3.53 4.31 5.02 6.28

Consumer Goods 9.15 8.63 9.17 9.40 10.22 8.44 8.14 8.34 11.63 13.79 14.72 15.09 15.62

Consumer Services 10.64 12.32 13.99 13.43 12.97 12.84 10.45 14.49 12.57 10.51 9.59 10.09 11.45

Financials 17.33 22.12 21.25 21.01 21.08 19.04 18.02 14.11 16.92 19.31 16.89 15.11 13.51

Health Care 11.62 11.43 12.17 13.33 14.56 14.28 14.23 9.21 12.44 11.35 11.08 11.11 9.90

Industrials 13.46 12.62 12.64 11.87 11.68 12.07 12.54 11.98 11.89 13.47 14.35 14.39 14.50

Oil & Gas 11.64 9.29 7.10 6.05 6.32 5.88 6.00 4.51 5.46 7.17 7.88 7.45 7.91

Technology 15.06 13.58 14.50 16.10 13.53 17.12 19.89 25.59 16.43 11.78 12.25 9.99 8.76

Telecommunications 3.26 3.21 3.00 3.09 3.81 5.03 5.19 6.96 7.20 5.67 5.36 7.29 7.24

Utilities 4.13 3.76 3.24 2.98 3.15 3.02 3.56 2.34 3.12 3.43 3.57 4.45 4.82

Data based on market-cap information as of December 31, 2007.


Page 8

Basic Materials 3.47 4.41 32.86 17.63 32.86 17.94 20.27 8.71 9.83

Consumer Goods -1.68 0.70 9.69 14.91 9.69 8.75 12.56 5.87 9.62

Consumer Services -4.02 -8.04 -7.18 14.36 -7.18 1.35 8.77 5.13 8.76

Financials -4.91 -13.23 -17.66 19.43 -17.66 1.54 9.43 5.96 12.93

Health Care -2.58 0.23 8.36 6.88 8.36 7.85 9.39 7.12 9.91

Industrials -0.30 -3.42 13.57 13.87 13.57 10.67 16.19 6.11 9.95

Oil & Gas 7.32 4.36 34.84 22.77 34.84 30.45 29.88 15.07 15.51

Technology 1.24 -0.29 15.70 10.10 15.70 9.59 15.13 5.77 12.94

Telecommunications 3.01 -6.69 10.04 36.83 10.04 13.07 12.99 1.22 6.80

Utilities 0.52 6.72 17.76 21.28 17.76 18.10 20.61 8.59 9.45

Total Return (%) Annualized Total Return (%)

Industry 1-Month 3-Month YTD 2006 1-Year 3-Year 5-Year 10-Year Since Inception

HISTORICAL PERFORMANCE RETURNS


CORRELATION COEFFICIENTS

CORRELATION COEFFICIENTS: U.S. INDUSTRY INDEXES VS. U.S. INDEX AND SIZE INDEXES

Data based on total-return index values as of December 31, 2007. Inception date December 31, 1991. Correlation data based on monthly total-return index values fromDecember 31, 2004 to December 31, 2007.

Industry 1000 3000 5000 8000 4000 2000 0001 9000 6000 7000

Basic Materials 1.0000

Consumer Goods 0.4883 1.0000

Consumer Services 0.5100 0.6824 1.0000

Financials 0.3716 0.6341 0.7188 1.0000

Health Care 0.1589 0.7166 0.4071 0.5388 1.0000

Industrials 0.7291 0.5678 0.7805 0.5717 0.2747 1.0000

Oil & Gas 0.6300 0.2268 0.0456 0.0816 0.0842 0.2394 1.0000

Technology 0.6383 0.6365 0.7114 0.5280 0.3772 0.7740 0.2961 1.0000

Telecommunications 0.4165 0.3874 0.5717 0.6082 0.3824 0.5736 0.1816 0.4923 1.0000

Utilities 0.1993 0.4564 0.1036 0.2214 0.4454 -0.0063 0.3480 0.1320 0.1416 1.0000

Industry DJ U.S. Index DJ U.S. Large-Cap Index DJ U.S. Mid-Cap Index DJ U.S. Small-Cap Index

Basic Materials 0.7296 0.6802 0.7688 0.7555

Consumer Goods 0.8087 0.8316 0.6985 0.6480

Consumer Services 0.8165 0.7854 0.8108 0.7899

Financials 0.7915 0.8151 0.6767 0.6524

Health Care 0.5937 0.6321 0.4764 0.4065

Industrials 0.8181 0.7899 0.8152 0.7740

Oil & Gas 0.4441 0.3974 0.4984 0.4883

Technology 0.8490 0.8286 0.8039 0.8291

Telecommunications 0.6646 0.6729 0.5763 0.6025

Utilities 0.3426 0.3352 0.3306 0.3154

Source: Dow Jones Indexes. Data is based on total return index values as of 12/31/07.

Dow Jones U.S. Economic Sector Review

63May/June 2008www.journalofindexes.com

SPDRs (S&P 500)

iShares MSCI EAFE

iShares MSCI Emerg Mkts

streetTRACKS Gold Shares

iShares S&P 500

PowerShares QQQQ

iShares R1000 Growth

iShares Lehman 1-3 Treas

Vanguard Total Stock Market

iShares R1000 Value

iShares Lehman Aggregate

iShares Russell 2000

iShares Japan

DIAMONDS Trust

MidCap SPDR (S&P 400)

iShares Brazil

iShares Lehman TIPS Bond

iShares FTSE/Xinhua China

Vanguard Emerging Markets

iShares DJ Sel Dividend

iShares S&P 500 Growth

Energy SPDR

Financial SPDR

iShares S&P 400 MidCap

SPY

EFA

EEM

GLD

IVV

QQQQ

IWF

SHY

VTI

IWD

AGG

IWM

EWJ

DIA

MDY

EWZ

TIP

FXI

VWO

DVY

IVW

XLE

XLF

IJH

0.10

0.36

0.77

0.40

0.10

0.20

0.20

0.15

0.07

0.20

0.20

0.20

0.57

0.18

0.25

0.74

0.20

0.74

0.30

0.40

0.18

0.26

0.26

0.20

66,486.5 46,849.5 26,030.7 19,966.6 17,539.1 16,421.8 13,210.7

9,893.4 9,732.4 8,632.7 8,500.9 8,382.4 8,161.8 8,142.1 7,916.6 7,522.0 6,386.3 6,155.5 6,098.0 5,949.8 5,872.9 5,783.6 5,440.2 4,432.5

-9.05

-7.87

-6.54

16.06

-9.04

-16.18

-9.65

2.81

-8.93

-8.03

2.18

-10.28

-3.99

-7.12

-7.94

2.55

5.24

-12.79

-6.92

-8.62

-9.55

-3.76

-11.55

-7.91

11.50

20.92

-

-

11.54

11.77

10.30

3.51

12.74

13.70

-

14.98

14.24

11.72

15.13

65.15

-

-

-

-

9.14

29.65

6.59

15.36

51,981

34,620

22,888

-

50,106

34,081

32,852

-

31,031

44,137

-

997

17,784

106,949

3,285

38,581

-

86,130

18,735

9,388

55,497

65,729

45,476

3,290

15.5

12.3

16.3

-

15.5

26.2

18.1

-

16.7

13.5

-

16.2

14.8

15.3

17.1

16.3

-

21.4

18.0

12.8

16.7

12.5

11.2

16.4

8.74

10.98

19.95

15.69

8.74

15.59

9.79

1.60

9.17

8.79

2.87

13.93

11.97

8.69

11.09

29.58

4.98

29.70

-

8.99

9.32

19.92

12.84

11.08

2.03

2.75

1.37

0.00

2.09

0.33

1.01

4.07

1.96

2.61

4.81

1.13

1.08

2.30

1.28

0.92

4.58

1.38

2.02

4.00

1.29

1.03

3.38

1.40

Fund Name Ticker Assets ER

-9.69

-9.98

-6.60

23.76

-9.67

-16.34

-9.98

3.06

-9.49

-8.92

2.41

-10.34

-7.69

-7.75

-8.16

6.32

5.08

-17.13

-7.27

-11.54

-9.42

3.94

-16.38

-8.10

3-Mo YTD

5.40

10.97

34.55

31.07

5.44

19.07

11.63

7.30

5.56

-0.29

6.57

-1.47

-4.33

8.71

7.64

76.60

11.46

58.66

39.05

-5.37

8.93

36.36

-18.79

7.80

15.69

26.00

30.71

23.44

15.70

7.03

8.86

3.83

15.66

22.00

4.13

18.17

5.49

18.81

10.05

44.27

0.29

83.19

29.53

19.41

10.81

18.40

18.90

10.14

2007 2006

5.27

12.59

26.10

30.15

5.31

5.20

5.71

5.26

5.89

5.65

5.03

3.85

6.66

6.72

6.71

51.86

6.64

40.09

-

2.27

4.30

21.62

-2.31

6.89

3-Yr 5-Yr Mkt Cap P/E

0.14

0.75

1.06

1.49

0.14

0.13

0.18

0.51

0.20

0.18

0.23

0.03

0.24

0.30

0.25

1.43

0.45

1.15

-

-0.19

0.04

0.87

-0.46

0.27

Sharpe Std Dev Yield

Total Return %$US Millions Annualized Return %

Largest U.S.-listed ETFs Sorted By Total Net Assets In $US Millions

*Source: Morningstar. Data as of 2/29/08. ER is expense ratio. 3-Mo is 3-month. YTD is year-to-date. Assets are total net assets in $US millions. Source: www.indexuniverse.com/ETFWatch

Market Vectors Agribusiness

Vanguard Ttl Bnd Mkt

Market Vectors Russia

Vanguard Europe Pacific

ProShares UltShrt FTSE/Xin China

Vanguard Sht-Term Bnd ETF

SPDR Lehman International Treas

United States Natural Gas

ProShares UltraShort MSCI EM

iShares S&P National Municipal

Claymore S&P Global Water

iShares iBoxx $ HiYld Cor

SPDR S&P Intl Small Cap

PowerShares Global Water

ELEMENTS Rogers Agriculture

Vanguard Int-Term Bnd

SPDR S&P BRIC 40

Market Vectors GlbAlt Energy

iPath DJ AIG Agriculture

AdvisorShares Country Allocation

Barclays GEMS Strategy ETN

BGI S&P India Nifty 50 Index

iShares MSCI Turkey

Claymore/MAC Global Solar Energy Index ETF

ETSpreads High Yield Fund

Grail U.S. Value Fund

MacroShares Medical Inflation Trust Up

NETS Dow Jones Wilshire Global Total Market

Index Fund

PowerShares Active AlphaQ Fund

Powershares NASDAQ Next-Q Portfolio

ProShares 130/30 Fund

ProShares Barron's 400

ProShares UltraShort Euro

SPA MarketGrader Technology

SPDR S&P International Mid Cap ETF

Market Vecotrs - Global Solar Energy

United States Heating Oil Fund

Wilder Asian Emerging Markets

WisdomTree Chinese Yuan Fund

MOO

BND

RSX

VEA

FXP

BSV

BWX

UNG

EEV

MUB

CGW

HYG

GWX

PIO

RJA

BIV

BIK

GEX

JJA

0.65

0.11

0.69

0.12

0.95

0.11

0.50

0.60

0.95

0.25

0.65

0.50

0.60

0.75

0.75

0.11

0.40

0.65

0.75

Fund Name Ticker ER0.60

1.89

-7.60

-8.43

18.01

3.01

6.06

26.15

9.67

-3.89

-5.98

-2.64

-5.51

-7.83

18.49

3.20

-8.39

-25.21

23.79

YTD13.92

2.15

-2.36

-10.87

30.75

3.30

5.33

27.10

9.98

-3.58

-4.98

-1.43

-8.10

-7.76

25.54

3.34

-8.40

-19.42

33.44

3-Mo8/31/2007

4/3/2007

4/24/2007

7/20/2007

11/8/2007

4/3/2007

10/2/2007

4/18/2007

11/1/2007

9/7/2007

5/14/2007

4/4/2007

4/20/2007

6/13/2007

10/17/2007

4/3/2007

6/19/2007

5/3/2007

10/23/2007

Launch Date 1,520.8 1,469.6

833.5 800.2 767.4 536.6 517.1 459.2 360.4 357.0 355.8 352.5 308.1 301.3 291.5 276.9 272.1 222.5 198.6

Assets

Largest New ETFs Sorted By Total Net Assets In $US Millions Selected ETFs In RegistrationCovers ETFs launched since 3/31/2007

*Source: Morningstar. Data as of 2/29/08. Assets are total net assets in $US millions. ER is expense ratio. 3-Mo is 3-month. YTD is year-to-date. Mkt cap is geometric average market capitalization.

P/E is price-to-earnings ratio. Sharpe is Sharpe ratio. Std Dev is 3-year standard deviation. Yield is 12-month.

Exchange-Traded Funds Corner

May/June 200864

An Interview With Benedict Okoh

The Last Word

Benedict Okoh is the founder of AfriFinance LLC, a New York advi-sory firm that also develops financial products and Africa-focused indexes. The AfriFinance Indexes™ provide detailed measurements of particular sectors of African equity markets.

Journal of Indexes (JoI): What led you to develop the AfriFinance indexes?

Benedict Okoh (Okoh): As a result of the advisory work that AfriFinance does, I visit the continent quite often, and I saw that there was a lot of economic activity taking place. But there wasn’t a stock market index that told me a story of what was happening. For example, some of the African stock exchanges have “all share” indices. Well, an all-share index is precisely that: It contains all the shares, which can be good because it tells you that everything in general is going up or down, but it doesn’t tell a story.

JOI: What kind of indexes do you offer?

Okoh: The indices fall into two broad categories. The coun-try-specific indices focus on specific sectors within particular countries, while the regional indices track sectors across several countries. For example, the AfriFinance Nigerian Banking Index contains Nigerian banks listed on the Nigerian Stock Exchange, while the AfriFinance African Telecom & Infrastructure Index contains companies domiciled in several countries and trading on different stock exchanges.

JOI: How are the indexes weighted?

Okoh: We decided to do a straight price weighting. Part of the reason we didn’t go with market-cap weighting is that the governance in a number of African countries hasn’t quite reached the same level as the U.S. The price is out there, and it’s not disputed, so we use that for our weighting.

JOI: Why did you focus the initial indexes on Nigeria? Okoh: From a political perspective, things were beginning to take shape: a democratic government was becoming entrenched; all the proper reforms were being done; etc. From an economic standpoint, a lot of good things were also beginning to happen. If you went to Nigeria in 1998, all you saw in the major cities like Lagos were very old cars that were dying on the streets. Also, there were only about 500,000 fixed phone lines in the country, though the population was over 100 million. If you went to Lagos in 2004 or 2005, you didn’t see those old cars anymore. Everything is now brand new. Also, mobile phone subscribers grew from scratch in 2001 to over 30 million within six years. And Nigerian banks now raise money on the London Stock

Exchange without any guarantees whatsoever. So you could see that the economy was rebounding.

Nigeria is also just a huge country in terms of population and potential market size. Approximately one in five Africans is a Nigerian. And right now, the market cap on the Nigerian stock exchange is about $112 billion. It’s at a size that you could base products on it. So all the stars were aligned. JOI: What other African countries are you developing indexes for?

Okoh: We’re looking at countries like Kenya, Ghana and Botswana, among others, and we’re looking at a range of criteria in putting together country-specific indices.

In the case of Botswana, democracy is very well entrenched and the stock exchange has done very well. People are very comfortable, and corporate governance is not as bad as it is in some other African countries. In the case of Ghana, democracy is beginning to take root. They had some political upheavals many years ago, but by and large I think Ghana is pretty much on track now. Kenya, unfortunately, let’s just say democracy hasn’t quite put down very strong roots there, but I don’t expect things to get much worse.

JOI: What are your goals for the indexes in the coming years?

Okoh: Since these indices were launched, a number of the “bulge bracket” investment banks have expressed an interest in providing their high net worth clients with exposure to Africa using vehicles that are based on the AfriFinance indexes. A number of African financial institu-tions have also expressed a very keen interest in launch-ing products that are based on the indices. So my expecta-tion is that in the next year there should be a number of products that are based on these indices. JOI: As a small independent index provider, what can you bring to the market that a larger index provider might not? Okoh: Number one is an innate knowledge of those markets—I was born there, grew up there, and have family there. The second thing is relationships. We have deep relationships with people across the board, whether it’s the most senior levels of corporations or middle management. Number three is it helps if you can speak the language and you understand the place. When I go to African countries like Nigeria, I don’t just sit in a five-star hotel in the capital. I travel around the country.

Of course, as a small company you are also more nimble than the larger ones. If you combine knowledge of U.S. standards with our local knowledge and the ability to move quickly, that gives us a competitive advantage over some of these larger companies.

Documents

Don Chance John Neumann Robert Waid and Kelly Haughton · 2016-04-21 · The following best describes my primary business activity ... Do you personally sell, ... work in the index