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Exchange-Traded Funds

by Brady Finkenaur





Exchange-Traded Funds

• Walks Like a Stock

• Talks Like a Mutual Fund

• Not Exactly Like Either

• Gradually Taking the Place of the Mutual Fund in the Financial Ecosystem


History of ETFs: The First Mutual Fund

• Developed in the Netherlands-1774

• Liquidity Crisis in Amsterdam

• Vehicle for Small Investors to Pool Funds

• Broadly Diversified Across 100 assets on Three Different Continents

• Lasted Over 120 Years


History of ETFs: The Modern Day Mutual Fund

• Early1970’s: Research Shows That Actively Managed Funds Underperform Benchmark Indicies

• 1975: Jack Bogle Launches Vanguard 500, the First Index Mutual Fund

• Originally Ridiculed, Bogle’s Passive Investing Strategy Soon Gains Popularity


History of ETFs: Emergence of the ETF

• 1987: Stock Market Crash Creates Another Liquidity Crisis

• 1989: AMEX and Philadelphia Stock Exchange Trade “Index Participation Shares” (IPS)

• Chicago Mercantile Exchange and CFTC file suit to stop IPS


History of ETFs: The SPDR

• 1993: Standard and Poor’s 500 Depositary Receipt

• Unit Investment Trust Type Structure

• State Street Bank as Trustee

• Passive Index Fund That Tracks the Performance of the S&P 500


ETF Mechanics: Warehouse Receipts

Process

Farmer

Warehouse

Trader

Kellog’s

Receipt

Receipt

Grain

CashR

eceipt

Cash

Grain

Receipt


ETF Mechanics: Process


ETF Mechanics: Process


ETF Mechanics: Basket Composition

• Price-Weighted Index (Dow Jones Industrial Average)

• Market Capitalization-Weighted Index (S&P 500, NASDAQ)

• SPDR 500 (SPY) Scaled to 1/10th of the S&P 500 Portfolio and Contains Constituent Stocks in Proper Proportions


ETF Mechanics: Basket Composition-SPY Top 10 Holdings

Company Ticker % of portfolioApple Inc. AAPL 2.96

Exxon Mobil XOM 2.88

General Electric GE 1.71

Chevron CVX 1.64

Johnson & Johnson JNJ 1.62

IBM IBM 1.59

Microsoft MSFT 1.54

Google Inc. GOOG 1.51

Procter & Gamble PG 1.5

Pfizer PFE 1.48


ETF Mechanics: Net Asset Value

• Value of Underlying Portfolio

• Creation/Redemption Process Takes Place at the NAV

• Calculated and Disseminated Once a Day

• Intra-day Portfolio Value (IPV) Tracks Intrinsic Value During Trading


ETF Mechanics: How Do I Know I’m Getting The Right Price?

• Authorized Participants Engage in Arbitrage to Obtain Profit

• If ETF Shares Trade at a Discount to IPV, Then AP Would Buy ETF Shares, Exchange for Basket and Sell Stocks

• If ETF Shares Trade at a Premium to IPV, AP Would Buy Basket, Exchange for ETF Shares and Sell Shares


ETF Mechanics: Arbitrage

• Constant Arbitrage Throughout the Day Keeps the ETF Price in Line With the NAV

• Fees and Trading Costs Create “Bubble” Around NAV Where Arbitrage is Not Profitable

• Market Makers Also Profit From Bid/Ask Spread


ETF Mechanics: Tracking Error

• Divergence Between Price Behavior of ETF and Underlying Basket That Can’t Be Arbitraged

• “Cash Drag”: Dividends, Distributions, etc.

• Thinly Traded Index

• Large Portfolio Turnover

• Average Tracking Error 0.39-0.52%


ETFs Versus Mutual Funds


SPY Versus Vanguard 500

SPY• Expense Ratio: 0.11%

• AUM (billions): $128

• Tax-Adjusted 10 year return: 7.98%

Vanguard• Expense Ratio: 0.17%

• AUM (billions): $129

• Tax-Adjusted 10 year return: 8.07%


ETF and Mutual Fund AUM (in $ trillions)


ETFs Catching Up

• Net Inflows of $806 Billion vs. $804 Billion Mutual Fund Inflows Since 2006

• Over 1,400 Different ETFs Now Available

• Can Invest by Sector, Commodity, Geography, Asset Class, etc.

• Efficiency Increases With The Trading Volume


References

• Ackert L. F. and Y. S. Tian. “Arbitrage and Valuation in the Market for Standard and Poor’s Depositary Receipts”, Financial Management (2000) v29, 71-87.

• Daley, Paul, P. Dorencz and D. Bargerstock. “ETF Liquidity Explained: A Framework for the ETF Trader,” Journal of Indexes, March/April 2010.

• Davidson, Lee. “The History of Exchange Traded Funds,” Morningstar.com, http://www.morningstar.co.uk/uk/news/69300/the-history-of-exchange-traded-funds-etfs.aspx , (Last Accessed 4/19/2013)

• Deville, Laurent. “Exchange Traded Funds: History, Trading, and Research,” Paris-Dauphine University, 2006. http://halshs.archives-ouvertes.fr/docs/00/16/22/23/PDF/ETF-survey.pdf (Last Accessed 4/18/2013)

• “How Do ETFs Work?” Flexshares.com. http://www.flexshares.com/education-research/how-work (Last Accessed 4/19/2013)

• Richards, Archie Jr., “All About Exchange-Traded Funds,” McGraw-Hill, New York, 2003.

Documents

Powerpoint Templates Page 1 Powerpoint Templates Exchange-Traded Funds by Brady Finkenaur