Exchange Traded Funds (ETF) Felix Popescu & Simon Yu Wednesday, February 27 © SIA, 2007 – 2008.

Exchange Traded Funds (ETF)

Felix Popescu & Simon Yu

Wednesday, February 27

© SIA, 2007 – 2008

Exchange Traded Funds (ETF)• What is an ETF?

– Open-End Mutual Fund– Exchange traded fund tracking an index, commodity,

or set of bonds – virtually every asset class now. – Not actively managed.

• Brief History and Growth– S&P Depository Receipts (Spiders) hit the market in

1993.– In the past 12 months 252 new ETFs were launched

worldwide and assets increased globally by 46%.– There are about 665 equity, bond, commodity, and

currency ETFs, with combined assets of $525 billion

Source: Seeking Alpha

TRENDS…

Benefits

• Behave in the market just like a stock– Can be shorted, bought on margin, have options

traded on, and you can buy just a single share.

– Can allow investor access to exotic market niches.

– Low cost, diversification, tax efficiency. (Low turnover doesn't typically lead to big capital-gains hits.)

• Capital Gains generated from fund transactions generally not taxable to the ETF investor.

– Instant exposure, as opposed to mutual fund delay

Drawbacks• Cannot use them to benefit from what you think may be an

exceptional manager.

• Value can separate from NAV (Net Asset Value).

• Some track narrow market sectors – can be very volatile.

• Single country ETFs: (Singapore, Malaysia, Mexico, Brazil to name a few popular ones presently) are posting double digit returns and investors don’t realize they are assuming much higher risk (a handful of large companies dominate these ETFs) ex: Brazil: Petroleo Brasileiro

• Another example of this, iSHARES South Korea – 3 companies account for 1/3 of total assets.

• Lack long term track records.

‘Hidden’ Costs

• You have $10,000 to invest and have narrowed down your choices to two alternatives:– Vangaurd Small-Cap Value Fund– Vanguard Small-Cap Value VIPERs (ETF)

• Annual Fees– Fund charges 0.23% annually– ETF charges 0.10% annually – Difference of $13.00

‘Hidden’ Costs (cont.)• Other things to consider:

– Transaction Costs (Depending on broker)• $15 to buy and $15 to sell = $30

– Loss on Trading Spread• How market makers make their $$$

• Average spread on VIPERs is 0.13% (Price the dealer is willing to pay is called the bid price; price the dealer will sell is called the ask price. Spread between that is the basic source for dealer profits.)

• Do the math– Break-Even analysis: $23.00x = $43.00 + $10.00x

• Must hold ETF for approx. 3 years

• If you plan to contribute over time, stick to Funds

Companies Managing

• I-shares by Barclay’s – Manages many internationals (EWJ, ILF)– Government bond exposure (TLT, IEF, SHY)– Corporates (AGG, LQD)

• Streettracks – GLD

• SPYders – (SPY, DIA, QQQQ)

• Holdrs by Merrill Lynch – (SMH, OIH)

• VIPERs by Vanguard

Market Outlook to take into Consideration for a model

portfolio…• Quick Plays:• Japan (EWJ) - JPN Yen flowing out of Japan

because of low domestic yields. (Rates increased to 0.5%)

Domestic contraction, some inflation possible – rising interest rates may indicate prospects for the future. (IFIIX)

• Norway – raising rates – lots of oil• Germany – restructuring after Berlin wall –

slower to access returns than rest of comparable economies of scale – still unlocked value.

Market Outlook Continued:

• Brazil – commodity play – lower interest rates – fiscal / monetary discipline, banks and consumer products also key.

• (INDAX) – Opportunity for tech play – growth is cheap, large cap cheap – tech still undervalued after 2000 boom, semiconductors and hardware (NOT!! software / internet stocks)

• Recovery growth from 06’ – Europe• Market still STRONG! (Largest period of

unchanged rates since 90s, (dot com boom), yet P/E ratios on average haven’t skyrocketed.

Diversification Strategies:

• Some investors choose to use ETFs to build core holdings, and actively managed mutual funds for smaller allocations to other asset classes (bonds, emerging markets, etc)

Examples of Interesting New Concepts:

• “Life-cycle” ETFs (such as life cycle retirement plans) – convert to more conservative pool of ETFs as investor nears retirement.• Claymore/Clear Spin-Off ETF (CSD) – Like the MO – Altria stock we discussed at last weeks meeting, A new ETF has been created to track companies experiencing, or with a high-probability of

experiencing spin-offs to unlock the value in the divestiture. • ETFs tracking environmentally-responsible companies.• Index selected base on patent valuations. • New IPO tracking funds. • ETFs reflecting companies with favorable corporate insider buying trends. • ETF tracking companies with positive returns the prior quarter AND one’s that performed well on down days. • Companies who have repurchased at least 5% or more of its outstanding shares for the trailing 12 months.

Things to Watch out for:

• Don’t be deceived into purchasing mutual funds that are creating ETF targeting portfolios. They are far MORE EXPENSIVE than buying ETFs directly.

• Example: Seligman TargETFund 2045: exp ratio 1.27%,

• While the underlying ETFs have a .29% ratio!

Building a ETF Portfolio:

• Use a SPY or another fund to track the S&P 500 index, and another one to track an international contingency of similar nature.

• The more conservative you chose to be, the larger percentage of your assets you should allocate to this core part of your portfolio.– Why? Broad exposure to the market, low fees, and

relatively low risk. (Your not betting AGAINST the market)

Example ETFs to Diversify Your Portfolio:

• Example ETFs that reflect asset classes discussed:

- US Stocks: (SPY)- REITs: (VNQ) - Foreign Stocks: (EFA)- Commodities: (GSP)- US Govt. Bonds: (IEF).

Sample Portfolio Allocation 1:

• 20% US Stocks (S&P 500)• 20% Foreign Stocks [MSCI EAFE]• 20% US 10Yr Gov Bonds• 20% Commodities [GSCI]• 20% Real Estate [NAREIT]

Source: www.seekingalpha.com

Another Sample Allocation:Sample ETF Portfolio

NASDAQ 100 Trust Shares (QQQQ)

SPDRs (SPY)

iShares Lehman Aggregate Bond (AGG)

iShares Russell 2000 Index (IWM)

iShares Cohen & Steers Realty Majors (ICF)

iShares MSCI Emerg Mkts Index (EEM)

iShares Goldman Sachs Natural Resourc (IGE)

iShares Lehman TIPS Bond (TIP)

iShares MSCI EAFE Index (EFA)

If your going into banking…

• Securities lending -- loaning out the stocks and bonds in its iShares ETF portfolios (usually gets cash, and reinvests in low risk securities to generate additional returns).

• The gains are significant -- at its Russell 2000 fund, for instance, securities lending effectively boosted Barclays' revenues from the fund by 50%.

• 0.01% to 0.15% for investors…• In its role as lending agent, Barclays collected $1.5

million in fees on the iShares Nasdaq Biotechnology fund for the year ending March 2006, amounting to an additional 19% above its basic fee for managing the fund

Source: Wall Street Journal

Source: Wall Street Journal