Introduction to ETFs By: Rama Neil, Kevin Ortiz, Ida Nilsson, Kevin Lim, Sammy Cuccinelo, Agustinus Santosa, Kevin Lim, & Yeranuhi Makhtesyan.

Introduction to ETFsBy: Rama Neil, Kevin Ortiz, Ida Nilsson, Kevin Lim, Sammy Cuccinelo, Agustinus Santosa, Kevin Lim, & Yeranuhi Makhtesyan

OUTLINE What are ETFs? ETFs vs Mutual Funds How are ETFs

created? ETF Strategies ETF Classification

Providers of ETFs Smart Beta ETFs Factors of Price Cost of Owning ETFs Tracking Error Conclusion &

Questions

What are ETFs? Exchange Traded Funds

“ETFS are index tracking funds that can be traded on exchanges just like a stock “ (Financial Times)

Tracks securities in an index, sector , or region Most ETFs are passively managed

ETFs vs. Mutual Funds

ETF Indexed Open-End Mutual Fund

Secondary Market (trades like a stock) Primary Market

Fixed Capitalization Unfixed Capitalization

Constantly change in price (NAV is close to share price)

Priced once a day (Priced at NAV at market close every day)

Low expense ratio (but pays commission to broker) Higher expense ratio (sales load fee, management costs)

More Tax Efficient Less Tax Efficient

Short selling, limit, and stop orders allowed Short selling and limit orders not allowed

How are ETFs Created Creation

A sponsor submits a plan to SEC AP purchase the underlying assets

Gathered into one single fund Delivered to custodian bank

Issuer receives the ETFs as a Creation Unit ETFs sold to investors on secondary market

Redemption Sell on market, or Exchange the ETF shares (creation unit) for the

underlying assets

ETF Strategies Passive Investing Active Trading Actively Managed ETFs

Passive InvestingTraditional ETFs

Constructed to provide a single security to track a particular market index

The manager makes only minor periodic adjustments to keep the fund in line with its index

Fewer administrative costs Tax efficiency - fewer trades into and out mean

fewer taxable distributions and a more efficient return on investment

Active Trading Active trading strategies can be used when

trading ETFs, although still trading as a passive investor Track the direction of the market and trade

accordingly Take advantage of short-term movements Strategies that can be used include:

Market Timing Sector Rotation Short Selling Buying on margin

Actively Managed ETFs An ETF that has a manager making decisions on

the underlying portfolio allocation Will still have a benchmark index Not necessarily perfectly mirrors the underlying

index Managers may change sectors, market-time trades

or deviate from the index Aims to deliver above-average returns

Ex: PIMCO’s Enhanced Short Maturity Strategy Fund (Mint)

ETF Classification Based on Region:

US Market ETFs Style ETFs Sector and Industry ETFs Asset Class ETFs

Foreign Market ETFs (Broad Based Foreign ETFs) Emerging Market ETFs Developing Market ETFs Asset Class ETFs Individual Country ETF

U.S. Market ETFs Style ETF

Tracks certain investment style or market capitalization Entire Index Small Cap, Mid Cap, Large Cap Value Stock Growth Stock

Style ETF Performance

U.S. Market ETFs Sector and Industry ETFs

Tracks a sector index representing a certain industry Some Examples:

SPDR Dow Jones Average industrial ETF (DIA) iShares TR U.S. Industrial ETF (IYJ)

Industrial ETF Performance

U.S. Market ETFs Asset Classes ETFs

Commodity Metals Energy Agriculture

Currency Fixed Income Equity Real Estate Multi Asset

US Commodity ETF

Foreign Market ETF Emerging Market ETF

An Emerging Market is a country that has some characteristics of a developed market, but does not meet the standard to be a developed market

Focuses on the stocks of emerging market economies, such as Latin America, Asia, and Eastern Europe

Some Example: Vanguard FTSE Emerging Market ETF (VWO) iShares MSCI Emerging Market ETF (EEM)

Emerging Market ETF Performance

Foreign Market ETF Developed Country ETF

The flip side of Emerging Market ETF countries Consists of securities in developed coutries such as

Europe and the United States Some Examples:

iShares MSCI EAFE ETF (EFA) Region: Europe Australia, Far East Region Asst Class Size & Style: Large Cap Blend Benchmark: MSCI EAFE Index

iShares MSCI EAFE ETF (EFA) Performance

Foreign Market ETF Asset Classes ETFs

Commodity Metals Energy Agriculture

Currency Fixed Income Equity Real Estate Multi Asset

Foreign Market Commodity ETF

Providers of ETF EG Shares

Emerging Global Advisors

PowerShares ETFs Invesco

PowerShares Direxion

Rafferty Asset Management

iShares (IVV) Black Rock

SPDR (SPY) State Street

Global Advisors VanGuard ETF

(VOO) VanGuard

EG Shares Emerging Global Shares More exposure to risk: Greater returns or greater

losses These particular ETFs can mirror the underlying

performance in BRIC (Brazil, Russia, India, and China) MIST (Mexico, Indonesia, South Korea, and Turkey)

Economic uncertainty in Venezuela

PowerShares ETFs Invesco was founded in 2002 and is a boutique

investment firm Has marketed PowerShares since 2006

QQQ ETF which follow the NASDAQ 100 Uses market capitalization to weight its assets

FTSE RAFI Asia Pacific excluding Japan ETF Uses smart-beta to weight different asset classes

Direxion Specialize in leveraged ETFs First to offer 3x leveraged ETFs (“Triple

Leverage”)Fund Inception Date:2008

Track: S&P 500

Name (SPXL) Bull Fund + 300%

(SPXS) Bear Funds -300%

Expense Ratio .98% .99%

YTD Returns -16.19% .10%

iShares (IVV) Largest provider of ETFs in the world: ~$645

billion in assets BlackRock is the largest asset holder amounting to

around $4.65 trillion Legally Structured as an open-end ETF

Allows for the reinvestment of dividends The availability of leveraging ETFs

IVV tracks the S&P 500 Average Spread: .02% Expense Ratio: .07%

SPDR (SPY) Has around $2.3 Trillion in assets under

management Legally structured as a Unit Investment Trust

Dividends must be paid out in cash cannot be automatically reinvested

Restricted from lending out securities SPY ETF tracks the S&P 500

Average Spread: .01% Expense Ratio: .09%

VanGuard (VOO) Low cost ETF offerings similar to their Mutual

Funds Providing ETFs at a 76% lower expense than

comparable firms Legally structured as an open-end ETF Additional Tax benefits

The fund has the option to sell off high cost-basis securities

VOO tracks the S&P 500 Average spread: .04% Expense Ratio: .05%

Smart Beta

Smart beta ETFs seek better returns and lower volatility than traditional ETFs

Like traditional ETFs, smart betas track indices, but instead use alternative weighting schemes (Financial Times)

Smart Beta Most major indices are capitalization-weighted,

and traditional ETFs copy this strategy

Popular smart beta strategies (Schwab, 2015) Low volatility weighting Fundamental weighting Equal weighting

Comparison: SPX, SPY, SPLV S&P 500 and SPY are capitalization-weighted SPLV is volatility-weighted

(Yahoo Finance)

1 yr (2014-2015)

(MacroRisk)

2 yr (2013-2015)

(MacroRisk)

4 yr (2011-2015)

(MacroRisk)

Smart Beta Overall, SPY and SPLV both outperformed the S&P

500 SPY: highest returns, SPLV: lowest volatility SPLV weighting scheme produced desired result

(MacroRisk)

Smart Beta According to an article in the Financial Analysts

Journal, all three strategies exploit the inefficiencies of cap-weighted indices, and outperform benchmarks

Performance Comparison 1964-2009

(Chow, Hsu, Kalesnik, & Little, 2011)

Factors Of Price Main Driving Factors of Price

Market Supply and Demand (Economic Trends) Ex. Devaluation of Yuan (Chinese Currency)

Net Asset Value Selling at a Premium or Discount

Liquidity How frequently is it selling?

Cost and Fees of ETFs 4 Factors to look into:

Commission Expense Ratio Bid/Ask Spread Tracking Error

Commission Two ways commission could affect owning costs

Lump Sum Dollar Cost Averaging

Expense Ratio The Expense Ratio is a

charge on shareholders to cover operating expenses

What makes up the Expense Ratio Administrative Cost,

Management Cost, Operation Costs

Bid/Ask SpreadBid/Ask Spread is the difference between the

“ask” at which the ETF can be bought and the “bid” is the market price the ETF can be sold.

The more liquid the ETF the smaller the spread

Example of Cost of Owning

Tracking Error A tracking error is when the ETF return differs

from the total return of the underlying index Two main reasons for tracking error

Market Capitalization Diversification Rule

Advantage & Disadvantage of ETF Advantages:

Trades like a stock Diversification Lower fees More tax efficient

Disadvantage: Trading cost Market inefficiencies

QUESTIONS???

Sources By Slide What Are ETFS

“An Introduction to Exchange-Traded Funds” https://www.wilmingtontrust.com/wtcom/index.jsp?fileid=3000252

“Definition of Exchange Traded Funds ETFs“ http://lexicon.ft.com/Term?term=exchange-traded-funds--ETFs

Exchange Traded Funds” http://www.investopedia.com/terms/e/etf.asp

Hawkins, Ken “Exchange Traded Funds (ETFs)” http://www.investopedia.com/university/exchange-traded-fund/

“What Are ETFs” http://www.nasdaq.com/etfs/what-are-ETFs.aspx

ETF vs Mutual Fund “Compare ETFs vs. mutual funds”

https://investor.vanguard.com/etf/etf-vs-mutual-fund

ETF vs Mutual Fund (Cont.) “Complete Guide to Investment Companies, Funds and REITS”

http://www.investopedia.com/walkthrough/fund-guide/mutual-funds-etfs/which-is-better/shortcomings.aspx

“Understanding how mutual funds, ETFs, and stocks trade” https://www.fidelity.com/learning-center/trading-investing/trading/trading-

differences-mutual-funds-stocks-etfs

How are ETFs Created? McMahon, Oliver “ETF 101: The Basics of ETF Construction”

http://ca.ishares.com/content/en_ca/repository/resource/article_etf_watch_structure_march_2011_en.pdf

Smith, Lisa “An Inside Look At ETF Construction” http://www.investopedia.com/articles/mutualfund/05/062705.asp

Passive vs Active Management “Actively Managed ETF”

http://www.investopedia.com/university/exchange-traded-fund/etf4.asp#ixzz3l4DEUYYv

Hawkins, Ken “Exchange-Traded Funds: Active Vs. Passive Investing” http://www.investopedia.com/university/exchange-traded-fund/

etf4.asp#ixzz3l4DEUYYv McWhinney, James E. “Active Vs. Passive ETF Investing”

http://www.investopedia.com/articles/mutualfund/05/activepassive.asp#ixzz3l4ECVLFX

Pylypczak-Wasylyszyn, Daniella “The Top 5 Actively Managed ETFs” http://etfdb.com/active-etf-center/the-top-5-actively-managed-etfs/#more-

101915

ETF Classification Ashworth, Will “6 Popular ETF Types For Your Portfolio”

http://www.investopedia.com/articles/exchangetradedfunds/11/ten-popular-etf-types.asp

ETF Classification (Cont.) “iShares MSCI China ETF”

https://www.ishares.com/us/products/239619/ishares-msci-china-etf Kennedy, Mark “13 Types of ETFs (And More)”

http://etf.about.com/od/typesofetfs/tp/4_Types_of_ETFs.htm

ETF Providers “All SPDR ETFs”

https://www.spdrs.com/product/ “Chapter Three: Exchange-Traded Funds”

http://www.icifactbook.org/fb_ch3.html “iShares Core S&P 500 ETF”

https://www.ishares.com/us/literature/fact-sheet/ivv-ishares-core-s-p-500-etf-fund-fact-sheet-en-us.pdf

Justice, Paul & Samuel Lee “Untangling ETF Tax-Efficiency Myths” http://www.morningstar.com/advisor/t/54272084/untangling-etf-tax-efficiency-

myths.htm

ETF Providers (Cont.) “Low-cost, Commission-free Vanguard ETFs”

https://investor.vanguard.com/etf/why-vanguard Patton, Mike “Under the Hood; Tax Treatment of ETFs vs. Mutual Funds”

http://www.thinkadvisor.com/2015/03/02/under-the-hood-tax-treatment-of-etfs-vs-mutual-fun?page=2

Pylypczak-Wasylyszyn, Daniella “The Best S&P 500 ETF: Spy vs. IVV vs. VOO” http://etfdb.com/equity-etfs/closer-look-at-sp-500-options/

“SPDR S&P 500 ETF” https://www.spdrs.com/product/fund.seam?ticker=spy

“S&P 500 ETF (VOO)“ https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/

productoverview?fundId=0968&WT.mc_id=2014magVOO “What are the five ETF Structures”

https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_FiveStructures

Smart Beta ETFs Chow Tzee-man, Jason Hsu, Vitali Kelsnik, and Bryce Little “ A Survey of

Alternative Equity Index Strategies” http://www.researchaffiliates.com/Production%20content%20library/

FAJ_SeptOct_2011_A_Survey_of_Alternative_Equity_Index_Strategies.pdf “Definition of Smart Beta”

http://lexicon.ft.com/Term?term=smart-beta “Smart Beta Investing: Are All Strategies the Same”

http://insights.schwab.com/portfolio-management/smart-beta-investing-are-all-strategies-same?cmp=em-SDV

Factors of Price “Exchange-Traded Funds-Expenses”

http://www.investopedia.com/walkthrough/fund-guide/mutual-funds-etfs/etf/expenses.aspx

“Frequently Asked Questions About ETF Basics and Structures” https://www.ici.org/pubs/faqs/faqs_etfs

Cost and Fees of ETFs Bryan, Alex & Michael Rawson “The Cost of Owning ETFs and Index

Mutual Funds” http://global.morningstar.com/us/documents/pr/Cost-Of-Owning-Index-ETF-

MFS.pdf Devcic, John “5 ETFs Flaws you Shouldn’t Overlook”

http://www.investopedia.com/articles/mutualfund/07/etf_downside.asp “Expense Ratio”

http://www.morningstar.com/invglossary/expense_ratio.aspx Folger, Jean “Pay Attention To Your Fund’s Expense Ratio”

http://www.investopedia.com/articles/personal-finance/092613/pay-attention-your-funds-expense-ratio.asp

Iachini, Michael “ETFs: How Much do they Really Cost?” http://www.schwab.com/public/schwab/nn/articles/ETFs-How-Much-Do-They-

Really-Cost

Cost and Fees of ETFs (Cont.) Justice, Paul & Samuel Lee “ ETFs Under the Microscope: Tax Efficiency

Survey” http://corporate.morningstar.com/US/PR/TaxEfficiencyPaper.pdf

Tracking Errors “ETF Pricing: Determining the True Cost of Ownership”

https://www.spdrs.com/library-content/public/ETF%20Pricing%20-%20Determining%20the%20True%20Cost%20of%20Ownership.pdf?docname=ETF+Pricing%3A+Determining+the+True+Cost+of+Ownership&onyx_code1=1300&onyx_code2=NA

Fontinelle, Eric “ETF Tracking Errors: Protect Your Returns” http://www.investopedia.com/articles/exchangetradedfunds/09/tracking-error-

etf-funds.asp