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A presentation on : General Applications of Exchange Traded Funds

A presentation on : General Applications of Exchange Traded Funds. Justin Pascoe Director of Investments 20. 8. 2002. Table of Contents. What are ETF s Why have ETFs become so popular Users and Applications of ETF Global Developments of ETF Developmental Challenges Conclusion.

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A presentation on : General Applications of Exchange Traded Funds

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  1. A presentation on: General Applications of Exchange Traded Funds Justin Pascoe Director of Investments 20. 8. 2002

  2. Table of Contents • What are ETFs • Why have ETFs become so popular • Users and Applications of ETF • GlobalDevelopments of ETF • Developmental Challenges • Conclusion

  3. What are ETFs?

  4. What are ETFs? Characteristics • Commingled fund structure • Listed on the exchange • Trade like ordinary shares • Passively managed against an index • Usually priced at a fraction of the index • e.g: TraHK is 1/1000th, SPDR is 1/10th, • QQQ is 1/40th • Contribute and redeem in-kind

  5. In-kind Subscription/Redemption • Not as simple as taking a mutual fund and listing it on the exchange • Special in-kind creation and redemption mechanism Share basket Investor ETF Creation Units Units ETF Investor Redemption Share Basket

  6. Importance of in-kind Creation and Redemption • Reduces transaction costs borne by the fund that result from investors’ activities • The ordinary mutual fund has to acquire/sell stocks in its portfolio when investors buy into and/or redeem from the fund, thereby incurring transaction costs • In-kind mechanism contributes to the lowering of the expense ratio of the fund • Facilitates arbitrage activities • Specialists, market makers and arbitrageurs compete to capture pricing discrepancies, which results in the ETF trading at its fair value • Hence increases the liquidity of ETFs

  7. Arbitrage Activities ETF Cash Futures • Investors will: • accumulate the share basket • create the units • sell the units Unit price >NAV Unit price closely tracking the NAV • Investors will: • accumulate the units • redeem the units • sell the underlying shares Unit price<NAV Additional dimension for arbitrage improves market efficiency

  8. ETF Arbitrage Matrix If Units Cheap vs. If Units Expensive vs. +Units - Stocks - Units + Stocks Stocks Redeem units for stocks which are used to cover the borrowed stocks Use stocks to create new units to replace the borrowed units OR buy back units and sell stocks when units are cheap +Units -Futures - Units + Futures Buy units and sell futures before it expires; or buy units and let futures expire on the expiration day Sell units and covert futures before it expires; or sell units and let futures expire on the expiration day +Long position (Buy) -Short position (Borrow and sell) Opening Trade Closing Trade Futures

  9. TraHK Premium/Discount Analysis

  10. Two Levels of Tracking • Tracking of the ETF’s traded price against the NAV • depends on the efficiency of the arbitrage process • Tracking of the ETF’s NAV against the index (Tracking Error) • depends on the expertise of the fund manager – in the design of the basket and in the rebalancing techniques • need to subtract the accrued dividend from the ETF’s NAV before comparing with the index

  11. Hybrid ProductSubscription /Redemption as Open-ended Mutual Funds, Traded on stock exchange as Close-ended Mutual Funds Retail Investors Institutional Investors Intermediaries 次級市場 Secondary Market Market Price Arbitrage provides critical link between ETF, Equity and Futures markets Primarily Market Fund Subscription/Redemption at NAV Stock Stock Unit Unit Subscription Institutional Investors/Intermediaries Redemption Institutional Investors/Intermediaries

  12. Why ETF is getting more and more popular?

  13. Benefits to the Investors • Special Features of ETF • Only one transaction to buy a diversified portfolio • Low expense ratio • Fair pricing • Adds to market depth, liquidity and efficiency • In Korea • Exemption from 0.3% transaction tax on the sale of ETF units • Short-selling of ETF exempted from the up tick rule • Virtues of Indexation • Indexation enforces diversification • Obtains broad market exposure • Transparency – Investments & Performance • Advantages of Listing on Stock Exchange • Simple and flexible dealing • Small board lot size (10 shares) • Trading throughout the day • Can buy on margin or short-sell • Can place limit orders • Highly liquid

  14. Cost is a a Major ConsiderationAnnual Cost Comparison Annual Trading Volume / 2 Fund Size * Annual portfolio turnover =

  15. Comparison of ETFs with other Investment Products

  16. ETFs vs Active Mutual Funds

  17. ETFs vs Closed-ended Mutual Funds

  18. ETFs vs Open-ended Index Funds

  19. ETFs vs Index Futures

  20. ETFs Users and Applications

  21. ETFs Users • Institutional Investors • Market Intermediaries • Hedge Funds • Financial Advisors • Retail Investors

  22. Applications of ETFs Asset Allocation/Sector & Style • Use ETFs to gain country or sector exposure while limiting stock-specific risk – avoid frustration of the right country or sector choice, but the wrong stock pick • Rebalance allocation anytime during market hours and without the hassles of multi-stocks settlement • Efficient access to markets which have restrictions on foreign capital participation • Build core portfolio cheaply with broad-based & country ETFs and the “satellite” portfolio with industry sector ETFs

  23. Core/Satellite Asset Allocation Strategy Equity Risk Pyramid Large-Cap Higher Risk/Higher Reward Sector Funds Growth Individual Stocks Core Investments Sector Funds Value Individual Stocks Large, Mid, Small-Cap Funds Growth & Value Funds Small-Cap Broad-based Indices Lower Risk/Lower Reward 資料來源 Source: MSDW 股票研究 MSDW Equity Research

  24. Applications of ETFs Equitize Cash Inflows • Avoid drag of cash position on equity portfolio returns • achieve temporary equity exposure until portfolio manager decides which stocks to buy

  25. Applications of ETFs Enhance Management of Cash Outflows • Use ETFs to create equitized liquidity reserve • To satisfy redemptions or withdrawals, compared to selling individual stocks, the ETF liquidity reserve can be liquidated • Quicker • Easier • Lower transactions costs • No effect on individual stock price

  26. Applications of ETFs Hedge Equity Portfolio Exposure • Short ETF position can provide hedge against price declines • Alternative to futures and without the roll risk – especially attractive for institutions which are not permitted or prefer not to use derivatives • Allows the hedging of exposure to specific stock indexes or market segments not available with futures

  27. Applications of ETFs Manager Transition Trades • Facilitate transition of assets from a terminated investment manager to a new investment manager • Liquidate terminated manager’s portfolio and invest in ETFs to maintain equity exposure • When new manager is selected, ETFs can be sold to deliver cash or redeemed to deliver component stocks of ETF to new manager

  28. Applications of ETFs Relative Value, Long/Short Strategies • Strategies can include: • Go Long broad market Indexes, country or sector Indexes expected to outperform • Go Short the broad market Indexes, country or sector Indexes expected to underperform • Position can be leveraged by doubling the size of the long position versus the short • Anticipate sector rotations with long or short positions in industry sector ETFs

  29. Applications of ETFs Privatization of Shares Held by Government • Innovative use of ETFs designed by SSgA – First used by the Hong Kong Government and hence the creation of TraHK • Government repackaging their shareholdings into ETF units and placing the units to institutional and retail investors through an initial public offering • Key advantages are: • Minimal market impact • Stock neutral • Diversifies ownership amongst retail and institutional investors • Broadens the capital markets with the introduction of a new investment product • Recently adapted for the unwinding of cross-holdings of Japanese banks • But a crucial difference – there is a lack of new investors and new sources of liquidity into the Japanese product

  30. Trends and Development of ETFs

  31. Worldwide ETF Growth in Assets By 28 June 2002, assets under management reached US$120.6b in 238 ETFs DAX, TALI 25, M-S CAC 40, TSE300, XMTCH (SMI) LDRs, iShares,streetTRACKS DJ CN 40, Xact OMX,SATRIX 40 QQQs, iUnits 60, TraHK DIAMOND, Sector SPDRs WEBs Midcap SPDR SPDR Data as of Dec 31, 2001 (USD millions) Source: SSgA ETF group, AMEX

  32. Existing Products SSgA manages more than 33% of the ETF assets worldwide, including: SPDR, Fortune, Select Sector SPDR, DJ Canada 40, StreetTRACKS, & TraHK MidCap SPDRs 5,890 Others 38,072 TSE Topix 8,024 OSE Nikkei 225 2,687 DIAMONDS 3,430 iShares Russell 2000 2,742 QQQ 19,040 Select Sector SPDR 2,805 iShares S&P 500 3,629 TraHK 3,586 iShares MSCI EAFE 3,999 SPDRs 26,896 Source: Bloomberg Data as of Jun 30, 2002 (USD Millions)

  33. ETFs in the Global MarketTop 10 Global ETFs by Turnover *Average daily turnover for the year ended 28 June 2002 Source: SSgA ETF Group, Bloomberg

  34. ETFs in the Global MarketExisting Products AUM : US$120.6b in 238 funds* Europe & Middle East AUM : US$ 8.9 bn No. Funds : 93 * Including N America AUM : US$ 93.5 bn No. Funds : 118 STI Singapore’s first local ETF listed on 17 Apr 2002 Asia Pacific AUM : US$ 17.6 bn No. Funds : 24 South Africa AUM : US$ 0.6 bn No. Funds : 3 Source: Morgan Stanley Research * Data as of 28 June 2002, not including HOLDRS

  35. U.S. Lead in ETFs - Reasons for dominance of the US market • First mover advantage • Favorable end-user response • The number of institutional investors reporting holding one or more US listed ETFs or HOLDR has increased to 1,162 in June 2002 from 911 institutions in June 2001 (Source: Morgan Stanley Research and Thomson Financial) • Well developed market infrastructure • Key theme is asset growth • In the 1st half of 2002, assets have grown by US$5.5 billion to about US$93.5 billion and 1 new ETF was launched

  36. ETFs in Europe • ETFs are winning investors • Significant increase in usage of ETFs by European institutions, from 32 institutions in June 2000 to 246 in June 2002 (Source: Morgan Stanley Research) • Rapid product launches • In the 1st half of 2002, there were 21 new ETF launches and assets increased by US$2.9 billion to about US$8.5 billion • Cross-listing is common • As of 28 June 2002, the number of primary listings was 92 but the number of total ETF listings was 154. • Key theme is pan-Europe sector based ETFs • Introduction of Euro • Institutional investors move from country based to sector based allocation

  37. ETFs in Asia Pacific ETFs in Asia Pacific • Hong Kong • Japan • Australia • Singapore

  38. ETFs in Hong Kong • Tracker Fund of Hong Kong (TraHK) was the first ETF listed outside North America in 1999 • US$4.3 billion IPO the first stage of Hong Kong Government’s disposal of shares purchased in events of August 1998 • Tap Mechanism an on-going disposal mechanism for the Government’s remaining holdings • Incentive package with Loyalty Bonuses has resulted in TraHK being less liquid initially than typical ETF of this size • Current assets under management of about US$3.8 billion • Cross-trading iShares in Hong Kong from May 2001 • Korea & Taiwan the first 2 of a planned 6 • Launch of iShares MSCI China Free in Hong Kong in November 2001 • Current assets under management of about US$38 millions for Hong Kong retail investors

  39. Observations from TraHK • Local investors prefer local indices • Low cost and transparency are the major appeal • Benefits to the capital market: • More investment choices – benefits investors • Development of long-term equity holding culture – 70% of investors from IPO still retaining their units even after the distribution of all loyalty bonuses • Increased efficiency of index futures pricing • Increased liquidity resulting from arbitrage activities • Active trading of derivatives positive for the development of the product

  40. Observations from TraHK (Con’td) • Marketing important aspect especially in the initial stages • To increase investor awareness and familiarity • Operationally demanding product • Need to interact with numerous parties • Importance of fully integrated systems • Experience is key - steep learning curve and inexperience incurs the risk of developing a flawed product • Extremely profitable business for the stock exchange

  41. ETFs in Japan • Japan ‘mass launch’ of 5 ETFs in July 2001 • Indices approved for ETF development increased from 4 to 8: Nikkei 225, Nikkei 300, Topix, S&P Topix 150, MSCI Japan, FTSE Japan, DJ Industrial Average, Nasdaq-100 • A total of 17 ETFs listed currently, with total assets of about US$14 bn • 60% of the ETF assets came from the injection of crossholdings of Mitsubishi Tokyo Financial Group (MTFG) and Meiji Life. • No clear evidence of strong institutional use of ETFs except for the unwinding of cross-holdings in the above cases by MTFG and Meiji Life. • As these ETF units were created for share unwinding purpose, it has resulted in persistent short futures open interests in the market as well as these ETFs being less liquid than typical ETF of this size. • Product design far from satisfactory • Different creations and redemptions processes due to different interpretation of the trust law by the ETF issuers • Trade basket is typically published more than 1 day prior to the trade date – creates uncertainty in the fund management process especially when large corporate actions are pending.

  42. Japan ETFs - Trading Dominated by Proprietary Trading Source: Tokyo Stock Exchange

  43. ETFs in Australia • ASX 200 & ASX 50 ETFs launched in August 2001 • Rapid growth from US$ 40 mn at launch to US$ 114 mn at the end of June 2002 • Importance of complementary futures contract • ETF tracking Listed Property Trust Index launched in Feb ’02, with AUM of about US $21mn as at end of June 2002

  44. ETFs in Singapore • Cross-listing 5 US ETFs in Singapore from May 2001 • SPDR, iShares S&P500 and Diamonds • DJ US Technology • iShare Singapore • streetTRACKS Straits Times Index Fund launched on 17 April 2002 • Replicating many key features of TraHK • based on well-known local index • drawing new investors into market (CPF approved) • low cost structure • but no Tap Mechanism or loyalty bonuses => ‘organic growth’

  45. ETF Asia Overview • Asia clearly under-represented globally • Why? • Less sophisticated market infrastructures • settlement, ability to short-sell, etc • Index construction issues - liquidity & concentration • Investor focus has been on active management / stock selection • Limited offering of cost-effective products • institutions / arbitrageurs very cost sensitive • New funds coming as providers meet demand

  46. Developmental Challenges

  47. Developmental Challenges Operational Fiscal Funding • Hybrid Product • Shareholder Protection • Investment Concentration Restrictions • Securities Marketplace Infrastructure • Disseminating Information • Settlement • Basket Creation • Financial Status • Tax on Creations and Redemptions • Distribution • Incentive Structure • Marketing Regulatory

  48. Interaction with Multiple Parties

  49. Funding Challenge - Launching by IPO or Seed Capital Advantages of IPO • Achieve investor awareness immediately • Enable the ETF to gather sufficient assets to attain a economically viable size • Assures liquidity • Equal chance of participation by all investors

  50. Precedents of Launching ETF via IPO Both the Tracker Fund of Hong Kong and Satrix40 are one of the most liquid counters traded on their respective exchanges.

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