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Exchange-Traded Funds by Brady Finkenaur. Powerpoint Templates. 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.

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  1. Exchange-Traded Funds by Brady Finkenaur Powerpoint Templates

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. ETF Mechanics: Warehouse Receipts Process Receipt Farmer Trader Cash Grain Cash Receipt Receipt Receipt Warehouse Kellog’s Grain

  8. ETF Mechanics: Process

  9. ETF Mechanics: Process

  10. 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

  11. ETF Mechanics: Basket Composition-SPY Top 10 Holdings

  12. 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

  13. 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

  14. 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

  15. 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%

  16. ETFs Versus Mutual Funds

  17. 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%

  18. ETF and Mutual Fund AUM (in $ trillions)

  19. 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

  20. 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.

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