Exchange Traded Funds (ETFs)

1. Exchange Traded Funds (ETFs) An Overview

2. Index Products • "A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money" Warren Buffett* * Jonathan Stempel, “Buffett: Index funds better for most investors,” Reuters.com, May 6, 2007

3. The Economist

4. What are ETFs? • Exchange Traded Funds are pooled investments that are traded on an organized exchange (NYSE Arca, TSX) • Each fund tracks a basket of securities, e.g., S&P500 • Introduced in: • Canada – 1990 • US – 1993 (oldest ETF: SPY) • Europe – 2000 • Japan – 1995

5. What are ETFs? • May 2013 Global ETF market * • Assets: $2.14 trillion • 4849 ETFs and other ETPs • 9875 listings • 211 providers • 56 exchanges • US market • End of 2012: US – 10.28% of mutual fund assets ** • US – 30% of daily trading volume *ETFGI database ** Investment Company Institute Fact Book 2013

6. SPDR S&P 500 ETF (ticker: SPY)

7. Types of ETFs • Passive • Tracks an index • Active • Tracks an actively managed portfolio • Leveraged • Magnifies the return of an index (or the inverse) • Asset classes • Equities • Fixed income • Commodities • Hedge fund indices

8. Regular Mutual Funds • NAV calculated once a day at 4pm • Trading and tax consequences as investors buy and redeem shares Investors Mutual Fund Manager

9. ETF’s Creation and Redemption Process • Main difference from a mutual fund • Unique structure Trading in secondary market ETF Investors ETF Investors Authorized Participants (APs) ETF Fund Manager In-kind transfers Minimizes trading or tax consequences at the fund level

10. Advantages of ETFs • Tax efficiency • Real time trades • Low costs (Management Expense Ratios) • For retail investors – yes • Institutional investors – sometimes no • Example (TD Bank): S&P500 index mutual funds • 3 bps for institutional investors • 35-54 bps for retail investors • S&P500 ETFs (tickers: SPY, IVV): 7-9 bps • A rare financial product that charges retail and institutional investors the same fees

11. Advantages of ETFs: Cross-sectional comparison • Compare bid-ask spreads of an ETF and its underlying basket of securities. iShares examples: Source: iShares Institutional Trading report 2010 Small fund low trading volume

12. The ETF market

13. Who are the Providers? • SPDR and iShares have been around the longest • If you can’t beat them, join them: Gus Sauter, Vanguard Group's chief investment officer, vividly recalls the first time he proposed exchange-traded funds to his boss. "That's the dumbest idea you've ever had," then-CEO Jack Brennan told him after a five-minute discussion back in 1998....... ...... (C)urrent Vanguard CEO, Bill McNabb, "ETFs will become almost by default a bigger and bigger part of what we do.“ Pressman, Aaron. “In great ETF war, Vanguard topples iShares.” Globe and Mail. December 3, 2010 • In Canada: BMO and RBC have introduced ETFs • Different providers may offer ETFs that track the same index

14. 8 Pairs of that Track the Same Index Source: Shum and Chen (2012)

15. Replication • Physical replication • Fund holds the underlying assets • Synthetic replication • Fund enters into a swap contract with a counterparty, who supplies the returns • Fund uses derivatives, such as futures contracts, to gain exposure to the assets (e.g., commodities, volatility, hedge fund index) • Hedge fund replication strategy: use of liquid futures contracts on several different asset classes, including equity indices, currencies, fixed income securities and commodities

16. Synthetic Replication: Unfunded Swap Structure Swap Counterparty ETF Investors Swap ETF buys a “substitute” basket of securities from counterparty using cash Index return Basket return Authorized Participant (AP) ETF

17. Synthetic Replication: Funded Swap Structure Swap Counterparty ETF Investors Swap Collateral securities posted by counterparty, held by 3rd party custodian Index return Cash Authorized Participant (AP) ETF

18. Issues with Swap-based Synthetic Replication • Swap structure • Counterparty risk • When the counterparty collapses. This risk is measured as the difference between the value of the collateral/substitute basket and the NAV of the ETF • Collateral/substitute basket risk • Securities in basket maybe unrelated to ETF • Securities in basket maybe illiquid • Value of basket may be different from the NAV of the ETF • Incentive of investment banks • Most swap-based ETFs are partially or wholly owned by an investment bank • Swap counterparty can be the investment bank’s trading desk

19. Synthetic ETFs and Their Counterparties • Examples:

20. Issues with Futures-based Synthetic Replication • Examples: gold, VIX • Rolling over of short-term futures contracts, to obtain near-spot prices • Pitfall: spot price may be stable, but ETF investors are exposed to the roll yield • Contango - Roll yield is negative - Not sustainable over the long term - Do NOT buy and hold Futures prices Spot

21. Issues with Futures-based Synthetic Replication • Front-running • A strategy of trading ahead of standard index rolls • Products are changing to avoid front-running • Do not track traditional commodity indices • “Enhanced” index products • Roll almost every business day

22. Breakdown of Creation/Redemption Process • Exchange traded notes (ETNs) • Not backed by an actual portfolio of cash and futures. Investors exposed to the credit risk of the note’s backing bank • TVIX • Credit Suisse volatility (VIX) ETN • Good example of how the creation/redemption process could break down • Lost 61% over 4-5 days

23. Bond Market Sell-off in late June 2013* • June 20, 2013 • Earlier in the month, Bernanke hinted at the end of easy money • Led to a bond market sell-off and drying up of liquidity • ETF providers could not handle the large volume of municipal bond ETF redemption • Cash redemption is an option for APs (for a fee**) • June 20-21: • State Street - allowing in-kind redemption only • APs faced the risk of having illiquid bonds on their books • Citi temporarily disallowed redemption of their muni bond ETFs *http://blogs.wsj.com/moneybeat/2013/06/21/state-street-temporarily-stops-cash-redemptions-for-muni-bond-etfs/ ** https://www.spdrs.com/library-content/public/Variable_Fee_Matrix_with_Tiers-v8_LS2%20%282%29.pdf

24. No Magic Liquidity Conclusion: Creation/redemption process relies on liquidity of the underlying basket

25. Issues with commodity ETFs • “Financialization of commodities” • Growth of index investment products in commodities • They track broad commodity indices • Commodities within an index are not necessarily related (metals, cattle, soybean, cotton and energy) • Increases correlation amongst commodities. No long determined by just supply and demand in their respective markets • Since energy prices are volatile, this increase in correlation makes other commodity prices more volatile

26. Performance Measures • Tracking error • How well does the ETF track the index over a specific period of time? • Volatility of deviations from underlying assets • Compare ETF’s NAV per share with underlying assets • Trading premium/discount • Compare market price with ETF’s NAV • “(Blackrock) believes that institutional investors will take advantage of differences between the NAV and the trading price of iShares through arbitrage opportunities; but cannot guarantee that they will.” (www.ishares.com)

27. Trading Premiums and Discounts As of August 1, 2012, TVIX is still Trading at a premium (7 - 8%)

28. International ETFs: Price Discovery • Explaining Daily Returns • January 1 to December 31, 2008 • Regression analysis • The underlying indices for the Hong Kong, Korean, and Japanese ETFs are their corresponding MSCI indices, converted to US dollars, and the underlying index for the Chinese ETF is the FT/Xinhua 25. An asterisk denotes parameter estimates that are statistically significant at five percent; t-statistics are reported in parentheses. Number of observations: 252.

29. International ETFs Explaining Close-to-Open Returns January 1 to December 31, 2008

30. International ETFs Explaining Intraday Volatility • January 1 to December 31, 2008 The standard deviation of intraday returns of each Asian ETF on day t is regressed on the contemporaneous standard deviation of intraday returns of spy. Returns are calculated using the average price within each 15-minute interval

31. Ticker: FXI

32. Leveraged ETFs • Numerous media articles warning investors about these products: • "Prudent investors .... should consider the use of leveraged funds with great caution.“ • These products are for "sophisticated investors who understand ... (the) consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investments ...“ • Investor alerts issued by the SEC, FINRA, IIROC • The Financial Industry Regulatory Authority (FINRA) fined a number of large brokerage houses in May 2012 a combined total of $9.1 million for allegedly improper sales of leveraged ETFs • Other brokerages ban their advisors from selling these products (e.g., Morgan Stanley, UBS, BoA)

33. Leveraged ETFs • Example of the confusion • 2008 performance TSX Global gold index: 0.8% HGD (2x bear ETF): -84.5%! • Designed to replicate daily returns. • What happens if you hold the fund for two days?

34. Leveraged ETFs – impact of compounding Net return of the index is: Net return of the 2x bull ETF is: Net return of the 2x bear ETF is: • Same implication for longer holding periods* • In general, • Momentum (or trends) works in the investor’s favour • Negatively autocorrelated returns will result in a loss even if index breaks even * Shum and Kang (2013)

35. Leveraged ETFs – management factors • Previous example assumed perfect replication. There may be addition deviations due to the different risks involved • Use of leverage • Use of swap structure • Hedging/trading costs of counterparties  when • Volatility is high • Liquidity is low • Costs are passed onto ETF investors

36. Leveraged ETF Providers • US: Proshares, Direxion, Rydex • Canada: Horizon BetaPro

37. Characteristics of U.S. ETF Investors Source: Investment Company Institute Fact Book 2013