All About EXCHANGE-TRADED FUNDS

THE EASY WAY TO GET STARTED

By SCOTT PAUL FRUSH

The McGraw-Hill Companies, Inc.

Copyright © 2012 The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-177011-8

Contents

IntroductionPART 1: BASICS OF EXCHANGE-TRADED FUNDSChapter 1 Getting Started: A Primer on Exchange-Traded FundsChapter 2 History and Milestones: The ABCs of the ETF RevolutionChapter 3 Advantages and Drawbacks: Making the Case for ETFsChapter 4 Underlying Indexes: The Benchmarks and Strategies That ETFs
TrackChapter 5 Internal Workings: The Technical Features of ETFsChapter 6 Regulations and Issuance: Bringing an ETF to MarketChapter 7 Players and Participants: The Who’s Who of All Things ETFsPART 2: TYPES OF EXCHANGE-TRADED FUNDSChapter 8 Broad-Based ETFs: Spiders, Diamonds, and Cubes, Oh, My!Chapter 9 Sector and Industry ETFs: From Basic Materials to UtilitiesChapter 10 Fixed-Income ETFs: Bonding With Corporates, Municipals,
Treasuries, and MoreChapter 11 Global ETFs: Country, Region, Style, and Broad-Market
OpportunitiesChapter 12 Real Asset ETFs: The REIT Moves With Commodities and
CurrenciesChapter 13 Specialty ETFs: Leveraged, Inverse, and Long-Short FundsPART 3: USE OF EXCHANGE-TRADED FUNDSChapter 14 Risk and Return: Fundamentals of Investing 101Chapter 15 Asset Allocation: An All-Important OverviewChapter 16 Leading Misconceptions: Separating ETF Fact From FictionChapter 17 Traditional Portfolios: ETF Models Based on Life Cycle and
Risk ProfileChapter 18 Specialized Portfolios: Bullish, Bearish, Sideways, and Focus
ModelsChapter 19 Future of ETFs: Outlook, Perspectives, and Developing TrendsAppendix A: ETF ResourcesAppendix B: Asset Allocator QuestionnaireAppendix C: ETF Closures by YearIndex

Excerpt

CHAPTER 1

Getting Started: A Primer onExchange-Traded Funds

Exchange-traded funds (ETFs) have grown by over 1,000 percent during the 10-yearperiod of 2001 to 2010. At the beginning of 2001, ETFs had combined assets undermanagement (AuM) of approximately $70 billion with nearly 90 funds available inthe U.S. marketplace. Fast-forward 10 years to the end of 2010 and AuM haveballooned to over $1 trillion with nearly 1,100 ETFs available in themarketplace. This is extraordinary growth that few ever predicted when the firstETFs were envisioned and launched only decades earlier. (See Figure 1-1for a list of the 10 most actively traded U.S. ETFs.)

ETFs are a relatively recent innovation, but have become increasingly popularwith casual, sophisticated, and institutional investors alike. ETFs offershareholders, including those of moderate means, an opportunity to invest in ahighly diversified, tax-efficient, and cost-effective basket of securities, suchas common stocks, preferred stocks, bonds, real estate investment trusts(REITs), and commodities.

ETFs are not investment strategies; they are the basic structure, wrapper, orbasket that contains the underlying securities. It is how the securities aremanaged that dictates an investment strategy or strategies. The same can be saidfor mutual funds and hedge funds, for that matter. However, each of theaforementioned investment structures offers unique features and characteristicsnot available—either partially or fully—in the other investmentstructures. To use an analogy, think of ETFs as a car in which the driver is theETF provider, the passengers are the shareholders, the engine is the underlyingsecurities, and the road map is the tracking index. A car only drives to wherethe driver steers it (i.e., the strategy). Cars do not drive themselves.However, not all cars are created the same. Some are faster than others, someare safer than others, some come with more conveniences, some hold morepassengers, and some are considered more prestigious. Consequently, some typesof investment structures (e.g., ETFs, mutual funds, hedge funds) make more sensefor one strategy or shareholder but not for others.

When ETFs were initially created, they were designed to track market indexesmuch like the index mutual funds of the day. However, since 2008 when the firstactively managed ETF was launched, most of the new ETFs have been designed tofollow proprietary customized indexes. This essentially means that these ETFsare tossing aside the traditional index philosophy and incorporating active-managementmethodologies, all with the intent to outperform the market ratherthan generate market returns. Many ETF providers that emphasize activemanagement claim their strategies—and therefore their ETFs—arebetter than all other ETFs in the marketplace. Perhaps the providers will evenboast stellar performance to justify their claim. Smart investors know there isno Holy Grail of investing. Most money managers do not outperform theirrespective benchmarks in any given year, and those that do cannot outperformconsistently over time. There will always be money managers who outperform andthose who underperform. It’s simple mathematics and the law of large numbers.However, where ETFs do add to the bottom line is in their unique structure thataffords them favorable cost savings—namely, taxes, expenses, and tradingefficiencies. These factors alone give ETFs built-in advantages and shareholdersfinancial benefits and incentives.

WHAT IS AN ETF?

An ETF is an investment company organized under either the Securities Act of1933 or the Investment Company Act of 1940 that offers shareholders aproportionate share in a portfolio of stocks, bonds, commodities, or othersecurities. From one perspective, ETFs can be considered a cross between commonstocks and mutual funds whereby an ETF trades intraday on a stock exchange atcontinuously market-determined prices like common stocks and holds a diversifiedportfolio of securities like a traditional mutual fund. Mutual funds are”forward priced,” meaning they can only be purchased and sold at the end of thetrading session, whereas ETFs can be traded at any time the market is open forbusiness. Additionally, ETFs offer stocklike tradability features such asselling short, purchasing via margin, and executing trades using market, limit,stop loss, and other discretionary order types.

One of the most important differences between ETFs and mutual funds is the priceat which a shareholder can purchase or sell the fund. Mutual funds aretransacted at marked-to-market net asset value (NAV), while ETFs are transactedat market-determined prices, which can differ from NAV. Although the marketprice for an ETF reflects the market values of the underlying securities, themarket price on the fund level is also dictated by simple shareholder supply anddemand. Thus, premiums or discounts to NAV can occur. Closed-end funds are muchlike ETFs in that closed-end funds trade on exchanges and hold pools ofsecurities. However, closed-end funds trade with sometimes significant premiumsor more typically discounts to NAV—sometimes as high as 30 percent.

Two features of an ETF’s structure ensure that market prices approximate NAV.The first is transparency of holdings. When market participants know an ETF’sholdings, they are far less likely to buy or sell at prices that deviate fromthe aggregate market value—called intraday indicative value(IIV)—associated with the holdings. Second, large institutional investorscalled authorized participants (APs) are contractually involved to buy or sellETF shares in a continuous risk-free arbitragelike manner until the spreadbetween the market price and NAV is negligible. Shareholders benefit from thisarrangement as the ETF share price is aligned with its NAV, and APs benefit bymaking a small profit in the process.

As previously mentioned, ETFs are designed to track either market indexes orproprietary custom indexes. The decision about which index to track is up to theETF provider. Before an ETF can be listed on an organized stock exchange, suchas the NYSE Arca (which we will simply refer to as NYSE throughout this book),an ETF provider must receive approval from an appropriate legal entity. In theUnited States, approximately 90 percent of ETFs are approved and regulated bythe Securities and Exchange Commission (SEC) and the remaining 10 percent by theCommodities Futures Trading Commission (CFTC). (See Figure 1-2 for alist of the 15 largest U.S. ETFs.)

How ETFs Operate

ETFs originate with ETF providers, such as Vanguard or PowerShares, which selectan ETF’s tracking index, establish the basket of securities underlying the ETF,and decide how many shares to offer to the investing marketplace. For instance,when an ETF provider selects an appropriate tracking index, that providercontracts with an AP to obtain the predetermined holdings that make up thebasket of securities and to deposit them with the provider. In turn, theprovider delivers to the AP what is called a “creation unit” typicallyrepresenting between 50,000 and 100,000 ETF shares. APs can either hold the ETFshares or sell all or part of them on the open market, which are then purchasedby you and me. Chapter 5 provides greater detail of this creation andredemption process.

As a result of the creation and redemption process, shareholders technically donot transact directly with an ETF provider—which is in contrast to mutualfunds—and instead transact with APs. The SEC has mandated that ETFproviders disclose this material fact in all their prospectuses and otherclient-approved written materials, such as advertisements.

Major Categories of ETFs

There are six major categories of ETFs available for shareholders to purchaseand sell. These ETFs track a number of traditional market indexes in the UnitedStates and abroad as well as custom indexes created by ETF providers to employproprietary investing strategies. The six major categories of ETFs include thefollowing:

1. Broad-Based ETFs: These ETFs track indexes based on both size (largecaps, mid caps, and small caps) and style (growth, value, and blend). Examplesof these include the SPDR (Spider) S&P 500 ETF and the PowerShares QQQ, whichtracks the Nasdaq-100 Index.

2. Sector and Industry ETFs: These ETFs track indexes that targeteconomic or industry groups such as energy, health care, technology, and homebuilders. Examples of these include the Financial Select Sector SPDR ETF and theVanguard Information Technology ETF.

3. Global ETFs: These ETFs track indexes that target various countries,geographic regions, and major divisions, such as developing and emergingmarkets. Examples of these include the Vanguard MSCI Emerging Markets ETF andthe iShares MSCI Brazil Index ETF.

4. Real Asset ETFs: These ETFs track indexes associated with alternativeinvestments such as REITs, commodities, and currencies. Examples of theseinclude the PowerShares DB Commodity Index Tracking ETF and the Vanguard REITIndex ETF.

5. Fixed-Income ETFs: These ETFs track the expansive bond marketincluding Treasuries, municipals, agencies, and corporates. Examples of theseinclude the Vanguard Total Bond Market ETF and the iShares iBoxx InvestmentGrade Corporate Bond ETF.

6. Specialty ETFs: These ETFs track indexes associated with lesstraditional investment approaches such as leveraged and inverse strategies.Examples of these include the ProShares Ultra Financials ETF and the DirexionDaily Financial Bear 3X Shares ETF.

ETF Expenses

ETFs that follow a strict passive-management strategy typically have very lowmanagement fees—generally less than 30 basis points, or the equivalent of0.3 percent. For ETFs that employ a more active management strategy, expenseswill be higher, often-times around 60 basis points or more. In addition tomanagement fees, shareholders will need to transact these shares on an exchange,and that means trading commissions will be incurred for both purchases andsales. As a result, be mindful and consider the expenses of these funds prior tobuilding a portfolio of them. (Other minor costs associated with ETFs aredetailed in Chapter 5.)

Undivided Interest in ETFs

When a shareholder purchases shares of an ETF, that shareholder owns anundivided and proportional interest in each of the underlying securities. Alloutstanding shareholders do not divvy up each underlying security whereby eachtakes a few shares of one or two stocks. Shareholders are owners of each andevery security held in the ETF. Consider an analogy of three people going intobusiness with one another and buying a car dealership in equal proportion. Eachof the three business owners will own an undivided interest in the tools in theshop, the buildings on the property, and the cars for sale on the lot. Oneperson will not get the tools, another person the building, and the last personthe cars on the lot. Each owns an undivided interest in all of these and theother assets. The same goes for ETF shareholders.

DEFINING ATTRIBUTES

Very specific and definable attributes underlie any investing concept orstrategy. ETFs are no different. As Figure 1-3 shows, ETFs can be easilydefined by a number of different attributes that present them in a unique light.Although we will discuss each one of these attributes in varying degrees in thisbook, this section will present the most essential attributes to showcase theirimportance and compelling benefits. This is a key section for someone who wantsto understand why he or she should invest with ETFs since this is the sectionthat will outline the specific reasons for doing so. Note that there are otherattributes—such as having high intraday liquidity and having no minimuminitial purchase requirements—but these are considered not as important asthe following defining attributes, which are presented in no particular order.

ETFs Are Highly Diversified

Although ETFs look like stocks, they resemble mutual funds in many more ways.ETFs, like mutual funds, have a large number of underlying securities and thusprovide built-in diversification. Diversification is appealing since it helpssafeguard a portfolio against the severe negative impact on returns from any onesecurity. ETFs adhere to the “don’t put all your eggs in one basket”methodology.

ETFs Offer Instant Exposure

Given the substantial number of securities underlying any ETF and the index theETF is attempting to track, ETFs provide shareholders with instant built-inexposure to the asset class or market segment that the ETF tracks. With onequick and easy purchase, a shareholder can begin reaping the benefits and returnpotential of the direct exposure he or she desires.

ETFs Offer Stocklike Tradability

One of the first advantages that casual investors recognize is the stockliketradability offered by ETFs. Although mutual funds are rather constrained by howa shareholder can transact, the same is not true with ETFs. The originalblueprint for ETFs called for a significant emphasis on stocklike tradability inorder to go head-to-head with stocks and attract new AuM and new revenues forboth ETF providers and stock exchanges. Stocklike tradability affordsshareholders the ability to execute any number of discretionary order types longreserved for stock investors. These order types include market orders, limitorders, stop-loss orders, buying on margin, and selling short. Individualbrokerage firms expand on this list with their own proprietary order types.

ETFs Are Low Expense

One of the most important defining attributes underlying ETFs is their favorablecost structure, especially in comparison with mutual funds. ETFs typically havemuch lower expense ratios than comparable mutual funds as well as no up-front orback-end sales loads nor any subsidy trading costs. Not having any subsidycosts, or cost of flow, provides protection to shareholders over and aboveanything available with mutual funds. Low expenses are critical since smallannual differences add up to substantial savings over many years.

ETFs Are Highly Transparent

Transparency of fund holdings and applicable costs is essential to evaluatingand investing in the most appropriate ETF. In addition to mutual funds notproviding a satisfactory level of transparency, their fund-level disclosures arenowhere on the same level as that of ETFs. Shareholders have the ability toinvestigate the holdings of an ETF on a daily basis. Furthermore, they also havethe knowledge of the expenses of the ETF on both the fund level and portfoliolevel and the confidence that knowledge brings. Shareholders demand to get whatthey pay for, and full transparency ensures they achieve that aim.

ETFs Are Tax Efficient

Mutual funds are notorious for passing through capital gains tax liabilitiesthat derive from partial or complete liquidations of underlying securities withembedded unrealized gains. ETF shareholders are not exposed to this irritatingand financially unfavorable drawback due to the highly innovative and beneficialcreation and redemption process. ETF shareholders are confronted with capitalgains tax liabilities when they sell shares of their funds with capital gains,but at least that is a controllable decision left to the discretion of theshareholder and not the portfolio manager working for the mutual fund company.

ETFs Are Fully Invested

Many shareholders may not be aware of the fact that most mutual funds are notfully invested and therefore hold a modest to significant cash position. Thisnot only is necessary to satisfy mutual fund shareholder liquidations, but alsois necessary for tactical asset allocation purposes. Higher-than-expectedinvestment inflows can also lead to abnormally high cash balances. Irrespectiveof the reason why, holding cash on the fund level translates to an unintendedasset mix that overweights fixed income at the expense of equities—thusgiving control over asset allocation policy to an outside party. Since ETFs donot have to satisfy shareholder liquidations and because shareholder cashinflows do not directly flow into ETFs, ETF providers can choose to be fullyinvested without the need to consider the ramifications a mutual fund would facein the same situation. An ETF that is fully invested takes advantage of risingmarkets rather than having cash sit idle and not participate in stock marketrallies.

ETFs Deliver Market Performance

One of the most striking disadvantages of mutual funds and other activelymanaged investments is their historical underperformance against appropriatebenchmarks. Research has clearly demonstrated that most actively managedinvestments do not outperform their relative benchmarks in any given year, andwhen they do outperform, the likelihood of them repeating this achievement ismuch lower. All active managers outperforming their relative benchmark want youand other shareholders to believe they have truly special investing skills andjudgment. From a mathematical perspective, someone is always going tooutperform—and some with consistency year after year. In contrast, ETFs donot worry about generating alpha, or outperformance, since many ETFs focus ongenerating beta, or market returns (see Figure 1-4). This may seemsomewhat boring, but when you consider the higher costs and less favorable taxefficiency that you get with mutual funds, then accepting market performanceisn’t so bad after all.

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(Continues…)Excerpted from All About EXCHANGE-TRADED FUNDS by SCOTT PAUL FRUSH. Copyright © 2012 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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