The Nuts and Bolts of ETFs

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1 The Nuts and Bolts of ETFs The Institute for Quantitative Research in Finance April 5, 2005 Gus Sauter, CIO and Managing Director The Vanguard Group For 2005 Internal the Vanguard use only Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

2 The Nuts and Bolts of ETFs ETF Structure Mechanics of the Creation Process Advantages/Characteristics of ETFs Users and Uses of ETFs Miscellany > 2

3 ETF Structure [ETFs] Are Better Than Index Mutual Funds Forbes Magazine August 21, 2000 > 3

4 ETF Structure Investment Company Act of 1940 Three Types Of Registered Investment Companies (RICs) Management Investment Companies Unit Investment Trusts (UITs) SPDRs MidCap SPDRs QQQs Diamonds Face Amount Certificate Company Open-End Mutual Funds All Other ETFs Closed-End > 4

5 ETF Structure Conventional Fund Structure Conventional Shares Investor Index Mutual Fund > 5

6 ETF Structure ETF Structure Investor A Specialist/AP Index Mutual Fund Investor B > 6

7 ETF Structure Exemptive Relief Needed To Create an ETF 2(a)(32) Mutual fund securities must be redeemable 22(d) and 22(c)-1 Every investment company security transaction must receive the NAV next determined 24(d) Prospectus delivery requirement for every secondary market trade 17(a)(1) and 17(a)(2) > 7 Investors who own more than 5% of a RIC are affiliates and can not invest or redeem inkind

8 ETF Structure ETFs are a Great New Product > 8

9 ETF Structure ETFs Are Another Way To Distribute An Old Product If an investor does not want to invest in the underlying investment, then they do not want an ETF. > 9

10 ETF Structure To date ETFs have focused on index funds, but they might develop into a distribution channel for other investments Commodities Gold (GLD) Active Mutual Funds Currencies Derivatives > 10

11 The Nuts and Bolts of ETFs ETF Structure Mechanics of the Creation Process > 11

12 Mechanics of the Creation Process Hurdles To Creating An ETF Can an investment pool be created? Does the investment allow for transparency of the holdings? Is a creation/redemption unit feasible? > 12

13 Mechanics of the Creation Process Information Needed To Create An ETF Delivery Basket Intraday Indicative Value (IIV) Hedging Basket Also Need Real-Time Index Level > 13

14 Mechanics of the Creation Process Creation Process ETF sponsor transmits Portfolio Creation File (PCF) to Custodian on t-1 2,583 shares XOM 4,200 shares GE 4,299 shares MSFT 2,045 shares C 1,688 shares WMT Residual Cash > 14

15 Mechanics of the Creation Process Creation Process ETF sponsor transmits Portfolio Creation File (PCF) to Custodian on t-1 Custodian processes PCF and sends it to NSCC on t-1 NSCC sends file to SIAC (for pricing service) and Approved Participants (AP) on t-1 Approved participant purchases securities in PCF and Notifies sponsor of intention to create before 4 p.m. eastern standard time on t > 15

16 Mechanics of the Creation Process Source of Information Needed To Create An ETF Indexed Active Delivery Basket PCF ETF Intraday Indicative Value (IIV) PCF PCF Hedging Basket PCF PCF Real-Time Index Level Index Provider N/A? > 16

17 The Nuts and Bolts of ETFs ETF Structure Mechanics of the Creation Process Advantages/Characteristics of ETFs > 17

18 Characteristics of Indexed ETFs Historical long-term outperformance Low cost Broad diversification relative to investment style Relative tax efficiency Flexible trading Real time Short sale Purchase on margin (if qualified) > 18

19 Characteristics of Indexed ETFs Are ETFs Low Cost Index Funds? Yes, But There are 106 ETFs with conventional alternatives 64% compete against lower cost retail or high net worth shares 100% compete against lower cost institutional shares > 19 Source: Strategic Insight and The Vanguard Group as of 2/15/2005

20 Characteristics of Indexed ETFs Source Of Low Cost Inherent to indexed approach Shareholder recordkeeping cost borne by brokerage community > 20

21 Characteristics of Indexed ETFs Shareholder Recordkeeping by Fund Type Conventional Fund Millions of Shareholders ETF DTC Street Millions of Name Shareholders > 21

22 Characteristics of Indexed ETFs If ETFs become dominant distribution channel for long-term investments, can they maintain low cost? Will the brokerage community continue to eat the cost of shareholder recordkeeping, or will brokers charge asset based fees? > 22

23 Characteristics of Indexed ETFs Source of Relative Tax Efficiency Inherent to low turnover index strategy Tax loophole for RICs for in-kind distributions > 23

24 Characteristics of Indexed ETFs Arbitrage Ensures ETFs Trade Near Fair Value ETFs are open to creation/redemption daily ETF trading rich AP sells ETF at premium and hedges position by purchasing stocks in market AP submits stocks for creation unit at fair value at end of day > 24

25 Characteristics of Indexed ETFs Comparison of ETFs And Conventional Classes Of Index Funds ETF Conventional Expense Ratio X X Transaction Costs X Relative Tax Efficiency X X Trading Flexibility Number of Products X X Buy with Leverage* X X * If qualified. > 25

26 The Nuts and Bolts of ETFs ETF Structure Mechanics of the Creation Process Advantages/Characteristics of ETFs Users and Uses of ETFs > 26

27 Evolution of ETF Usage Traders Hedgers Speculators Arbitrageurs Institutions Hedge Funds Corporations Portfolio Managers Intermediaries Broker Dealers RIAs Retail Individuals > 27

28 Users and Uses of ETFs Traders Futures Substitute Day Trading Market Timing Arbitrage Hedging > 28

29 Users and Uses of ETFs Institutions Long-Term Investment Futures Substitute Tactical Asset allocation Cash equitization Transition management Tax management Hedging Duration/Credit Fine Tuning > 29

30 Users and Uses of ETFs Intermediary Appeal Diversification Access Convenience/Flexibility Portability Anonymity > 30

31 Users and Uses of ETFs Intermediaries Asset allocation Strategic Long-Term Investment Portfolio Completion Tactical Sector Rotation Cash equitization Tax management > 31

32 Users and Uses of ETFs Retail Uses Long-Term Investment Broad Diversification Portfolio Completion Tactical Asset allocation Tax management > 32

33 The Nuts and Bolts of ETFs ETF Structure Mechanics of the Creation Process Advantages/Characteristics of ETFs Users and Uses of ETFs Miscellany > 33

34 Miscellany Hurdles For Active ETFs Preserving the integrity of the fund Must provide a certain degree of transparency Capacity constraints (fund closure) Arbitrage process breaks down ETFs can trade at a premium (but not at a discount) Clone versus exchange traded share The SEC > 34

35 Miscellany Out-Market Making A Market Maker Sponsor generates incorrect PCF Intraday indicative value is incorrect If market maker doesn t recognize mistake, more astute trader can arbitrage the quotes > 35

36 Miscellany The Future For ETFs Consolidation of look-alike funds? More niche products? Active ETFs? A sea change in the way funds are distributed? Pricing? > 36

37 > 37

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