A Look at Exchange Traded Funds September 16, 2010

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1 A Look at Exchange Traded Funds September 16, 2010 Exchange traded funds, or ETFs, are one of the fastest growing products in the investment industry. Used by both professional and individual investors, ETFs are rapidly taking market share from traditional open-end mutual funds. At Pathlight, we introduced our all-etf Global Macro portfolio in July Gaining confidence and experience using ETFs, we are using them on occasion in the Quality Growth portfolio as an effective way to invest in a specific sector or geographic region. Due to the growing use and popularity of ETFs, we are providing the following education on the structure, dynamics, use, benefits, and risks of exchange traded funds. History The growth of exchange traded funds has been nothing short of spectacular. Although first introduced in 1989, it was not until 1993 that the first ETF took hold. This fund, the SPDR Fund (symbol SPY), tracks the performance of the S&P 500 and is still active today with more than $70 billion in assets. The ETF industry has grown impressively and currently has combined assets exceeding $600 billion. Many analysts expect that ETFs will continue to grow in popularity and assets will surpass $1 trillion in the coming years. Structure There are ETFs for virtually any investment. U.S. and non-u.s. stocks, bonds (government, corporate, municipal), specific sectors (energy, healthcare), industries (clean energy, semiconductors), precious metals, and foreign currencies can all be invested in through exchange traded funds. Most funds are comprised of individual securities that seek to provide exposure to its defined investment category, much like a mutual fund. For example, the I-Shares Global Healthcare Sector fund (IXJ) holds 82 stocks of global healthcare companies including such well known companies as Johnson & Johnson, Novartis, Pfizer, Merck, and Glaxo Smithkline. Since most ETFs are index funds, this basket of 82 stocks is not actively managed and will only change when there is a change to the global healthcare index. Creation and Redemption The manner in which ETFs are created and redeemed is important to understand, for it is this process that provides many of the benefits that make ETFs attractive to investors. There are three major players in the creation-redemption process: (1) the ETF sponsor (2) an index creator and (3) an Authorized Participant. As a hypothetical illustration to show how the parties work together, let us assume Vanguard, one of the leading ETF sponsors, wants to create a new ETF which will allow clients to invest in the restaurant industry, symbol (REST).

2 Vanguard will hire an index creator (Dow Jones, S&P, MSCI, or Russell) to develop an index representative of the industry. This index will likely include the stocks of restaurants, restaurant supply companies, food distributors, and food processing firms. It is the responsibility of the index creator to maintain the index and make changes as appropriate. A common change would be replacing a company that was acquired. Most indexes do not change more often than quarterly and usually changes are minor. Now that there is a sponsor and an index, Vanguard must find an Authorized Participant (APs). APs (usually large investment banks) are chosen by the sponsor and responsible for maintaining liquidity in the ETF. For simplistic purposes the process works like this: an order is placed to buy 50,000 shares of REST. The AP purchases the proportional shares of each stock in the index. The shares of stock are then delivered to the ETF sponsor in exchange for 50,000 shares of REST which are then delivered to the investor. This process allows for seamless liquidity in the marketplace as new ETF shares can be created as needed. ETFs vs. Mutual Funds Below is a chart highlighting some major differences between ETFs and Mutual Funds: Trading and Pricing Costs Transparency Tax Efficiency ETFs Traded on an exchange, priced and traded frequently Lower operating expenses. Often 1/4-1/3 of mutual fund expense ratios Underlying securities published on a daily basis Creation-redemption process allows for greater tax efficiency. Often only responsible for your gain/loss and income distribution Mutual Funds Bought and sold through fund company. Priced at net asset value at day's end Higher operating costs due to active management Underlying securities updated quarterly. Intraquarter changes not made public Gain/loss of fund distributed to all shareholders, regardless of holding period. No control over cap gain distribution

3 Pricing and Liquidity Since ETFs are traded on an exchange, just like stocks, they are constantly priced and allow for intraday trading. They can be bought and sold with limit or stop orders ensuring one buys or sells at a price to their liking. Conversely, open-end mutual funds are not priced intraday and can only be bought and sold at market close directly through the mutual fund company. Costs Since most ETFs are linked to an index, they are considered passive investments. This means there is not a portfolio manager actively managing the assets on a daily basis. Instead changes are made only if there are changes to the underlying index. For this reason the costs associated with operating an ETF are much lower than those of a mutual fund. These savings are passed along to the investor through lower operating expenses. A typical range of operating costs in equity ETFs is 0.25%-0.50%. This compares favorably to an equity mutual fund where a 1.0%- 1.50% expense ratio is common. Transparency Unlike many investment funds that only disclose their holdings quarterly, most ETFs publish their exact holdings on a daily basis. This transparency makes it easier to know what each fund owns allowing for better risk management. At Pathlight, we believe the transparency of ETFs is of great benefit because we can manage investment exposure on a regular basis. Tax Efficiency ETFs have shown to be more tax efficient than mutual funds. Largely this is related to the unique creation-redemption process and ease of liquidity. When shares are redeemed, the ETF sponsor delivers the underlying securities back to the authorized participant in-kind. This allows for the delivery of shares with the highest cost basis. If these shares are then sold, it minimizes the impact of capital gains to the fund. For this reason, it is common for ETFs to have no capital gains tax distribution to fund holders. Risks We highlight the following four risks with ETF ownership: (1) Tracking error (2) Leveraged ETFs (3) Fund closure and (4) ETNs. Since ETFs are designed to track a specific index, the difference in performance between the ETF and the index is known as tracking error. An effective ETF should perform close to its index after fees. If it does not there are issues inherent to the fund that must be investigated.

4 Leveraged ETFs have gained popularity as a way to maximize investment returns. These ETFs take in a dollar and invest two or three dollars. This leverage can provide a benefit in rising markets, but be disastrous in falling markets. Many of the leveraged ETFs use derivatives rather than individual securities, further complicating these products. The growth of ETFs is bringing with it numerous start-up funds, often with niche investment indexes. Many of these new funds will not attract enough assets to stay in business and therefore we recommend using larger funds. Our industry contacts suggest that an ETF needs a minimum of $50 million to stay active. If an ETF is unable to attract adequate assets it will close and return funds to shareholders. ETNs are often confused with ETFs. ETNs are exchanged traded notes that are created by investment banks. These notes do not own underlying securities and represent an unsecured obligation of the creator. In owning an ETN, the investor is assuming the credit risk of the issuing bank. How Pathlight uses ETFs In our Quality Growth portfolio we have used ETFs to gain exposure to sectors or regions that we believe hold attractive investment opportunity. Specifically, we own a technology and telecom ETF as a way to gain exposure to these sectors. The reason we believe an ETF is better than owning individual tech or telecom stocks is the frequency of change in industry leadership and the importance of having exposure to new and emerging companies. Pathlight s Quality Growth strategy, mandating that all holdings must pay a cash dividend, eliminates some high growth companies from consideration. In the case of technology, an ETF allows us to invest in market leaders as well as smaller, innovative companies and still receive a cash dividend. We would not be able to adequately maintain our desired technology exposure without an ETF. We have also used an ETF to invest in emerging markets. Similarly to the tech and telecom ETF, it is difficult to find individual securities that can act as a proxy for an entire country or region s economy. In these fast growing regions, it is important to have exposure to a broad range of industries and the ETF is an efficient way to gain multi-country, multi-industry exposure. Pathlight also manages an all-etf portfolio strategy, Global Macro. Although it is a stand-alone portfolio, it also complements the Quality Growth strategy. In the Global Macro portfolio, ETFs are managed to achieve our desired investment exposure to numerous asset classes, sectors, geographies, and industries. Since they are traded on an exchange and completely transparent, we have the ability to truly manage the portfolio. For this reason, the Global Macro portfolio has become our preferred strategy versus outsourcing certain investments to mutual funds. When appropriate we recommend 10-15% of clients investment assets be allocated to the Global Macro strategy.

5 There is little doubt that exchange traded funds will continue to evolve and play an increasing role in the investment strategies of both institutional and individual investors. In the future, ETFs will likely be an option in company 401K and other pension plans. Like any investment product it is important to understand the inherent risks and research each investment choice, or hire a professional that can manage the investments in a manner suitable to ones objectives, goals and risk tolerance. The information contained herein should not be construed as personalized investment advice, and should not be considered as a solicitation to buy or sell any security or engage in a particular investment strategy. Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this update will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Pathlight Investors is an SEC registered investment adviser with its principal place of business in Arizona. Pathlight Investors and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which Pathlight Investors maintains clients. Pathlight Investors may only transact business in those states in which it is noticed filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by Pathlight Investors with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Pathlight Investors, please contact Pathlight Investors or refer to the Investment Adviser Public Disclosure web site ( For additional information about Pathlight Investors, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein