Expert Series: Myths & Realities of ETFs. Sponsored by:

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1 Expert Series: Myths & Realities of ETFs Sponsored by:

2 Speakers: Matt Hougan President, ETF Analytics Global Head of Editorial IndexUniverse Dave Nadig Director of Research IndexUniverse Gus Sauter Chief Investment Officer Vanguard

3

4 Meanwhile In The Senate:

5 Growth Of ETFs 1458 ETFs 111 new in in Registration 1500 # of Products

6 Funds ETFs ($33,251) $119, Flows Millions Source: Morningstar, IndexUniverse

7 Funds ETFs ($237,161) $122, Flows Millions Source: Morningstar, IndexUniverse

8 Funds ETFs ($953) $104, Flows Millions Source: Morningstar

9 Trading Volume: 40% % of Total Market (incl. OTC/BB) 30% 20% 10% 0% Mar-11 % of Cons Tape % of Value Traded Mar-12

10 Is There Any Truth In This?

11 TVIX: A Cautionary Tale 20 11:10amEST: TVIX premium reaches almost 100% Credit Suisse halted creations on the VelocityShares Daily 2X VIX Short ETN, TVIX February 22, 2012 ETN placed on threshold list Price 7:42pmEST: Credit Suisse issues press release announcing re-opening of the ETN NAV March 20, 2012 March 22, 2012

12 Can You Believe It? 3.50% Absolute Return Fees 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% CSLS CPI CSMA RRF ICI LSC DBV MNA QAI MCRO PTO QLT BTAL NOMO CHEP MOM SIZ BTAH GTAA HDG RALS WDTI ALT CSMN MATH DENT AGLS

13 Can You Believe It? 3.50% Absolute Return Fees 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% CSLS CPI CSMA RRF ICI LSC DBV MNA QAI MCRO PTO QLT BTAL NOMO CHEP MOM SIZ BTAH GTAA HDG RALS WDTI ALT CSMN MATH DENT AGLS

14 1.00% REIT Expense Ratio & Tracking Difference 0.80% 0.60% 0.40% 0.20% 0.00% -0.20% REZ FNIO FTY RTL IYR ICF RWR VNQ Expense Ratio Annual Tracking Difference

15 ER & Tracking Difference & Spreads 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% -0.20% REZ FNIO FTY RTL IYR ICF RWR VNQ Expense Ratio Annual Tracking Difference Spread

16 Total Cost For Annual Round Trip 1.00% 0.90% 0.80% 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% REZ FNIO FTY RTL IYR ICF RWR VNQ Total Cost Expense Ratio

17 Special Situation: Geared ETFs 90% 70% 50% Total Return 30% 10% -10% -30% -50% -70% April-11 March-12 FAS XLF FAZ

18 Daily Resets: Not Tracking Error Day 1: Index Level: % ETF Level: 100 Index up 10% Day 2: Index Level: % ETF Level: 80 Index down 10% Day 3: Index Level: % ETF Level: 96

19 Special Situation: Commodoties 5% 0% -5% -10% Total Return -15% -20% -25% -30% -35% -40% -45% December-11 January-12 February-12 March-12 April-12 UNG UNL Natural Gas Spot

20 Most ETF Assets Are Simple Beta 1 Equity and Fixed Income 87% Everything Else 13%

21 SPY Since Inception 400% 350% 300% Total Return 250% 200% 150% 100% 50% 0% -50% 29/01/ /05/2012 S&P 500 SPY

22 Are ETFs Broken? No: These are sophisticated instruments You MUST be aware of what you re buying Sophisticated ETFs need GATING

23 Myths & Realities of ETFs IndexUniverse May 2012 For INVESTMENT Institutional PROFESSIONAL Investor Use Only. USE Not ONLY. For NOT Public FOR Distribution. PUBLIC DISTRIBUTION.

24 ETF assets and product growth ETF assets (billions) Number of ETF products Sources: Bloomberg and Vanguard analysis, as of December 31, > 24 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

25 Spikes in VIX have coincided with macro shocks Financial Crisis Greek / VIX volatility index Russian Debt Asian Contagion Internet Bubble Flash Crash U.S. Debt Source: Chicago Board Options Exchange via Bloomberg. Data shown as of January 31, > 25 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

26 Volatility of balanced portfolio correlated with volatility of economic conditions Notes: Volatility in economic conditions is defined here as the rolling standard deviation over the past 36 months in the Federal Reserve Bank of Philadelphia s Aruoba-Diebold-Scotti Business Conditions Index, which is designed to track real business conditions at high frequency. Its underlying (seasonally adjusted) economic indicators blend high- and low-frequency information and stock and flow data. Financial market volatility is defined here as the rolling standard deviation over the past 36 months in the total returns of a hypothetical 50% U.S. stock/50% U.S. bond portfolio. For U.S. bond market returns, we use the Citigroup High Grade Index from 1969 to 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 to 1975, and the Barclays Capital U.S. Aggregate Bond Index thereafter. For U.S. stock market returns, we use the S&P 500 Index from 1969 to 1974; the Dow Jones Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. Data shown are through September 30, Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: Barclays Capital, Thomson Reuters Datastream, and Vanguard calculations using data from the Federal Reserve Bank of Philadelphia and index returns. > 26 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

27 US volatility matches German volatility Source: Chicago Board Options Exchange, Deutsche Boerse via Bloomberg. Data shown as of October 31, > 27 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

28 No correlation between ETF trading volumes and market prices ETF Market Share 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% S&P 500 Price Changes 0% 0.0% Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 ETF Market Share (30-day average) S&P 500 Price Changes (30-day average) Source: Vanguard calculations, using data from Thomson Reuters Datastream and ArcaVision. Data shown as of April 30, > 28 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

29 Pair wise correlation is a function of volatility and dispersion Source: Bruno Solnik, Professor of Finance, Hong Kong University of Science and Technology, and Distinguished Emeritus Professor, HEC-Paris. > 29 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

30 Correlation changes with dispersion and volatility Source: Bruno Solnik, Professor of Finance, Hong Kong University of Science and Technology, and Distinguished Emeritus Professor, HEC-Paris. > 30 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

31 Dispersion is in line with long term norm 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% % 80% 70% 60% 50% 40% 30% 20% 10% 0% 3-Month Returns Dispersion: Russell 1000 Index constituents 6-Month Returns Dispersion: Russell 1000 Index constituents 12-Month Returns Dispersion: Russell 1000 Index Constituents Source: Vanguard calculations. Dispersion of returns is measured using cross-sectional standard deviation, which captures the variation in returns among the stocks in the Russell 1000 for a given period. The results are Winsorized, meaning that the impact of outlying 2% of results is minimized. Data shown as of April 30, > 31 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

32 Correlation between stocks linked to market volatility 100% 70% 90% 60% 80% Pairwise Correlation 70% 60% 50% 40% 50% 40% 30% Index Volatility 30% 20% 20% 10% 10% 0% 0% Pairwise Correlations: Russell 1000 Index constituents Index Volatility: Russell 1000 Index Source: Vanguard calculations; Pairwise correlations and index volatility are based on daily returns of prior six months (126 days). Data shown as of May 1, > 32 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

33 Reduction in IPOs Number of IPOs with offer price $ Sarbanes Bear markets Source: Jay R. Ritter, Cordell Professor of Finance, University of Florida; Vanguard. Data as of December 31, > 33 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

34 Disclosures All investments are subject to risk, which may result in the loss of principal. Investments in bond funds are subject to interest rate, credit, and inflation risk. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss in a declining market. For more information on Vanguard funds and Vanguard ETF Shares, visit advisors.vanguard.com or call to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. U.S. Pat. No. 6,879,964 B2; 7,337,138; 7,720,749; 7,925,573; 8,090,646. > 34 INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

35 Speakers: Matt Hougan President, ETF Analytics Global Head of Editorial IndexUniverse Dave Nadig Director of Research IndexUniverse Gus Sauter Chief Investment Officer Vanguard

36 Thank You. Questions?