TOOLS FOR EFFICIENTLY MANAGING BETA EXPOSURE: Index Funds, Futures, and Exchange-Traded Funds

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1 WHITE PAPER February 2015 Daniel Wamre, CFA Senior Portfolio Manager Emily Pechacek Investment Specialist TOOLS FOR EFFICIENTLY MANAGING BETA EXPOSURE: Index Funds, Futures, and Exchange-Traded Funds Beta plays an important role in a portfolio s risk and return, and the proper management of this beta will help the portfolio seek to achieve its long-term goals. Index funds, ETFs, and futures all strive to obtain the same return, but different investing situations may suit one vehicle better than another. By understanding the unique costs and characteristics of these tools, investors can more efficiently manage their beta. Parametric 3600 Minnesota Drive Suite 325 Minneapolis, MN T F Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities.

2 Systematic risk drives a portfolio s risk and returns and, thus, properly managing systematic risk is crucial. Index funds 1, Exchange-Traded Funds (ETFs), and futures are all tools that don t require extensive over-the-counter ( OTC ) legal contracts and can add a desired beta to a fund. 2 Some distinguishing factors among these tools are cost, availability, tracking error, and appropriateness for a given investing situation. When implementing a beta product, consider these factors and their impact on the portfolio s performance and management. COST When implementing beta, one of the first factors to consider is cost. Although index funds, ETFs, and futures may all track similar benchmarks, they have different trading costs. Both ETFs and futures are exchange traded, which means trading costs will be based on commission, market impact, and bid/ask spread. As margined instruments, futures have financing costs that are effectively paid when the contracts roll. Financing costs arise from two sources: one, demand for one side of a futures agreement exceeds supply (demand for the other side of the agreement), creating a premium paid by investors taking the popular side to compensate investors taking the unpopular side; two, cost of capital charged by market makers for the ability to purchase a futures position on margin. Index funds and ETFs do not have financing costs, but they do have management fees (also called expense ratios). Figure I below compares futures financing costs to ETFs and index management fees to determine the annual estimated holding costs for each instrument. Figure I: Comparison (in bps) 1 Index funds include mutual funds, commingled accounts, separately managed accounts, and other vehicles. 2 OTC instruments may be appropriate for some investment applications, like receiving total return via swaps, but these instruments are not the focus of this paper. 3 cost includes estimates for commissions, bid/ask spread and market impact to initiate and maintain the position for 1 year. 4 Index Fund/ETF: Fund s annual expense ratio (management fee) excludes potential securities lending income. Futures: 12 month average roll mispricing (financing cost) as of 12/31/2014. Assumes cash collateral earns LIBOR annually. 5 Estimated with dividends reinvested net of withholding taxes. Institutional Index (VINIX) SPDR ETF (SPY) S&P 500 Emini Future Total Developed Market Index (VTMNX) ishares MSCI EAFE ETF (EFA) MSCI EAFE Mini Future Total Source: Parametric, and Bloomberg. Date: January 27, Russell 2000 Index (VRTIX) ishares Russell 2000 ETF (IWM) Russell 2000 Mini Future Total Market Index (VEMIX) ishares MSCI Market ETF (EEM) MSCI Markets Mini Future Total STYLE OR SECTOR INVESTING The ability to invest in more custom strategies, like selecting specific sectors or over/under weighting a particular country, has been increasing as investors seek simple, economical, and efficient ways to diversify their portfolios. The growth has primarily occurred in the ETF and index 2015 Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities. 02

3 fund space, as futures generally cover the major indexes. According to the Investment Company Institute, there were 7,707 different ETFs listed globally with 1,294 ETFs listed in the United States by the end of By comparison, there are around 15 very liquid domestic equity futures that are traded currently. In general, when looking for a style or sector specific investment, ETFs and index funds are often better vehicles to provide the desired. Futures may not be able to efficiently replicate myriad benchmarks, but for the most common beta, futures are generally more liquid than ETFs. As of January 27, 2015, the average, 20 day volume of S&P 500 futures was over $163 billion compared to over $30 billion for the three most popular S&P 500 ETFs (SPY, IVV, and VOO) combined. 7 TRACKING ERROR Index funds, ETFs and futures all seek to mimic the return of the same benchmarks, but often experience slightly different returns. Tracking error is an important risk to consider when implementing a strategy. The broader the index coverage, the more difficult it is for these instruments to successfully replicate the returns of the benchmark. The MSCI EAFE Index is comprised of 910 different holdings from 21 developed countries, and as of January 27, 2015, the ishares ETF replicating the MSCI EAFE Index had 914 holdings. 8 An example of a futures replication of this index consists of an optimized basket of up to seven CFTC approved futures. There is also a single futures contract that trades in the U.S. which replicates the MSCI EAFE Index, but this contract still faces observed tracking error because the contract trades during different hours than the constituents that make up the MSCI EAFE benchmark. For example, the value of the futures contract will have the opportunity to incorporate any news during the U.S. trading day while the majority of the constituent trading markets of the underlying index are already closed. However, the underlying index will often catch up the following day. ETFs and futures price values may deviate from the benchmark for this reason. The result is that traditionally defined tracking error based on closing price may be artificially high. ETFs tracking error is measured in two ways. Market tracking error is based on ETFs market return. Net Asset Value (NAV) tracking error compares the value of the index to the value of the ETFs holdings, which attempts to correct any timing discrepancies. Another way to look at tracking error for futures contracts, which suffer from this timing difference, is to measure the average monthly return difference (as shown in figure II). Any underperformance/outperformance in one period should reverse itself in the next period. Figure II: One Year Tracking Error for Futures and ETFs (January 27, January 27, 2015) Index ETF Symbol Market NAV Future Symbol Tracking Error Average Monthly Return Difference S&P 500 SPY 0.29% 0.04% ES 0.13% -0.02% Russell 2000 IWM 0.62% 0.05% RTA 0.33% 0.04% Investment Company Fact Book Investment Company Institute. May 14, < org/pdf/2014_factbook.pdf> 7 Source: Bloomberg; Date: January 27, Source: Bloomberg, January 27, 2015; MSCI, December 31, MSCI EAFE EFA 4.76% 0.08% MFS 2.54% -0.10% MSCI Markets EEM 6.19% 0.15% MES 3.27% -0.12% Source: Parametric, Bloomberg. Date: January 27, This is not intended to be, and should not be interpreted as, a recommendation or an offer to buy or sell securities. It is not possible to invest directly in an index Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities. 03

4 Tracking error will always be present when trying to replicate a benchmark and is just one factor to consider when choosing among investment vehicles. FLEXIBILITY & LIQUIDITY One of the most distinguishing characteristics among index funds, ETFs, and futures is the ability (or inability) to trade in and out of s intraday. The liquidity of index funds depends on the type of fund. A settlement period where there is no access to the proceeds is common. ETFs provide intra day trading which enables flexibility to add or remove at a specific time of day. When liquidating ETFs, funds generally receive the proceeds in three days, but next day settlement is available for some at possible additional cost. While futures trade all day like ETFs, some futures continue to trade around the clock. Unlike ETFs, futures have same day liquidity. When a futures position is sold, the fund has access to the vast majority of the cash the same day. Futures, therefore, provide the most flexibility and liquidity for plan sponsors. 9 CORE INDEXED HOLDINGS Although index funds had long been the most common choice for long-term investment, in the last five years, ETFs have risen to the front. According to the Investment Company Institute, at the close of 2013, there were $1.7 trillion in index mutual funds. This compares to $2.3 trillion in worldwide ETF assets at the end of Index fund and ETF costs have been driven down by the decrease in active management and competition among providers. Both vehicles provide to many betas. A portfolio looking for a specific style investment can find multiple vendors offering low-cost access to the specific sector of the market the portfolio needs. Index funds do enjoy a cost advantage for long-term holding; they tend to have lower management fees and no trading costs. The relative cost of a futures position will depend on the index and its current financing costs. Time frame is a major factor when deciding which investment vehicle to choose. A longer time frame generally favors the index funds. As time frames become shorter, futures and ETFs may be the preferred vehicles because of their tradability. ETFs may be preferable for fully funded positions. However, futures may be the best vehicle for partially funded needs, and have many potential applications in a portfolio. APPLICATIONS FOR UNFUNDED BETA POSITIONS 9 See appendix for side-by-side comparison of index funds, ETFs, and futures contracts Investment Company Fact Book Investment Company Institute. May 14, < org/pdf/2014_factbook.pdf> CASH SECURITIZATION: STRIVING TO MAINTAIN A FULLY INVESTED STATUS Portfolio sponsors desire to hold a comfortable level of on-demand cash to fulfill known (e.g. benefit payments) and less predictable (e.g. private equity calls) cash needs. Investors must balance operational efficiency (higher balances) versus the expected and meaningful expected opportunity cost. A beta management program can nearly eliminate this conflict by neutralizing the expected opportunity costs of holding fund level cash balances. Access to capital, liquidity and flexibility can be the main concerns when securitizing cash; therefore, index funds and ETFs may not be not viable options. ETFs and index funds have settlement constraints (typically 1-3 days or more), that may make using them for liquidity problematic. Additionally, there may not be a way to securitize residual cash focused in other portfolios due to the need to fully fund a position. Therefore, the best option for reducing the cash drag on performance may be securitizing cash with futures. Futures allow for same day liquidity, so cash can be securitized up to the moment it is either invested with a manager or transferred out of the account. All residual portfolio cash can be synthetically invested, greatly reducing cash drag. There is no disruption to the underlying managers since the futures are held in a separate account. Futures can track the most common 2015 Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities. 04

5 benchmarks via a single contract or be combined to replicate other benchmarks. PORTFOLIO REBALANCING: KEEPING ASSET ALLOCATIONS CLOSE TO TARGET Both ETFs and futures can help maintain proper levels of to the different asset classes within the guidelines of the fund. The key characteristic futures enjoy over ETFs is the ease of removing market via short beta positions. Without moving physical securities, futures can short out the overweight asset classes while simultaneously providing long to the underweight asset classes. By entering into equal amounts of long and short, no leverage is employed. However, the small number of betas available limit the ability to rebalance to alternative asset benchmarks. GAP EXPOSURE COVERAGE: MAINTAINING A FULLY INVESTED PORTFOLIO DURING TRANSITIONS Transitions may arise in a portfolio because of policy target adjustments, manager terminations, reallocation of assets among existing managers, and other similar changes. Index funds, ETFs or futures can all be used to bridge the gap. Index funds, though, may only be effective when the net asset value (NAV) date of the liquidating fund can be matched up with the NAV date of the new fund. Both ETFs and index funds may also be limited by the need to fully fund positions. Futures, on the other hand, can be used to facilitate a smooth transition in most circumstances. Futures can help in bridging gaps in when physical securities in one asset class are reduced. As the managers sell in the overweight asset class, futures can be purchased in the underweight asset class. Once the managers in the underweight asset class receive the funds and begin investing, the futures are removed. When alternative asset managers are terminated, there can be a long delay before funds are received which may result in an opportunity cost or cash drag. Since futures are marginable, they can be used to gain market on the funds being held back by the alternative investment manager. 11 ETFs and index funds are not nearly as capital efficient from a margin perspective, and therefore often times will not be able to bridge such an gap. Optimal Investment Vehicle for Given Objective Core Benchmark Exposure Cash Securitization Portfolio Rebalancing Transition Management Index Funds Futures Futures Futures/ETFs Low cost Transparent Many beta choices Marginability No manager impact Same day liquidity Ability to go long/ short Quick/efficient/cheap ETFs provide sector/ style Futures allow for management flexibility & efficiency 11 Futures will not be able to replicate alternative asset classes. CONCLUSION Beta plays an important role in a portfolio s risk and return, and the proper management of this beta will help the fund seek to achieve its long-term goals. Index funds, ETFs, and futures all strive to obtain the same return, but different investing situations may suit one vehicle better than another. When a portfolio is looking for a long-term liquid beta position, index funds may be the best fit. ETFs may also represent a good choice for certain long-term or intermediateterm liquid beta. Futures contracts may provide the greatest flexibility to address shortterm risk management and performance enhancement goals such as cash securitization, portfolio rebalancing, and transition management. By understanding the unique costs and characteristics of these tools, investors can more efficiently manage their beta Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities. 05

6 Parametric White Paper / February 2015 Tools for Efficiently Managing Beta Exposure Appendix: Creating Market Exposure Vehicle Strategy Advantages Disadvantages/Risks (Estimated ) Index Funds ETFs (Exchange Traded Funds) Futures Purchase fund or passively managed diversified portfolio Invest cash via ETFs (securities certificates that state legal right of ownership over part of a basket of securities) Create market through the purchase of futures contracts; invest remaining available cash in money market instruments Minimal tracking error Low cost Style/sector specific Transparent Liquid All day trading Can trade in relatively small size Tax efficiency Low cost Transparent On demand access to cash Ability to adjust around the clock Do not have to fully fund Require capital to fund Potential trading costs or restrictions on redemptions Settlement related cash access delays Require capital to fund Settlement related cash access delays Brokerage fees Management fees Do not always trade at net asset value (NAV) Modest tracking error in most cases Collateral return slippage (e.g. money market fees) Financing costs and quarterly rolls Documentation Low to medium depending on market Low to high depending on market Low to medium depending on market About Parametric Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Para metric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT (home to Parametric subsidiary Parametric Risk Advisors LLC, an SEC-registered investment adviser). Disclosure Parametric Portfolio Associates LLC ( Parametric ), headquartered in Seattle, Washington, is registered as an investment adviser under the United States Securities and Exchange Commission Investment Advisers Act of This information is intended solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Information and data may have originated from various sources including, but not limited to, Bloomberg, MSCI/Barra, FactSet, and/or other systems and programs. Parametric makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party. Derivatives such as futures, swaps, and other investment strategies have certain disadvantages and risks. Futures require the posting of initial and variation margin. Therefore, a portion of risk capital must be preserved for this purpose rather than being allocated to a manager. Liquid futures may not exist for published benchmarks which may result in tracking error. Also, some intra-period mispricing may occur. Standard & Poor s and S&P are registered trademarks of S&P Dow Jones Indices LLC ( S&P ), a subsidiary of The McGraw-Hill Companies, Inc. This strategy is not sponsored or endorsed by S&P, and S&P makes no representation regarding the content of this material. MSCI and MSCI Index names are service marks of MSCI Inc. ( MSCI ) or its affiliates. The strategy is not sponsored, guaranteed or endorsed by MSCI or its affiliates. MSCI makes not warranty or bears any liability as to the results to be obtained by any person or any entity from the use of any such MSCI Index or any data included therein. Russell and all Russell index names are registered trademarks or service marks of Russell Investment Group and Frank Russell Company ( Russell ). This strategy is not sponsored or endorsed by Russell, and Russell makes no representation regarding the content of this material. Please refer to the specific service provider s website for complete details on all indices. Indexes are unmanaged and may not be invested in directly. Parametric is headquartered at th Avenue, Suite 3100, Seattle, WA Parametric s Minneapolis investment center is located at 3600 Minnesota Drive, Suite 325, Minneapolis, MN For more information regarding Parametric and its investment strategies, or to request a copy of Parametric s Form ADV, please contact us at (Seattle) or (Minneapolis), or visit our website, Parametric Portfolio Associates LLC. For Informational Purposes Only. Not an Offer to Buy or Sell Securities. 06