5o Congresso Inernacional de Mercado Financiero e de Capiais, Campos de Jordao, Augus 2011 The ETF Revoluion: Inernaional and Brazilian Perspecives Marco Avellaneda New York Universiy Finance Conceps LLC
Exchange-raded funds Similar o muual funds, wih addiional flexibiliy: -- shares rade on exchanges -- rading is similar o socks (bid/ask, shor, margin) -- opions on ETFs available -- began as as index rackers -- acively managed and synheic ETFs since mid 2000 s Arbirage: auhorized paricipans can creae or redeem ETFs in ``creaion unis -- creaion unis: 25K o 100K shares -- APs ofen ac as marke makers, providing liquidiy
FUND AUTHORIZED PARTICIPANTS Basic ETF Srucure Primary marke Secondary marke SELLERS Creaion* ETF Cash Redempion** Arbirage, Mk-making EXCHANGE ETF Cash BUYERS * Give baske of shares, receive ETFs ** Receive baske of shares, give ETFs
Brief Hisory Milesones: 1993: firs US ETF 1998: firs European ETFs 2006-2008: ETPs, firs acively managed ETFs Hisory: 1989: Index Paricipaion Shares, sopped by Chicago Mercanile Exchange (IP prob.) 1993: SPY Tracking S&P 500 (a.k.a. Spiders or SPDRS, issuer: Sae Sree) 1996: BGI creaes WEBS (World Equiy Benchmark Shares), laer called ishares (e.g.: EWZ: MSCI Brazil Index Fund) 1998: Secor SPDRS rack 9 secors of he S&P 500 2008: 680 ETFs in US wih 610B in asses, increase of 125B in 12 monhs January 2010: US ETF marke breaks he 1,000 billion mark in AUM ETPs= ETFs covering, fixed-income, FX, Commodiies, Volailiy
ETF AUM Growh in Differen Markes
Global ETFs by Exposure Does no include European synheics
March 2011, 60 Larges US-based ETFs by AUM (in $BB; highlighed: ishares MSCI Brazil) Rank Ticker Descripion Marke Cap 1 SPY SPDR S&P 500 90.21 2 GLD SPDR Gold Shares 56.03 3 VWO Vanguard MSCI Emerging Markes 43.73 4 EFA ishares MSCI EAFE Index 38.15 5 EEM ishares MSCI Emerging Markes 36.24 6 IVV ishares S&P 500 Index 26.95 7 QQQQ PowerShares QQQ 24.21 8 TIP ishares Barclays TIPS Bond 19.89 9 VTI Vanguard Toal Sock Marke 18.98 10 IWM ishares Russell 2000 Index 15.39 11 IWF ishares Russell 1000 Growh 13.29 12 LQD ishares iboxx Invesmen Grade 12.98 13 EWZ ishares MSCI Brazil Index 12.54 14 SLV ishares Silver Trus 12.38 15 IWD ishares Russell 1000 Value 11.80 16 VEA Vanguard MSCI EAFE ETF 11.34 17 MDY SPDR S&P MidCap 400 11.11 18 AGG ishares Barclays Aggregae Bond 11.06 19 BSV Vanguard Shor-Term Bond ETF 10.72 20 IJH ishares S&P MidCap 400 10.72 21 XLE Energy Selec Secor SPDR 10.38 22 BND Vanguard Toal Bond Marke 9.25 23 DIA SPDR Dow Jones Indusrial 9.21 24 VNQ Vanguard REIT ETF 8.58 25 HYG ishares iboxx High Yield 8.32 26 XLF Financial Selec Secor SPDR 8.05 27 SHY ishares Barclays 1 3 7.93 28 CSJ ishares Barclays 40546 Year 7.82 29 IJR ishares S&P SmallCap 600 7.38 30 FXI ishares FTSE China 25 7.25 Rank Ticker Descripion Marke Cap 31 VEU Vanguard FTSE All-World ex-us 7.21 32 JNK SPDR Barclays Capial High 7.06 33 IWB ishares Russell 1000 Index 7.00 34 PFF ishares S P U 6.79 35 XLK Technology Selec Secor SPDR 6.79 36 EWJ ishares MSCI Japan Index 6.47 37 IWR ishares Russell Midcap Index 6.37 38 VIG Vanguard Dividend Appreciaion ETF 6.10 39 IVW ishares S&P 500 Growh 6.05 40 DVY ishares Dow Jones Selec 5.99 41 EWC ishares MSCI Canada 5.97 42 TBT Proshares UlraShor 20+sy 5.68 43 IAU ishares Gold Trus 5.67 44 VUG Vanguard Growh ETF 5.42 45 SDY SPDR S&P Dividend 5.37 46 VTV Vanguard Value ETF 4.84 47 VB Vanguard Small-Cap ETF 4.64 48 VV Vanguard Large-Cap ETF 4.61 49 IWN ishares Russell 2000 4.56 50 IVE ishares S&P 500 4.51 51 EWY ishares MSCI Souh Korea 4.38 52 SHV ishares Barclays Shor TSY 4.16 53 IWO ishares Russell 2000 4.02 54 XLU Uiliies Selec Secor 3.91 55 EPP ishares MSCI Pacific ex-jp 3.80 56 XLI Indusrial Selec Secor 3.69 57 VO Vanguard Mid-Cap ETF 3.66 58 DBA DB Agriculure Fund 3.59 59 IWS ishares Russell Midcap 3.42 60 IWV ishares Russell 3000 3.42
60 Larges US ETFs by AUM (in $BB; highlighed: commodiies) Rank Ticker Descripion Marke Cap 1 SPY SPDR S&P 500 90.21 2 GLD SPDR Gold Shares 56.03 3 VWO Vanguard MSCI Emerging Markes 43.73 4 EFA ishares MSCI EAFE Index 38.15 5 EEM ishares MSCI Emerging Markes 36.24 6 IVV ishares S&P 500 Index 26.95 7 QQQQ PowerShares QQQ 24.21 8 TIP ishares Barclays TIPS Bond 19.89 9 VTI Vanguard Toal Sock Marke 18.98 10 IWM ishares Russell 2000 Index 15.39 11 IWF ishares Russell 1000 Growh 13.29 12 LQD ishares iboxx Invesmen Grade 12.98 13 EWZ ishares MSCI Brazil Index 12.54 14 SLV ishares Silver Trus 12.38 15 IWD ishares Russell 1000 Value 11.80 16 VEA Vanguard MSCI EAFE ETF 11.34 17 MDY SPDR S&P MidCap 400 11.11 18 AGG ishares Barclays Aggregae Bond 11.06 19 BSV Vanguard Shor-Term Bond ETF 10.72 20 IJH ishares S&P MidCap 400 10.72 21 XLE Energy Selec Secor SPDR 10.38 22 BND Vanguard Toal Bond Marke 9.25 23 DIA SPDR Dow Jones Indusrial 9.21 24 VNQ Vanguard REIT ETF 8.58 25 HYG ishares iboxx High Yield 8.32 26 XLF Financial Selec Secor SPDR 8.05 27 SHY ishares Barclays 1 3 7.93 28 CSJ ishares Barclays 40546 Year 7.82 29 IJR ishares S&P SmallCap 600 7.38 30 FXI ishares FTSE China 25 7.25 Rank Ticker Descripion Marke Cap 31 VEU Vanguard FTSE All-World ex-us 7.21 32 JNK SPDR Barclays Capial High 7.06 33 IWB ishares Russell 1000 Index 7.00 34 PFF ishares S P U 6.79 35 XLK Technology Selec Secor SPDR 6.79 36 EWJ ishares MSCI Japan Index 6.47 37 IWR ishares Russell Midcap Index 6.37 38 VIG Vanguard Dividend Appreciaion ETF 6.10 39 IVW ishares S&P 500 Growh 6.05 40 DVY ishares Dow Jones Selec 5.99 41 EWC ishares MSCI Canada 5.97 42 TBT Proshares UlraShor 20+sy 5.68 43 IAU ishares Gold Trus 5.67 44 VUG Vanguard Growh ETF 5.42 45 SDY SPDR S&P Dividend 5.37 46 VTV Vanguard Value ETF 4.84 47 VB Vanguard Small-Cap ETF 4.64 48 VV Vanguard Large-Cap ETF 4.61 49 IWN ishares Russell 2000 4.56 50 IVE ishares S&P 500 4.51 51 EWY ishares MSCI Souh Korea 4.38 52 SHV ishares Barclays Shor TSY 4.16 53 IWO ishares Russell 2000 4.02 54 XLU Uiliies Selec Secor 3.91 55 EPP ishares MSCI Pacific ex-jp 3.80 56 XLI Indusrial Selec Secor 3.69 57 VO Vanguard Mid-Cap ETF 3.66 58 DBA DB Agriculure Fund 3.59 59 IWS ishares Russell Midcap 3.42 60 IWV ishares Russell 3000 3.42
The invesor perspecive: Main advanages of ETFs Reail Invesors -- Diversificaion a an affordable price -- Behave like index muual funds bu are more flexible -- Limi orders, shor-selling, opions -- Lower fees (?) -- Tax efficiency: lower urnover han MFs (no need o sell asses each ime someone sells, less capial gains ax impac) Professionals & Pension Funds -- Used for rading & hedging by pros (HF managers, raders) -- Proxies for marke facors for explaining sock reurns -- Tacical allocaion (core/saellie,..) -- ``Equiificaion of commodiies, currencies and fixed-income Large insiuional growh is expeced going forward wih ETFs replacing radiional MFs
Main caegories of ETFs Trackers: indusry secors Trackers: counry Currency: based on non-deliverable forwards (NDFs) Commodiy: based on physical Commodiy: based on rolling fuures Acively managed Leveraged & inverse
Examples of Counry ETFs issued in he US TICKER DESCRIPTION AUM ($B) ADV ($M) EWZ MSCI Brazil 12.5 830 EWJ MSCI Japan 8.2 500 FXI Xinghua 25 6.7 600 EWT Taiwan 3.4 150 EWY Korea 5.0 180 EWC Canada 5.5 90 EWH Hong Kong 2.1 80 EWS Singapore 1.9 30 RSX Russia 3.1 120 EWA Ausralia 3.0 90 EWW Mexico 1.7 100 ADV=Average daily volume
US ETFs providing Brazilian exposure Index Trackers AUM ($ million) EWZ - ishares MSCI Brazil Index Fund 1250 BRF - Small Cap 900 BRXX - Infrasrucure 900 EWZS - Small Cap 60 BRAQ - Consumer 30 BRAZ - Mid Cap 30 BRAF - Financials 8 Leveraged UBR - (2X) MSCI Ulra-long 20 BZQ - (-2X) MSCI Ulra-shor 10 Currency BZF - Real Money Marke Fund 500
Srucuring: ETF Zoology 101 All ETFs Synheic (swaps, fuures) Physical Index Commodiy FX, Fixed Income Index Commodiy Leveraged Inverse Acive, exoic Benchmark Tracking `Sampling Acive, long/shor
Synheic srucure (``unfunded ) Secondary marke Asses reurn Asses sold Collaeral asses may or may no be relaed o he underlying index
Synheic srucure (``funded ) Secondary marke (source: BIS)
How does a ypical Index ETF work? (A.: a mix of asses and swaps) Asses Cash
Profiabiliy of he ETF indusry in Europe Europe ETF In EUR million EUR million Profi is esimaed a EUR 1.2 B in Europe, EUR 5B globally (including US) Securiies lending revenue is esimaed a 498 mm EUR (2500 MM globally) Indirec revenues are imporan!
Physical vs. Synheic? Physical replicaion is preferred by Asse Managers (e.g. Black Rock, Vanguard) wih experise in porfolio managemen and index racking Synheic replicaion is preferred by Banks which have large swaps and srucured noes business (DB, Soc Gen, Surge) and less capabiliy in equiy porfolio managemen This explains he recen surge of synheics in Europe where banks have naural disribuion channels and OTC businesses Energy fuures-based ETFs are he province of banks, in general (e.g. DB), and some specialized commodiy raders
Main issue for regulaors: ransparency Need beer disclosure on: Physical Replicaion Securiies lending -- Percenage of NAV len ou -- Collaeral Agreemens -- Who receives he profis from securiies lending? Benchmark index composiion: wha are we really invesin g in? Tracking mehods -- Full replicaion or sampling? -- Repors on sampling effeciveness.
Main issue for regulaors: ransparency Synheic Replicaion Need beer disclosure on: Mehod of synheic replicaion (funded, unfunded) Who are he swap counerparies? Wha collaeral aken on he swap? Collaeral ownership agreemens Legal opinion on recourse for invesors in case of defaul
ETFs in Lain America Regisraions Primary Lisings Toal Lisings Providers AUM (USD B) Brazil 9 9 9 2 1.8 Chile * 350-50 - - Mexico 348 19 348 3 8.3 Peru * 295 - - - - (*) Chile and Peru only allow ETF invesmen by pension funds Mos of Mexico s AUM are in US Index ETFs (Nasdaq, S&P, Dow Jones, Canada, Japan) Larges issuer: Black Rock Significan expansion underway in erms of regisraions ( Source: Black Rock, BM&F Bovespa)
ETFs Made in Brazil Curren legislaion, Insrucao CVM 359, allows only for ETFs on Brazilian equiy shares, wih physical replicaion (a leas 95% physical replicaion) According o informed sources, a new Insrucion is under review by CVM, which will allow for ETFs on commodiies, foreign shares and fixed-income Major Fund Symbol AUM ($B BRL) ADV(`000) ADV($m) PIBB Fundo Indice Brasil 50 PIBB11 1.2 13 1.8 ishares Brasil Fundo de Indice BOVA11 0.45 507 21 PIBB issued by Banco Iau was firs mover BOVA issued by BlackRock is capuring marke share rapidly
Some ideas for ETFs issues in Brazil Commodiy ETFs, especially Agriculural and Mining BDRs no on single socks, bu on major marke indexes! (QQQ, SPY, Eurosoxx, Nikkei, Russell 2K) Cross border ETFs based on regional socks (including Argenina, Chile & Brazil) Very ineresing opporuniy o inroduce new asses o he Brazilian invesor communiy bu The appropriae design of hese new producs is imporan in order o avoid well-known pifalls. Opporuniy o shine
Brazilian peroleum or mineral commodiy synheic srucure ETF Collaeralized swap or srucured noe Perobras/EBX Financial Producs Auhorized Paricipans Creaion, redempion Hedge wih physical commodiy Cash vs. ETFs Perobras/EBX BM&F Bovespa
Known pifalls in commodiy ETFs: Physical vs. Fuures Physical commodiy: GLD (SreeTracks Gold Shares) IAU (ishares Comex Gold Trus) Fuures-based: DGL (Powershares DB Gold Fund) Fuures-based ETFs are based on mainaining a posiion in a consan-mauriy fuures by rolling from one conrac o he nex as hey reach mauriy This may resul in underperformance wih respec o he spo commodiy for a leas 3 reasons -- rolling coss (including fron-running) -- posiion limis in fuures exchanges limis AUM growh and produce disorions -- conango /backwardaion
Growh of Gold Bullion ETFs over he las 6 years GLD s AUM = USD 67 Billion
Difference Beween Spo Gold and Fuures-based Gold ETFs
Commodiy Fuures: Conango T1 T2 T3 Fuures are said o be in conango if he fuures price increases wih he ime-o-delivery (fuures is higher han spo) If he fuures are in conango, his means ha he ``convenience yield is low and he cos of soring and financing make he forward delivery more expensive as ime goes by
Commodiy Fuures: Backwardaion T1 T2 T3 Fuures are said o be in backwardaion if he fuures price decreases wih he ime-o-delivery (fuures is lower han spo) Associaed wih a high convenience yield. For example, renal for gold could be expensive, ec.
Fuures-based ETFs: he rolling conundrum Mandae: -- posiion in one or more conracs, aiming o carry a fixed-mauriy -- change (roll) conracs as expiraion arrives di I a df F 1 1 df 1 a 2 F 2 rd I F i value of he index a dae fuures wih selemen dae T i
Rolling wih consan mauriy Discree rolling (USO, UNG) a( ) 1, 0, if if 1 2 1 2 T T 1 1 T T 2 2 Presen ime Consan arge mauriy T T1 2 Coninuous rolling (VXX, VXZ) a T2 T 2 T 1 Typically, au > T2-T1
Conango implies fuures drop owards spo Simple model for F F ( i) S e ( r d i i )( T ) i conango r i d i 0 S spo price r rae for expiraion T i d i i convenience yield - sorage cos for ma. T i df F ( i) ( i) ds S r d i i d, In a low ineres rae environmen, conango means ha convenience yields are negaive. ( 0 ) d i
Consequence for fuures-based ETFs di I a ds S ds S df F (1) (1) [ a [ a r d 1 a r d d 1 1 1 a 1 df F (2) (2) 1 a d ] d 2 rd 2 2 ] d rd Negaive drif relaive o spo px if convenience yield is negaive
Theory mees pracice: he USO oil ETF
UNG: Naural Gas ETF
Long-Shor Physical vs. Fuures ETF Since fuures-based ETFs underperform spo, we should be able o profi (heoreically, a leas) from going long physical ETF and shoring he fuures-based ef on he same commodiy. Case sudy: Physical ETF: GLD Fuures-based: DGL X Y reurn of reurn of GLD DGL P P X Y r s P T P T X Y rs 0 1 1
A firs back-es (no borrow raes) Theoreical performance: 1.8% per year (daily compounding) 3.3% volailiy per year Sraigh line suggess ha he difference should correspond o funding coss
bu borrow raes ``kill his arbirage Assume ha GLD can be financed a general collaeral (e.g. 0.25%), so he Issue is how much does is cos o shor DGL. DGL shor rae= -2.381% (from large broker, March 23, 2011). This is a negaive rae: you pay on cash balances.
Leveraged ETFs Producs offer a muliple of he daily reurn of a reference index Examples: Proshares Ulra Financials ETF (UYG) Offers a daily exposure o 2 imes he Dow Jones Financial Index (long 200% of underlying index, via TRS) Proshares UlraShor Financials ETF (SKF) Offers a daily exposure o -2 imes he Dow Jones Financial Index (shor 200% of underlying index, via TRS)
Pifalls of leveraged ETFs for buy-and hold invesors Issues have been raised in he markeplace peraining o he suiabiliy of leveraged ETFs for long-erm invesors seeking o replicae a muliple of an index performance ``UBS AG U.S. brokerage business sopped selling ETFs ha use leverage because such producs do no conform o is emphasis on long-erm invesing Bloomberg News, July 27, 2009 `` Due o he effecs of compounding, heir performance over longer periods of ime can differ significanly from heir saed daily objecive. Therefore, inverse and leveraged ETFs ha are rese daily ypically are unsuiable for reail invesors who plan o hold hem longer han one rading session, paricularly in volaile markes FINRA Regulaory Noice, June 31, 2009 SEC issued a similar warning noice in 2009
8/4/2008 9/4/2008 10/4/2008 11/4/2008 12/4/2008 1/4/2009 2/4/2009 3/4/2009 4/4/2009 5/4/2009 6/4/2009 7/4/2009 Tracking error: UYG vs. 2X IYF, 1 year 120 100 80 60 40 20 UYG 2X IYF 0-20 -40 Lack of recovery in he bull mk of Q1 09
8/4/2008 9/4/2008 10/4/2008 11/4/2008 12/4/2008 1/4/2009 2/4/2009 3/4/2009 4/4/2009 5/4/2009 6/4/2009 7/4/2009 Tracking error: SKF vs. -2X IYF 250 200 150 100 SKF (-2)XIYF 50 0
Char Seings Scale Char Cursor OHLC Values Rese Ener skf nam SKF/UYG Pas 3 monhs
Pas year Noice ha boh reurns are negaive (big) over 1 year
Since incepion
Anoher example: FAS/FAZ Direxion 3X and -3X Financial ETF
Oil & Gas Proshares DIG (long) DUG (shor)
LETFs: The discree model f r R R L f r R R f L S R R n S N n n L N n n S n L n L n S 1 1 1 1 ETF expense raio for leveraged ETF he leveraged price of he underlying index or ETF price of ETF over he nh period he leveraged reurn of he underlying index over he nh period reurn of, 1, 1,,,,
Relaion beween LETF and underlying index L L S S exp 1 2 2 1 r f s ds 0 0 2 0 convexiy due o daily compounding financing & fees volailiy Avellaneda & Zhang (2009), Cheng and Madhavan (2009)
Pah-dependence of LETFs is caused by exposure o volailiy Tracking error: S 1 2 2 exp (1 ) ( ) s 0 S0 2 0 L r f ds L Avellaneda and Zhang (2009) examined 56 LETFs since heir incepion and showed ha he formula provides reasonable explanaion for he variaions of LETF prices, i.e. ha he racking error is small
Double leveraged bullish ETFs, 2/2008 o 3/2009
Double leveraged bearish ETFs, 2/2008 o 3/2009
Triple leveraged ETFs, since incepion (Nov 2008 Mar 2009)
Tracking SSO (2X SPY) Tracking SKF since December 2007 using he acual prices and he formula
Conclusions ETFs provide naural advanages o reail invesors (access), professional invesors and hedge funds (hedging, acical allocaion) and issuers (high-margin business) BM&F Bovespa, as a leader in regional and BRIC capial markes, is a naural habia for expanding local & regional exchange-raded producs Commodiies: his is an area where Brazil can shine, especially in srucuring physical or swap-based producs on gold, agriculure and minerals Poenial new businesses can arise as a consequence of his which are beneficial o he counry s economy
References Consaninides and Arnold, In he ETF Labyrinh, where does he hread begin? (July 2011), Deusche Bank, Global Markes Research Ramaswamy, S., Marke Srucures and Sysemic Risks of Exchange-Traded Funds, BIS Working Papers, April 2011 BlackRock, ETF Landscape, Indusry Review, end of Q1 2008 Os Fundos de Indice (ETFs) no Brasil, Revisa Bovespa. hp://www.cvm.gov.br/por/public/publ/ef_henri.hm Cheng, Minder and Madhavan, Ananh, The Dynamics of Leveraged and Inverse-Exchange Traded Funds (April 23, 2009). hp://ssrn.com/absrac=1393995 Avellaneda, Marco and Zhang, Sanley Jian, Pah-Dependence of Leveraged ETF Reurns (May 14, 2009). hp://ssrn.com/absrac=1404708 Non-Tradiional ETFs, FINRA Regulaory Noice (June 2009). www.finra.org/web/groups/indusry/@ip/@reg/@noice/documens/noices/p118952.pdf Leveraged and Inverse ETFs: Specialized Producs wih Exra Risks for Buy-and-Hold Invesors, SEC Aler (Augus 18, 2009). hp://www.sec.gov/invesor/pubs/leveragedefs-aler.hm