What s Inside Your ETF? A presentation to the University of Wisconsin Madison Retirement Association Michael Rawson, CFA Fund Analyst Morningstar Michael.rawson@morningstar.com February 2013 2011 Morningstar, Inc. All rights reserved. <#>
Agenda ETF Market Evolution ETF Basics A Closer Look Strategy ETFs Fixed Income ETFs Exchange-Traded Notes (ETNs) Commodity Exchange-Traded Products (ETPs) Leveraged Funds Putting ETFs to Work
ETFs: A Growth Story
ETFs Still Only About 13% of Total ETF and Mutual Fund Assets Assets Under Management $ Bil 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 ETF Mutual Fund 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 *Excludes money market funds. Source: Morningstar, Inc
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% Percent of Mutual Fund and ETF Assets Managed Passively 0% 1993 1994 1996 1998 2000 2002 2004 2005 2007 2009 2011 *Excludes money market funds. Source: Morningstar, Inc
10 Largest ETFs Name Ticker Total Assets $ Mil SPDR S&P 500 SPY 125,631 SPDR Gold Shares GLD 71,054 Vanguard FTSE Emerging Markets ETF VWO 61,434 ishares MSCI Emerging Markets Index EEM 52,185 ishares MSCI EAFE Index EFA 41,802 ishares Core S&P 500 ETF IVV 36,740 PowerShares QQQ QQQ 32,800 Vanguard Total Stock Market ETF VTI 26,762 ishares iboxx $ Invest Grade Corp Bond LQD 24,355 ishares Barclays TIPS Bond TIP 21,878 *As of 1/31/2013 Source: Morningstar, Inc 6
Over 80% of U.S. ETF Market Claimed by Top Three Providers
What is an ETF? Like a mutual fund Regulated just like a mutual fund Has a manager Has a structured package of assets But trades like a stock Listed on an exchange like a stock or closed-end fund Traded intraday Allows for stock like strategies such as shorting and margin investing, but this flexibility entails complexity
Advantages of ETFs Liquidity and Availability Mutual funds usually allow one trade execution time per day More precise portfolio management Cost Less overhead at fund provider Pass on economies of scale Tax Advantage In-kind creation and redemption process Low turnover of index funds
Availability ETFs have democratized exotic and previously difficult-toaccess markets Mutual Funds ETFs % Count % Assets % Count % Assets Alterna(ve 5% 1% 22% 3% Commodi(es 0% 1% 8% 9% Interna(onal Stock 15% 15% 18% 22% Sector Stock 6% 3% 22% 14% U.S. Stock 33% 33% 15% 36% Municipal Bond 8% 6% 2% 1% Taxable Bond 17% 25% 10% 16% Balanced 17% 17% 3% 0%
Passive, Long-Term Investing: Lowest Cost Wins
How a Mutual Fund Works
ETF Creation / Redemption
Intraday Premium/Discount in an ETF
ETF Creation / Redemption
Takeaways From the Flash Crash A CFTC-SEC report found that an unusually large automated trade of S&P futures drained liquidity and forced arbitrageurs to hedge the other side by selling stocks or ETFs such as SPY. Disproportionately affected ETFs Without timely quotes, market makers widened out bid-ask spreads Be cautious with stop-loss orders on ETFs A stop-loss order is an algorithmic trade a poor one at that Stop-loss orders became market orders when there was no liquidity and got matched with stub quotes Avoid trading during spikes in volatility Market rebounded within 20 minutes
ETF Trade Execution Gone Wrong
Liquidity General measures of liquidity More assets = more liquid Liquid underlying = more liquid Greater daily volume = more liquid (efficient execution) More precise measures of liquidity Premium/discount Bid-ask spread Market impact
Bid-Ask Spread
Trading Best Practices Use limit orders Avoid or be cautious with stop-loss orders Evaluate the market Premiums and discounts Bid-ask spread Avoid trading during extreme volatility (flash crash) Trade when the market for the securities underlying the ETF is open and functioning
Potential Drawbacks of ETFs Transaction fees (typically a small component of cost) Less advantageous within tax-protected accounts Do they encourage investors to trade too much or exert too much control? Total cost analysis is difficult Dividend reinvestment is not always available
ETFs vs. Mutual Funds: What Type of Investor Are You? This can be a key determinant in which vehicle is better for you. ETFs appeal most to two types of investors: those who prefer a passive index-based approach and those who like to actively manage their own portfolio through such strategies as market-timing. Mutual funds are more suited for investors who are looking for active management and for those who are looking to make regular frequent contributions (dollar-cost averaging).
Takeaways: ETFs vs. Mutual Funds Execution of ETFs is more complicated than with a mutual fund Costs can justify the effort and complexity Do your homework! Knowing what you own means more than just reading the name of the ETF
Passive Index Funds versus Strategy ETFs
The Case for Indexing "It must be the case that... after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar, William Sharpe, The Arithmetic of Active Management I don't rely on the efficient-markets hypothesis. I go by the "cost matters" hypothesis, Jack Bogle, Vanguard and founder of the first index mutual fund "If there is anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds, Russ Kinnel, Morningstar
Strategy ETFs: Not All Indexes Are Created Equal Two key considerations: What is the universe What is the selection and weighting methodology Traditional indexes market-cap weight a broad universe of stocks. Their diversified and passive approach makes them the ideal building blocks of a portfolio. These indexes are the basis for the efficient market hypothesis. The market portfolio is extremely hard to beat consistently you may not outperform, but you are guaranteed to not underperform the market. Strategy indexes may select from a subset of the entire stock universe and then employ a screen or different weighting method. There are no guarantees here.
Strategy ETFs Are More Expensive
Guggenheim S&P Equal Weight RSP vs. S&P 500 Each holds exactly the same stocks
Know the Appropriate Benchmark Can the same exposure be had for lower cost?
Know the Appropriate Benchmark Can the same exposure be had for lower cost?
Equally Weighted Can Be a Better Approach for Sector Funds XLE has 41% of assets in just 3 stocks Weight in XLE Weight in RYE
Fundamentally Weighted PowerShares FTSE RAFI US 1000 PRF vs. Russell 1000
Picks and Promising ETFs Vanguard Dividend Appreciation ETF VIG Dirt-cheap 0.13%; high quality Vanguard High Dividend Yield ETF VYM Also cheap 0.13%; efficient large-value tilt PowerShares S&P 500 Low Volatility SPLV 0.25% expense ratio; directly targets low-volatility stocks WisdomTree Emerging Markets Equity Income DEM Not cheap, but cheapest emerging-markets dividend fund at 0.63% Dividend strategies may work even better in emerging markets, where corporate governance may be less rigorous
Fixed Income ETFs
Fixed-Income ETFs Bond ETFs provide investors with a relatively liquid vehicle to gain access to illiquid over-the-counter fixed-income markets. Individual bonds trade on the OTC market infrequently, far less frequently than ETFs do. This liquidity mismatch will create premiums and discounts at times. Arbitrageurs cannot always fully hedge away these differences due to the high cost of trading individual bond securities. While there are diversified bond ETFs, many bond ETFs target specific exposures in fixed-income sectors, i.e. emerging-markets sovereign debt. These bond sector ETFs will be more volatile than diversified bond mutual funds and ETFs.
Fixed-Income ETFs Trading Characteristics Bond ETF NAV based on bid price
Fixed-Income ETF Premium and Discounts As the asset class becomes more illiquid the higher the premium or discount.
Exchange-Traded Notes (ETNs)
Exchange-Traded Notes (ETNs) Advantages ETNs can have tax advantages over ETFs for certain asset classes, such as commodity futures or MLPs ETNs promise the return on a given index, typically an index that is harder to track within another structure Disadvantages Whereas ETFs earned a good reputation from being low cost, transparent and simple, ETNs are just the opposite ETNs carry the credit risk of the issuing bank ETNs can be called away when it is convenient for the issuing bank to do so Some ETNs have path dependent fees
Comparisons Between ETNs and ETFs ETNs ETFs Liquidity Daily on exchange Daily on exchange Registration Securities Act of 1933 Investment Company Act of 1940 Recourse Issuer credit Portfolio of securities Principal Risk Market and issuer risk Market risk Short Sales Yes, on an uptick or downtick Path Dependent Fees On Some No Tracking Error Moderate, due to fees Minimal Yes, on an uptick or downtick
An ETN Warning
Commodity Exchange-Traded Products (ETPs)
Commodity Exchange Traded Products: Outline of Key Topics Commodities as an asset class Do asset class level benefits remain intact? Three ways to gain exposure: Equity-based Futures-based Physically backed
Commodity ETPs: Commodities as an Asset Class Do diversification benefits still remain? Influx of investor interest have driven correlations higher
Commodity ETPs: Equity-Based Exposure Hold a basket of equity securities Equity-based offerings only roughly track spot performance. Non commodity specific drivers Operational Leverage Miners vs. Gold varying performance
Commodity ETPs: Futures-Based Exposure Futures Contracts: Obligate the purchase or sale of a set quantity of a commodity, at a set date in the future and at a set price. Historically: Three Return Drivers Spot Return Collateral Yield Roll Yield ETPs are look through delivery vehicles for tax purposes a fund that holds commodity futures is subject to 60/40 long-term/shortterm capital gains treatment and that gains and losses must be marked to market at the end of every year. Because they are structured as limited partnerships, investors also receive K-1 statements in the mail although none have posted non-qualified income to date.
Commodity ETPs: Futures-Based Exposure Roll Yield: Return produced by rolling positions further into the future. Backwardation and Contango: Overall shape of the curve
Commodity ETPs: Futures-Based Exposure Contango has proven to be pernicious but dynamic strategies have managed better
Commodity ETPs: Physically Backed Exposure Hold the underlying commodity and thus offer perfect tracking (net a management fee). Only feasible for high Value/Size ratio commodities: gold, silver, etc Structured as grantor s trusts, so they are taxed as collectables there is no credit risk because they actually hold and warehouse the underlying commodities
Leveraged Funds
The Effects of Compounding and Volatility Drag Since inception, many positive (bullish) and negative (bearish) leveraged pairs BOTH have losses. A real example, since inception: Underlying index (IYF) is up about 35% Direxion Daily Financial Bull 3X Shares (FAS) down 70% Direxion Daily Financial Bear 3X Shares (FAZ) down 99%
Leveraged and Inverse ETFs Example Over long periods of time, the return will not equal the multiple of compound index return because of the volatility drag, which is magnified by the leverage. Day Index Net Return 3x Index Net Return Cumulative Index Return Cumulative 3x Index Return 1 10% 30% 1.1 0.7 2 10% 30% 0.99 0.91 3 10% 30% 1.09 0.64 4 10% 30% 0.98 0.83 Total Net Return 2% 17%
Putting ETFs to Work
Core and Explore Low cost and broadly diversified passive ETFs cover a variety of indexes, making them ideally suited to form the core of a portfolio. Active mutual funds that seek alpha can form the explore sleeve of a portfolio. Focused, niche ETFs can also be used by a portfolio manager seeking alpha by making tactical tilts.
A Diversified Core Portfolio with Five ETFs ETF Ticker Weight Expense Ratio Vanguard Total Stock Market VTI 30% 0.06 Vanguard Total International Stock VXUS 20% 0.18 Schwab U.S. Dividend Equity SCHD 5% 0.07 Pimco Total Return Bond BOND 40% 0.55 ishares Gold Trust IAU 5% 0.25 100% 0.29
Core and Explore Portfolio Example Fund Ticker Weight R-Squared Core Vanguard Total Stock Market VTI 25 100 Vanguard Total International VXUS 20 100 Stock Vanguard Total Bond Market BND 30 99 Explore Equity Sequoia SEQUX 5 86 Royce Special Equity RYSEX 5 95 Investment Oakmark International OAKIX 5 93 Explore Fixed Income Loomis Sayles Bond LSBDX 5 86 Templeton Global Bond TGBAX 5 76 R-Squared is to the best fit index, giving an indication of the degree to which a fund matches an index.
Investment Flows: past five years, outflows from U.S. stocks, strong inflows into fixed income 600 Mutual Fund and ETF Flows in $Bil 500 400 Other 300 200 100 U.S. Stock Bond - 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (100) Other includes commodities, alternative, balanced, international stock and sector stock
Within Fixed Income, Strong Flows into High Yield and Emerging Markets 70 Long Term OEF and ETF Flows in $Bil 60 50 40 30 20 10 High Yield Bond Emerging Markets Bond 0 (10) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (20)
High Yield Corporate Bond Credit Spreads Long-term average credit spread is 6.0%, median is 5.5% Current spread is 5.0% Source: FRED Federal Reserve Bank of St. Louis
High Yield Bonds Part of your stock or your bond allocation? High Yield bonds positively correlated to stocks, negatively correlated to Treasury Bonds
The Risk in High Yield Monthly return distribution for the past 25 years of High Yield and 3-7 Year US Treasury Bonds
Still Interested in High Yield? PIMCO 0-5 Year High Yield Corporate Bond HYS Lower interest rate risk than longer duration competitors Higher returns when compared to Master II index Holds bonds to maturity which reduces transaction costs PowerShares Fundamental High Yield Corp PHB Slightly lower yield but higher quality
US Treasury Bonds Don t Protect Against a Declining Dollar
Lower Debt and Higher Growth in Emerging Market Countries 100% Government Gross Debt / GDP (2010) 80% 60% 40% 20% 0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Expected Real GDP Growth (2009-2015) Advanced Emerging Source: IMF World Economic Outlook, Oct. 2010
ETFs for Non U.S. Dollar Exposure WisdomTree Emerging Markets Local Debt ELD Actively managed foreign currency bonds from 15 emerging market countries selected based on fundamentals Investment grade WisdomTree Emerging Markets Equity Income DEM Weights emerging market stocks by dividends paid
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