A presentation on:
General Applications of
Exchange Traded Funds
Justin Pascoe
Director of Investments
20. 8. 2002
Table of Contents
1.
What are ETFs
2.
Why have ETFs become so popular
3.
Users and Applications of ETF
4.
Global Developments of ETF
5.
Developmental Challenges
6.
Conclusion
2
What are ETFs?
What are ETFs?
Characteristics
Commingled fund structure
Listed on the exchange
Trade like ordinary shares
Passively managed against an index
Usually priced at a fraction of the index
e.g: TraHK is 1/1000th, SPDR is 1/10th,
QQQ is 1/40th
Contribute and redeem in-kind
4
In-kind Subscription/Redemption

Not as simple as taking a mutual fund and listing it on the exchange

Special in-kind creation and redemption mechanism
Share basket
Creation
Investor
ETF
Units
Units
Redemption
ETF
Investor
Share Basket
5
Importance of in-kind Creation and Redemption
 Reduces transaction costs borne by the fund that result from investors’ activities
 The ordinary mutual fund has to acquire/sell stocks in its portfolio when investors
buy into and/or redeem from the fund, thereby incurring transaction costs
 In-kind mechanism contributes to the lowering of the expense ratio of the fund
 Facilitates arbitrage activities
 Specialists, market makers and arbitrageurs compete to capture pricing
discrepancies, which results in the ETF trading at its fair value
 Hence increases the liquidity of ETFs
6
Arbitrage Activities
Investors will:
• accumulate the share basket
Unit price >NAV
• create the units
• sell the units
Unit price closely
tracking the NAV
Investors will:
Unit price<NAV
• accumulate the units
• redeem the units
• sell the underlying shares
Additional dimension for arbitrage improves
market efficiency
ETF
Cash
Futures
7
ETF Arbitrage Matrix
If Units Cheap vs.
Stocks
+ Units
- Stocks
- Units
+ Stocks
Redeem units for
stocks which are used to
cover the borrowed stocks
+ Units
- Futures
Futures
Use stocks to create new units to
replace the borrowed units OR buy back
units and sell stocks when units are cheap
- Units
+ Futures
Sell units and covert futures
before it expires; or sell units and
let futures expire on the expiration day
+ Long position (Buy)
Opening Trade
If Units Expensive vs.
Buy units and sell futures
before it expires; or buy units and
let futures expire on the expiration day
- Short position (Borrow and sell)
Closing Trade
8
TraHK Premium/Discount Analysis
1.50%
1.00%
0.50%
0.00%
-0.50%
-1.00%
-1.50%
Closing Premium/Discount
Average
-2.00%
9
Two Levels of Tracking
 Tracking of the ETF’s traded price against the NAV

depends on the efficiency of the arbitrage process
 Tracking of the ETF’s NAV against the index (Tracking Error)

depends on the expertise of the fund manager – in the design of the basket and
in the rebalancing techniques

need to subtract the accrued dividend from the ETF’s NAV before comparing with
the index
10
Hybrid Product
Subscription /Redemption as Open-ended Mutual Funds, Traded on stock exchange as Close-ended Mutual Funds
Retail Investors
Institutional Investors
Intermediaries
次級市場
Secondary Market
Market Price
Arbitrage provides critical link between ETF, Equity and Futures markets
Primarily Market
Subscription/Redemption
at NAV
Stock
Subscription
Institutional
Investors/Intermediaries
Fund
Unit
Unit
Stock
Redemption
Institutional
Investors/Intermediaries
11
Why ETF is getting more and more popular?
Benefits to the Investors
 Virtues of Indexation
 Indexation enforces diversification
 Obtains broad market exposure
 Transparency – Investments &
 Special Features of ETF
 Only one transaction to buy a diversified
portfolio
 Low expense ratio
Performance
 Fair pricing
 Adds to market depth, liquidity and efficiency
 Advantages of Listing on Stock
Exchange
 In Korea
 Simple and flexible dealing
 Small board lot size (10 shares)
 Exemption from 0.3% transaction tax on the
sale of ETF units
 Trading throughout the day
 Can buy on margin or short-sell
 Short-selling of ETF exempted from the up
tick rule
 Can place limit orders
 Highly liquid
13
Cost is a a Major Consideration
Annual Cost Comparison
Expenses
ETF
Actively Managed Mutual
Funds in Korea
Portfolio Turnover
(A)*
5.00 – 10.00%
100.00 – 200.00%
Manager Transaction Costs
(B)
0.50 – 1.20%
0.50 – 1.20%
Yearly Expenses
(A) X (B)
0.025 – 0.12%
0.50 – 2.40%
Management Fee
0.25%
0.50%
Other Expenses
0.42%
1.00%
Total
0.695 – 0.79%
2.00 – 3.90%
* Annual portfolio turnover =
Annual Trading Volume / 2
Fund Size
14
Comparison of ETFs with other Investment Products
ETFs vs Active Mutual Funds
ETF
Actively Managed
Mutual Funds
Expense Structure
<70 basis points
>200 basis points
Performance
In line with Index
Possible outperformance or
underperformance
Traded on Stock Exchange
Yes
No
Ability to Short/Borrow
Yes
No
In-specie
Cash
Any time market open
Daily Price
Subscription/Redemption
Add/Remove Exposure
16
ETFs vs Closed-ended Mutual Funds
ETF
Closed End Funds
Expense Structure
<70 basis points
>200 basis points
Market Price and NAV
Tracking Closely
Large discount or premium
that can persist
Traded on Stock Exchange
Yes
Yes
Liquidity
High
Low
In-specie
No
Yes
Limited
Subscription/Redemption
Ability to Short/Borrow
17
ETFs vs Open-ended Index Funds
ETF
Open-ended Index Fund
Low
Low
Minimal
Higher than ETF
Yes
No
Add/Remove Exposure
Any time market open
Daily
Ability to Short/Borrow
Yes
No
In-specie
Cash
Expense Structure
Tracking Error
Traded on Stock Exchange
Subscription/Redemption
18
ETFs vs Index Futures
ETF
Index Futures
Expense Structure
Low
Commission cost in
rolling position
Need to Roll Position
No
Yes – hence roll risk
Margin Calls from Mark-to-Market
No
Yes
None
High
Dividends
Yes
No
Ability to Short
Yes
Yes
Many
Less
No – but can create leverage
by borrowing to buy ETF
Yes
Margin Accounting Complexities
Types and Volume
Leverage
19
ETFs Users and Applications
ETFs Users

Institutional Investors

Market Intermediaries

Hedge Funds

Financial Advisors

Retail Investors
21
Applications of ETFs
Asset Allocation/Sector & Style

Use ETFs to gain country or sector exposure while limiting stock-specific risk – avoid
frustration of the right country or sector choice, but the wrong stock pick

Rebalance allocation anytime during market hours and without the hassles of multistocks settlement

Efficient access to markets which have restrictions on foreign capital participation

Build core portfolio cheaply with broad-based & country ETFs and the “satellite”
portfolio with industry sector ETFs
22
Core/Satellite Asset Allocation Strategy
Equity Risk Pyramid
Large-Cap
Higher Risk/
Higher Reward
Sector
Funds
Growth
Individual
Stocks
Core
Investments
Value
Sector Funds
Individual
Stocks
Large, Mid, Small-Cap Funds
Growth & Value Funds
SmallCap
Broad-based Indices
Lower Risk/
Lower Reward
資料來源 Source: MSDW 股票研究 MSDW Equity Research
23
Applications of ETFs
Equitize Cash Inflows

Avoid drag of cash position on equity portfolio returns

achieve temporary equity exposure until portfolio manager decides which stocks to
buy
24
Applications of ETFs
Enhance Management of Cash Outflows

Use ETFs to create equitized liquidity reserve

To satisfy redemptions or withdrawals, compared to selling individual stocks, the ETF
liquidity reserve can be liquidated
– Quicker
– Easier
– Lower transactions costs
– No effect on individual stock price
25
Applications of ETFs
Hedge Equity Portfolio Exposure

Short ETF position can provide hedge against price declines

Alternative to futures and without the roll risk – especially attractive for institutions which
are not permitted or prefer not to use derivatives

Allows the hedging of exposure to specific stock indexes or market segments not
available with futures
26
Applications of ETFs
Manager Transition Trades

Facilitate transition of assets from a terminated investment manager to a new
investment manager

Liquidate terminated manager’s portfolio and invest in ETFs to maintain equity exposure

When new manager is selected, ETFs can be sold to deliver cash or redeemed to deliver
component stocks of ETF to new manager
27
Applications of ETFs
Relative Value, Long/Short Strategies

Strategies can include:
 Go Long broad market Indexes, country or sector Indexes expected to
outperform
 Go Short the broad market Indexes, country or sector Indexes expected to
underperform
 Position can be leveraged by doubling the size of the long position versus the
short
 Anticipate sector rotations with long or short positions in industry sector ETFs
28
Applications of ETFs
Privatization of Shares Held by Government

Innovative use of ETFs designed by SSgA – First used by the Hong Kong Government
and hence the creation of TraHK

Government repackaging their shareholdings into ETF units and placing the units to
institutional and retail investors through an initial public offering

Key advantages are:


Minimal market impact

Stock neutral

Diversifies ownership amongst retail and institutional investors

Broadens the capital markets with the introduction of a new investment product
Recently adapted for the unwinding of cross-holdings of Japanese banks
 But a crucial difference – there is a lack of new investors and new sources of
liquidity into the Japanese product
29
Trends and Development of ETFs
Worldwide ETF Growth in Assets
By 28 June 2002, assets under management reached US$120.6b in 238 ETFs
DAX, TALI 25, M-S CAC 40,
TSE300, XMTCH (SMI)
$103,242
2001/12/31
LDRs, iShares,streetTRACKS
DJ CN 40, Xact OMX,SATRIX 40
QQQs, iUnits 60, TraHK
1999
DIAMOND, Sector SPDRs
1998
WEBs
1997
Midcap SPDR
1996
SPDR
$74,337
2000
31,025
14,598
6,205
2,159
1995
1,055
1994
423
1993
462
0
20,000
40,000
60,000
80,000
100,000
Source: SSgA ETF group, AMEX
31
Existing Products
SSgA manages more than 33% of the ETF assets worldwide,
including:
SPDR, Fortune, Select Sector SPDR, DJ Canada 40, StreetTRACKS, &
TraHK
MidCap SPDRs
5,890
Others
38,072
TSE Topix
8,024
OSE Nikkei 225
2,687
DIAMONDS
3,430
iShares Russell
2000
Select Sector SPDR 2,742
2,805
iShares S&P 500
3,629
QQQ
19,040
TraHK
3,586
iShares MSCI EAFE
3,999
Source: Bloomberg
Data as of Jun 30, 2002 (USD Millions)
SPDRs
26,896
32
ETFs in the Global Market
Top 10 Global ETFs by Turnover
Rank
Name
Symbol
Tracking Against
Daily Turnover
Manager/Trustee
(in USD mn)*
1
NASDAQ-100 Index
Tracking Stock
QQQ
NASDAQ 100
2,871.6
Bank of New York
2
SPDRs (Standard & Poor’s
Depository Receipts)
SPY
S&P 500
2,103.5
State Street Global
Advisors
3
DIAMONDS Trust
DIA
Dow Jones
Industrial Average
444.5
State Street Global
Advisors
4
MidCap SPDRs
MDY
S&P MidCap 400
Index
114.1
Bank of New York
5
iShare Russell 2000
IWM
Russell 2000
71.5
Barclays Global
Investors
6
DAXEX
DAXEX
GR
Germany DAX
Index
53.0
IndexChange
7
Master Share CAC 40
CAC FP
France CAC 40
Index
42.6
Lyxor Asset
Management
8
Select Sector SPDR –
Financial Fund
XLF
S&P Financial
Index
40.0
State Street Global
Advisors
9
iShare MSCI EAFE
EFA US
MSCI EAFE Index
35.4
Barclays Global
Investors
10
iUnits S&P/TSE 60 Index
Fund
XIU CN
Canada S&P /
TSE 60 Index
35.2
Barclays Global
Investors
Source: SSgA ETF Group, Bloomberg
* Average daily turnover for the year ended 28 June 2002
33
ETFs in the Global Market
Existing Products AUM : US$120.6b in 238 funds*
N America
AUM : US$ 93.5 bn
No. Funds : 118
Europe & Middle East
AUM : US$ 8.9 bn
No. Funds : 93
* Including
STI
Singapore’s first local ETF
listed on 17 Apr 2002
Asia Pacific
AUM : US$ 17.6 bn
No. Funds : 24
South Africa
AUM : US$ 0.6 bn
No. Funds : 3
Source: Morgan Stanley Research
* Data as of 28 June 2002, not including HOLDRS
34
U.S. Lead in ETFs - Reasons for dominance of the US market
 First mover advantage
 Favorable end-user response
 The number of institutional investors reporting holding one or more US listed ETFs or
HOLDR has increased to 1,162 in June 2002 from 911 institutions in June 2001
(Source: Morgan Stanley Research and Thomson Financial)
 Well developed market infrastructure
 Key theme is asset growth

In the 1st half of 2002, assets have grown by US$5.5 billion to about US$93.5 billion
and 1 new ETF was launched
35
ETFs in Europe
 ETFs are winning investors

Significant increase in usage of ETFs by European institutions, from 32 institutions in June 2000
to 246 in June 2002 (Source: Morgan Stanley Research)
 Rapid product launches

In the 1st half of 2002, there were 21 new ETF launches and assets increased by US$2.9 billion
to about US$8.5 billion
 Cross-listing is common

As of 28 June 2002, the number of primary listings was 92 but the number of total ETF listings
was 154.
 Key theme is pan-Europe sector based ETFs

Introduction of Euro

Institutional investors move from country based to sector based allocation
36
ETFs in Asia Pacific
ETFs in Asia Pacific
 Hong Kong
 Japan
 Australia
 Singapore
37
ETFs in Hong Kong
 Tracker Fund of Hong Kong (TraHK) was the first ETF listed outside North
America in 1999

US$4.3 billion IPO the first stage of Hong Kong Government’s disposal of shares purchased in
events of August 1998

Tap Mechanism an on-going disposal mechanism for the Government’s remaining holdings

Incentive package with Loyalty Bonuses has resulted in TraHK being less liquid initially than
typical ETF of this size

Current assets under management of about US$3.8 billion
 Cross-trading iShares in Hong Kong from May 2001

Korea & Taiwan the first 2 of a planned 6
 Launch of iShares MSCI China Free in Hong Kong in November 2001

Current assets under management of about US$38 millions for Hong Kong retail investors
38
Observations from TraHK
 Local investors prefer local indices
 Low cost and transparency are the major appeal
 Benefits to the capital market:

More investment choices – benefits investors

Development of long-term equity holding culture – 70% of investors from IPO still
retaining their units even after the distribution of all loyalty bonuses

Increased efficiency of index futures pricing

Increased liquidity resulting from arbitrage activities
 Active trading of derivatives positive for the development of the product
39
Observations from TraHK
(Con’td)
 Marketing important aspect especially in the initial stages
 To increase investor awareness and familiarity
 Operationally demanding product
 Need to interact with numerous parties
 Importance of fully integrated systems
 Experience is key - steep learning curve and inexperience incurs the risk of
developing a flawed product
 Extremely profitable business for the stock exchange
40
ETFs in Japan
 Japan ‘mass launch’ of 5 ETFs in July 2001
 Indices approved for ETF development increased from 4 to 8:
Nikkei 225, Nikkei 300, Topix, S&P Topix 150, MSCI Japan, FTSE Japan, DJ Industrial Average,
Nasdaq-100
 A total of 17 ETFs listed currently, with total assets of about US$14 bn
 60% of the ETF assets came from the injection of crossholdings of Mitsubishi Tokyo
Financial Group (MTFG) and Meiji Life.
 No clear evidence of strong institutional use of ETFs except for the unwinding of cross-
holdings in the above cases by MTFG and Meiji Life.
 As these ETF units were created for share unwinding purpose, it has resulted in persistent short
futures open interests in the market as well as these ETFs being less liquid than typical ETF of
this size.
 Product design far from satisfactory
 Different creations and redemptions processes due to different interpretation of the trust law by
the ETF issuers
 Trade basket is typically published more than 1 day prior to the trade date – creates uncertainty in
the fund management process especially when large corporate actions are pending.
41
Japan ETFs - Trading Dominated by Proprietary Trading
< TRADI NG VAL UE >
J ul. 01- Fe b . 2002
J an. 2002
J ul. 01- De c . 01
Rat io
Rat io
Rat io
< Pr ope r ty>
688,727
73%
469,290
77%
59,283
65%
< Br oke r age >
256,962
27%
140,366
23%
31,962
35%
25,632
10%
12,131
9%
5,964
19%
5
0%
5
0%
0
0%
< Busi ne ss Compani e s>
23,392
9%
10,279
7%
3,006
9%
< S e cur i ti e s Compani e s>
14,438
6%
8,581
6%
1,605
5%
< I ndi vi dual s-cash>
87,164
34%
51,695
37%
10,236
32%
< I ndi vi dual s-mar gi n>
60,482
24%
34,419
25%
7,269
23%
< F or e i gne r s>
45,849
18%
23,255
17%
3,881
12%
< F i nanci al I nsti tuti ons>
< I nve stme nt Tr usts>
Source: Tokyo Stock Exchange
42
ETFs in Australia
 ASX 200 & ASX 50 ETFs launched in August 2001

Rapid growth from US$ 40 mn at launch to US$ 114 mn at the end of June 2002

Importance of complementary futures contract
ETFs
(Data as of 28 June 2002)
Assets under
Management
(USD mn)
Average Daily
Turnover
(USD)
StreetTRACKS S&P /
ASX 200
73.7
4,169,660
StreetTRACKS S&P /
ASX 50
14.0
40,000
Source: Bloomberg
 ETF tracking Listed Property Trust Index launched in Feb ’02, with AUM of about
US $21mn as at end of June 2002
43
ETFs in Singapore
 Cross-listing 5 US ETFs in Singapore from May 2001

SPDR, iShares S&P500 and Diamonds

DJ US Technology

iShare Singapore
 streetTRACKS Straits Times Index Fund launched on 17 April 2002
 Replicating many key features of TraHK
 based on well-known local index
 drawing new investors into market (CPF approved)
 low cost structure
 but no Tap Mechanism or loyalty bonuses => ‘organic growth’
44
ETF Asia Overview
 Asia clearly under-represented globally
 Why?
 Less sophisticated market infrastructures
– settlement, ability to short-sell, etc
 Index construction issues - liquidity & concentration
 Investor focus has been on active management / stock selection
 Limited offering of cost-effective products
– institutions / arbitrageurs very cost sensitive
 New funds coming as providers meet demand
45
Developmental Challenges
Developmental Challenges
Regulatory
•
•
•
Hybrid Product
Shareholder Protection
Investment Concentration Restrictions
Operational
•
•
•
•
Securities Marketplace Infrastructure
Disseminating Information
Settlement
Basket Creation
Fiscal
•
•
Financial Status
Tax on Creations and Redemptions
Funding
•
•
•
Distribution
Incentive Structure
Marketing
47
Interaction with Multiple Parties
Service Provider
Stock Exchange
Regulator
Index Provider
Example: SPDR / TraHK
AMEX/HKEX
SEC / SFC
S&P / HSI Services
Investment Manager
SSgA
Clearing Depository
DTC / HK Clearing
Role
 Conduit for trading
 Promotes the product
Provides the legal infrastructure
Engineers the index to be tracked
Tracks the designated index
Settles the transactions
Registrar
DTC / Central Registration
Registers the units of the trust
Trustee/Custodian
State Street Bank & Trust
Values the trust and holds trust assets
Market Maker
Participating Dealers
Distributor
Spear Leeds
(for SPDR)
Securities Houses
ALPS Mutual Fund Services
(for SPDR)
 Ensures liquidity
 Promotes the product
Ensure fluid trading
Promote and sell the product
48
Funding Challenge - Launching by IPO or Seed Capital
Advantages of IPO
 Achieve investor awareness immediately
 Enable the ETF to gather sufficient assets to attain a economically viable size
 Assures liquidity
 Equal chance of participation by all investors
49
Precedents of Launching ETF via IPO
Hong Kong
South Africa
Tracker Fund of
Hong Kong
Satrix40
EFIL
(Hong Kong
Government)
CoreCapital Bank,
Gensec bank, and
Johannesburg Stock
Exchange
Development Bank of
Brazil
12 November 1999
27 November 2000
Under preparation
Benchmark Index
Hang Seng Index
All Share Top 40
Companies
Bovespa Index
Assets under management at
launch
HKD 33.3 billion
Rand 2.6 billion
N/A
Assets under management
(as of 31July 2002)
HKD 27.3 billion
Rand 3.6 billion
N/A
Daily turnover
(average for the year ended
31July 2002)
USD 7.5 million
USD 1.1 million
N/A
ETF
Promoter
Date of launch
Brazil
To be announced
Both the Tracker Fund of Hong Kong and Satrix40 are one of the most liquid
counters traded on their respective exchanges.
50
Funding Challenge - Launching by IPO or Seed Capital
(cont’d)
Launching by reliance on seed capital
 The main advantage is minimal expense
 Disadvantages are:

It will take a much longer time before the assets in the ETF build up – see the
example of SPDRs and other ETFs

As a result, liquidity is usually constrained in the initial period

As the APs are not the end-user, there is no new capital inflow into the market
51
Conclusion
Benefits that a Successful ETF can bring to the Capital Market
 Increased investor choice
 Low cost investment vehicle
 Development of long-term equity culture
 Benefits of indexation – e.g. enforcing diversification
 Can be used as a risk management tool
 Increase in market liquidity
 ETFs rank among the most liquid counters in most markets
53
So what is a successful ETF?
 Asset under management – large
 Liquidity – high
 Bid/ask spread (re market price) – narrow
 Total expense ratio – low
 Tracking error against the index – minimal
 Difference between traded price and NAV - small
54
The State Street Advantage
Product and Personnel Experience
 State Street is the pioneer of exchange traded funds (ETFs) – began the
design and development of SPDR in 1990 in conjunction with AMEX
 Largest, sole service provider of ETFs worldwide with over 33% market
share worldwide, including structuring, distribution and management
 Manager of US$28 billion SPDR, largest ETF in the world and US$3.8
billion Tracker Fund of Hong Kong, largest ETF in Asia (ex-Japan)
 Preferred partner of stock exchanges to development their system platform
for ETFs

AMEX, Toronto Exchange, Hong Kong Exchange, Singapore Exchange,
Australia Exchange
 Invested and committed significant time and resources in the development
of ETFs that vary by legal structure and trade under different market
conditions
 Specialists are involved in every step of the ETF process, from
development, to conversion, and to successful implementation in North
America, Europe and Asia - dedicated, experienced ETF Asian Team
55