How to Understand, Evaluate
and Trade Exchange-Traded Funds
Dave Nadig
Director of Research
IndexUniverse.com
Why ETFs?
Intraday Trading
Lower Costs
Tax Efficiency
Transparency
Access To Anything
Why ETFs?
Really?
Creation/Redemption
Lessons from the Flash Crash:
ETFs Are Complex
Rydex S&P 500 Equal-Weight ETF (NYSEArca: RSP)
ETF Selection Matters
Subsectors too: Three regional banking ETFs
66% spread in performance
Not Even All ETFs Tracking The Same
Index Are Created Equal
EEM vs. VWO: Same Index, Different Results
Sometimes, the ETF industry reminds me of the
cereal aisle at my supermarket …
Completely
overwhelming.
Structuring ETF Choices: Three
Decision Points
Efficiency
Tradability
Fit
What’s Efficiency?
Efficiency is how well a fund delivers on its core
promise to investors.
What’s Efficiency?
• Expense Ratio
• Tracking Error
• Optimization/Full Replication
• Fund Structure
• Tax Treatment And History
• Fund Closure Risk
• Credit Risk
What’s Efficiency?
BND vs. AGG on Optimization
BND
AGG
Issues in
Benchmark
8,717
8,717
Issues in Fund
3,743
224
Fund Ex-Ante
Tracking Error
+/- 7 bps/year
+/- 27 bps/year
What’s Efficiency?
EEM vs. VWO on Tracking Error
EEM
VWO
Expense Ratio
0.72%
0.27%
Issues in Benchmark
756
756
Issues in Fund
623
849
Goal of Optimization
Tax/Trading Efficiency Replication
% Weight In Brazil
15.34%
15.55%
% Weight In India
6.96%
7.93%
1-Year Performance
18.29%
20.75%
Holdings 4/30/10, returns through 5/31/10
What’s Efficiency?
It’s Favorable Tax Treatment
Product Category
Long-Term
Max Rate
Equities
15%
Bonds
15%
Commodity ETFs (Futures)
23%
Commodity ETNs
15%
Next-Gen Commodity ETFs (Futures)
15%
Commodity ETFs (Bullion-based)
28%
Currency ETFs
35%
Currency ETNs
35%
Certain WisdomTree Currency ETFs
15%
What’s Efficiency?
It’s Fund Structure: Grantor Trust, 1940 Act, Commodity Pool, etc.
What’s Tradability?
Myth 1: You Can’t Buy An ETF With
Less Than $50 Million In Assets.
8,300 = Average Daily Volume
145,000 = Total Volume for the Day
92,800 = Size of a Single Trade
$4.6m (28%) = Growth in the Fund for the Day
What’s Tradability?
Myth #2a: An ETF is as liquid as its underlying
IWO
56.92
56.87
56.82
NAV Ask
IWO Ask
IWO Bid
NAV Bid
56.77
56.72
12:35:00 PM 12:37:09 PM 12:39:05 PM 12:41:04 PM 12:42:50 PM 12:44:30 PM
Intelligent Limit Order
Sweeping The Book
(total volume during trade: 72,600 shares)
(total volume during trade: 43,800 shares)
What Is Tradability?
Fair Value In Challenging Markets
HYG Premium/Discount Over Time
15%
Premium (%)
10%
5%
0%
-5%
-10%
J-08
A-08
S-08
O-08
N-08
D-08
J-09
F-09 M-09
A-09 M-09
J-09
What’s Fit?
It means
knowing
what you
own.
What’s the Market Cap of Wheat?
GSCI
DJ-AIG
DBCI
RICI
Energy
Industrial
Metals
Precious
Metals
Ags
1-Yr Perf.
70.88%
8.80%
3.08%
17.14%
25.87%
31.46%
20.92%
12.89%
34.73%
20.53%
55.00%
12.50%
10%
22.50%
17.83%
44.00%
15.00%
6.80%
34.20%
31.73%
Data as of March 31, 2010
Evaluating Commodity Exposure For Fit:
USO vs. Spot Oil
Conclusion