ETF Fundamentals

ETF Fundamentals: How ETFs Work, And What Hidden Risks Really Exist Welcome How ETFs Work Features & Benefits Issues & Risks MaL Hougan President, ETF Analy2cs Global Head of Editorial IndexUniverse IndexUniverse.com Exchange‐Traded Funds Report Journal of Indexes Inside ETFs Inside ETFs Europe InsHtuHonal‐Caliber Research Panel Discussion MaL Hougan President, ETF Analy2cs Global Head of Editorial IndexUniverse Michael Johnston Co‐Founder ETFdb.com Tom Lydon Founder and CEO ETFTrends.com An ETF is … … a mutual fund It’s structured It’s managed It’s regulated A Mutual Fund With A Twist Listed on an exchange (like a stock) It’s Traded intraday (like a stock) Why ETFs? Intraday Trading Lower Costs Tax Efficiency Transparency Access To Anything How A Mutual Fund Works $10,000 $10,000 $10,000 $10,000 100 @ $100 100 @ $100
Mutual Fund 100 @ $100 100 @ $100 $40,000 How A Mutual Fund Works 100 @ $100 100 @ $100 100 @ $100 100 @ $100 Mutual Fund $40,000 How It Really Works $10,000 of XYZAB Please! Broker $10,000 Big Funds, Inc. 702 @ $14.23 How It Really Works $10,000 of XYZAB Please! Broker $10,000 Big Funds, Inc. 702 @ $14.23 12 9 3 Assets: 6 $14.23 $ 1203,580,25.8
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How An ETF Works 100 shares of SPY Please! Broker Bid: 101.20 Ask: 101.23 12 9 3 6 Market 100@ $97.23
ETF Anatomy: CreaHon/RedempHon Security Basket $2.5 million IBM MSFT AAPL CAT CSCO ETFs, Inc. Authorized ParHcipant ETF Anatomy: CreaHon/RedempHon Security Basket $2.5 million ETFs, Inc. 100K @ $25 Authorized ParHcipant ETF Anatomy: CreaHon/RedempHon Authorized 100K @ $25
ParHcipant 50K @ $25 IBM MSFT Security ETFs, Inc. Basket AAPL CAT CSCO Market ETF Anatomy: CreaHon/RedempHon 100K @ $25 ETFs, Inc. Security Basket Authorized ParHcipant Market
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Fair Value: $50 Sell! Benefit 1: Intraday Trading Trade AnyHme the Market’s Open Benefit 2: Lower Costs ETFs cost fund companies less. So ETFs cost investors less. Equity ETF: 0.53% Average Equity Mutual Funds: 1.42% Average Benefit 3: Tax Efficiency 23.5% of mutual fund gains sacrificed to taxes 2010 ETF Scorecard •  No Major DistribuHons •  iShares = 5 of 219 ETFs •  SPDRs = 9 of 94 ETFs •  PowerShares = 3 of 112 ETFs •  ProShares = 0 of 90 ETFs Benefit 4: Transparency Daily Disclosure vs. “Whenever we want” Benefit 5: Access 1,123 ETFs 232 New 789 Coming Issue: Flash Crash Rydex S&P 500 Equal‐Weight ETF (NYSEArca: RSP) Flash Crash ConHnued ETFs represented 70%, or 227, of the 326 securi2es for which trades were cancelled by the exchanges, owing to a price drop of 60% or more.   Returns of some ETFs underperformed the underlying porbolios by more than 60%.  
Issue: Commissions Every transacHon has a cost, no maLer how low* *Note new zero‐cost commission ETFs Issue: Spreads Liquid Funds = Penny Spreads Illiquid Funds = > 4% Spreads Issue: Fair Value Most ETFs trade close to NAV But all funds can get out of balance iNAV only a parHal soluHon Issue: Liquidity in Fixed Income Issue: Emerging Markets Issue: Counterparty Risk A small issue for funds that use swaps: ‐  Inverse ‐  Leveraged A major issue for exchange‐traded notes and ETFs owning only swaps Issue: DerivaHve Use Market Vectors China (PEK) Fund Holdings as of 03/07/2011 CSI300 TR Index Swap (CS) Net Other Assets / Cash Contracts No2onal Value Market Value 38,440 $19,311,647 $1,344,002.67 0 0 $19,346,595.33 Issue: SecuriHes Lending Issuers Who Lend Issuers Who Don’t Not All ETFs Are Created Equal Not Even All ETFs Tracking The Same Index Are Created Equal EEM vs. VWO: Same Index, Different Results Issue: The Knowledge Gap: Spot Oil vs. USO vs. USL The Knowledge Gap: Spot Natural Gas vs. UNG vs. UNL The Knowledge Gap: Leveraged ETFs Issue: Tax Treatment Product Category Long‐Term Max Rate Equi2es Bonds Commodity ETFs (Futures) Commodity ETNs Next‐Gen Commodity ETFs (Futures) Commodity ETFs (Bullion‐based) Currency ETFs Currency ETNs Certain WisdomTree Currency ETFs 15% 15% 23% 15% 15% 28% 35% 35% 15% Issue: ALacks On ETFs •  Kaufmann Report •  Bogan Report •  Various Blogs and Web sites ETFs: World‐Class Tools Hundreds of choices Extreme efficiency Easy access Complete transparency InsHtuHonal quality