A primer on ETFs

Tolmas Wong, CFA,

Aug 2008

Outline

� How ETFs work?

� The ETF revolution

� Key selling points� Key selling points

� Risk factors

� Equity ETFs

� Bond ETFs

� Commodity & currency ETFs

� ETFs on SGX

� Managing your ETF portfolios

� Going forward……

What are ETFs?

� ETF represents shares of ownership in either index funds or trusts that are listed on an exchange & hold portfolios of common stocks or bonds which are designed to track the price & yield performance of their underlying indexesperformance of their underlying indexes

� ETF gives investors the opportunity to buy or sell an entire portfolio of stocks or bonds in a single security, as easily as buying or selling a share of stock

� While index funds are priced once after the end of each trading session, ETF prices change throughout the day because they trade like shares. Also can be sold short & bought on margin. It add the flexibility, ease & liquidity of stock trading to the benefits of traditional index funds

� ETF holders are eligible to receive their pro-rata share of dividend, if any, accumulated on the stocks/bonds held in the ETF

ETF structure

How ETFs work?

� Unlike open-end mutual funds, ETF shares aren’t sold/redeem directly to/from the public for cash

� Instead, fund companies exchange large blocks of ETF shares called creation units for actual shares of the underlying stocks called creation units for actual shares of the underlying stocks turned in by ‘authorized participants’. Most transactions are at least 50,000 ETF shares or multiples thereof

� After an ETF creation unit is issued, the institutions either hold the unit in their portfolio or break it up into individual ETF shares & sell to the general public via the stock exchange

� When an institution redeems an ETF creation unit, they receive individual securities + a cash portion from unpaid dividends

� As an individual investor, you can’t transact directly with the fund company. Rather, all trades must go through a stock exchange

� Such in-kind transactions help to minimize tax liability to the ETF as no capital gain will be realized on redemption

Key selling points

� Exposure to a diversified portfolio at lower cost & management fees

� Transparency of underlying securities in the portfolio� Transparency of underlying securities in the portfolio

� Access to a wide range of asset classes, markets & sectors

� Small capital outlay & cost effective(no load fees)

� Ability to buy & sell anytime throughout the trading day

� Minimum premiums/discounts to NAV. Market price of a single ETF share usually trades close to its NAV

� Ability to short sell

Key Selling Points

Expense ratio comparison

Fund Category Avg Active Fund

Avg Index Fund ETF

US Bond 1.08% 0.52% 0.15% (LQD)US Bond 1.08% 0.52% 0.15% (LQD)

Large Blend 1.38% 0.765 0.09% (SPY)

Large Value 1.42% 0.19% 0.15% (IWB)

Midcap 1.54% 0.88% 0.2% (IJH)

Small cap 1.67% 0.86% 0.2% (IWM)

Foreign equity 1.76% 0.99% 0.34% (EFA)

Sector 1.9% 1.49% 0.65% (KOL)

The ETF revolution…

� Poor investment returns, high fees & questionable loyalties by the purveyors of active mutual funds caused an outcry for a low-cost index solution

� The Vanguard Group introduced the 1st index fund & � The Vanguard Group introduced the 1st index fund & revolutionized the investment industry since then

� Amex pioneered the creation of SPDR in 1993 & is followed by the debut of DIAMONDs, QUBEs, iShares, VIPERs….on NYSE, AMEX & Nasdaq

� Different ETFs have have different pricing structures e.g. 1/10 of the index value or some other set fraction

� Over the last 5 years, the ETF universe has exploded to include new asset classes & extended into narrower subsegments of the market, more strategy-based & theme-based indexes

ETFs guaranteed mediocrity?

� Like actively managed funds, ETFs could also lose ground to the market. But they lose by less than other funds, which makes them a winning investment

� ‘What we need is a no-load, minimum management fee mutual fund � ‘What we need is a no-load, minimum management fee mutual fund that simply buys the hundreds of stocks making up the broad market averages & does no trading from security to security in an attempt to catch the winners’. - Burton Malkiel

� Some of the lowest cost index funds charge <0.3% p.a. in annual expense & doesn’t incur much trading cost because they rarely buy & sell stocks

� Bottomline : Are average returns better than below average returns?

� For long term investors, ETFs provide a broadly diversified exposure, keep investment costs to a bare minimum, & may be tax efficient to some investors.

Sector ETF outperforms

Foreign ETFs

Diversification choices

� Fund providers have expanded offerings of ETFs to include a wide range of equity sector funds, style funds, international funds, commodity funds & currency funds

� Different size companies – big, mid & small caps� Different size companies – big, mid & small caps

� Styles – value, growth, dividend yield

� Worldwide selection – single country, regional & global

� Specific industries - e.g. iShares S&P Global Clean Energy

� Specialized indexes e.g. S&P 500 Equal Wt Index

� Specific asset classes – TIPS, water, coal

� Inverse ETFs that bet against an index e.g. Short Proshares

� Leveraged ETFs that turbocharged the upside/downside changes of an index e.g. Ultras, Rydex 2X Russell 2000 ETF (RRZ), S&P 500 Bull 3X & Bear 3X Shares (filing to SEC in Jun’08)

SPDRs (1993)

DIAMONDs (1997)

Qubes (1999)

Biotech HOLDR (BBH)

Energy Select sector SPDR (XLE)

SPDR Metals & Mining (XME)

iShares Emerging Markets (EEM) -1 year

iShares Emerging Markets (EEM) -5 Year

iShares MSCI Malaysia (EWM)

Nomura Nikkei 225 ETF (1321 JP)

iShares Lehman Aggregate Bond (AGG)

Fund invests primarily in investment grade debt issues

(rated in top four grades) with dollar-weighted

average maturities of five to ten years. average maturities of five to ten years.

iShares Lehman Aggregate Bond (AGG)

streetTracks Gold Trust (GLD)

US Oil Funds

IShares S&P GSCI Commodity ETF

Funds that invest primarily in the equity securities of

domestic and foreign companies engaged in trading

commodities such as food, grains, metals, foreign commodities such as food, grains, metals, foreign

currencies, futures contracts, and financial

instruments, which can be interchangeable with

another product of the same type.

IShares S&P GSCI Commodity ETF

Coal ETF

� Van Eck Market Vectors Coal ETF (KOL) tracks the Stowe Coal Index which isn’t designed to track actual coal prices but rather stock prices of coal-related companies.

� Stowe Copal Index contains 60 companies worldwide that derive � Stowe Copal Index contains 60 companies worldwide that derive at least half of their revenue from coal.

� Divided into 5 sectors: coal mining & production (73%), power generation (15%), mining equipment producers (9%), coal technology & transportation (3%)

� About 60% of the index is in non-US stocks & top holdings include Bumi Resources, China Shenhua Energy & China Coal

� Van Eck Global also launches an agribusiness ETF (MOO), a Gaming ETF (BJK) & a steel ETF (SLX)

Market-Vectors-Coal ETF (KOL)

PowerShares DB Agriculture

Rydex 2x Russell 2000

Ultrashort Dow 30

Fund that employs portfolio strategies that consistently

create a "net short" exposure to the market. This

objective also includes short only funds, i.e. funds that objective also includes short only funds, i.e. funds that

pursue short sales of stock or stock index options.

Ultrashort Dow 30

Short Russell 2000 Proshares

Risk factors

� Market, asset class or sector risks when prices of underlying securities fall in a bear market

� Liquidity & attention aren’t uniform across all ETFs Tracking error risk especially untested indexesTracking error risk especially untested indexes

� FX risks if ETFs are traded in foreign currencies or consisting of foreign securities

� Trading risk as bid-ask spread can be large for some ETFs & no assurance of depth & liquidity in the secondary market especially those with small AUM

� Taxation. Non-US investors holding US established ETFs maybe subject to US withholding tax on dividends/distributions

Risk management on ETFs

� For some ETFs, there exist futures & options contracts on the same index, sufficiently diverse to allow for risk management. Optionable ETFs allow hedging via covered call writing or putscovered call writing or puts

� Combining both ETFs & options into an investment program works well in both bull & bear markets with steadier & more predictable returns

� In the US, about 69% of US-listed ETFs have options

� Examples of optionable ETFsDIA, QQQ, MDY, VTI, EFA,SPDR

� Eurex launched the first-ever futures & options contracts linked to ETFs in Europe in 2002

iShares DJ Select Dividend (DVY)

Case study: DVY

� DVY tracks an index of the 100 highest dividend yielding securities listed in the US & REITs are excluded

� Expense ratio 0.4%

� Traded 33% below its May’07 high on 22/1/08 & down 10.4% yoy � Traded 33% below its May’07 high on 22/1/08 & down 10.4% yoy & trailed behind S&P 500 by >4%, according to Morningstar

� Assets peaked at US$9.1bn in May’07 & currently stood at about US$6.3bn due to investor withdrawals & market decline on subprime & credit upheavals

� BGI disclosed that the financial sector accounts for almost 50% of ETF’s assets & utility sector for about 18%. (Vanguard had only 17% exposure to financial at end’07)

� Investors should be aware of sector allocations & ETFs can have significant sector bets (concentration risk) & not all are mainstream funds

Uses of ETFs

� Asset allocation. Provide investors with exposure to broad segments of the equity markets/asset classes & build customized portfolios or targeted industry sector exposure

Cash equitization. An alternative to equity derivatives for � Cash equitization. An alternative to equity derivatives for investors to seek immediate exposure to equity markets or segments

� Core/satellite strategy to fill in sector or regional exposure gaps

� Risk management. Can be borrowed & sold short for specific sector hedges/risk exposure with the increasingly broad array of ETFs. The smaller denominations in which ETFs trade relative to most derivatives contracts give a more accurate risk exposure match

Institutional Uses of ETFs

� ETFs can fit into active as well as passive strategies.

� Active managers use ETFs to augment or reduce sector weight

� In the same way, international & emerging market ETFs offer a In the same way, international & emerging market ETFs offer a manager quick & efficient exposure to foreign markets in country allocation decisions

� ETFs can provide an alternative to futures as a transitional tool, while moving from one manager or one asset allocation to another, & saving a roll cost

� Blend of Treasuries & fixed income ETFs help to shorten maturity & reduce interest rate & principal risks

Asset Allocation approach

Hypothetical Portfolio Annualized Returns

Optimize risk & return

ETFs on SGX

� streetTracks STI Index Fund

� streetTracks Gold Fund

� iShares MSCI India� iShares MSCI India

� Lyxor Asia

� Lyxor China H

� Lyxor Hang Seng

� Lyxor Japan

� Lyxor Korea

� Lyxor Taiwan

� Lyxor Commodity

� FTSE Shariah Japan 100

Lyxor Commodities CRB

The objective of the Fund is to replicate the

Reuters/Jefferies CRB Global - Total return index, by

using index replication strategies. The Fund invests its using index replication strategies. The Fund invests its

assets in stocks from the commodities sector,

specifically in the energy, metal and agricultural

products.

Lyxor Commodities CRB

Going forward.....

� Today, we have ETFs designed to track benchmarks of all possible hues & shapes

� ETF assets will probably rise to US$1.4 trillion by 2011, according to estimates by Financial Research Corp of Bostonto estimates by Financial Research Corp of Boston

� ETF providers will continue to push new boundaries with more funds tracking bonds, international small-cap stocks & commodities etc…& more elements of active management embedded in them with increased sophistication & deviating from the purist concept of ETFs

� More ETFs are also hitting the market that gives investors leveraged & inverse exposure to global markets. Inverse funds, which provide the opposite return of an index, allow investors to bet against sectors or hedge. Yet these leveraged funds can magnify losses as well as gain!

Don’t let emotions get in the way

In summary…

� Converting to an ETF portfolio doesn’t guarantee positive returns every year

� In the long term, economics drives market returns & a � In the long term, economics drives market returns & a well diversified ETF portfolio will make you more money with less risk

� Each year, different active fund managers become stars because of their short term superior performance but rarely able to maintain consistency.

� Empirical evidence has shown that low cost index funds beat most active funds over time

� ‘Great rewards grow from small differences in cost’