EXCHANGE-TRADED FUNDS AS AN INVESTMENT OPTION

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A. SEDDIK MEZIANI

Exchange-TradedFunds as an

Investment Option

© A. Seddik Meziani 2006

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP.

Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

The author has asserted his right to be identified as the author of this work in accordance with the Copyright,Designs and Patents Act 1988.

First published in 2006 byPALGRAVE MACMILLANHoundmills, Basingstoke, Hampshire RG21 6XS and175 Fifth Avenue, New York, N.Y. 10010Companies and representatives throughout the world.

PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd.Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries.

ISBN 978-1-349-51625-4

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ISBN 978-0-230-51337-2 (eBook)DOI 10.1057/9780230513372

To the memory of my father, who esteemedlearning and aspired to it, though life’s circumstances

and vicissitudes denied him the opportunity

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List of Figures xi

List of Tables xii

List of Boxes xiv

Acknowledgements xvi

Preface xviii

1 Active versus Passive Investing 1Introduction 1Implementing an Asset Allocation: A Passive or Active Approach? 1

The Efficient Market Theory 2Expanding the Scope of Indexing 12Measure of Bond Performance 15Summary 19

2 Security Market Indexes 21Introduction 21Factors Underlying the Demand for Security Market Indexes 21

Main Differentiating Characteristics of Market Indexes 23Other Stock Indexes 30Bond Indexes 35Summary 38

vii

Contents

3 Exchange-Traded Funds versus Mutual Funds – Weighting the Options 40Introduction 40Structure of ETFs 40Trading ETFs 43Impact of New Factors on the Liquidity of ETFs 48Lower Management Fees 50ETFs Drawbacks 55Summary 57

4 Tax Advantages of Exchange-Traded Funds 58Introduction 58The Rebalancing Process 58Taxable Gain at the Inception of Investment 60Redemption in Stock or in Cash 61Tax Efficiency of Redemption 62Tax Consequences on ETF Shareholders 66Summary 69

5 Tax Savings of ETFs over Mutual Funds: A Case Study 70Inroduction 70Actual Tax Savings: Methodology 70Tax Efficiency, but … 80Other Considerations Underlying this Tax Advantage 83iShares on Benchmark S&P 500 85Summary 90

6 Evolution and Outlook of Equity ETFs 91Introduction 91History of Equity ETFs 91Exchange-Traded Funds by Asset Category 96ETF Outlook 108Sources of Information 116Summary 120

7 Fixed-Income ETFs 121Introduction 121Circumstances Surrounding the Launch of Fixed-Income ETFs 122Current Product Universe 126ETF Advisors’ Fixed Income Trust Receipts or FITRS 133General Features and Benefits 135Out of the Gate 137Summary 141

CONTENTSviii

8 Exchange-Traded Funds and the Wash-Sale Rule:New Twists on an Old Plot 143Introduction 143Investors have become More Tax-aware 144Tax-Loss Offset Strategies based on Securities Swaps 146Tax-Loss Offset Strategies as they Apply to Investment Products other than ETFs 147Tax-loss Offset Strategies as They Apply to ETFs 149Could Stocks and ETFs Possibly Constitute “Substantially Identical Securities”? 158Summary 159

9 Anatomy of the ETF Landscape in Europe:General Market Conditions 161Introduction 161Common Features but … 162Anatomy of Europe’s ETF Market 166Asset Allocation 173Actively Managed ETFs 176Summary 179

10 ETFs for Europe and Other Market Exposures 181Introduction 181Traditional Methods of Investing in Foreign Securities 181Global Asset Allocation with MSCI’s iShares 186International ETFs Tracking Indexes Other than MSCI’s 194International ETFs Trading in Foreign Markets 198Concerns and Other Points of Interest 214Summary 225

11 The Advent of ETFs in Imperfect Markets: Case of Mainland China 227Introduction 227Brief Overview of China’s Markets 228Index Review 233China’s ETFs 237Are China’s ETFs an Idea Whose time has Come? 242Summary 246

12 Long–Short Investment Strategies using ETFs 248Introduction 248Essentials of Short Selling 249Short Selling with ETFs 251

CONTENTS ix

Practical Strategies 259Global Perspectives of Short Selling 264Summary 269

13 Other ETF Investment Strategies and Applications 270Introduction 270Futures Contracts 270Futures Contracts on ETFs 273Futures on European ETFs 277Margin Trading with ETFs 282Summary 288

14 Investment Strategies using Options on ETFs 290Introduction 290Basic Features of Option Contracts 290Options on ETFs 293Investment Strategies using ETF Options 299Other Options Strategies 304Summary 310

Index 311

CONTENTSx

2.1 Market performance in 2004 of selected countrys’ indexes 333.1 Role of ETF market makers in providing liquidity in

ETFs transactions 464.1 Index turnover 59

11.1 Market capitalization split by share type 23914.1 iShares Lehman 20� year Treasury Bond Fund – TLT 30814.2 iShares Lehman 1–3 year Treasury Bond Fund – SHY 30914.3 iShares GS $ InvesTop Corporate Bond Fund – LQD 309

xi

List of Figures

2.1 Selected measures of total US securities markets 303.1 Vanguard’s ETFs 493.2 Aggregate costs of buying and owning ETFs 513.3 Cost of owning the ten largest ETFs, ranked by

asset size 543.4 A comparison of ETFs and traditional index mutual funds 555.1 Top 10 ETFs by assets 715.2 Tax rates 735.3 Historical distributions per share 1993–2003 745.4 Historical distributions per dollar invested 1993–2003 775.5 Tax comparison – SPDR 500 versus Vanguard 500 795.6 iShares 500 index fund (IVV) historical distributions 875.7 Tax comparison – iShares 500 index fund (IVV)

versus VFINX 886.1 US equity ETFs by AUM, net issuance of shares,

and number of funds 946.2 Trends in stock mutual fund investing 956.3 ETF market at a glance ($billion) 976.4 AMEX – listed broad-based ETFs 996.5 AMEX – Listed Industry Sector ETFs 1107.1 Current ETFs as per Standard & Poor’s credit

rating classification 1257.2 Characteristics of fixed-income ETFs 1277.3 Listed fixed-income ETFs growth and market share 1387.4 Fixed-income ETFs – historical distributions 1408.1 Select sector SPDR health care (XLV) – top 10

holdings as of December 31, 2004 1538.2 Sample of sector ETFs with similar investment

characteristics 155

xii

List of Tables

8.3 Top industry sectors of the QQQQ and IYW 1569.1 Europe’s iShares MSCI ETFs: change in TER (bps) 1649.2 Listed ETF growth: US versus Europe 1679.3 Managers of European listed ETFs 1689.4 ETF trading volume in Europe 1719.5 ETF exposure by index category 174

10.1 Amex-Traded MSCI international iShares,September 2004 188

10.2 BGI’s iShares – premium and discount 19010.3 Other US-traded international ETFs 19610.4 List of international ETFs trading outside the US 20110.5 Fund concentration 21710.6 List of international fixed-income ETFs 22311.1 Index characteristics 23411.2 Monthly discount/premium summary 24011.3 Concentration risk: FTSE/Xinhua versus

iShares MDCI China Tracker 24412.1 ETFs short interest (based on mid-month

settlement date) 25312.2 Global perspectives of short selling 26613.1 Futures on the Diamonds 27413.2 Main characteristics of Eurex Futures on ETFs 27913.3 Hedging strategy based on the Dow Jones EURO

STOXX 50 EX Futures contracts 28114.1 US listed EFT option contracts trading volumes 29614.2 Options on Canadian listed ETFs 30114.3 Options on European listed ETFs 30214.4 Value of covered position at option expiration 306

LIST OF TABLES xiii

1.1 Gains on index funds tend to outpace returns on managed funds 10

1.2 Passive investing is catching on fast in Japan 142.1 What’s behind the recent underperformance of the

Dow industrials? 242.2 Socially responsible investing 363.1 An illustration of arbitrage 453.2 Rule 12(b)-1 or the hidden costs within the

mutual-fund industry 524.1 How to run up a $10,000 tax bill without even trying 634.2 Cashing out like crazy 645.1 Mutual funds possess a stash of losses to carry forward 835.2 Barclays new introduction 866.1 Actively managed ETFs near 1176.2 The internet and information concerning

exchange-traded funds 1187.1 Fixed-income ETFs: investors now have a new

option to consider 1237.2 Calculation of real and nominal rates of return

on a TIPS bond 1318.1 Tax-loss harvesting using ETFs 1518.2 Balance investment profits with losses 1579.1 Barclays asks European Commission to regulate ETFs

on a pan-european basis 1659.2 ETF Firm launches quasi-active ETFs 178

10.1 Arbitrage is a riskier proposition on international ETFs 19310.2 A weakening dollar can improve the returns on

foreign investments 199

xiv

List of Boxes

11.1 China’s bourses are still roller coasters of instability – and change may take some time 230

11.2 Chinese share description 23211.3 China futures 24312.1 Illustration of a short sale 24912.2 How short-the-market works 26313.1 Are single stock futures treacherous for individual investors? 27213.2 Portfolio margining for the sophisticated investors 28714.1 Strategic possibilities increase with options on ETFs 29414.2 McGraw-Hill seeks temporary restraining order against

ISE and OCC 300

LIST OF BOXES xv

Parts of this book grew out of articles written for various academic andpractitioners’ journals, in particular Institutional Investors’ InvestmentGuides on ETFs. As such, I would like to thank the numerous reviewers,anonymous and otherwise, who criticized, challenged, encouraged, and attimes complimented my efforts. I hope they will all be pleased to know thattheir thoughtful input has permeated the content of this volume.

It would not have been possible to write this book without the expertiseand guidance provided by many of my colleagues and friends at MontclairState University. I am particularly indebted to James Yang, professor ofaccounting and taxation, upon whose expertise I called several times to nav-igate through the tax issues; and to Phillip LeBel, Professor of Economics,for his inquisitive and challenging contributions in our many stimulatingdiscussions.

Of all those who provided critical input to this work, only two peopleother than myself have read the entire manuscript: Karen Dennis andAndrew Pole. Karen, who is Assistant Dean of the School of Business ofMontclair State University, has served as my de facto internal editor bygenerously giving her time and expertise as a reviewer. I truly appreciate thecountless hours she spent tightening up the language and improving theflow of the discussion, which helped make writing this book both efficientand enjoyable. I cannot thank her enough.

Andrew Pole is a managing partner at Tiedemann Invictus Partners,a New York hedge fund company. He has expansive experience in hedgefund risk management and building equity trading models. He has madenumerous contributions to most parts of the book though his constructivecriticism and insightful feedback. I owe a great debt to his careful anddetailed recommendations for making the book both more readable andinformative.

xvi

Acknowledgements

Last, but certainly not least, I wish to thank my wife Jacqueline and ourchildren Harris and Hanna for the patience and support they demonstratedduring those uncountable hours spent on the book: day by day, inimmeasurable ways, they shared with me the process of writing it.

A. Seddik Meziani, Ph.D.

ACKNOWLEDGEMENTS xvii

In today’s constantly changing financial markets, there are many newchallenges in the process of making investment choices: What are the bestinvestment vehicles among the multitude of new products constantly broughtto market? What is the market outlook in light of the staggering and often con-flicting information available to investors? How can commissions on transac-tions be further reduced? What are the tax implications of a given investmentstrategy? Which of the newly formed international financial markets will fur-ther enhance a portfolio? What about risk? What roles can options and futuresplay in an investment program? These are a few of the questions investors askthemselves before committing to a specific investment plan.

This book is designed to answer such questions regarding one relativelynew investment product, the Exchange-traded fund (ETF), providing theknowledge needed to actively develop and monitor ETF portfolios. It is ourhope that the book will meet many of the needs of practicing investmentprofessionals who are its focus.

The book is also a valuable resource for professors and students who areincreasingly curious about these financial products, which have attractedover $300 billion of investor funds worldwide as of early 2005; many willwant more information about ETFs than is available even in the latesteditions of investment textbooks. By elaborating on innovative investmentvehicles and highlighting important issues and Real-life scenarios throughthe liberal use of examples, with point of interest boxes in each chapter, wehope to guide such readers through the material productively.

The book is organized into 14 chapters that provide a structured frame-work for learning about ETFs. Many readers will chose to go through itscontent in the order presented, although most chapters can be read in anysequence.

The book as a whole integrates theoretical concepts with practical invest-ment applications, and, because of its dual purpose, mixes description and

xviii

Preface

theory. For example, the descriptive material relates the evolution of ETFsand discusses availability and growth in the United States and around theworld. As recently as 15 to 20 years ago, most individuals invested almostexclusively in purely domestic investments. Today, investors routinely lookfor foreign investment opportunities as well. In theory, the book both detailsthe underpinnings of ETFs and carefully evaluates the pros and cons of eachinvestment strategy so that the reader can knowledgeably include them in aportfolio that will satisfy specific risk-return objectives.

A number of key points are emphasized throughout the book. Becauseinvestors need to invest at a risk level that is consistent with their personalrisk preferences and constraints, we adopt the familiar academic strategy ofemphasizing the informational differences that exist among various types ofsecurities. Higher returns can be expected only from investment strategiesthat take on additional risk. Hence, while the degree of market efficiency isa matter of opinion and debate, there is a trade-off between expected returnsand risks, a fact that should be considered by ETF investors as with anyothers. Although the bulk of this dialogue is confined to Chapter 1, theimplications of the efficient market hypothesis also permeate discussion inthe sequel.

Chapter 2 reviews the main market averages and the methodologiesunderlying their construction. This discussion is important because twoindex funds with the same objective do not necessarily generate the samerisk adjusted return. If one ETF tracks the Russell 2000 and another theS&P 600, two small cap market averages compiled differently, one shouldnot expect the two funds to show identical performances.

Often described as hybrid investment vehicles that combine the tradingflexibility of individual stocks with the diversification benefits of mutualfunds, ETFs have raised the question for some investors as to whether theymay be a practical alternative to mutual funds. Chapter 3 compares thesetwo investments, exploring whether ETFs offer investors realizable advan-tages not available to mutual funds owners, and vice versa. This comparisonis continued in Chapters 4 and 5, where the two investment alternatives arecompared in terms of the tax advantages they offer.

The tax assessment of ETFs also continues in Chapter 8, where they areevaluated in terms of a tax-loss offset strategy that may allow ETF holdersto take advantage of tax laws that allow the netting of capital gains andcapital losses. This tax-management strategy is examined in detail, espe-cially as it applies to ETFs, to determine whether it truly can enhance theability of knowledgeable investors to engage in portfolio tax management.

Chapter 6 traces the evolution of, and sketches out future prospects forETFs. Only in 1998, after enduring five years of distinct obscurity sincetheir launch on the American Stock Exchange in 1993, did ETFs start toexperience success. Their popularity has grown so dramatically since then

PREFACE xix

that many enthusiasts have openly proclaimed them as the future of theinvestment industry.

This success is further emphasized in Chapters 9, 10, and 11 describing theglobal expansion of ETFs, which was fueled by asset managers’ efforts todevelop new product offerings in order to meet the growing global investmentneeds of both institutional and individual investors. With this broadening ofattention to the international setting, the general consideration that developedmarkets are informationally more efficient than emerging markets makesrevisiting the efficient market hypothesis desirable (Chapter 10).

Chapter 11, in particular, narrates the advent of ETFs in the information-ally imperfect market of mainland China. The allure of China is well knownand investors now have the opportunity to broaden their exposure to itsequity markets through the relatively new iShares FTSE/Xinhua China 25Index Fund and PowerShares Golden Dragon Halter USX China. Yet eco-nomic growth doesn’t necessarily translate into steady stock-market gains.Chinese stock markets face numerous challenges, ranging from poor corpo-rate governance and doubtful accounting standards to efforts by the govern-ment to sell large stakes in Chinese companies without hurting share prices.These are pertinent issues that investors should carefully consider beforeallocating any part of their portfolios to China’s ETFs.

The fact that fixed income ETFs currently represent only a small fractionof the total ETF market should not prevent us from treating them as the full-blown asset class they really are. Chapter 8 offers an extensive coverage ofthese products in terms of their immediate features such as their tax effi-ciency (or lack of it) in relation to equity ETFs, as well as the differences intheir yield properties based on whether they track an index of governmentsecurities, an index of corporate bonds, or one that includes both, such asthe Lehman U.S. Aggregate Index.

Chapters 12, 13, and 14 of the book are dedicated to various investmentstrategies that can be used with the derivative securities available to ETFinvestors. These strategies typically possess a high level of risk because theyusually have uncertain returns. The key derivative securities discussed areoptions and futures on ETFs. They are introduced in terms of their specula-tive use, but also as hedging instruments used to protect existing investmentpositions against unstable market values. The coverage of these tradingstrategies reflects the gradual success with investors experienced by ETFs.Indeed, such strategies would not have been possible had ETFs not experi-enced a dramatic growth both in volume and scope.

As a general word of caution, the reader should not assume that mentionof a specific ETF or description of an investment strategy constitutes arecommendation to buy that security or engage in that strategy. These exam-ples have been chosen for the sole purpose of illustrating specific points, notto pass judgment on individual ETFs or specific trading strategies.

PREFACExx

Finally, I have heard it asserted that the pleasure of authoring a bookcomes from writing about a subject that you enjoy. I cannot agree more: theexploration of this subject has been a pleasure, and I hope that readers willfind the topic and the discussion as engaging and as productive as I have. Asexchange-traded funds and their derivatives continue to grow in importancefor both institutional and individual investors, our understanding of thesefinancial instruments inevitably will grow; I hope this book provides a solidfoundation for that evolving knowledge.

PREFACE xxi