Innovations in Financial Products - Case Study Example

Applied Portfolio Management Exchange-traded funds Name: Course Unit: Name of Supervisor: Date: Introduction One of the benchmarks of market development in the bourse is innovation. An example of fairly recent innovation originates from the mutual fund sector; the inception of exchange traded funds (ETF). The novelty with ETFs is that although they lay claim to similar fundamental capital as the more mainstream open-end mutual funds, they have a different framework and therefore varied character and outcomes for those who invest in them. ETFs and other innovations are produced in order to snare some element of the competitive market, and barring the expense involved in their development, they represent considerable benefit to the investor. This is due to their value addition that fosters greater liquidity, facilitates trade, and brings about the possibility for hedging and arbitrage amongst other services (Agapova, 2006). The Exchange-traded fund can be defined as a combined asset medium whose aim is to reflect the performance of a particular index and is traded as a solitary stock. This implies that it fuses the benefits of diversification inherent to an index tracking fund with the liquidity advantages of trading singular shares. ETFs generally follow the doings of a commodity index, stock or bond. As it is with individual stock, ETFs also possess a ticker, SEDOL and ISIN number. It is also traded on the Exchange. ETFs first came to light in the nineties, with the pioneer being based on the American S&P500 index. From here, it is estimated by Morgan Stanley that ETFs worldwide under management will exceed US$2 trillion by the end of this year (Selftrade, 2008). The Exchange traded funds are enjoying phenomenal universal success and gain continued popularity due to its rapid proliferation. There was a 22% drop in Asset under Management (AUM) in Europe in 2008; this contrasts with the AUM for ETFs which rose by 23% in the same period according to the 2009 Barclays Global Investors ETF Industry Preview. The volumes of ETFs traded are also on the increase. The London Stock Exchange has seen the value of ETFs traded rise by 80% since 2007 while the number traded has recorded a two-fold increase according data from the 2009 London Stock Exchange Monthly Trading Volume. Demand for ETFs could be ascribed to their affordability, convenience, flexibility, miscellany, intelligibility and liquidity. All these are seen as crucial attributes of any investment portfolio. There is a wide range of available literature on the more mainstream mutual funds which address various factors in the sector including management, framework and performance (Elton et al (1993); Sirri & Tufano (1998). By contrast, very little data is on hand on ETFs. This is due mainly to the limited length of time that they have been in existence. The original mutual fund was incepted in the 1940s, with increased acceptance and usage recorded from the 1970s. The ETFs on the other hand, were first created in 1993, although there has been rapid growth and proliferation amongst investors in recent years. The Origin of Exchange-Traded Funds In a paper written by Hakansson (1976), a hypothetical “Purchasing Power Fund” predicted an innovative financial medium composed of “Supershares” that reproduce a dividend only at pre-designated points of market return. The fundamental capital of the Purchasing Power Fund was identified as index funds. A White Paper on ETFs by Novakoff (2000) outlines their origins as follows: Leland, O’Brien, Rubenstein Associates (LOR), is a firm which in the late 1980s was known for development of portfolio insurance products, perceived the need for a basic edition of the Purchasing Power Fund as a hedge product. Under sponsorship of substantial institutional investors, IBM pension fund for one, LOR sought to develop a ‘SuperTrust’ that was fashioned upon Hakansson’s ‘Supershares’ ideas. For the ‘SuperTrust’ to be effective, it required the product to have a principal index investment. The investment must be listed on a stock exchange and have the ability to constantly proffer and transfer shares; in other words, an ETF. Prior to this development, the U.S Securities and Exchange Commission (SEC) had sanctioned securities that were either open-ended or exchange-listed but not both. LOR embarked on the difficult and costly undertaking in 1990 to lobby the SEC to permit the formation of an ETF as the fundamental safety measure for the SuperTrust. They chose the S&P 500 Index as the framework and dubbed it the ‘Index Trust SuperUnit’. In the same year, the SEC released the Investment Company Act Release No. 17809 also known as the ‘SuperTrust Order’ that authorised LOR particular exclusions from the Investment Company Act of 1940. These explicitly allowed exclusion from the regulations governing unit investment trusts and the SEC restrictions that oversee investment companies. They also exempted LOR from the regulations that governed the manner in which securities were traded and exchanged. This facilitated the inception of the first ETF. Subsequent legal delays followed, but in 1993 LOR established the SuperTrust and the Index Trust SuperUnit. These products had benefits over other hedge products however; it ultimately turned out to be too complicated for the marketplace and therefore did not win the patronage that LOR had anticipated. This coincided with a drop in demand for hedge products and resulted in the cessation of the SuperTrust in 1996. LOR intended the Index Trust SuperUnit to be a hedge product investment, but there was also some discourse on the value of the product as an individual S&P 500 Index investment. Although the Index Trust SuperUnit facilitated direct trade in the S&P 500 Index in the same way as a corporation, it was promoted and valued as a hedge product hence were not feasible on its own. This was followed by a petition from the American Stock Exchange LLC, via its ancillary group; PDR Services LLC and the Standard & Poors Depository Receipt (SPDR) Trust. They were successful and received an SEC Order which, in 1992, endorsed a separate S&P 500 Index-based ETF to act as a unit investment trust. Known as the SPDR (pronounced ‘spider’) order, it outlined further exclusions that facilitated for more straightforward exchange of shares, and were well received in the market and achieved commercial success as an ETF unlike the Index Trust SuperUnit. A year later, Morgan Stanley exploited the leeway existing in regulation for the issuance of securities in Luxembourg to incept the Optimised Portfolios as Listed Securities (OPALS) which are listed on the Luxembourg stock exchange. OPALS can be defined as ETFs that mirror various Morgan Stanley Capital International (MSCI) indexes. Their target market is principally institutional investors within OPAL-friendly governments. OPALS are not expensive and have basis points ranging from 9-40. There was invaluable expertise gained by Morgan Stanley with the OPALS. Due to their unrestricted nature when it came to SEC-sanctioned unit investment trust, there was a wider range of management discretion attributed to Morgan Stanley when it came to OPALS. It gave them the chance to experiment with innovative techniques that were later practised upon SEC-approved ETFs. In 1995, there was an order issued by the SEC, similar to the 1992 SPDR Order, with the exception that it followed the S&P MidCap 400 Index and it covered the MidCap SPDR. This was an ETF that exhibited a tax failing that allowed for further tax distributions. This was not rectified until 1999. Morgan Stanley went further in 1996 with the intention to present investments comparable to OPALS to market investors in the United States. They collaborated with Barclays Global Investments and the American Stock Exchange to produce the World Equity Benchmark Shares (WEBS) which, unlike OPALS, were SEC sanctioned. With its background managing OPALS, Morgan Stanley was able to arrange WEBS to run as an investment firm instead of a Unit Investment Trust. WEBS introduced the technique whereby the exchange of shares reduced tariff liabilities produced by ETFs, a departure from SPDR and MidCap SPDR which were deficient in this respect. WEBS also adopted the phrase ‘index fund’ to refer to their ETFs, prior to which, was attributed only to open-ended mutual funds. A new Order by the SEC covering Diamonds ETF was issued in 1997. The Diamonds ETF is founded upon the Dow Jones Industrial Index and is backed by the sponsors of SPDRs. The Diamonds integrated the tax characteristics of WEBS while still remaining a unit investment trust. This was clearly spelt out during its formation unlike with WEBS where the tax advantages were inferred. The following year, this group set aside the unit investment trust framework and applied for permission from SEC to manage particular SPDRs as an asset firm. This was approved and an Order issued in the course of 1998 which included beneficial taxation. These Select SPDRs were developed jointly with Merill Lynch thus they contributed to the expansion of promotion of ETFs. 1999 saw the issue of Nasdaq-100 Trust Order by the SEC under the unit investment trust framework. This trust uses a customised capitalisation-weighted index as its base, primarily for policy reason. Therefore, the Nasdaq-100 ETF is obliquely managed, with restrictions that are still crucial. It quickly gained acceptance in the market. In the same year, Barclays Global Fund Advisors also put in an application to the SEC asking for an Order to cover approximately fifty ETFs which they dubbed ‘Exchange Traded Funds’. From the experience gained through its WEBS collaboration with Morgan Stanley, it utilised the investment firm framework to produce what can be called augmented indexes tracking Russell, S&P, and Dow Jones Indexes. In its application, Barclays allowed itself considerable leeway in management of products while still classifying them as index-based investments. ETFs exploded in the market in about March of 1999 due to the launch of Nasdaq-100 also known as Cubes or Qubes due to its initial ticker, QQQ; which has been recently modified to QQQQ. By the second trading year, Qubes were doing a daily average of 70 million shares or 4% of NASDAQ volume. This created a ripple effect within ETFs, increasing their general popularity. Total AUM increased by more than twofold in 2000, doing a maximum of $70billion by December (Frino & Gallagher, 2001). The ETFs have continued to grow from strength to strength; a 27% rise in 2001, 23% in 2002, 48%, 50% and 31% in ’03, ’04 and ’05 respectively. This has resulted in ETFs being perceived as a substitute for more conventional non-traded index mutual funds and has seen key rivals, for example Vanguard, or Fidelity, reduce their fee by a maximum of 10 basis points (Deville, 2006). ETF Index Sponsors DIAMONDS Dow Jones Industrials AMEX Sector SPDRS Sector AMEX, Merrill Lynch Nasdaq-100 Nasdaq-100 Nasdaq/AMEX SPDR S&P 500 AMEX MidCap SPDR S&P 400 AMEX WEBS MSCI Morgan Stanley, Barclays Table 1: ETFs now available to Retail Investors Operation of the ETF Market Just as it is with MFs and unit investment trusts, the exchange traded funds can be acquired at the close of daily trading for its net-asset value (NAV). Furthermore, ETFs are able to trade as close-end funds which are available all through the day, for a price that may differ from its NAV. When a depositor in open-ended mutual funds decides to cash in their shares, the fund may be forced to liquidate a part of their assets to finance the redemptions. When this happens on a large scale, the formation procedure occurs backwards and the ETF is not obliged to liquefy assets in order to pay investors. These are retrieved ‘in kind’ and this process is not expected to produce capital gains within the fund which would affect Federal tax, but must at a later time be disseminated amongst shareholders. The less substantial shareholders cash in by putting their shares up for sale on the exchange (Johnston, 2009). ETF trading worldwide is similar to that used by AMEX to trade SPDRs. The concept developed by Nathan Most, designer of ETFs was to manage them as product store receipts with the actual goods being conveyed and warehoused and transactions done via the receipts only; with the proviso that receipt holders could receive goods. This ‘in kind’ design and recovery concept has been expanded from goods to stock baskets. Players in the market including institutions deposit the stock baskets that make up the index with a trustee and obtain shares in exchange. These can then be used to trade at an exchange as stock or recovered for the original stock basket that makes up the index. The remarkable thing about this creation process is that the result received by the creator of the shares later redeemed equals the performance of the index less the fee regardless of whether the index has altered since. Figure 1: Primary and Secondary ETF market structure Above is an illustration of how the trading procedure is structured for ETFs; there are two markets, the primary one which is aimed at institutions which design and redeem ETF shares in bundles acquired straight from the fund while the secondary market is less restricted as to the size of purchase. Some provisos such as volume of units can differ from fund to fund but there is a distinctive equity ETF process; i. Formation of Fresh Dividends This is done by institutional investors, who are authorised participants (APs), who enter into an arrangement with the sponsor of the fund and are permitted to create new shares in lots of precise minimal value called creation units. These are not static and differ in proportion from fund to fund with its scope anywhere from 25000 to 300000 shares. The mean usually evens out at 50000 shares or 500 times the dollar value of the ETF underlying index. APs deposit this amount as a stock basket in addition to a calculated top up amount into the fund in return for the commensurate volume of shares. ii. Recovery of Outstanding Shares One cannot redeem shares individually but only by posting a tender to the trust shares in creation units which responds ‘in kind’. There is an offer of the stock basket in addition to monetary compensation for the creation units. Funds are free to recover ETF units using currency with terms and conditions applying, which could include postponements or outlay (Deville, 2006) The creation process for an ETF starts when an index is identified by creators and fund sponsors. Authorisation is sought from the SEC to initiate an ETF and once this is obtained, the sponsors and the APs come to an arrangement by which the ETF and its shares are managed. The sponsors furnish the APs with a portfolio composition folder that outlines the workings and credence of the fundamental securities which reflect the designated index. The APs purchase or have loan of these securities and swap these baskets for creation units that are conveyed to a guardian and the APs get ETF shares. The value of the creation unit and the total value of ETF are the same. The APs trade these shares on the open market and their value is pegged upon the value of the securities they are based upon as well as supply and demand. Whenever the SEC approves an ETF, it excludes it from various requirements of the ICA; which is a huge investment in time. They therefore are recommending a fresh rule to accelerate this process. The proposal is dubbed Rule 6c-11 will exclude ETFs from these provisions, provided certain conditions are met (Novakoff, 2000). Types of ETF Products Available To Investors At the LSE alone, there are over 200 ETFs available, many of which were previously unavailable to the retail investor. However, due to recent changes in the industry, the categories of investment outlined in Table 2 are now accessible. Table 2: Different types of ETFs now accessible NAME DESCRIPTION Industrial Markets U.K, U.S.A, Europe, Japan, World. Rising Markets Regional and Individual Countries e.g. India, China and Brazil Diverse Investment Approach Value/Growth; Small/ MidCap; High Dividends. Fixed income Government Bond Shari ‘a compliant Global, European, Japan, U.S indices Money market and currencies Track overnight market rates for key currencies e.g. Euro, dollar or sterling. Commodities Diversified indices covering a wide assortment of commodities. Investment themes and sectors For example infrastructure or healthcare. Short and leveraged index ETFs For fiscally refined investors who want to use ETFs as a short term day trading instrument to hedge their portfolio or take contrarian views. 3: SOURCE: dbXtrackers, 2009 The legal framework of ETFs vastly hinges on the exchange on which it is listed. Regulations to do with Securities and the stock exchange vary depending upon the country of origin and sponsors interested in cross-listing stock must contend with this. In the United States, there are three co-existing legal frameworks i.e. open-ended index mutual funds, unit investment trusts and exchange-traded grantor trusts. While ETFs are regulated by the SEC under mutual funds, there are still no Orders that would allow them to be listed directly. As stated earlier, ETFs were first designated as Unit Investment Trusts (UIT) to simplify the process and reduce costs (Gastineau, 2002) but the more recent ETFs prefer the additional room to manoeuvre that mutual funds offer. The principle variance between these two structures is that the latter is able to utilise dividends and hold securities. The former will not be able to reinvest dividends produced by the core stock (Elton et al, 2002) and are forced to use cash. The mutual funds are permitted to use derivatives like futures that give them leeway to turn their dividend stream to equity and lastly, they differ from UITs in that they can derive income from lending their held securities. S&P 500 SPDRs, Qubes and DIAMONDS are fashioned as UITs while iShares and Select Sector SPDRs are open-end index mutual funds. ETFs were supposed to imitate broad-based stock indices originally but as investors familiarised themselves with the tool, their mandate gradually stretched to imitate indices associated with industries, nations or techniques. This trend continued with the advent of fixed-income, commodity and lastly currency ETFs. The most prominent ETFs that are fashioned upon broad based indices comprise SPDRs shaped upon the S&P 500, Qubes which imitates the Nasdaq 100, DIAMONDS that replicates the DJIA and iShares Russell 2000 which imitates the Russell 2000 index. Specific ETF series reduce these indices down to ‘growth’/ ‘value’ management techniques, as well as small, medium or large capitalisation stock volumes. These broad-based ETFs are useful in establishing rapid market positions globally and turning temporary finances into equity. The can also be utilised for long term investment, as an instrument for the hedging of highly diverse portfolios or to put into practice various strategies. Core satellite strategies commonly utilise these broad based ETFs to construct their base allotment. Trading strategies to do with small, medium and large capitalisation ETFs are implemented based on capitalisation size. The overseas equity market indices are used by national or regional ETFs as a baseline. National ETFs imitate indices from an individual state while the regional ones are based upon geographical or fiscal zones such as Europe, Asia, or the Euro zone. They are a simple and fast means to worldwide diversification however divergence between ETFs and their NAV may be greater for this tool since there is no call for synchronous trading with underlying stock. The first state ETFs were the WEBs which emerged in 1996 while iShares MSCI series are available internationally as country ETFs. Another way to break down broad-based indices was by sectors; a few of which are designed with a specific index in mind. Select Sector SPDRs for instance, reduce to industry components the S&P 500 index that varies from the traditional S&P sector indices. Sector ETFs have proved to be constructive as implementers of sector rotation stratagems due to ease of over- or under-weighing sectors in one operation. Fixed-income ETFs were incepted in Canada in the year 2000 and currently there are only six such products present in the U.S. market; all of which are produced by Barclays as iShares funds as of 2002. These are based on Goldman Sachs and Lehman Brothers bond indices that are a measure of both public and corporate obligations with differing maturities and issuers. These ETFs preserve a portfolio which mirrors the core indexes objective maturity but does not mature on its own. They are utilised for portfolio diversification, transition management or core holding for bond portfolios, etc. in the European marketplace, country-specific fixed-income ETFs are listed. StreetTracks Gold Shares were the first commodity ETFs launched in the United States. The aim was to outline the performance of gold bullion. APs are obliged to deposit designated quantities of gold in addition to hard cash to create shares. A similar in-kind basket is offered for redemption of shares. Commodity ETFs expose investors to gold, oil, silver and various other commodities including those from miscellaneous sectors such as energy, agriculture, metals and livestock. These include EasyETF GSCIs from Goldman Sachs Commodity Index, Lyxor ETF commodities, etc. they differ from traditional ETFs in that they deal in futures contracts on the base commodity (Deville, 2006). Table 4: Key Legal Structures on ETFs.5: SOURCE; ETFguide.com ETF Legal Structures Open End Fund Unit Investment Trust Grantor Trust Exchange-Traded Notes Products iShares, Select Sector SPDRs, PowerShares, Vanguard, and WisdomTree BLDRs, Diamonds, SPDRs, and PowerShares QQQ Trust Currency Shares, streetTRACKS Gold Shares, iShares Silver Trust, and Merrill Lynch HOLDRs iPath ETNs, ELEMENTS ETNs Reinvests Dividends Yes No No Varies Replication of Index May optimize index Must fully replicate index Custom weighted basket Varies Registered Under Investment Company Act of 1940 Investment Company Act of 1940 Securities Act of 1933 Securities Act of 1933 U.S. Tax Reporting Method* Form 1099 Form 1099 Grantor Trust Letter N/A The Risks and Opportunities of ETFs There are various advantages to ETFs when compared to stocks and mutual funds though this hinges on your investment aims. The opportunities of ETFs include diversification with speed and cost efficiency. If one is seeking practicality and efficiency in the market, they are best in class. They are also the best option when purchasing a particular asset type or within a specific sector. Fees for ETFs comprise just 9% in entry costs which compares favorably with the 16% typically charged by mutual funds (Herold, 2011). ETFs offer diversification at an inexpensive cost through the procurement of a lone exchange traded security. Meanwhile as they provide diversification advantages of a mutual fund, they also enable trading of shares with the flexibility of a listed stock. Furthermore, they evade the discounts and premiums characteristic of closed-end funds by constantly producing and recovering ETF shares in creation units thus generating arbitrage opportunities. ETFs are also characterized by low expense ratios. This is because they are passively managed similarly to index funds and commonly do not have high rates of turnover in portfolio securities; a natural consequence of which is lower administration fees and brokerage operating costs. Some ETFs boast even lower expense ratios than commensurate index funds due to shareholder recordkeeping and service expenses of lower level. ETFs also limit orders and short-selling options. They are used for hedging by more sophisticated investors, are tax efficient due to having a lower turnover than mutual funds and there is no ‘load’ in form of entrance or exit fees as is usual for mutual funds (Avellaneda, 2009). They also have fewer tracking errors (Agapova, 2006). ETFs have evolved over the years, becoming more complicated as they grow. In recent years, leveraged and inverse ETF have come into play that are different from their traditional antecedents. Leveraged ETFs or ‘ultrashort’ funds, aim to multiply the performance of the index they follow. Inverse ETFs are also known as ‘short’ funds are supposed to deliver the opposite of their benchmark index. They do this using a variety of strategies including contracts, swaps or futures amongst others. The inverse ETFs are reset daily and have very specific short term objectives. Their performance on the long term, therefore, may not live up to expectations. This phenomenon is exaggerated in unstable markets and therefore investors need to beware. They may also be more costly than traditional ETFs as well as less tax-efficient (Office of Investor Education and Advocacy, 2011). Conclusion Exchange Traded Funds can be seen to have huge advantages over other types of fund instruments. They are especially beneficial to tax conscious institutions such as pension funds. Research done on ETFs mostly dwells on their effectiveness and results. They also examine their comparison to other index markets. When viewed side by side with closed-end funds, the characteristics of ETFs such as in kind creation and the redemption procedure results in greater price efficiency. There has been an augmentation of individual stock liquidity due to the entrance of ETFs in the market. The price discovery process has also benefited from the crucial though not overt role that ETFs play. REFERENCES Agapova, A. (2006). Innovations in Financial Products. Conventional Mutual Index Funds Versus Exchange Traded Funds. Georgia State University. Atlanta GA. Avellaneda, M. (2009). Exchange- Traded Funds. Lecture 4. Spring Semester. Deville, L. (2006). Exchange Traded Funds: History, Trading and Research. In "Handbook of Financial Engineering, C. Zopounidis, M. Doumpos, P. Pardalos (Ed.) (2008) 1-37 DbXtrackers. (2009). A ten-step guide to Exchange Traded Funds. Deutsche Bank. London. Retrieved 3rd May, 2011 from www.dbxtrackers.com Elton, E., M. Gruber, G. Comer, and K. Li. “Spiders: Where are the Bugs?” Journal of Business, vol. 75 (3): 453-473 Gastineau, Gary L. (2002). The Exchange-Traded Funds Manual. New York, NY: John Willey and Sons. Hakansson, N. (1976). The Purchasing Power Fund: A New Kind of Financial Intermediary. Financial Analysts Journal November/December edition. Herold, T. (2011). What are the Major Advantages to Exchange Traded Funds? Retrieved 4th May, 2011 from http://www.wealthbuildingcourse.com/major-advantages-exchange-traded-funds.html Johnston, Michael. (2009). Deloitte: ETFs to Challenge Mutual Funds. Retrieved 4th May, 2011 from http://etfdb.com/2009/deloitte-etfs-to-challenge-mutual-funds/ Novakoff, J. L. (2000). Exchange Traded Funds: A White Paper. Retrieved 4th May, 2011 from http://www.indexfunds.com/articles/20000224_etfwhite2_adv_veh_JN.htm Office of Investor Education and Advocacy. (2011). Leveraged and Inverse ETFs: Specialized products with extra risks. Retrieved 4th May, 2011 from http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm Selftrade. (2008). Exchange Traded Funds. An Introduction provided by SPA Exchange Traded Funds. Talos Securities Ltd. London E14 9LA. Sirri, E., and P. Tufano. (1998). Costly Search and Mutual Funds Flows. Journal of Finance, Vol 43 (5): 1589-1622 Read More