Insights into Evaluating Exchange Traded Funds (ETFs)

Transcription

1 Insights into Evaluating Exchange Traded Funds (ETFs) The impact ETFs have had in reshaping the way investors build and manage portfolios is a testament to the appeal of their core benefits, which include diversification, lower fees and expenses, liquidity and transparency. As the industry expands, institutions, investment professionals, and retail investors have demanded a greater variety of ETFs to meet a broader range of objectives and risk tolerances. ETF providers have responded by expanding product lines to encompass a wider range of asset classes, including fixed income, emerging market equities and bonds, currencies, commodities and other alternatively weighted and strategic indices. However, the proliferation of ETFs is causing some confusion among many investors and industry observers, as it has made the ETF screening process more challenging. Knowing what you own is an important investment principle regardless of whether you are buying a security, mutual fund, or exchange traded fund. To this end, investors should understand that not all ETFs are created equally. Variables such as product structure, benchmark selection, costs, liquidity, and the manager s track record and risk management processes should be carefully considered before investing in an ETF. The rapid increase in the number of ETFs in the marketplace in recent years has made the task of navigating the landscape progressively more onerous. Consider the fact that there were 654 global product launches in 2011 alone helping to bring the number of industry offerings to over 3,200 with assets of $1.5 trillion worldwide today. 1 This growth has been fueled by products that offer exposure to more diverse asset classes, including fixed income, emerging market equities and bonds, currencies, commodities and other alternatively weighted indexes and strategies. These ETFs also offer various ways to access this exposure, as determined by product structure and selected benchmark. The expansion of the product landscape has provided investors cost-efficient access to asset classes and strategies that have historically only been available to large institutions. These developments have made the task of evaluating ETFs more complex, as products that appear similar at first glance may be quite different upon closer inspection. The increased scrutiny of ETFs is evidence of the industry s greatest opportunity and challenge promoting a better understanding of the structures and safeguards that span a rapidly growing industry. An evaluation of a fund s underlying index is no longer sufficient, as the ETF makeup may deviate from the composition of the underlying index as a result of the portfolio optimization process. 2 The concerns echoed in recent reports by regulators underscore the need for ETF providers to work toward ensuring that investors fully understand the structure of the products they buy. This article provides advisors with a framework for evaluating an index and the corresponding ETF. I. EVALUATING AN INDEX The first step in analyzing an exchange traded fund is to examine the index to which the product is benchmarked. Historically, indexes have served as a barometer for the overall performance of a specific market. However, extensive academic work has highlighted the benefits of diversification and passive asset class exposure within a portfolio. Today, the widespread recognition of the benefits of low-cost beta exposure can be illustrated by fund flows. In fact, since 2001 index funds have steadily increased their share among mutual fund assets, as compared to active funds. From December 2001 to December 2011, index funds share of US total industry assets grew by 33%. Furthermore, the presence of ETFs has grown from just 1.5% in 2001 to 11.7% in 2011, an increase of 683% (Figure 1). In our view this represents an increased appetite for liquidity, transparency, and cost-effectiveness. The market turbulence and volatility that has characterized the last three years has only served to heighten the demand for these characteristics. 1

2 FIGURE 1: ETFS AS A PERCENT OF OVERALL US FUND ASSETS PERCENT OF FUND ASSETS FOR ACTIVE FUNDS, INDEX FUNDS AND ETF 100% 90% 80% 70% 1.5% 3.2% 3.5% 4.5% 5.3% 6.0% 7.3% 9.5% 10.2% 11.2% 11.7% 9.8% 9.3% 9.6% 10.5% 10.5% 10.6% 10.7% 11.1% 11.3% 12.3% 13.1% 88.7% 87.5% 86.8% 85.0% 84.3% 83.5% 82.0% 79.4% 78.5% 76.5% 75.2% 60% 50% 40% 30% 20% 10% 0% % in Active Funds % in Index Funds % in ETFs Source: Morningstar Direct, SPDR ETF Research & Anlaytics Team, as of 12/31/2011. Data is US open-end mutual funds and ETFs as defined by Morningstar. Mutual Funds used are exclusive of money market funds and fund of funds. INDEX WEIGHTING METHODOLOGY Historically, indexes have used market capitalization weighting, meaning that the constituent s weight in the index is determined by its respective market capitalization. More recently, proprietary indexes have emerged using an assortment of different weighting techniques (Figure 2). Fundamentally-weighted indexes that weight companies based on characteristics such as dividends, revenue or earnings have been launched at a feverish pace in the last three years. Concurrently, many new ETFs based on these indexes have come to market. For example, as of December 31, 2011, there were 96 fundamentally-weighted ETFs with approximately $49 billion in assets. This compares with only 6 at year end FIGURE 2: INDEX WEIGHTING SCHEMES AND EXAMPLES INDEX WEIGHTING SCHEME DESCRIPTION EXAMPLES ETFS MARKET-CAPITALIZATION PRICE-WEIGHTED FUNDAMENTALLY WEIGHTED EQUAL-WEIGHTED Source: SPDR ETF Research & Anlaytics Team. Stocks are weighted by their representative market capitalization Stocks are weighted by their respective price per share Companies weighted by fundamental characteristics such as dividends, revenue or earnings All component stocks receive the same weighting S&P 500 Index, S&P MidCap 400 Index, Russell 2000 Index Dow Jones Industrial Average Index, Dow Jones Transportation Average Index S&P High Yield Dividend Aristocrats Index, FTSE/RAFI US 1000 Index S&P Homebuilders Index, S&P Regional Banks Select Industry Index SPY, MDY, IWM DIA SDY XHB, KRE WHY DOES THE INDEX WEIGHTING MATTER? An index s weighting methodology can lead to inconsistencies in performance and risk/return characteristics among seemingly similar indexes. These inconsistencies may be driven in part by the sector weights that define each product. For example, financial companies are generally among the highest paying dividend components of an index. As a result, dividend weighted indexes tend to overweight financials. These discrepancies can be reflected in the ETFs that are benchmarked to these indexes. Consider the example of the SPDR S&P MidCap 400 ETF (MDY) vs. the WisdomTree MidCap Dividend Fund (DON). A sector analysis reveals significant differences in sector weights (Figure 3). The WisdomTree MidCap Dividend Fund (DON) has a 37% weight in financials while the market capitalization weighted SPDR S&P MidCap 400 ETF (MDY) has only 21%. Logically, a variance in weights in the financials leads to detractions elsewhere. The SPDR S&P MidCap 400 ETF (MDY) has a 15% weight in information technology stocks, as compared to just 4% in the WisdomTree MidCap Dividend Fund (DON). 2

3 These differences in sector weights are important when consider ing performance from an attribution standpoint. Financial and information technology stocks will not always move in lockstep with one another considering the meaningful changes occurring in both industries at a macro economic level. When technology stocks are performing well and financial stocks are lagging, (all other things being equal) it should be expected that the performance of the S&P MidCap 400 Index may be slightly better than the WisdomTree MidCap Dividend Index, with the opposite being true when financial stocks are outperforming the technology sector. FIGURE 3: MIDCAP ETF SECTOR WEIGHTS % WEIGHT Consumer Discretionary Consumer Staples OTHER CONSIDERATIONS Energy Financials SPDR S&P MidCap 400 ETF (MDY) Health Care SECTOR WisdomTree MidCap Dividend Fund (DON) Industrials Information Technology Source: FactSet, SPDR ETF Research & Anlaytics Team, as of 12/31/2011. Materials Telecommunication Services Utilities GROWTH VERSUS VALUE Another consideration to be mindful of when evaluating an index is the breakdown between growth and value stocks. An index or ETF that is fundamentally weighted by dividends may have an inherent bias toward value companies that pay a higher dividend. As a result, the performance between a fundamentally-weighted index and a market capitalization weighted index tracking the same market segment could vary during a time when growth and value stock performance has deviated. MARKET-CAPITALIZATION DISTRIBUTION The same logic used to derive differences in growth, value and sector exposure can be used to help explain why an index s market capitalization distribution may vary depending on how the index is constructed. For example, in 2008 small cap stocks across the globe were clobbered, only to rebound sharply in 2009 and 2010 as credit and global equity markets stabilized. In markets where the small cap segment is outperforming, it can be expected that an ETF with more small cap exposure will benefit. However, in years when small cap names are out of favor, an index or ETF with a large cap tilt will better withstand the downward pressure. A fitting paradigm of the importance of market cap distribution to the fund s overall representation is offered by the SPDR S&P China ETF (GXC) and the ishares FTSE/Xinhua China 25 ETF (FXI). Despite appearing similar on the surface, the products display a wide variance in their market capitalization exposure. Consequently, two seemingly similar products exhibit varying performance characteristics depending on market cycles (Figure 4). FIGURE 4: DIFFERENCES IN MARKET CAPITALIZATION FOR CHINA ETFS 12/31/ /31/2011 MARKET CAP (M) AVG. WEIGHT SPDR S&P CHINA ETF [GXC] TOTAL RETURN CONTRIBUTION TO RETURN AVG. WEIGHT ISHARES FTSE/XINHUA CHINA 25 ETF [FXI] TOTAL RETURN CONTRIBUTION TO RETURN > 10, , , < 2, TOTAL Source: FactSet, SPDR ETF Research & Anlaytics Team, as of 12/31/2011. To be sure, this is not to say that one index or weighting methodology is superior to another. Rather, we believe it is critical for the investor to ensure the exposure a given ETF provides aligns with the convictions and views they are trying to express. II. EVALUATING AN ETF EVALUATE THE PROVIDER Several new entrants into the exchange traded market have made the evaluation of the ETF provider a necessary exercise. Since 2004, 29 new providers have entered the space bringing the total to 36. Despite the expansion in the number of providers, more than 83% of assets remain concentrated in ETFs issued by BlackRock, State Street, and Vanguard (Figure 5). 3

4 FIGURE 5: US ETF PROVIDERS, PRODUCTS, AND MARKET SHARE AS OF 12/31/2011 MANAGER # OF ETFs ASSETS ($MIL) MARKET SHARE (%) BLACKROCK 234 $449, STATE STREET 105 $257,103* 24.5 VANGUARD 64 $170, BNY 6 $34, VAN ECK 43 $23, PROSHARES 126 $23, POWERSHARES 116 $18, WISDOMTREE 47 $12, POWERSHARES/DB COMMODITY SVCS. 11 $11, RYDEX 37 $7, DIREXION SHARES 52 $6, FIRST TRUST ADVISORS 60 $6, SCHWAB 15 $5, PIMCO 17 $3, ETF SECURITIES USA 7 $3, GUGGENHEIM 44 $3, UNITED STATES COMMODITY FUNDS 10 $2, SPROTT 2 $2, ALPS 7 $2, GLOBAL X MANAGEMENT CO LLC/ETF 39 $1, GREENHAVEN 1 $ EMERGING GLOBAL SHARES/USA 19 $ NORTHERN TRUST 4 $ REVENUESHARES 6 $ INDEXIQ 15 $ ADVISORSHARES 11 $ RUSSELL 24 $ DEUTSCHE BANK 10 $ PRECIDIAN FUNDS 1 $ FIDELITY 1 $ TEUCRIUM 6 $ FOCUSSHARES 15 $ QUANTSHARES 7 $ COLUMBIA MANAGEMENT 5 $ FACTOR ADVISORS 5 $ PAX 2 $ Source: Bloomberg, SPDR ETF Research & Anlaytics Team, as of 12/31/2011. * As of December 31, This AUM includes the assets of the SPDR Gold Trust (approx. $63 billion as of December 31, 2011), for which State Street Global Markets, LLC, an affiliate of State Street Global Advisors serves as the marketing agent. There are a variety of characteristics to look for in a provider. Figure 6 highlights some of the elements we believe to be valuable features. A company with significant size and scale typically has the product management capabilities already in place to support the development, management and distribution of an exchange traded product. Sound product development, skillful portfolio management and widespread distribution capabilities provide the foundation for a successful product launch. FIGURE 6: CHARACTERISTICS OF AN ETF PROVIDER Commitment to the Industry History Resources Size and Scale Portfolio Management Expertise Product Support Capabilities Portfolio management expertise has become increasingly important as ETFs based on indexes that are difficult to replicate have become more highly optimized. For example, the Barclays Capital Municipal Managed Money Index had 18,045 issues as of December 31, The SPDR Nuveen Barclays Capital Municipal Bond ETF (TFI) that is benchmarked to the index had only 309 holdings. Despite the significant differences between the two, the SPDR Barclays Capital Municipal Bond ETF (TFI) tracking error in 2011 was only 9 basis points (bps), which is lower than the 30 bps expense ratio. 3 Replicating the risk/return characteristics of an index with more than 18,000 issues using only 309 bonds takes extraordinary portfolio management skill, particularly in a market as opaque and illiquid as the municipal bond market. As the product landscape expands and products become more complex, so too do the advisor s due diligence responsibilities. To accommodate the advisor, several ETF sponsors have dedicated resources to respond to client inquiries and requests for analyses. These resources can be helpful to the advisor not only in helping to decipher the difference between similar ETFs, but also by offering a point of contact for potential questions that may arise. 4

5 The evaluation of the ETF provider has grown in significance not only because of the steady increase in the number of products and providers, but also because of the lack of traction being gained by some ETFs. Although a product s break-even point will vary by ETF, provider, and resources committed to a launch, a commonly recognized asset level at which an ETF becomes sustainable is $100 million. Using this as a gauge, consider that 671 ETFs, or almost half of the ETFs currently in market, have less than $100 million in assets. Moreover, of that, 537 less than $50 million (Figure 7). This raises the issue of which products will be sustainable over the long term. The ETF provider plays a vital role in a product s long-term success by generating revenues on other products that can potentially offset some of these less successful ventures. FIGURE 7: NUMBER OF US ETFS BY ASSETS UNDER MANAGEMENT ASSETS (BIL) $600 $500 $400 $300 $200 $100 $0 < $50M $50M- $100M- $500M- $1B- $5B- >$10B $100M $500M $1B $5B $10B # of ETFs Combined Assets $8.1B $9.7B $68.4B $52.5B $203.2B $226.8B $481.3B Assets # of ETFS Source: Bloomberg, SPDR ETF Research & Anlaytics Team, as of 12/31/2011. III. ASSESS THE INVESTMENT APPROACH There are several different investment techniques used by ETFs around the world. The three most common are: full replication; optimisation-based tracking; and synthetic replication. PURE ETFS The full replication and optimization-based approaches are characteristics of physical ETFs, which seek to replicate index results by holding the actual physical securities that comprise its benchmark index. FULL REPLICATION The full replication approach involves the manager holding all securities at the same weight as the underlying index. Over time, the manager then tracks changes in the index and manages cash flow from dividends. This strategy will therefore likely provide very close tracking with the underlying index NUMBER OF ETFs OPTIMIZATION-BASED (OR REPRESENTATIVE SAMPLING) In the optimization-based approach, the manager uses a sampling process to create a representative or optimized portfolio of securities that closely matches the characteristics of the underlying index. This strategy is designed to control trading costs and promote liquidity; however these funds generally carry a higher potential for tracking error than full replication funds. To date, all SPDR ETFs across the globe are supported by the physical replication model using either full or optimized replication and have an established track record spanning nearly two decades. During this period of time, which encompasses several prominent market disruptions, SPDR ETFs have efficiently handled significant inflows and outflows, and consistently delivered index-tracking performance. SYNTHETIC REPLICATION ETFs that use synthetic replication (also known as synthetic funds) attempt to replicate index returns by purchasing total return swaps in agreements providers arrange with one or more investment banks or counterparties. The counterparty agrees to deliver the return of the underlying index, sometimes minus a small spread, in exchange for the performance of a pool of securities that is held by the ETF. If the counterparty defaults, this collateral pool provides safety for investors in the ETF. To minimize the risks, some synthetic ETF providers over-collaterise the swap and/or use multiple swap counterparties. A synthetic ETF should track the underlying index closely, but it does not physically hold the index s component shares. This structure may give investors access to certain asset classes that are not available or difficult to manage in physical ETFs. In return, investors must be comfortable with these products counterparty risks. Synthetic ETFs have come under increased scrutiny in the industry for introducing opacity, complexity and credit risk to ETF products. SSgA does not presently offer any synthetic ETFs, but recognizes that this structure may offer benefits to investors who are comfortable with the risk-return profile of these products particularly as it relates to gaining access to asset classes that are not accessible through the physical replication model. In general, while there are benefits and risks to each approach, SSgA does not believe that ETFs pose a unique systemic risk. However, increased disclosure, greater transparency and improved investor education are vital to helping investors decide which financial products are most appropriate for their investment needs. Figure 8 outlines the differences between exchange traded products (ETPs) and unlisted derivatives, outlining the features and benefits for each product structure. 5

6 FIGURE 8: EXCHANGE TRADED PRODUCTS COMPARISON STRUCTURED FUNDS EXCHANGE TRADED FUNDS (ETFs) EXCHANGE TRADED COMMODITIES (ETCs) EXCHANGE TRADED NOTES (ETNs) AND CURRENCY ETFs (ETCs) FULL REPLICATION REPRESENTATIVE SAMPLING SYNTHETIC REPLICATION COMMODITY TRUSTS FUTURES BASED COMMODITY ETCs DESCRIPTION All of the index s securities are purchased in their respective weights A subset of physical securities that closely resembles the index Represent a derivative contract with a bank or other counterparty Physical commodities held by most Trusts Track commodity indices of futures contracts on physical commodities Provide returns indexed to various market benchmarks OWNERSHIP Shares represent fractional ownership of assets held Shares represent fractional ownership of assets held A total return swap contract that represents the contractural right plus collateral or other assets to provide returns of the underlying index Shares represent fractional ownership of assets held Asset backed bonds, fully collateralised Senior, unsecured, unsubordinated debt, issued by an underlying bank REGULATORY STRUCTURE Open Ended Fund under Investment Company Act of 1940, UCITS Structure or other local regulated structure Grantor Trusts under Securities Act of 1933 Open Ended Commodity Funds under Securities Exchange Act of 1934 or offshore legal structure (e.g.- Cayman, Mauritius, Virgin Island structures) Debt obligations registered under the Securities Act of 1933 offshore legal structure (e.g.-cayman, Mauritius, Virgin Island structures) BENEFITS Closely tracks the return of the index Transparent Clarity of owndership Reduces operating cost and capital necessary from not owning every security in the index Transparent Provide lower cost of operation May offer access to assets that cannot be fully replicated Typically backed by physical commodity. Avoid the risk and cost of holding physical commodities ETCs track commodities not commodity countries and enable investors to gain exposure to commodities without trading futures or taking physical delivery Wide product choice Offer easy access to hard-to-reach assets such as currencies and countries that impose limits on foreign investment Clarity of owndership LIMITATIONS Can have higher costs due to trading costs Not all asset classes can be covered Securities may fail to track the index resulting in tracking error Not all asset classes can be covered Risk of rehypothetication of collateralised assets Credit risk Counterparty risk Reduced transparency (uncertainty of holdings) Normally cannot directly redeem shares for underlying bullion or precious metals Typical high tracking error due to contango and backwardation related to futures, leading to losses from rolling futures contracts in contangoed markets and gains in backwardated markets Not secured debt; there is no principal protection ETNs do not pay interest and the issuer is subject to default risk Credit rating risk Source: SSgA, as of December IV. EXAMINE THE PRODUCT STRUCTURE An often overlooked aspect of exchange traded product evaluation is the product s structure. There are several different types of product structures used by ETFs, which can lead to differences in how the products are managed and taxed. UNIT INVESTMENT TRUSTS The first ETF, launched in 1993, was the SPDR S&P 500 (SPY) which today has more than $95 billion in assets under manage ment.* SPY and some of the earlier ETFs were structured as Unit Investment Trusts (UITs), which are registered as 1940 Act Funds. The UIT structure requires the investment manager to fully replicate the underlying index. Another notable distinction of UITs is that the dividend payments the fund receives in between distributions cannot be reinvested in additional securities. Instead, the fund manager will generally hold the income in cash or a cash equiva lent until fund distributions are made. Finally, UITs are not permitted to engage in securities lending, a practice that has become common among their open-end counterparts. OPEN-END FUNDS The majority of ETFs are structured as open-end funds registered under the Investment Company Act of The open-end fund structure gives the manager the flexibility to either fully replicate or optimize the portfolio, making this structure more sensible for most new funds. Expansion in the industry has been driven in large part by international and fixed income products whose underlying indexes can be difficult to fully replicate.the openend fund structure removes the burden of requiring the advisor to fully replicate the index and allows the fund manager to use optimization and sampling techniques to match the risk/return characteristics of the index. * As of December 31,

7 GRANTOR TRUSTS Some exchange traded products are governed under the Securities Act of 1933 Grantor Trusts and Exchange Traded Notes. Shares in a grantor trust represent fractional ownership in the underlying assets of the trust. The most well known example is the SPDR Gold Shares ETF (GLD). The gold that underlies Gold Shares is held in the form of allocated 400 oz. London Good Delivery bars in the London vault of HSBC Bank USA. The distinguishing feature of a grantor trust that is different from a 1940 Act fund is the way in which it is taxed. Investors are taxed as though they own the physical commodity. Much like other exchange traded product structures, grantor trusts have unique characteristics that should be considered. EXCHANGE TRADED NOTES Exchange Traded Notes (ETNs) are senior, unsecured, unsub ordinated debt instruments that are organized like structured products. ETNs provide access to market benchmark returns less any applicable fees. They have proven to be useful by offering exposure to markets that have traditionally been difficult to access using conventional investment product structures. However, ETNs have several differences from exchange traded funds that should be considered, most notably the assumption of issuer credit risk. The ETN issuer promises to pay the returns, less fees, of the underlying product benchmark. Because these products function like a corporate bond or structured product, a thorough analysis of the product might include a review of the issuer s balance sheet and potential default risk. The added dimension of the issuer s credit risk coupled with the market risk inherent in the market benchmark makes ETN analysis markedly different from that of an ETF. V. CONSIDER THE TOTAL COSTS One clear advantage of index based products over their actively managed counterparts is cost effectiveness, as measured by the fund s expense ratio. To illustrate, consider that the average Large Cap blend ETF has an expense ratio of just 34 basis points (bps) compared to 122 bps for the mutual fund in the same category. 4 The disparity is uniform across the domestic and international equity product set and is even more pronounced for passive fixed income funds. In terms of expense ratio, the average fixed income ETF has an expense ratio of 30 bps whereas the average bond mutual fund has an expense ratio of 103 bps. 5 Extensive work has been done that demonstrates the impact of a fund s expenses and fees on an investor s net return. In this arena, ETFs have a compelling and decisive advantage. The expense ratio is not the only cost associated with ETFs. Commissions and transaction costs apply when buying shares in the secondary market. ETF shares trade like any other stock on major exchanges. As a result, any commissions would be absorbed by the investor purchasing or selling shares. This is different from mutual fund transactions that occur at the endof-day NAV and do not incur costs of trading on exchanges. However, this negative aspect of ETF share purchases and sales may be partially offset by the ability to buy and sell shares throughout the day. The fund s expense ratio and expected commission payments are costs that can be accurately forecasted. However, there are a number of less transparent costs that may arise from ETF transactions. EXPLORE THE LESS TRANSPARENT COSTS BID/OFFER SPREAD The nature of exchange traded funds can lead to implicit costs of investing. The primary implicit costs are trading costs and tracking error. Aside from commissions, the most obvious trading cost is the bid/offer spread. While some ETFs trade at spreads within a few cents, other thinly traded ETFs may widen out. For example, the SPDR S&P 500 (SPY) is one of the most liquid securities in the world, in that it traded an average of more than 215 million shares per day in 2011, or in dollar terms, more than $27 billion per day. 6 It can be expected that the average bid/ask spread on the SPDR S&P 500 (SPY) will be very tight. However, an ETF that has less volume will typically have wider spreads. PREMIUM/DISCOUNT TO NAV An ETF s premium or discount is another element that should be considered in a thorough evaluation. The market price for an ETF reflects market supply and demand for an underlying product while the Intraday Indicative Value (IIV) or Intraday Optimized Portfolio Value (IOPV) is a signal of the underlying value of the securities in the fund. The creation/redemption mechanism is responsible for keeping the market price of the fund in line with the IOPV. For example, if an ETF s market price was trading at a significant premium to the indicative value, an arbitrage opportunity may exist for the Authorized Participants (AP). 7 The AP might be enticed to create more shares and capitalize on the difference. The existence of more shares in the market should cause the market price to come back into formation with the IOPV. However, in markets where pricing of the underlying securities in an ETF are dislocated, or illiquidity limits an AP s ability to hedge their position, it can be expected that the ETF s market price may drift further from the IOPV. It can also be expected that international products will tend to have a higher premium or discount than products tracking US securities. For international products, the intraday indicative value is based on prices of securities traded in markets that are often closed for much, if not all, of the US trading day. As a result, the market price may diverge from the intraday indicative value based on US market sentiment and expectations for that particular market the following day. In extreme cases, certain events can trigger a spike in trading of ETF shares which can cause the fund to trade at a premium or discount, depending on the news. For example, if a natural disaster were to take place in a particular country, demand for ETF shares based on that country s equity markets could plummet, sending share prices to a steep discount to the IOPV. In these situations, the largest and most heavily traded ETFs tend to trade at the sharpest discounts, as investors flee a particular market. In this example, it might make sense to look for an ETF tracking the same asset class whose share price more closely represents the intraday indicative value. In any case, it is always prudent to analyze the market quality of an exchange traded product and to potentially control trading risk by using tools like limit orders when investing. 7

8 SECURITIES LENDING Securities lending plays a major role in the efficient functioning of the securities markets worldwide. It is an important and significant business practice in which one party (the lender) temporarily transfers securities to another (the borrower). Many ETFs, including SPDR ETFs in some regions, engage in securities lending programs. Typically, an ETF uses a lending agent to lend a portion of securities in the ETF portfolio to brokers, dealers, and other financial institutions. Securities lending within our family of SPDR ETFs (where applicable) directly benefits shareholders, as the income it generates reduces fund expenses and improves index tracking after expenses. Security lending programs are not new nor are they unique to ETFs. They are in fact a common practice for many traditional commingled and mutual fund offerings. Important measures are taken to ensure the safety of these programs associated with SPDR ETFS. For instance, SPDR ETFs participate in an indemnified securities lending program, which means that State Street Bank & Trust, the securities lending agent for SPDR ETFs will indemnify the ETFs in the event of a borrower default. In addition, the operational procedures for share creation and redemption are designed to protect the interest of the fund s shareholders by contractually requiring the fund s Authorized Participants (i.e., approved institutional trader or market maker known as an AP ) to represent that shares being tendered for redemption are settled shares in the possession of the AP or the client they represent. As such, a SPDR ETF is not directly impacted by the amount of lending in the secondary market ( short interest ) and cannot be redeemed for more than its actual shares outstanding. Though they are widely available in many countries, securities lending programs are still in their early stages in much of the Asia Pacific region, where SPDR ETFs do not currently engage in this practice. Details and risks of securities lending programs are disclosed in qualifying SPDR ETF prospectuses. TRACKING ERROR Tracking error is another important indicator of a fund s overall quality. Investors using ETFs are looking for cost effective beta exposure to a desired market segment. Excessive tracking error can negate this fundamental purpose of ETF investing. Tracking error has many definitions, although the simplest is defined as the difference between a fund s NAV performance and the total return of the underlying index. It is important to note that it is the fund s NAV performance that should be considered, as opposed to the market price performance of the ETF. Depending on an investor s time horizon, tracking error can be measured daily, monthly, quarterly or annually. For example, an investor actively trading ETFs would be more concerned with how an ETF tracks on a daily basis, whereas a long-term investor might only monitor a fund s tracking on a yearly basis. In either case, funds with tighter tracking should have a competitive advantage. Tracking error has been an area of growing concern as new managers enter the arena and ETFs that are highly optimized become more prevalent. Funds that are fully replicated tend to exhibit low tracking error. However, ETF expansion has been propelled by growth in products offering access to more nontraditional markets that tend to be heavily optimized. ETFs that are more heavily optimized or sampled have a greater likelihood of exhibiting wider tracking error. For example, an emerging market ETF that excludes a specific country has the potential to deviate widely from the index performance if that country contributes significant positive and negative total return to the index. Additionally, funds that have a relative underweight to the smaller, less liquid securities will lag the index when small cap names exhibit strong performance. In order to efficiently optimize a fund, the fund provider s portfolio management history and skill play an important role. In general, an investment manager with a history of indexing strategies and the foundations in place to support ETF growth should have success transferring those skills to ETF management. CONCLUSION The dynamics of the ETF landscape continue to evolve. Moving in lockstep with this evolution is the growing complexity of ETF analysis. Financial Research Corporation (FRC) projects that ETFs will continue to capture market share from other investment product categories over the next four years with the highest five year compounded annual growth rate among all categories. For this growth to continue, educating advisors on the differences among the array of products will play a vital role. Exchange traded products that appear to represent the same market segment can sometimes look markedly different beneath the veil in terms of index and product construction, as well as market quality measures. In the end, the overarching goal of an ETF analysis should be whether or not the asset class, index, and ETF are a good fit with the investor s risk/return profile and investment goals and objectives. 8

9 DEFINITIONS BREAK-EVEN A fund s break-even point is the point at which revenues generated by the fund are equal to the total expenses and there is neither a profit nor loss. LIQUIDITY The degree to which an asset or security can be bought or sold in the market without affecting the asset s price. Liquidity is characterized by a high level of trading activity, typically measured by share volume traded or dollar volume traded. TRANSPARENCY The accessibility of information on the order flow for a particular stock, allowing knowledge of the quantities of stock being offered and the bids at the various price levels. INDEX DEFINITIONS BARCLAYS CAPITAL MUNICIPAL MANAGED MONEY INDEX The Barclays Capital Municipal Managed Money Index tracks the US longterm, tax-exempt bond market and includes general obligation, revenue, pre-refunded and insured issues. The Index is a rules-based, market valueweighted index engineered for the tax-exempt bond market. DOW JONES INDUSTRIAL AVERAGE INDEX The Dow Jones Industrial Average SM is comprised of thirty (30) blue-chip US stocks. At 100-plus years, it is the oldest continuing US market index. It is called an average because it originally was computed by adding up stock prices and dividing by the number of stocks. (The very first average price of industrial stocks, on May 26, 1896, was ) The methodology remains the same today, but the divisor has been changed to preserve historical continuity. The DJIA is the best-known market indicator in the world, partly because it is old enough that many generations of investors have become accustomed to quoting it, and partly because the US stock market is the globe s biggest. DOW JONES TRANSPORTATION AVERAGE INDEX The Index measures the performance of the transportation sector of the US equity market, including airlines, industrial transportation companies and general industrial services companies. Companies are selected for inclusion in the index by the editors of the Wall Street Journal. The Index, for practical purposes, is a subset of the Dow Jones U.S. Index. The component stocks are weighted based on the price of the component securities, with the highest priced securities generally having higher weighting in the Index. The Index is adjusted to reflect changes in capitalization resulting from mergers, acquisitions, stock rights, substitutions and other capital events. FTSE/RAFI US 1000 INDEX The Index is designed to track the performance of the largest US equities, selected based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends. The 1000 equities with the highest fundamental strength are weighted by their fundamental scores. The fundamentally weighted portfolio is rebalanced and reconstituted annually. S&P REGIONAL BANKS SELECT INDUSTRY INDEX The S&P Select Industry Indices are designed to measure the performance of various narrow Global Industry Classification Standard (GICS ) subindustries. S&P Regional Banks Select Industry Index constituents are drawn from the Regional Banks sub-industry. RUSSELL 1000 INDEX The Index measures the performance of the large capitalization sector of the US equity market. It is a subset of the Russell 3000 Index and serves as the underlying index for the Russell 1000 Growth and Value Indices, and the Russell Top 200 and MidCap series. The Index is capitalization-weighted and represents the approximately 1,000 largest companies in the Russell 3000 Index. Component companies are adjusted for available float and must meet objective criteria for inclusion to the Index. Reconstitution is annual. S&P 500 INDEX The S&P 500 Index is composed of 500 selected stocks, all of which are listed on the Exchange, the NYSE or NASDAQ, and spans over 24 separate industry groups. Since 1968, the S&P 500 Index has been a component of the US Commerce Department s list of Leading Indicators that track key sectors of the US economy. Current information regarding the market value of the S&P 500 Index is available from market information services. The S&P 500 Index is determined, comprised and calculated without regard to the Trust. S&P HIGH YIELD DIVIDEND ARISTOCRATS INDEX The S&P High Yield Dividend AristocratsTM Index is comprised of the 60 highest dividend yielding constituents of the stocks of the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years. These stocks have both capital growth and dividend income characteristics, as opposed to stocks that are pure yield, or pure capital oriented. S&P HOMEBUILDERS INDEX The S&P Homebuilders Select Industry TM Index represents the home building sub-industry portion of the S&P Total Markets Index TM. The S&P TMI tracks all the US common stocks listed on the NYSE, AMEX, NASDAQ National Market and NASDAQ Small Cap exchanges. The Homebuilders Index is an equal weighted market cap index. S&P MIDCAP 400 INDEX S&P MidCap 400 covers over 7% of the US equities market, and is part of a series of S&P US indices. Included in the index are companies with market cap in the range of US $1 billion to US $4.5 billion. This range is reviewed from time to time to ensure consistency with market conditions. The index also includes companies that should have four consecutive quarters of positive as-reported earnings, where as-reported earnings are defined as GAAP Net Income excluding discontinued operations and extraordinary items. WISDOMTREE MIDCAP DIVIDEND INDEX The WisdomTree MidCap Dividend Index is a fundamentally weighted index that measures the performance of the mid-capitalization segment of the US dividend-paying market. The Index is comprised of the companies that compose the top 75% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. This index was established with a base value of 200 on May 31,

10 STATE STREET GLOBAL ADVISORS State Street Financial Center One Lincoln Street Boston, MA Bloomberg, as of 12/31/ Definition: Portfolio optimization seeks to create a portfolio which matches the risk/return characteristics of an index. 3 SPDR ETF Research & Analytics Team. 4 Morningstar Direct, data as of 12/31/2011. Average Prospectus Net Expense ratio for Large Blend ETFs and open end large blend mutual funds as defined by Morningstar. 5 Morningstar Direct, data as of 12/31/2011. Average Prospectus Net Expense ratio for Fixed Income ETFs and Fixed Income open end funds as defined by Morningstar. 6 Bloomberg, Lipper, SPDR ETF Research & Analytics Team, as of 12/31/ An Authorized Participant is usually an institutional investor, specialist or market maker who has signed a participant agreement with a particular ETF sponsor or distributor. Becoming an Authorized Participant allows an investor to transact directly with the fund or trust on an in kind basis in a process known as Creations/Redemptions. FOR PUBLIC USE. IMPORTANT RISK INFORMATION ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Diversification does not ensure a profit or guarantee against loss. Securities lending programs and the subsequent reinvestment of the posted collateral are subject to a number of risks, including the risk that the value of the investments may decline in value and may at any point be worth less than the original cost of that investment. Engaging in securities lending could have a leveraging effect, which may intensify the market risk, credit risk and other risks associated with investing. Prior to October 24, 2011, the S&P Regional Banks Select Industry Index was known as the KBW Regional Banking Index and the SPDR S&P Regional Banking ETF was known as the SPDR KBW Regional Banking ETF. The Russell 1000 Growth, Russell 1000 and the Russell 2000 Value Indices are trademarks of the Frank Russell Company. Russell TM is a trademark of the Frank Russell Company. Dow Jones & Company, Inc. is the owner of the trademarks and copyrights relating to the Dow Jones Indexes. Barclays Capital is a trademark of Barclays Capital, the investment banking division of Barclays Bank PLC ( Barclays Capital ) and has been licensed for use in connection with the listing and trading of the SPDR Barclays Capital ETFs. The products are not sponsored by, endorsed, sold or promoted by Barclays Capital and Barclays Capital makes no representation regarding the advisability of investing in them. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. STANDARD & POOR S, S&P, S&P 500 and S&P MIDCAP 400 are registered trademarks of Standard & Poor s Financial Services LLC. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products. Further limitations and important information that could affect investors rights are described in the prospectus for the applicable product. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., a registered broker-dealer, is distributor for SPDR S&P 500, SPDR S&P MidCap 400 and SPDR Dow Jones Industrial Average, all unit investment trusts, and Select Sector SPDRs and the WisdomTree MidCap Dividend Fund. ALPS Distributors, Inc. is separate and not affiliated with State Street Global Markets, LLC or WisdomTree. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit. Read it carefully State Street Corporation. All Rights Reserved. IBG-5595 Exp. Date: 2/28/2013 IBG.EDU.IPC.0312 SPD