EXCHANGE-TRADED FUNDS AS AN INVESTMENT OPTION

EXCHANGE-TRADED FUNDS AS AN INVESTMENT OPTION

This page intentionally left blank

Exchange-Traded Funds as an Investment Option A. SEDDIK MEZIANI

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 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies 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 ISBN 978-0-230-51337-2 (ebook) DOI 10.1057/9780230513372 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 15 14 13 12 11 10 09 08 07 06

To the memory of my father, who esteemed learning and aspired to it, though life s circumstances and vicissitudes denied him the opportunity

This page intentionally left blank

Contents List of Figures List of Tables List of Boxes Acknowledgements Preface xi xii xiv xvi xviii 1 Active versus Passive Investing 1 Introduction 1 Implementing an Asset Allocation: A Passive or Active Approach? 1 The Efficient Market Theory 2 Expanding the Scope of Indexing 12 Measure of Bond Performance 15 Summary 19 2 Security Market Indexes 21 Introduction 21 Factors Underlying the Demand for Security Market Indexes 21 Main Differentiating Characteristics of Market Indexes 23 Other Stock Indexes 30 Bond Indexes 35 Summary 38 vii

viii CONTENTS 3 Exchange-Traded Funds versus Mutual Funds Weighting the Options 40 Introduction 40 Structure of ETFs 40 Trading ETFs 43 Impact of New Factors on the Liquidity of ETFs 48 Lower Management Fees 50 ETFs Drawbacks 55 Summary 57 4 Tax Advantages of Exchange-Traded Funds 58 Introduction 58 The Rebalancing Process 58 Taxable Gain at the Inception of Investment 60 Redemption in Stock or in Cash 61 Tax Efficiency of Redemption 62 Tax Consequences on ETF Shareholders 66 Summary 69 5 Tax Savings of ETFs over Mutual Funds: A Case Study 70 Inroduction 70 Actual Tax Savings: Methodology 70 Tax Efficiency, but 80 Other Considerations Underlying this Tax Advantage 83 ishares on Benchmark S&P 500 85 Summary 90 6 Evolution and Outlook of Equity ETFs 91 Introduction 91 History of Equity ETFs 91 Exchange-Traded Funds by Asset Category 96 ETF Outlook 108 Sources of Information 116 Summary 120 7 Fixed-Income ETFs 121 Introduction 121 Circumstances Surrounding the Launch of Fixed-Income ETFs 122 Current Product Universe 126 ETF Advisors Fixed Income Trust Receipts or FITRS 133 General Features and Benefits 135 Out of the Gate 137 Summary 141

CONTENTS ix 8 Exchange-Traded Funds and the Wash-Sale Rule: New Twists on an Old Plot 143 Introduction 143 Investors have become More Tax-aware 144 Tax-Loss Offset Strategies based on Securities Swaps 146 Tax-Loss Offset Strategies as they Apply to Investment Products other than ETFs 147 Tax-loss Offset Strategies as They Apply to ETFs 149 Could Stocks and ETFs Possibly Constitute Substantially Identical Securities? 158 Summary 159 9 Anatomy of the ETF Landscape in Europe: General Market Conditions 161 Introduction 161 Common Features but 162 Anatomy of Europe s ETF Market 166 Asset Allocation 173 Actively Managed ETFs 176 Summary 179 10 ETFs for Europe and Other Market Exposures 181 Introduction 181 Traditional Methods of Investing in Foreign Securities 181 Global Asset Allocation with MSCI s ishares 186 International ETFs Tracking Indexes Other than MSCI s 194 International ETFs Trading in Foreign Markets 198 Concerns and Other Points of Interest 214 Summary 225 11 The Advent of ETFs in Imperfect Markets: Case of Mainland China 227 Introduction 227 Brief Overview of China s Markets 228 Index Review 233 China s ETFs 237 Are China s ETFs an Idea Whose time has Come? 242 Summary 246 12 Long Short Investment Strategies using ETFs 248 Introduction 248 Essentials of Short Selling 249 Short Selling with ETFs 251

x CONTENTS Practical Strategies 259 Global Perspectives of Short Selling 264 Summary 269 13 Other ETF Investment Strategies and Applications 270 Introduction 270 Futures Contracts 270 Futures Contracts on ETFs 273 Futures on European ETFs 277 Margin Trading with ETFs 282 Summary 288 14 Investment Strategies using Options on ETFs 290 Introduction 290 Basic Features of Option Contracts 290 Options on ETFs 293 Investment Strategies using ETF Options 299 Other Options Strategies 304 Summary 310 Index 311

List of Figures 2.1 Market performance in 2004 of selected countrys indexes 33 3.1 Role of ETF market makers in providing liquidity in ETFs transactions 46 4.1 Index turnover 59 11.1 Market capitalization split by share type 239 14.1 ishares Lehman 20 year Treasury Bond Fund TLT 308 14.2 ishares Lehman 1 3 year Treasury Bond Fund SHY 309 14.3 ishares GS $ InvesTop Corporate Bond Fund LQD 309 xi

List of Tables 2.1 Selected measures of total US securities markets 30 3.1 Vanguard s ETFs 49 3.2 Aggregate costs of buying and owning ETFs 51 3.3 Cost of owning the ten largest ETFs, ranked by asset size 54 3.4 A comparison of ETFs and traditional index mutual funds 55 5.1 Top 10 ETFs by assets 71 5.2 Tax rates 73 5.3 Historical distributions per share 1993 2003 74 5.4 Historical distributions per dollar invested 1993 2003 77 5.5 Tax comparison SPDR 500 versus Vanguard 500 79 5.6 ishares 500 index fund (IVV) historical distributions 87 5.7 Tax comparison ishares 500 index fund (IVV) versus VFINX 88 6.1 US equity ETFs by AUM, net issuance of shares, and number of funds 94 6.2 Trends in stock mutual fund investing 95 6.3 ETF market at a glance ($billion) 97 6.4 AMEX listed broad-based ETFs 99 6.5 AMEX Listed Industry Sector ETFs 110 7.1 Current ETFs as per Standard & Poor s credit rating classification 125 7.2 Characteristics of fixed-income ETFs 127 7.3 Listed fixed-income ETFs growth and market share 138 7.4 Fixed-income ETFs historical distributions 140 8.1 Select sector SPDR health care (XLV) top 10 holdings as of December 31, 2004 153 8.2 Sample of sector ETFs with similar investment characteristics 155 xii

LIST OF TABLES xiii 8.3 Top industry sectors of the QQQQ and IYW 156 9.1 Europe s ishares MSCI ETFs: change in TER (bps) 164 9.2 Listed ETF growth: US versus Europe 167 9.3 Managers of European listed ETFs 168 9.4 ETF trading volume in Europe 171 9.5 ETF exposure by index category 174 10.1 Amex-Traded MSCI international ishares, September 2004 188 10.2 BGI s ishares premium and discount 190 10.3 Other US-traded international ETFs 196 10.4 List of international ETFs trading outside the US 201 10.5 Fund concentration 217 10.6 List of international fixed-income ETFs 223 11.1 Index characteristics 234 11.2 Monthly discount/premium summary 240 11.3 Concentration risk: FTSE/Xinhua versus ishares MDCI China Tracker 244 12.1 ETFs short interest (based on mid-month settlement date) 253 12.2 Global perspectives of short selling 266 13.1 Futures on the Diamonds 274 13.2 Main characteristics of Eurex Futures on ETFs 279 13.3 Hedging strategy based on the Dow Jones EURO STOXX 50 EX Futures contracts 281 14.1 US listed EFT option contracts trading volumes 296 14.2 Options on Canadian listed ETFs 301 14.3 Options on European listed ETFs 302 14.4 Value of covered position at option expiration 306

List of Boxes 1.1 Gains on index funds tend to outpace returns on managed funds 10 1.2 Passive investing is catching on fast in Japan 14 2.1 What s behind the recent underperformance of the Dow industrials? 24 2.2 Socially responsible investing 36 3.1 An illustration of arbitrage 45 3.2 Rule 12(b)-1 or the hidden costs within the mutual-fund industry 52 4.1 How to run up a $10,000 tax bill without even trying 63 4.2 Cashing out like crazy 64 5.1 Mutual funds possess a stash of losses to carry forward 83 5.2 Barclays new introduction 86 6.1 Actively managed ETFs near 117 6.2 The internet and information concerning exchange-traded funds 118 7.1 Fixed-income ETFs: investors now have a new option to consider 123 7.2 Calculation of real and nominal rates of return on a TIPS bond 131 8.1 Tax-loss harvesting using ETFs 151 8.2 Balance investment profits with losses 157 9.1 Barclays asks European Commission to regulate ETFs on a pan-european basis 165 9.2 ETF Firm launches quasi-active ETFs 178 10.1 Arbitrage is a riskier proposition on international ETFs 193 10.2 A weakening dollar can improve the returns on foreign investments 199 xiv

LIST OF BOXES xv 11.1 China s bourses are still roller coasters of instability and change may take some time 230 11.2 Chinese share description 232 11.3 China futures 243 12.1 Illustration of a short sale 249 12.2 How short-the-market works 263 13.1 Are single stock futures treacherous for individual investors? 272 13.2 Portfolio margining for the sophisticated investors 287 14.1 Strategic possibilities increase with options on ETFs 294 14.2 McGraw-Hill seeks temporary restraining order against ISE and OCC 300

Acknowledgements Parts of this book grew out of articles written for various academic and practitioners journals, in particular Institutional Investors Investment Guides on ETFs. As such, I would like to thank the numerous reviewers, anonymous and otherwise, who criticized, challenged, encouraged, and at times complimented my efforts. I hope they will all be pleased to know that their thoughtful input has permeated the content of this volume. It would not have been possible to write this book without the expertise and guidance provided by many of my colleagues and friends at Montclair State University. I am particularly indebted to James Yang, professor of accounting and taxation, upon whose expertise I called several times to navigate through the tax issues; and to Phillip LeBel, Professor of Economics, for his inquisitive and challenging contributions in our many stimulating discussions. Of all those who provided critical input to this work, only two people other than myself have read the entire manuscript: Karen Dennis and Andrew Pole. Karen, who is Assistant Dean of the School of Business of Montclair State University, has served as my de facto internal editor by generously giving her time and expertise as a reviewer. I truly appreciate the countless hours she spent tightening up the language and improving the flow of the discussion, which helped make writing this book both efficient and 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 hedge fund risk management and building equity trading models. He has made numerous contributions to most parts of the book though his constructive criticism and insightful feedback. I owe a great debt to his careful and detailed recommendations for making the book both more readable and informative. xvi

ACKNOWLEDGEMENTS xvii Last, but certainly not least, I wish to thank my wife Jacqueline and our children Harris and Hanna for the patience and support they demonstrated during those uncountable hours spent on the book: day by day, in immeasurable ways, they shared with me the process of writing it. A. Seddik Meziani, Ph.D.

Preface In today s constantly changing financial markets, there are many new challenges in the process of making investment choices: What are the best investment vehicles among the multitude of new products constantly brought to market? What is the market outlook in light of the staggering and often conflicting information available to investors? How can commissions on transactions be further reduced? What are the tax implications of a given investment strategy? Which of the newly formed international financial markets will further enhance a portfolio? What about risk? What roles can options and futures play in an investment program? These are a few of the questions investors ask themselves before committing to a specific investment plan. This book is designed to answer such questions regarding one relatively new investment product, the Exchange-traded fund (ETF), providing the knowledge needed to actively develop and monitor ETF portfolios. It is our hope that the book will meet many of the needs of practicing investment professionals who are its focus. The book is also a valuable resource for professors and students who are increasingly curious about these financial products, which have attracted over $300 billion of investor funds worldwide as of early 2005; many will want more information about ETFs than is available even in the latest editions of investment textbooks. By elaborating on innovative investment vehicles and highlighting important issues and Real-life scenarios through the liberal use of examples, with point of interest boxes in each chapter, we hope to guide such readers through the material productively. The book is organized into 14 chapters that provide a structured framework for learning about ETFs. Many readers will chose to go through its content in the order presented, although most chapters can be read in any sequence. The book as a whole integrates theoretical concepts with practical investment applications, and, because of its dual purpose, mixes description and xviii

PREFACE xix theory. For example, the descriptive material relates the evolution of ETFs and discusses availability and growth in the United States and around the world. As recently as 15 to 20 years ago, most individuals invested almost exclusively in purely domestic investments. Today, investors routinely look for foreign investment opportunities as well. In theory, the book both details the underpinnings of ETFs and carefully evaluates the pros and cons of each investment strategy so that the reader can knowledgeably include them in a portfolio that will satisfy specific risk-return objectives. A number of key points are emphasized throughout the book. Because investors need to invest at a risk level that is consistent with their personal risk preferences and constraints, we adopt the familiar academic strategy of emphasizing the informational differences that exist among various types of securities. Higher returns can be expected only from investment strategies that take on additional risk. Hence, while the degree of market efficiency is a matter of opinion and debate, there is a trade-off between expected returns and risks, a fact that should be considered by ETF investors as with any others. Although the bulk of this dialogue is confined to Chapter 1, the implications of the efficient market hypothesis also permeate discussion in the sequel. Chapter 2 reviews the main market averages and the methodologies underlying their construction. This discussion is important because two index funds with the same objective do not necessarily generate the same risk adjusted return. If one ETF tracks the Russell 2000 and another the S&P 600, two small cap market averages compiled differently, one should not expect the two funds to show identical performances. Often described as hybrid investment vehicles that combine the trading flexibility of individual stocks with the diversification benefits of mutual funds, ETFs have raised the question for some investors as to whether they may be a practical alternative to mutual funds. Chapter 3 compares these two investments, exploring whether ETFs offer investors realizable advantages not available to mutual funds owners, and vice versa. This comparison is continued in Chapters 4 and 5, where the two investment alternatives are compared in terms of the tax advantages they offer. The tax assessment of ETFs also continues in Chapter 8, where they are evaluated in terms of a tax-loss offset strategy that may allow ETF holders to take advantage of tax laws that allow the netting of capital gains and capital losses. This tax-management strategy is examined in detail, especially as it applies to ETFs, to determine whether it truly can enhance the ability of knowledgeable investors to engage in portfolio tax management. Chapter 6 traces the evolution of, and sketches out future prospects for ETFs. Only in 1998, after enduring five years of distinct obscurity since their launch on the American Stock Exchange in 1993, did ETFs start to experience success. Their popularity has grown so dramatically since then

xx PREFACE that many enthusiasts have openly proclaimed them as the future of the investment industry. This success is further emphasized in Chapters 9, 10, and 11 describing the global expansion of ETFs, which was fueled by asset managers efforts to develop new product offerings in order to meet the growing global investment needs of both institutional and individual investors. With this broadening of attention to the international setting, the general consideration that developed markets are informationally more efficient than emerging markets makes revisiting the efficient market hypothesis desirable (Chapter 10). Chapter 11, in particular, narrates the advent of ETFs in the informationally imperfect market of mainland China. The allure of China is well known and investors now have the opportunity to broaden their exposure to its equity markets through the relatively new ishares FTSE/Xinhua China 25 Index Fund and PowerShares Golden Dragon Halter USX China. Yet economic growth doesn t necessarily translate into steady stock-market gains. Chinese stock markets face numerous challenges, ranging from poor corporate governance and doubtful accounting standards to efforts by the government to sell large stakes in Chinese companies without hurting share prices. These are pertinent issues that investors should carefully consider before allocating any part of their portfolios to China s ETFs. The fact that fixed income ETFs currently represent only a small fraction of the total ETF market should not prevent us from treating them as the fullblown asset class they really are. Chapter 8 offers an extensive coverage of these products in terms of their immediate features such as their tax efficiency (or lack of it) in relation to equity ETFs, as well as the differences in their yield properties based on whether they track an index of government securities, an index of corporate bonds, or one that includes both, such as the Lehman U.S. Aggregate Index. Chapters 12, 13, and 14 of the book are dedicated to various investment strategies that can be used with the derivative securities available to ETF investors. These strategies typically possess a high level of risk because they usually have uncertain returns. The key derivative securities discussed are options and futures on ETFs. They are introduced in terms of their speculative use, but also as hedging instruments used to protect existing investment positions against unstable market values. The coverage of these trading strategies reflects the gradual success with investors experienced by ETFs. Indeed, such strategies would not have been possible had ETFs not experienced a dramatic growth both in volume and scope. As a general word of caution, the reader should not assume that mention of a specific ETF or description of an investment strategy constitutes a recommendation to buy that security or engage in that strategy. These examples have been chosen for the sole purpose of illustrating specific points, not to pass judgment on individual ETFs or specific trading strategies.

PREFACE xxi Finally, I have heard it asserted that the pleasure of authoring a book comes from writing about a subject that you enjoy. I cannot agree more: the exploration of this subject has been a pleasure, and I hope that readers will find the topic and the discussion as engaging and as productive as I have. As exchange-traded funds and their derivatives continue to grow in importance for both institutional and individual investors, our understanding of these financial instruments inevitably will grow; I hope this book provides a solid foundation for that evolving knowledge.