The Exchange-Traded Funds Manual
|
"Exchange Traded Funds are simply the biggest development for the average retail investor in the past decade. No more need to pay huge fees for opaque mutual funds/unit trusts. Just go to an exchange, buy the fund and hey presto you can track indices and have total price transparency for as long as the exchange is open. I championed ETFs in my book 'Capital Market Revolution' and I am delighted to see that ETF pioneer Gary Gastineau has produced a terrific, comprehensive book on every aspect of Exchange Traded Funds. If you have any questions about ETFs, they will be answered by this book...”—Patrick L Youngauthor "Capital Market Revolution"CEO, erivatives.com
“Exchange-traded funds are the hottest finance innovation of the past decade. Gary Gastineau, who played a critical role in their development, demystifies the working of these instruments, lucidly describes their advantages and disadvantages, and guides investors on their use. This gem of a book will be the ETF bible for years to come.”—Burton Malkiel, Chemical BankChairman’s Professor of Economics,Princeton University“This is the first comprehensive book on exchange-traded funds. The author displays an institutional and practical knowledge of exchange-traded funds that makes this book necessary reading for not only the knowledgeable investor but for the professional researcher seeking to understand this relatively new investment vehicles.”—Martin J. Gruber, Nomura Professor of Finance,Stern School of Business, New York University“Gary Gastineau is a national treasure. Exchange-traded funds are the wave of the future, and Gary has been instrumental in their development from day one. His knowledge is encyclopedic, and his style and subtle humor make it all accessible to the reader.”—Wayne H. Wagner, Chairman,Plexus Group, Inc.“The introduction of exchange-traded funds was one of the success stories of Wall Street in the 1990s. Gary Gastineau was a key contributor to this success, and his book is an important benchmark on both the current status of this important new category and the vast potential of its next generation products.”—Salvatore Sodano,Chairman and Chief Executive OfficerAmerican Stock Exchange Order a copy of The Exchange-Traded Fund Manual
|
Someone Will Make Money On Your Funds - Why Not You?
|
This book covers critical investment and planning topics, while focusing on providing a unique, effective approach to picking mutual funds and ETFs. This accessible guide alerts you to problems inherent in some types of funds that can sabotage your returns, and discusses how to avoid funds that are used by market timers. From financial planning to considering cost and tax features when picking winning funds, this book gives you the investment information you need from an objective expert you can trust."This book is a treasure trove of practical research and pithy thoughts based on Gastineau's decades of experience; a valuable guide for the thoughtful investor."-HAROLD EVENSKY, Chairman, Evensky, Brown & Katz"Will jar armchair mutual fund investors out of their PJ's. If you think checking out your funds in Morningstar and Lipper has you covered, you best read this book."-MAUREEN NEVIN DUFFY, Editor/Publisher, The Turnaround Tactician"A must-read for fund investors. Gastineau carefully discusses many important factors such as taxes, capital gains overhang, trading costs, turnover, benchmark selection, active management, expense ratio, and aggressive trading by market timers."-VIJAY SINGAL, J. Gray Ferguson Professor of Finance and Chairperson of the Finance Department, Pamplin College of Business of Virginia Tech, and author of Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing"Gastineau's message is very powerful. He not only challenges some conventional wisdom on investing, but truly emphasizes how to add value to a portfolio."-Dan Dolan, Director, Wealth Management Strategies, Select Sector SPDRsOrder a copy of Someone Will Make Money On Your Funds - Why Not You?
|
Articles and Working Papers
|
The phenomenal growth of Exchange-Traded Funds (ETFs) is a frequent topic in the financial press. These funds, with assets more than doubling each year since 1995, have been warmly embraced by most advocates of low-cost index funds. Vanguard, the leading advocate of index funds, has announced plans to add exchange-traded share classes to a number of its domestic index funds. Most of the press coverage has correctly noted the major advantages of ETFs – low-costs, intra-day trading and high tax efficiency with no material premiums or discounts to the funds’ intra-day net asset value. However, there is a fair degree of misunderstanding about how ETFs work, what sectors of the market are good candidates for ETFs and what sectors are not, why the expense ratios tend to be low, and how most of the funds manage to avoid significant capital gains distributions. This paper attempts to answer these and other questions frequently asked by investors.
|
Today’s equity index funds get more credit for low costs and high efficiency than they deserve. The original idea of a low-cost, low-turnover, diversified portfolio has been replaced by funds that deliver only on their pledges of low turnover and diversification. The concentration of trading by these funds at times when the index is changed causes investors to incur transaction costs far higher than the pioneers of indexing anticipated. Index funds based on popular equity benchmark indexes have become a much more costly way to invest than they used to be – and than they need to be.
|
The greatest weakness of the current generation of index funds is that the benchmark indexes they use as templates are created and published for other purposes. Consequently, anyone can buy stocks added to the index or sell stocks removed from the index in competition with the index fund. No active fund manager would accept an investment process that would tell the world what trades her fund would make and approximately when it would make them. With Silent Indexes, index funds can achieve the same kind of trading confidentiality that actively-managed funds enjoy.
|
Indices are designed for a number of different purposes. The use of stock indices as market indicators predated the idea of a theoretical “market portfolio” by decades. Understanding the nature of these indices – and understanding the differences among ETFs based on them – requires understanding the answer to five questions:
- Is the index comprehensive or sampled?
- Is the inclusion mechanism rules-based or discretionary?
- How is the index weighted?
- Are inclusion and weighting decisions consistent over time?
- Can the index be sensibly subdivided – e.g., into industrial sectors, or growth and value components?
|
Several years ago, I opined that it would be difficult or impossible to convert a conventional actively-managed fund to the ETF format. My feeling was that shareholders who do not value ETF tax efficiency would argue that the loss in portfolio confidentiality was more important to them than any advantage the ETF format offers. My conclusion was premature. The ETF structure does offer an important advantage to all ongoing fund investors.
|
Single stock futures (SSFs) contracts on exchange-traded funds (ETFs) are an attractive product, particularly for retail investors who find it difficult to borrow modest lots of ETF shares to take short positions. Arbitrage among related index-linked instruments helps keep spreads tight.
|
A significant problem with exchange-traded fund (ETF) underperformance has not been widely discussed: ETFs have generally underperformed competitive conventional mutual funds, apparently because the ETF structure and fund management process seems to discourage efforts to recapture transaction costs embedded in the benchmark index portfolio change process. This paper analyzes the problem and suggests a solution.
|
Eliot Spitzer, New York State Attorney General, extracted a $40 million settlement from a hedge fund management company that allegedly bought and sold mutual fund shares in “late trades” at the funds’ net asset value several hours after the net asset value was calculated. In addition, the hedge fund manager entered orders shortly before 4:00 p.m. with funds that claimed in their prospectus to discourage “market timing.” This paper examines the cost of these prominent trades and other, less notorious, late-afternoon trades to ongoing fund shareholders. Trades entered late in the afternoon are often legal, but in the aggregate they cost ordinary fund shareholders $40 billion per year in lost performance. Requiring an earlier cutoff time for mutual fund buy and sell orders to be executed at net asset value is the only practical way to protect fund shareholders from these performance losses.
|
On the basis of higher sector volatilities, lower fund expenses, lower trading costs, and long-term tax efficiency, the Sector SPDRs currently are the top choice for sector-fund-based risk management and tax-loss harvesting.
|
There are at least three ways to meet demands of some investors for ETFs and demands of other investors for conventional mutual funds. Vanguard adds ETF share classes to their conventional funds. Fidelity plans separate funds with similar portfolios. A third possibility would make the ETF share class the only way in or out of a multiple share class fund. We conclude that investors choosing the Vanguard-type structure may not find the ETF shares as tax-efficient as the other choices are likely to be.
|
Most ways of breaking down the common stock universe from a total market index into sub-categories are easy to understand. Of course, there is not universal agreement on where size cut-off points or ranges belong or even what industry or sector every company should be assigned to, but most classifications are not too highly controversial. There is -- and should be -- significant controversy over how to divide the stock universe into growth and value components.
|
Short selling in ETF shares is a low-risk activity because short squeezes are not possible and most short sales are made to reduce an investor’s portfolio risk. While short selling will increase ETF trading activity, it is unlikely to have a significant effect on trading volume or trading spreads unless the ETF shares are based on a very popular index like the S&P 500 or the Nasdaq 100.
The market for ETF share lending has changed recently as market makers have reduced their inventories of ETF shares to lend in 2003’s low short-term interest rate environment. The share ownership requirements of the Jobs and Growth Tax Relief Reconciliation Act of 2003 promises future changes in ETF share lending practices. Perhaps the most interesting aspect of the very large aggregate short interests in many ETFs is the fact that changes in the short interest are often greater than changes in shares outstanding, obscuring the meaning of changes in investor commitments to ETFs.
|
The growth in exchange-traded funds (ETFs) has been stimulated by the appearance of new services offered by specialized managers. These managers use ETFs as portfolio components. They use passive vehicles -- index ETFs and index mutual funds -- and traditional active management vehicles -- mutual funds and specialized separate account portfolios -- in eclectic combinations. They pursue most of the goals that traditional separate account managers pursue. However, these managers enjoy some unique advantages which often permit them to provide a better investment service at a lower net cost to the investor.
|
What Is the Significance Of These High Short Interest Figures?
- Short Selling Increases Trading Volume
- The Short Interest Replaces Shares That Would Otherwise Be Issued By the Fund
- Short Selling May Reflect Fund Performance Weaknesses
- Individual Investors Should Make Sure That Their Broker Is Not Lending Their Equity ETF Shares
- Large ETF Short Interests Help Make Most Estimates Of Institutional Ownership of ETFs Into Gross Exaggerations
|
If the mutual fund had not been introduced into the United States in the 1920s, financial markets would be very different today. However, if the development and growth of mutual funds had not attracted about $8,000,000,000,000 ($8 trillion) to today’s “legacy” funds, no investor, no investment manager and certainly no conscientious regulator would suggest that the primary repository of U.S. investors’ financial assets in the 21st Century should have the characteristics of today’s mutual funds. Starting with the position that a few features of today’s mutual funds might be taken as examples of what not to do and taking advantage of available technology, I will sketch the outline of a new or “reinvented” fund structure and new investment processes.
My framework for new funds is very similar in some basic respects to the structure of today’s exchange-traded funds. The idea that the ETF has some advantages over the conventional mutual fund is supported by the fact that it took U.S. ETFs less than 12 years to attract over $226 billion in assets. Conventional mutual funds needed more than 66 years to accumulate as much. Certain features of the existing index ETFs need to be modified or, more accurately, generalized to accommodate a wider variety of funds and to overcome some of the weaknesses that are apparent in the existing index ETFs. Some of the features I propose for the new fund structure are closely linked. They clearly work best if adopted as a package. Other features might be as readily implemented separately or as part of a different set of fund procedures.
I begin by describing what I believe are the three most important problems with mutual funds. The features of the new funds that I will emphasize address these problems. While my description of solutions outlines most of the major structural features of the new funds, a number of features will be barely touched upon or omitted to keep the topic manageable. Whatever the final shape of the funds that emerge from a series of changes likely to happen over the next 5 – 10 years, the result will be a more flexible investment management structure that meets the needs of a wider range of individual and institutional investors better than any fund structure currently available.
|
From the book, Someone Will Make Money on Your Funds – Why Not You? – A Better Way to Select Mutual and Exchange-Traded Funds, John Wiley & Sons, published in September 2005 , John Wiley & Sons, published in September 2005
Capital Gains Overhang
Few investors fully appreciate the significance of the tax efficiency that the exchange-traded fund (ETF) structure provides. The table offers an arresting comparison of the capital gains tax status of the Vanguard 500 mutual fund and the SPDR ETF, two funds tracking the S&P 500 index that have been in existence for a number of years – over 12 years for the SPDR and over 25 years for the Vanguard 500. Both funds have had high rates of asset growth in a generally rising equity market. To make the comparisons as clear as possible, the relationships in the table are stated as percentages, with each fund’s net assets set at 100%.
Price Competition
In March of 2005, Vanguard made a dramatic change in its ETF pricing strategy. In response to Fidelity’s decision to become the low-cost provider of conventional mutual funds tracking broad market indexes and in recognition that the Vanguard VIPERS structure was not attracting taxable investors in large numbers, Vanguard apparently decided to become the low-cost provider of broad market index ETF share classes. The VIPERS now have expense ratios at least as low as the expense ratios of any comparable ETF or conventional fund share class. Since there is not – and probably never will be – an ETF share class of the Vanguard 500, this move will not make that fund any more attractive to taxable investors. In fact, all this price-cutting is likely to sharply reduce new share sales of the Vanguard 500. The effect on ETF cash flows will also be interesting to watch.
|
These two articles extend the analysis of “The Benchmark Index Exchange-Traded Fund Performance Problem” and are part of a growing literature on the problems caused by too much money tracking too few overly popular indices that reveal index changes to the world before the fund manager has the opportunity to change the fund portfolio.
|
Whatever the merits or demerits of fundamental indexing, intellidexes, active indexes and other recent additions to the workload of future generations of lexicographers, there is no scope for narrowing the definition of a financial market index. The cat is out of the bag, the horse has been stolen from the barn and, of course, Elvis has left the building.
|
From a presentation at the Brookings Institution, published in Fuchita and Litan New Financial Instruments and Institutions, (2007).
One of the best examples of serendipity in the financial markets – from several angles – is the early development of exchange-traded funds. In attributing some features of exchange-traded funds to serendipity, we certainly do not mean to minimize the role of the developers of the early exchange-traded funds. They deserve full credit for the wisdom they displayed in designing the ETFs introduced in Canada and the United States. Our focus is on the interaction of serendipity and financial engineering in the development of some important elements of the exchange-traded fund structure. Some key features became part of the ETF almost by accident, but they are so important that they serve as the basis for revolutionary financial engineering to reshape the U.S. fund industry.
|
Many long-only investment managers are looking for ways to offer 130/30 strategies and other "enhanced long strategies" or "constrained long-short portfolios." A conservative portfolio manager with little or no experience in short selling can use the sector evaluations from her firm's investment process to add alpha with short positions in exchange-traded funds (ETFs). Individual stock selection has the greatest potential to add value on the short side as well as on the long, but the difference in performance among various domestic sectors is a relatively close second to individual stocks. When the dispersion in sector performance is combined with some advantages of using exchange-traded funds to implement short sector positions, the use of sector ETFs to establish the short side of a 130/30 position can be a compelling choice for investment managers unprepared for fully-integrated long-short stock portfolios. Some sector ETFs are easy to trade, easy to borrow and easy to integrate as the short side of a long-short portfolio.
|
Results from several major studies of index composition changes indicate that trading transparency accounts for more than half of the market impact cost of composition changes in two of the most popular U.S. indexes. The growth of transparent custom index ETFs and the expected introduction of transparent trading in actively managed ETFs will increase investor exposure to trading transparency costs. Fortunately, researchers will be able to quantify the performance penalty from trading transparency.
|
Financial risk management is the measurement and the attempt to control trade-offs between risks and rewards in both profit-motivated enterprises and non-profit organizations. The vocabulary of financial risk management is the heart of the language of finance. Financial activities have grown more complex in recent years, and the terminology used by financial managers reflects that complexity.
The dictionary is designed for professional financial analysts and managers. It does not attempt to compete with such general reference works as the Barron’s Dictionary of Finance and Investment Terms or The Encyclopedia of Banking and Finance. The Dictionary of Financial Risk Management defines and describes many financial terms and concepts that these reference works do not attempt to cover. The principal criterion for inclusion in this volume is that a word or phrase be something that a working finance professional might want to look up.
|
ETF shares borrowed and sold short add to the supply of shares available to investors without increasing a fund's shares outstanding. Adding the short interest to shares outstanding gives the best measure of net investor interest in the fund. The spreadsheets here include short interest data through October 2007. Morgan Stanley has been publishing quarterly ETF short interest data on all U.S. ETFs, if you wish to have current data.For more details on short selling ETFs, see: Is Selling ETFs Short a Financial Extreme Sport?
|
|