Multi-purpose utility vehicle
ETFs, or exchange-traded funds are open-end mutual funds that trade on a securities exchange. Currently, all the ETFs trading in North America are index funds, designed to replicate the price and yield performance of a specified securities index. Although many investors believe that the product originated in the US, this is not true. Canadian innovators, operating in a more accommodating regulatory environment, launched the products and beat the US by several years. The TIPS-35 index trust was created by the Toronto Stock Exchange (TSE, earlier in 2002, the exchange changed its acronym to TSX to avoid confusion with the Tokyo Stock Exchange) based upon the TSE-35, its signature index at the time. The acronym stood for Toronto-35 Index Participation Units. Units of the TIPS-35 began trading on the TSE as the world’s first ETF in 1990.
The first successful US-based ETF, Standard & Poor’s Depository Receipts (SPDRs) based upon the S&P 500 Index, is popularly known as spiders. (A competing product, SuperTrust had beaten SPDRs to an AMEX listing by two months, but its more complex structure never caught on, and it was de-listed in 1996.) Under the ticker symbol, SPY, SPDRs began trading on the American Stock Exchange (AMEX) on January 29, 1993, after a three-year battle with the SEC. The shares were sponsored by a newly created AMEX subsidiary, PDR Services Corporation (PDRSC) with State Street Bank and Trust as trustee. Nine years later, SPDR’s is the North American leading ETF in assets under management with $29.2bn (E30bn) as of August 30, 2002. The product has been so popular that Spiders is often used as a generic term for the product category.
The next North American product was launched on the Toronto Stock Exchange in Canada in 1994. The HIPS, based on the broader TSE-100 index, was developed by the exchange in response to requests for “something broader” from institutional traders. The next US ETF was the MidCap SPDR, based upon the Standard & Poor’s 400 MidCap Index. Again, PDR Corporation remained as sponsor; the trustee was the Bank Of New York. In March 1996, Morgan Stanley sponsored the first ETF containing non-US securities. WEBS, (World Equity Benchmark Shares), later renamed by Barclays’ Global Investors (BGI) as iShares-MSCI (Morgan Stanley Capital International indices), was launched in March 1996 as 17 separate series of single-country-index-based ETFs listed on the AMEX. This product introduced another structural variation; it had an asset manager, not a trustee. Barclays Global Investors (BGI), the world’s pioneer in index funds and leader in indexed assets under management, was the WEBS’ manager.
In 1997, PDR Services Corp. applied the SPDRs team and structure to the Dow Jones Industrial Average. The new fund was assigned the AMEX symbol DIA, and is popularly known as ‘Diamonds’. Next, in December 1998, Merrill Lynch and State Street joined forces to group the stocks of the S&P 500 into underlying economic sectors in order to create nine new ETFs called the Select Sector Spiders. This launch brought the total of ETFs trading on the AMEX to 30, 13 domestic funds and 17 WEBS.
“Qubes” spur trading in ETFs
The next ETF would forever change the character of the ETF marketplace in the US. A newly formed subsidiary, Nasdaq Investment Product Services, Inc (NIPS) sponsored the NASDAQ-100 Trust based upon the newly reformulated NASDAQ-100 Index; the trust’s shares began trading on the American Stock Exchange in February 1999 with the ticker symbol QQQ. The symbol gave birth to its popular appellation, ‘the cubes’, or ‘Qubes’. The timing of the launch, at the height of the bull market in technology, was akin to catching lightning in a bottle. With the enormous outbreak of day-trading firms and hedge funds, Qubes quickly garnered fame and acceptance as a quick and easy way to buy, sell, short, and leverage the US technology industry. This increased market awareness for the other AMEX index ETFs, especially the MidCap SPDR.
In September 1999, BGI sponsored its first ETF. It listed on the Toronto Stock Exchange. The opportunity for such a product occurred when S&P acquired the rights to manage and co-brand the TSE family of Indexes. The TSE-35 and TSE-100 were combined and supplanted by the S&P/TSE-60 Index (now the S&P/TSX-60 Index). This left TIPS and HIPS as index funds tied to indices that were being phased out. BGI seized upon this opportunity to launch an ETF on the TSE based on the new index. The product line was branded iUnits, and the fund was called i60. BGI had already developed the iShares brand name they would unveil the next year in the US, but after testing Canadian authorities for potential flexibility, the fund/trust-unit structure still prevails. Hence, the series in Canada remains iUnits.
When iShares finally launched in the US, no baby steps were taken. In one fell swoop, they launched there first 30 funds based on well-known institutional benchmark indices. Providers used for the original iShares included S&P, S&P/BARRA, Russell, and Dow Jones. The idea was to allow direct ETF access to all market segments, sectors, and styles. In addition, BGI assumed sponsorship of the 17 WEBS from Morgan Stanley, and re-branded them iShares-MSCI. Since then, they have continued to add series and index providers to the family. As of this writing, 77 equity and four fixed income iShares, representing indices from eight distinct providers, were trading in the US.
In the interim, two other major US index managers have brought ETFs to market. In November 2000, SSgA launched 10 ETFs called StreetTracks on indexes provided by Fortune, Dow Jones, Morgan Stanley, and Wilshire. Next, the Vanguard Group became the first to launch an ETF as a new series of an existing conventional mutual fund, its Total Market Portfolio, in May 2001. It later introduced another VIPER as a share of its Extended Market Portfolio, and has confirmed recently that it expects to launch new VIPERS in the near future.
Canada continues to innovate
Since the original iUnit launch in 1999, two new iUnits, the G5 and the G10, based upon Canadian government bonds, were launched on the TSE in November 2000. Hence, bond ETFs were trading in Canada for 18 months before iShares introduced its fixed income ETFs in the US. Throughout 2001, seven more iUnits were introduced on the TSE. One fund, iGold, is the first North American ETF of the shares of companies in the business of a single commodity. TD Asset Management, a subsidiary of Canada’s Toronto Dominion Bank, introduced four ETFs, called under the brand ‘TD Select’ in 2001. Two TD Select funds are based on the S&P/TSX Indices, and two on Dow Jones Canadian Style Indexes, one growth and one value.
One fundamental reason for the burgeoning popularity of the ETF is its remarkably efficient product structure. For many investors and traders, it is more accessible and far simpler operationally than a future. And, since it doesn’t expire, there are no ‘roll’-related issues. These are the qualities envisioned by the men who most of the industry regards as the father of ETFs.
Nathan Most, now 87 years young and chairman of the iShares trust, began developing the SPDR in 1990, when he was in semi-retirement and working as a product development consultant for the AMEX. He readily admits borrowing from the commodity warehouse receipt concept. His inspiration for the creation of SPDR is to ‘give the AMEX something new to trade’. Little did he realise that in doing so, he created the prototype of what would be the securities industry’s fastest growing product during the ensuing 10 years. The structure was purposefully simple, yet remarkably flexible. ETFs trade on the open market. Investors can go long, short, or buy on margin in the same exact way they buy and sell other stocks, with one key advantage. ETFs are exempted from the uptick rule so they can be sold short on a downtick. This is important to those using ETFs as hedging instruments or surrogate futures.
The ETF eco-system
In the US, new ETF shares can be issued and outstanding ETF shares can be redeemed on any trading day, but there are fundamental restrictions that contribute to the ETF’s remarkable efficiency. The first is that the only way to create or redeem shares directly with the fund’s distributor is through an authorised participant (AP) in blocks of specified minimum amounts called ‘creation units’. In the US, most creation units are 50,000 shares or larger, meaning the minimum unit size ranges from as low as $1m to as high as $7.5m. The brilliant twist – instead of the fund receiving and delivering cash, it receives and delivers an in-species basket of its underlying securities. This means that customer flows do not trigger trading activity by the fund manager. In the US and Canada, where capital gains are taxed significantly, this process also helps minimise potential capital gains distributions. When a mutual fund sells a share for cash, the amount it receives over its original cost is taxed, but under the US and Canadian tax codes, in-species deliveries are not taxable events. Combine these remarkable efficiencies with universal accessibility and multi-purpose versatility, and it’s no wonder that many enthusiasts consider ETFs the future of the mutual fund industry.
The APs are significant players in the process. Since all the US ETFs list on exchanges that still have specialist systems, the exchange-assigned specialist needs to be an AP in order to keep orderly markets. Yet, significant incentives exist for other major institutions to register with the fund’s distributor as APs. APs often create and redeem in order to execute tactics and strategies for institutional clients. They also may engage in arbitrage activities that provide a guaranteed immediate profit, and are crucial to keeping the funds efficient. As one trader put it: “The arbitrageurs, in a very real sense, are the good guys here. They are the barracuda that gobble up the small fish to prevent potential gluts, thus keeping the eco-system efficient”. Whenever the share price on the exchange is significantly higher or lower than the fund’s NAV, an arbitrage opportunity exists.
The spread between ETF share price and NAV for ETFs containing US-traded securities needed for an arbitrageur to capture net profits is generally much lower in the US than in Europe. The increased efficiency is attributable to the automated clearing and settlement system run by the Depository Trust Clearing Corporation (DTCC). The index share process involves a portfolio of securities to be placed in custody the night before the trade, forming the components of ETFs. Henry Belusa of Depository Trust Clearing Corp, DTCC says, “The US clearing system is unique because of its fully automated and guaranteed creation and redemption process”. The process works so long as all the securities in the baskets are DTCC-eligible. As soon as the order is placed, the basket of securities is locked in the DTCC system, and the fund is protected from potential delivery failure. This assures the execution of successful arbitrage.
Many uses and users of ETFs
ETFs, in general, are predominantly used by institutional investors. In Canada, the four public fund managers to whom we spoke all use ETFs for equitisation, access and risk control in their in-house portfolios. In the US, most retirement systems and pension plans we spoke to do not use ETFs directly, but do allow outside managers to use them in their behalf. Fund managers can go long and short on funds and have easy access to gain exposure to particular sectors or countries for long term holding. Institutional investors can quickly and easily purchase ETFs for instant and extensive international exposure, compared with the associated expense and difficulty to assemble a portfolio of foreign securities from scratch. Generally, research pieces on ETFs, including trading strategies, emanate from the derivatives desk, underscoring that ETFs are frequently used as substitutes for derivatives. ETFs are also used by institutional investors to facilitate the manager transitions. Funds are parked in ETFs as an interim measure until the transition is complete. Alternatively, if the new manager decides to move from small cap to large cap stocks, he can use small cap ETFs to hedge while selling off the physical small cap stocks. It may take several days to sell small cap stocks due to liquidity issues. ETFs act as a fund stabilizer during the transition period.
Institutional trading desks at several of New York’s larger investment banks told us that the majority of ETF trading volume they see comes from hedge funds. ETFs empower them to formulate and execute many different strategies in attempts to capture excess returns. Allen Gillespie, CFA, founder of GNI Capital, a hedge fund manager that uses ETFs for a number of applications, says, “ETFs are very useful risk management tools. We use ETFs for 50% of the portfolio in pairs trading, usually on the short side.” GNI also trade ETFs against options to execute volatility trades. Other hedge fund managers cited a combination of contributory factors for their usage of ETFs, including: trading versatility; immediate diversification in virtually any targeted equity market segment; operational simplicity; no minimum trade size; and cost efficiency.
Nurturing small investors
Ironically, retail investors who stand the most to gain by using ETFs relative to more limited and more costly alternatives, are the least aware of their existence and applicability. Since inception, the AMEX has consistently made inroads by sponsoring educational workshops and conferences. Education has also been a major thrust of BGI’s iShares campaign. Increasingly, the financial planners who work with high net worth individuals are catching on. According to a recent US research study, financial planners have shown more growth since 1999 than any other single ETF user segment. At the rank-and-file level, there are certainly thousands, and perhaps, tens of thousands of do-it-yourselfers who have begun to use ETFs – even if many do not recognise the category name. As information continues to travel downstream and products continue to penetrate new market segments, they should become a more significant participant in the food chain.
Herbert Blank and Pauline Lam are with advisory firm QED International in New York