ETFs’ challenge to futures
Exchange-traded funds, an exciting and fast-growing asset class in the US, are expected to make their debut in Europe very soon. ETFs are essentially index funds that are listed and traded on exchanges like stocks. In the US, they are index-tracking open-ended registered funds or unit investment trusts that invest in a portfolio of stocks designed to track the performance and dividend yield of a specific index. At the same time they offer the benefits of trading like a stock on the American Stock Exchange. They are lendable, marginable, there is no sales load and they can be used to short an index even on a down tick
The ‘spider’ – Standard & Poor’s Depositary Receipt (SPDR) – was the first ETF, launched in the US in 1993. Designed to track the S&P500 index, the SPDR is today the most widely held ETF with an open interest of $17.5bn, which makes it the fifth largest index fund tracking the S&P500 in the US. In 1994 S&P launched MidCap 400 Depositary Receipts to track the S&P MidCap 400 Index.
In 1996, Morgan Stanley Dean Witter created World Equity Benchmark Shares (Webs), a series of funds designed to track 17 international Morgan Stanley Capital International (MSCI) Indices. Webs are managed by Barclays Global Investors, and have three other service providers, including SEI as distributor.
1998 saw the launch of Diamonds, designed to track the Dow Jones Industrial Average. In December 1998 Select Sector SPDR Funds were launched to track nine sectors within the S&P500: basic industries, consumer services, consumer staples, cyclical/transportation, energy, financial, industrial, technology and utilities. The Nasdaq-100 Index Tracking Stock, which is designed to track the Nasdaq-100 Index, was launched in 1999.
The prices of many ETFs are set as a percentage of the index value they are designed to track. SDPRs are priced to approximate one tenth of the value of the S&P500, MidCap SPDRs to approximate one fifth of the value of the MidCap 400 index, the Nasdaq-100 Index Tracking Stock is priced to approximate one fortieth of the value of the Nasdaq 100 index, Select Sector SPDRs are one tenth of the value of their indices, Damonds are one hundredth of the value of the Dow Industrials and Webs are priced to approximate the actual value of the underlying portfolio of shares.
ETFs are used by both retail and institutional investors, including pension plans, asset managers, private banks, insurance companies and hedge funds. The primary uses are to equitise cashflows for asset allocation and hedging.
ETFs are often seen as an alternative to using futures to manage cashflows. ETFs can be bought in smaller sizes than futures. In addition, investors, can buy a single share of an ETF, and do not have to worry about roll costs and margin requirements. ETFs can also be more liquid than futures and can provide better tracking, depending on the applicable benchmark.
Purchasing an ETF is an easy way to implement asset allocation decisions. From a settlement and administrative point of view ETFs are more efficient than purchasing a basket of shares to track a benchmark, as an investor only has to settle a single share rather than in some cases hundreds of shares. Many investors find Webs helpful in implementing international asset allocation, especially as they provide exposure to international benchmarks during US trading hours.
When portfolio managers decided they would like to hedge a portion of their exposure to a specific country or sector shorting the corresponding ETF provides a very easy way to achieve this objective.
Unlike closed-end funds ETFs tend to trade at or close to their underlying net asset values. This is because arbitrageurs look for opportunities when an ETF is trading at a significant premium or discount relative to the underlying index. An arbitrageur will buy/sell the ETF and place an offsetting buy/sell in the underlying basket of component stocks or futures.
ETFs afford investors two forms of liquidity: first, through trading the shares on a secondary basis on the Amex and second through the ‘creation unit’ process where an ‘authorised participant’ purchases the underlying basket of shares in the local market and deposits the basket ‘in kind’ into the ETF in conjunction with creation of more shares in that ETF.
There is now $39.5bn invested in the 30 ETFs in the US, more than double the open interest of $15.2bn at the end of 1998. ETFs have become a very important business for the Amex, where trading in these shares accounts for 50–70% of total daily trading volume. On most days the Nasdaq 100, SPDR and Diamonds are typically among the top five traded shares on the Amex.
The use of ETFs in the US is expected to continue to grow, fuelled by the expected launch of a further 40–50 ETFs. State Street Global Advisors, which manages the SPDRs, is expected to launch a number of new ETFs in the US during the next few months, including an ETF on the new Morgan Stanley Dean Witter Mox internet index. The New York Stock Exchange, working with the Deutsche Börse and the Tokyo Stock Exchange, has announced plans to launch a global ETF on the new S&P 100 global index. BGI expects to launch 36 new ETFs in the US, including some new Webs series under its iShares initiative during the next few months.
Given the growth of ETFs and the benefits they have brought to the Amex in terms of increased trading revenues, many stock exchanges around the world have decided to or are considering creating a platform to trade ETFs.
The Deutsche Börse has announced the creation of the XTF ETF segment and the London Stock Exchange has announced the creation of its Extramarket segment for ETFs. BGI, SSGA and other firms have announced that they plan to create ETFs for Europe. There are also discussions to cross-list some of the US ETFs in Europe as well as on other exchanges around the world.
Deborah Fuhr is vice president, global head of marketing for Opals and exchange-traded funds at Morgan Stanley & Co International in London