The ETF Revolution: International And Brazilian Perspectives
5to Congresso Internacional de Mercado Financiero e de Capitais,Campos de Jordao, August 2011The ETF Revolution:International and BrazilianPerspectivesMarco AvellanedaNew York UniversityFinance Concepts LLC
Exchange-traded fundsSimilar to mutual funds, with additional flexibility:-- shares trade on exchanges-- trading is similar to stocks (bid/ask, short, margin)-- options on ETFs available-- began as as index trackers-- actively managed and synthetic ETFs since mid 2000’sArbitrage: authorized participants can create or redeem ETFs in creation units’’-- creation units: 25K to 100K shares-- APs often act as market makers, providing liquidity
Basic ETF StructureSecondary marketPrimary marketFUNDCreation*Redemption**AUTHORIZED ANGECashETFBUYERS* Give basket of shares, receive ETFs** Receive basket of shares, give ETFs
Brief HistoryMilestones:1993: first US ETF1998: first European ETFs2006-2008: ETPs, first actively managed ETFsHistory:1989: Index Participation Shares, stopped by Chicago Mercantile Exchange (IP prob.)1993: SPY Tracking S&P 500 (a.k.a. Spiders or SPDRS, issuer: State Street)1996: BGI creates WEBS (World Equity Benchmark Shares), later callediShares (e.g.: EWZ: MSCI Brazil Index Fund)1998: Sector SPDRS track 9 sectors of the S&P 5002008: 680 ETFs in US with 610B in assets, increase of 125B in 12 monthsJanuary 2010: US ETF market breaks the 1,000 billion mark in AUMETPs ETFs covering, fixed-income, FX, Commodities, Volatility
ETF AUM Growth in Different Markets
Global ETFs by ExposureDoes not include European synthetics
March 2011, 60 Largest US-based ETFs by AUM (in BB; highlighted: iShares MSCI CSJIJRFXIDescriptionMarket CapRankSPDR S&P 50090.21SPDR Gold Shares56.03Vanguard MSCI Emerging Markets43.73iShares MSCI EAFE Index38.15iShares MSCI Emerging Markets36.24iShares S&P 500 Index26.95PowerShares QQQ24.21iShares Barclays TIPS Bond19.89Vanguard Total Stock Market18.98iShares Russell 2000 Index15.39iShares Russell 1000 Growth13.29iShares iBoxx Investment Grade12.98iShares MSCI Brazil Index12.54iShares Silver Trust12.38iShares Russell 1000 Value11.80Vanguard MSCI EAFE ETF11.34SPDR S&P MidCap 40011.11iShares Barclays Aggregate Bond11.06Vanguard Short-Term Bond ETF10.72iShares S&P MidCap 40010.72Energy Select Sector SPDR10.38Vanguard Total Bond Market9.25SPDR Dow Jones Industrial9.21Vanguard REIT ETF8.58iShares iBoxx High Yield8.32Financial Select Sector SPDR8.05iShares Barclays 1 37.93iShares Barclays 40546 Year7.82iShares S&P SmallCap 6007.38iShares FTSE China DBAIWSIWVDescriptionMarket CapVanguard FTSE All-World ex-US7.21SPDR Barclays Capital High7.06iShares Russell 1000 Index7.00iShares S P U6.79Technology Select Sector SPDR6.79iShares MSCI Japan Index6.47iShares Russell Midcap Index6.37Vanguard Dividend Appreciation ETF6.10iShares S&P 500 Growth6.05iShares Dow Jones Select5.99iShares MSCI Canada5.97Proshares UltraShort 20 tsy5.68iShares Gold Trust5.67Vanguard Growth ETF5.42SPDR S&P Dividend5.37Vanguard Value ETF4.84Vanguard Small-Cap ETF4.64Vanguard Large-Cap ETF4.61iShares Russell 20004.56iShares S&P 5004.51iShares MSCI South Korea4.38iShares Barclays Short TSY4.16iShares Russell 20004.02Utilities Select Sector3.91iShares MSCI Pacific ex-JP3.80Industrial Select Sector3.69Vanguard Mid-Cap ETF3.66DB Agriculture Fund3.59iShares Russell Midcap3.42iShares Russell 30003.42
60 Largest US ETFs by AUM (in BB; highlighted: LFSHYCSJIJRFXIDescriptionMarket CapRankSPDR S&P 50090.21SPDR Gold Shares56.03Vanguard MSCI Emerging Markets43.73iShares MSCI EAFE Index38.15iShares MSCI Emerging Markets36.24iShares S&P 500 Index26.95PowerShares QQQ24.21iShares Barclays TIPS Bond19.89Vanguard Total Stock Market18.98iShares Russell 2000 Index15.39iShares Russell 1000 Growth13.29iShares iBoxx Investment Grade12.98iShares MSCI Brazil Index12.54iShares Silver Trust12.38iShares Russell 1000 Value11.80Vanguard MSCI EAFE ETF11.34SPDR S&P MidCap 40011.11iShares Barclays Aggregate Bond11.06Vanguard Short-Term Bond ETF10.72iShares S&P MidCap 40010.72Energy Select Sector SPDR10.38Vanguard Total Bond Market9.25SPDR Dow Jones Industrial9.21Vanguard REIT ETF8.58iShares iBoxx High Yield8.32Financial Select Sector SPDR8.05iShares Barclays 1 37.93iShares Barclays 40546 Year7.82iShares S&P SmallCap 6007.38iShares FTSE China DBAIWSIWVDescriptionMarket CapVanguard FTSE All-World ex-US7.21SPDR Barclays Capital High7.06iShares Russell 1000 Index7.00iShares S P U6.79Technology Select Sector SPDR6.79iShares MSCI Japan Index6.47iShares Russell Midcap Index6.37Vanguard Dividend Appreciation ETF6.10iShares S&P 500 Growth6.05iShares Dow Jones Select5.99iShares MSCI Canada5.97Proshares UltraShort 20 tsy5.68iShares Gold Trust5.67Vanguard Growth ETF5.42SPDR S&P Dividend5.37Vanguard Value ETF4.84Vanguard Small-Cap ETF4.64Vanguard Large-Cap ETF4.61iShares Russell 20004.56iShares S&P 5004.51iShares MSCI South Korea4.38iShares Barclays Short TSY4.16iShares Russell 20004.02Utilities Select Sector3.91iShares MSCI Pacific ex-JP3.80Industrial Select Sector3.69Vanguard Mid-Cap ETF3.66DB Agriculture Fund3.59iShares Russell Midcap3.42iShares Russell 30003.42
The investor perspective:Main advantages of ETFsRetail Investors-- Diversification at an affordable price-- Behave like index mutual funds but are more flexible-- Limit orders, short-selling, options-- Lower fees (?)-- Tax efficiency: lower turnover than MFs (no need to sell assets each timesomeone sells, less capital gains tax impact)Professionals & Pension Funds-- Used for trading & hedging by pros (HF managers, traders)-- Proxies for market factors for explaining stock returns-- Tactical allocation (core/satellite, .)-- Equitification’’ of commodities, currencies and fixed-incomeLarge institutional growth is expected going forward with ETFs replacing traditional MFs
Main categories of ETFs Trackers: industry sectors Trackers: country Currency: based on non-deliverable forwards (NDFs) Commodity: based on physical Commodity: based on rolling futures Actively managed Leveraged & inverse
Examples of Country ETFs issuedin the ONMSCI BrazilMSCI JapanXinghua 25TaiwanKoreaCanadaHong KongSingaporeRussiaAustraliaMexicoADV Average daily volumeAUM ( B)12.58.26.73.45.05.52.11.93.13.01.7ADV ( M)83050060015018090803012090100
US ETFs providing Brazilian exposureIndex TrackersEWZBRFBRXXEWZSBRAQBRAZBRAF- iShares MSCI Brazil Index Fund- Small Cap- Infrastructure- Small Cap- Consumer- Mid Cap- FinancialsAUM ( million)12509009006030308LeveragedUBRBZQ- (2X) MSCI Ultra-long- (-2X) MSCI Ultra-short2010CurrencyBZF- Real Money Market Fund500
Structuring:ETF Zoology 101All ETFsSynthetic(swaps, cPhysicalFX, FixedIncomeBenchmarkTrackingIndex Sampling’CommodityActive,long/short
Synthetic structure ( unfunded’’)Secondary marketAssetsreturnAssetssoldCollateral assets may or may not be related to the underlying index
Synthetic structure ( funded’’)Secondary market(source: BIS)
How does a typical Index ETF work?(A.: a mix of assets and swaps)AssetsCash
Profitability of the ETF industry in EuropeEurope ETFIn EUR millionEUR millionProfit is estimated at EUR 1.2 B in Europe, EUR 5B globally (including US)Securities lending revenue is estimated at 498 mm EUR (2500 MM globally)Indirect revenues are important!
Physical vs. Synthetic? Physical replication is preferred by Asset Managers (e.g. Black Rock, Vanguard)with expertise in portfolio management and index tracking Synthetic replication is preferred by Banks which have large swapsand structured notes business (DB, Soc Gen, Surge) and less capabilityin equity portfolio management This explains the recent surge of synthetics in Europe where banks have naturaldistribution channels and OTC businesses Energy futures-based ETFs are the province of banks, in general (e.g. DB), andsome specialized commodity traders
Main issue for regulators: transparencyPhysical ReplicationNeed better disclosure on: Securities lending-- Percentage of NAV lent out-- Collateral Agreements-- Who receives the profits from securities lending? Benchmark index composition: what are we really investin g in ? Tracking methods-- Full replication or sampling?-- Reports on sampling effectiveness.
Main issue for regulators: transparencySynthetic ReplicationNeed better disclosure on: Method of synthetic replication(funded, unfunded) Who are the swap counterparties? What collateral taken on the swap? Collateral ownership agreements Legal opinion on recourse for investorsin case of default
ETFs in Latin AmericaBrazilChile *MexicoPeru *Registrations Primary Listings Total Listings Providers AUM (USD B)99921.8350503481934838.3295 (*) Chile and Peru only allow ETF investment by pension funds Most of Mexico’s AUM are in US Index ETFs (Nasdaq, S&P, Dow Jones,Canada, Japan) Largest issuer: Black Rock Significant expansion underway in terms of registrations( Source: Black Rock, BM&F Bovespa)
ETFs Made in Brazil Current legislation, Instrucao CVM 359, allows only for ETFs on Brazilian equityshares, with physical replication (at least 95% physical replication) According to informed sources, a new Instruction is under review by CVM, whichwill allow for ETFs on commodities, foreign shares and fixed-incomeMajor FundSymbolAUM ( B BRL) ADV( 000) PIBB Fundo Indice Brasil 50PIBB111.2 iShares Brasil Fundo de IndiceBOVA110.45PIBB issued by Banco Itau was first moverBOVA issued by BlackRock is capturing market share rapidlyADV( m)131.850721
Some ideas for ETFs issues in Brazil Commodity ETFs , especially Agricultural and Mining BDRs not on single stocks, but on major market indexes !(QQQ, SPY, Eurostoxx, Nikkei, Russell 2K) Cross border ETFs based on regional stocks (including Argentina,Chile & Brazil) Very interesting opportunity to introduce new assets to theBrazilian investor community but The appropriate design of these new products is important in orderto avoid well-known pitfalls . Opportunity to shine
Brazilian petroleum or mineral commoditysynthetic structureCollateralized swapor structured noteETFCreation, cialProductsHedge with physicalcommodityCash vs. ETFsPetrobras/EBXBM&F Bovespa
Known pitfalls in commodity ETFs: Physicalvs. FuturesPhysical commodity: GLD (StreetTracks Gold Shares)IAU (iShares Comex Gold Trust)Futures-based: DGL (Powershares DB Gold Fund)Futures-based ETFs are based on maintaining aposition in a constant-maturity futures by rollingfrom one contract to the next as they reach maturityThis may result in underperformance with respect tothe spot commodity for at least 3 reasons-- rolling costs (including front-running)-- position limits in futures exchanges limits AUM growth andproduce distortions-- contango /backwardation
Growth of Gold Bullion ETFs over the last 6 yearsGLD’s AUM USD 67 Billion
Difference Between Spot Gold andFutures-based Gold ETFs
Commodity Futures: ContangotT1T2T3Futures are said to be in contango if the futures price increaseswith the time-to-delivery (futures is higher than spot)If the futures are in contango, this means that the convenienceyield’’ is low and the cost of storing and financing make theforward delivery more expensive as time goes by
Commodity Futures: BackwardationtT1T2T3Futures are said to be in backwardation if the futures price decreaseswith the time-to-delivery (futures is lower than spot)Associated with a high convenience yield. For example, rental forgold could be expensive, etc.
Futures-based ETFs: the rollingconundrumMandate:-- position in one or more contracts, aiming to carry a fixed-maturity-- change (roll) contracts as expiration arrivesdI tdFt 1 dFt 2 a t 1 1 a t 2 rdtItFtFtI t value of the index at date tFt i futures with settlement date Ti
Rolling with constant maturity Discrete rolling (USO, UNG)1 T1 T2 1,ift 2a (t ) 1 0, if t T1 T2 2 Present timetConstant target maturityT1t Continuous rolling (VXX, VXZ)T t a t 2T2 T1Typically, tau T2-T1T2
Contango implies futures drop towards spotSimple model for FFt (i ) St e ( ri d i )(Ti t )contango ri d i 0St spot priceri rate for expiration Tid i convenience yield - storage cost for mat. TidFt (i ) dSt ri d i dt ,(i )FtStIn a low interest rate environment, contango means that convenience yields arenegative. ( d i 0 )
Consequence for futures-based ETFsdI tdFt (1)dFt ( 2 ) a t (1) 1 a t ( 2 ) rdtItFtFtdSt [a t r1 d1 1 a t r2 d 2 ]dt rdtStdSt [a t d1 1 a t d 2 ]dtStNegative drift relative to spot px if convenience yield is negative
Theory meets practice: the USO oil ETF
UNG: Natural Gas ETF
Long-Short Physical vs. Futures ETFSince futures-based ETFs underperform spot, we should be able toprofit (theoretically, at least) from going long physical ETF and shortingthe futures-based etf on the same commodity.Case study:Physical ETF: GLDFutures-based: DGLX t return of GLDYt return of DGL Pt X t Yt rs tPtT PT P0 1 X t Yt rs t t 1
A first back-test (no borrow rates)Theoretical performance: 1.8% per year (daily compounding)3.3% volatility per yearStraight line suggests that the difference should correspond to funding costs
but borrow rates kill’’ this arbitrageAssume that GLD can be financed at general collateral (e.g. 0.25%), so theIssue is how much does is cost to short DGL.DGL short rate -2.381% (from large broker, March 23, 2011). This is a negative rate:you pay on cashbalances.
Leveraged ETFsProducts offer a multiple of the daily return of a reference indexExamples:Proshares Ultra Financials ETF (UYG)Offers a daily exposure to 2 times the Dow Jones Financial Index(long 200% of underlying index, via TRS)Proshares UltraShort Financials ETF (SKF)Offers a daily exposure to -2 times the Dow Jones Financial Index(short 200% of underlying index, via TRS)
Pitfalls of leveraged ETFs for buy-and holdinvestors Issues have been raised in the marketplace pertaining to the suitabilityof leveraged ETFs for long-term investors seeking to replicate a multipleof an index performance UBS AG U.S. brokerage business stopped selling ETFs that use leveragebecause such products do not conform to its emphasis on long-terminvesting’’ Bloomberg News, July 27, 2009 Due to the effects of compounding, their performance over longer periodsof time can differ significantly from their stated daily objective. Therefore,inverse and leveraged ETFs that are reset daily typically are unsuitable forretail investors who plan to hold them longer than one trading session,particularly in volatile markets’’ FINRA Regulatory Notice, June 31, 2009 SEC issued a similar warning notice in 2009
Tracking error: UYG vs. 2X IYF, 1 year1201008060UYG402X IYF200-20Lack of recovery in the bull mkt of Q1 8-40
racking error: SKF vs. -2X IYF250200150SKF100(-2)XIYF500
Chart ScaleSettings Chart Cursor OHLC Values ResetEnter namskfSKF/UYG Past 3 months
Past yearNotice that both returns are negative (big) over 1 year
Since inception
Another example: FAS/FAZDirexion 3X and -3X Financial ETF
Oil & Gas Proshares DIG (long)DUG (short)
LETFs: The discrete modelRS ,n return of the underlying index over the nth periodRL ,n return of the leveraged ETF over the nth periodSt price of the underlying index or ETFLt price of the leveraged ETFf expense ratio for leveraged ETFRL ,n RS ,n 1 r t f tLt 1 RL ,n Nn 1 1 RS ,n 1 r t f t Nn 1
Relation between LETF and underlyingindex t Lt St 1 22 exp 1 rt ft s ds L0 S 0 20 convexity dueto dailycompounding financing& fees volatilityAvellaneda & Zhang (2009), Cheng and Madhavan (2009)
Path-dependence of LETFs is caused byexposure to volatilityTracking error: t Lt St 1 22 t exp (1 )rt ft ( ) s ds L0 S0 20 Avellaneda and Zhang (2009) examined 56 LETFs since their inceptionand showed that the formula provides reasonable explanation forthe variations of LETF prices, i.e. that the tracking error is small
Double leveraged bullish ETFs, 2/2008 to 3/2009
Double leveraged bearish ETFs, 2/2008 to 3/2009
Triple leveraged ETFs, since inception(Nov 2008 – Mar 2009)
Tracking SSO (2X SPY)Tracking SKF since December 2007 using the actual prices and the formula
Conclusions ETFs provide natural advantages to retail investors (access),professional investors and hedge funds (hedging, tactical allocation)and issuers (high-margin business) BM&F Bovespa, as a leader in regional and BRIC capital markets, is a naturalhabitat for expanding local & regional exchange-traded products Commodities: this is an area where Brazil can shine, especiallyin structuring physical or swap-based products on gold, agricultureand minerals Potential new businesses can arise as a consequence of this whichare beneficial to the country’s economy
ReferencesConstantinides and Arnold, In the ETF Labyrinth, where does the thread begin? (July 2011),Deutsche Bank, Global Markets ResearchRamaswamy, S., Market Structures and Systemic Risks of Exchange-Traded Funds,BIS Working Papers, April 2011BlackRock, ETF Landscape, Industry Review, end of Q1 2008Os Fundos de Indice (ETFs) no Brasil, Revista Bovespa.http://www.cvm.gov.br/port/public/publ/etf henri.htmCheng, Minder and Madhavan, Ananth, The Dynamics of Leveraged and Inverse-ExchangeTraded Funds (April 23, 2009). http://ssrn.com/abstract 1393995Avellaneda, Marco and Zhang, Stanley Jian, Path-Dependence of Leveraged ETFReturns (May 14, 2009). http://ssrn.com/abstract 1404708Non-Traditional ETFs, FINRA Regulatory Notice (June notice/documents/notices/p118952.pdfLeveraged and Inverse ETFs: Specialized Products with Extra Risks forBuy-and-Hold Investors, SEC Alert (August 18, fs-alert.htm
38 VIG Vanguard Dividend Appreciation ETF 6.10 39 IVW iShares S&P 500 Growth 6.05 40 DVY iShares Dow Jones Select 5.99 41 EWC iShares MSCI Canada 5.97 42 TBT Proshares UltraShort 20 tsy 5.68 43 IAU iShares Gold Trust 5.67 44 VUG Vanguard Growth ETF 5.42 45 SDY SPDR S&P Dividend 5.37 46 VTV Vanguard Value ETF
Morningstar is by far the most widely used website for ETF information. WEBSITES USED FOR ETF INFORMATION . Morningstar Seeking Alpha ETF.com Yahoo! Finance ETF Center ETF Database (etfdb.com)/ETF Trends S&P Capital IQ IBD ETF Center ETF Guide ETF Daily
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during and after the ETF Sum-up day will be invested to ETFs only at the ETF Execution day of the following month. ETF Sum-up day shall be the Monday before the ETF Execution day. If such day is a public holiday, the ETF Sum-up day shall move to the next possible business day. ETF Execution day - The day when positions for ETF portfolio are .
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ETF Mechanics: How an ETF and Its Shares Are Created An ETF originates with a sponsor that chooses the investment objective of the ETF. The sponsor of an index-based ETF chooses both an index and a method of tracking it. The sponsor of an actively managed ETF determines the investment objective of the fund and investment
