Exchanging Traded Funds - Research Paper Example

S ASSIGNMENT PROJECT ON EXCHANGE TRADED FUNDS TEST ASSIGNMENT DEADLINE: DECEMBER 5th, 2009 -5:30 p.m. GMT time. OVERVIEW The efficiency of financial markets and the rationality of investors have long been the cornerstones of financial economics. In recent years trading moving away from the exchange floor towards electronic trading platforms and the launch of Exchange Traded Funds 1, has resulted in an increase of market efficiency. Though clearly based on the technical features of these instruments, our discussion intends to examine different types of ETFs, investigate their performance in the last five years and calculate their returns. If Section 1 analyses a typical ETF product tracking an international stock index, Sections 2, 3, and 4 are more focused on a typical ETF product tracking a bond index, currency and commodity. 1. ETF tracking an international stock index: ETF SPY In 2001 the NYSE announced its request for regulatory approval for three active ETFs tracking international indexes, the Nasdaq-100 Trust Series Ι (“QQQ”), the Standard and Poor’s Depository Receipt Trust Series Ι (“SPY”) and the Dow Jones Industrial Average Trust Series Ι (“DIA”). Although these securities generated together an average daily trading volume of more than 4 $ billion, we have decided to focus the analysis of this section on the ETF SPY, the first successful ETF product tracking a stock index released by American Stock Exchange2 and characterised by an almost continuous average annual growth in assets since its inception. Designed to mirror the S&P 500 index by holding the same component stocks and matching its weighting scheme, this ETF stock index is structured to duplicate as closely as possible, before expenses, the total returns of the S&P 500 Index as confirmed by its share price structure corresponding to 1/10th of the S&P 500 index value. As a result of this underlying characteristic, the ETF SPY can offer potential investors a wide range of opportunities ranging from establishing long-term investments in the market performance of the leading companies to custom tailor asset allocations. However although this index seeks investment results corresponding generally to the price and yield performance of the S&P 500 index, there is no assurance that the performance of the S&P 500 Index can be fully matched. Exhibit N. 1 displays a summary of the performance of ETF SPY in the past five years detailing both its 52 week range and current value as at December 3rd, 2009. The first part of this exhibit identifies an intense volatility in line with other ETFs tracking indexes and generating a large disparity gap particularly during 2008 and 2009. Such a discrepancy which normally comes back into line over time, does not seem to break down.  The reason of this anomalous performance can be traced mainly in the SPY composition, including, compared to similar ETFs tracking indexes, various sectors such as for instance Finance and Energy particularly affected in the recession period as well as in this index diversification as proved by the 20% of his assets concentrated in the top 10 holdings. This assumption finds a finds a confirmation in the product ‘s returns during the past five years and presented in Exhibit 2, which seems to be perfectly in line with the S&P 500 performance in the same period due the turbulence recorded by various sectors such as Financials (-2.05%), Energy and Materials (-1.61%). However although S&P500 staged a panic bottom in Q1 and did not fully recover in Q2, it is now back trading above 800 level. With zero % interest rate and vast money still looking for home, we are neutral to mildly positive on both indexes3 especially considering the strong increase in the amount of the volumes traded in the latest three month, and the consistent reduction of negative returns in 2009. Exhibit 1-SPY ETF Performance and financial data AND AND - Splits:none Last Trade: 111.38 $ Trade Time: 5:30PM Change: 0.13 (0.12%) Prev Close: 111.25 Open: 111.55 Bid: 111.37 x 23 Ask: 111.38 x 141 1y Target Est: N/A Days Range: 111.03 - 112.18 52wk Range: 67.10 - 112.01 Volume: 88,176,735 Avg Vol (3m): 182,355,000 Market Cap: N/A P/E: N/A EPS : N/A . Exhibit 2-SPY ETF RETURNS Year SPY ETF 2005 + 4.86% 2006 +15.80% 2007 +5.12% 2008 -36.70% 2009 -1.56% Annualised returns of SPY ETF. Returns are to be intended until December 2nd, 2009. 2. ETF tracking a bond index: Barclays iShare Lehman Aggregate Bond (AGG) In sharp contrast to the increasing popularity of ETFs, bonds have always had a somewhat lackluster existence. However their extreme reliability contributed to generate a new type of ETFs carrying with them a great deal of transparency and offering low fees. The tendency to hold bonds until maturity makes difficult to ensure a bond ETF encompasses enough liquid bonds to track an index. This challenge is bigger for corporate bonds than for government bonds with suppliers of bond ETFs tracking only a sufficient number of bonds to represent an index in order to get around the liquidity problem by using representative sampling. The bonds used in the representative sample tend to be the largest and most liquid in the index. Although there are many ways to use bond ETFs and to select a correct investment strategy, we have decided to analyse Corporate Bonds ETFs. For example, the Barclays iShare Lehman Aggregate Bond Fund (AGG) is available on a global basis being available in U.S., Europe and Canada. This product seeks investment results that correspond to the price and yield performance, before fees and expenses, of the total United States investment-grade bond market as defined by the Barclays Capital U.S. Aggregate index. The fund invests approximately 90% of assets in the bonds represented in the underlying index and in securities that provide substantially similar exposure to securities in the underlying index. The underlying index measures the performance of the total United States investment-grade bond market generally excluding only those under 12 months in maturity, inflation protected bonds, municipal bonds and convertible bonds. Approximately a third of this ETF consists of government agency debt, a quarter in U.S. treasuries, and 14% in financial institution debt. In consideration of the fact that 75% of the portfolio is invested in AAA rated debt, with a little over a third of the portfolio at 0-4 years maturity and a little over 50% between 5-9 years, AGG can be considered a relatively broad and complete spectrum of the U.S. fixed income market. Although bond ETFs and index bond funds cover similar indices and use similar optimization strategies such as options and swaps to have similar performance in practice they hardly perfect matches due to obvious reasons. AGG in fact holds 247 out of a potential 10,000 in the actual index. And while there’s obviously a lot of overlap, little differences matter in fixed income as proved by AGG’s largest holding yesterday4 amounting to a 4.7 percent allocation to a 30-year AAA-rated government bond with a 4.5 percent coupon. The product financial data and performance are displayed in Exhibit 3 show this product returned 7.9% in 2008, far outpacing the performance of all equity indices. Exhibit 3- AGG Bond ETF Performance and Financial Data Open:  $104.88 Dividend:  $0.33 EPS:  $3.83 Market Cap:  $11,185.69 M Bid:  $102.21 Div Yield:  3.91% P/E Ratio:  27.42 Shares:  107 M Ask:  $106.32 200-Day EMA:  $103.00 YTD Return:  0.80% Volume:  744,730 Day Hi:  $105.03 52-Week Hi:  $107.95 52-Wk Rtrn:  5.17% Avg Volume:  581,909 Day Lo:  $104.77 52-Week Lo:  $97.88 Beta:  0.09 Bond ETFs Versus Index Bond Funds However, this is not a temporary phenomenon in fact during the current year bonds have outperformed stocks over the last 30 years, earning a total return of 9.4% versus 8.8% annually for stocks. In the current risk-averse environment, where sectors of the bond market offer attractive returns, investors and advisors are stepping up their fixed-income allocations, either proactively or by avoiding rebalancing as the value of their equity allocations declines. Despite this encouraging result, actively managed bond funds, in general, performed poorly both in 2008 and 2009. This can be motivated by high expense ratios which, in an efficient market, forces managers to own riskier bonds in order to equal the performance of a passive portfolio. In fact owning an actively managed bond fund requires a belief that the market is sufficiently inefficient to allow managers to overcome the expense ratio and outperform a passive portfolio. The first elements of this poor performance could be traced in 2007, particularly toward year-end when the financial crisis deepened and spreads on corporate bonds widened significantly peaking at nearly 20%. Fund managers who reached for higher yields faced losses, as yields continued to increase as spreads widened further as displayed in Exhibit 4. Although a declinein the level of return this product affected this product during the latest five years, the trouble for U.S. corporate bond ETF performance peaked in earnest mid-September of 2008 with the collapse of Lehman Brothers. Exhibit 4-AGG BOND ETF RETURNS Year AGG BOND ETF 2005 + 15.95% 2006 +11.47% 2007 +7.10% 2008 +7.9% 2009 +0.9% Annualised returns of AGG Bond ETF .Returns are to be intended until December 2nd, 2009. However AGG bond ETF diversification and low expense ration of 0.2%, motivating its successful outperformance other similar corporate bond ETFs during the crisis, have induced us to think this type of bond ETF will probably start its recovery in the next six months as confirmed by the increase of traded volumes in the last four months. 3. Currency ETFs: UDN, the PowerShares DB US Dollar Index Bearish ETF Only three years ago the first Currency ETF was introduced enabling investors to trade the Euro without having to buy and sell the currency directly. Since then, currency ETFs have exploded in number and scope, due to the wide range of opportunities offered both to potential investors and to a portfolio. Generally invested in a single currency or a basket of currency, currency ETFs aim to replicate movements in currency in the foreign exchange market by holding currencies either directly or through currency-denominated short-term debt instruments. This fact has induced investors to use them as an easy way to enter the currency market particularly to hedge inflation, due to the relatively inexpensive way to take advantage of fluctuations between currencies portfolio risk, and foreign risk by selling a currency from a low interest rate country and using the proceeds to purchase a currency from a high interest rate country. The idea is not to capture big moves, but to exploit the spread between the two countries’ interest rates. Although even in this case potential investors have a wide choice of products to match their investment strategy, this section will be focused on UDN, the PowerShares DB US Dollar Index Bearish ETF. This currency ETF that tracks the performance of the Deutsche Bank Short US Dollar Futures index, is an inverse ETF and consists of short futures contracts only designed to emulate the performance of being short the US Dollar against other currencies like the Japanese Yen, the Euro, the British Pound, the Canadian Dollar, the Swedish Krona and the Swiss Franc. While currency investing has traditionally included single country bets, there are a number of ETFs now available that offer exposure to a diversified basket of currencies. Just as diversification across asset classes reduces volatility of a portfolio, the “basket” approach to currency investing can smooth out bumps in a particular fund. The product financial data and performance are displayed in Exhibit 5. Comparing this product performance over the last two years with similar currency ETFs two interesting patters have emerged: 1) UDN maintains a strong correlation to the value of the euro, and 2) by holding a basket of currencies, UDN experiences much lower volatility than single currency funds. Despite the highly fluctuating returns in the past two years displayed in Exhibit 6, UDN ETF has seen its popularity surge in recent months along with its price. In fact the fund has taken in about $185 million in cash since the start of the year. With a very reasonable expense ratio of 50 basis points and a number of possible uses – including both hedging and speculation UDN ETF gained 2.2% in November. Exhibit 5- UDN, DB US Dollar Index Bearish ETF Performance and Financial Data Splits:none Last Trade: 28.71 Trade Time: Dec 3 Change: 0.00 (0.00%) Prev Close: 28.7075 Open: N/A Bid: 28.60 x 1000 Ask: 29.68 x 600 NAV¹: 28.36 Days Range: N/A - N/A 52wk Range: 24.09 - 28.87 Volume: 0 Avg Vol (3m): 408,039 YTD Return (Mkt)²: 6.67% Net Assets²: 376.58M P/E (ttm)²: N/A Yield (ttm)²: NaN% The dollar is expected to remain weak for some time, as the Federal Reserve in November signalled that it would keep interest rates low to maintain the current pace of economic recovery. Exhibit 6- UDN, DB US Dollar Index Bearish ETF RETURNS Year UDN, DB US Dollar Index Bearish ETF 2005 N.A. 2006 N.A. 2007 +6.23% 2008 +0.77% 2009 -1.55% Annualised returns of UDN, DB US Dollar Index Bearish ETF .Returns are to be intended until December 2nd, 2009. N.A. data in 2005 and 2006 The real estate sector should get a boost in the coming months, too, as Congress voted to extend the tax credits offered to first-time homebuyers, as well as homeowners looking to “upgrade” from their current homes. 4. Multi-contract ENERGY ETFs: DBE, the PowerShares DB Energy ETF Energy ETFs have outperformed for almost a decade. According to most measurements, energy is now the third largest industrial sector by market capitalization (after technology and healthcare). But factors which made investment in energy ETFs successful are changing offering investors looking for exposure to the energy sector, to hedge their energy investment risk, diversify their portfolio, or control inflation exposure as a part of their investment strategy. Although most energy ETFs consist of futures contracts in order to accomplish the goal of tracking energy commodities, in the case of multi-contract energy ETFs, the futures contracts track more than one particular commodity. An evident example of this type of Energy ETF, is DBE, the PowerShares DB Energy ETF, which tracks the Deutsch Bank Liquid Commodity Index, Optimum Yield Energy Excess Return. The index is composed of futures contracts on some of the most heavily traded energy commodities in the world such as Crude oil, heating oil, natural gas, and gasoline to name a few. Throughout the year, the weightings of each commodity component in the Index will naturally change based on changes in the underlying futures prices. The Funds underlying holdings are rebalanced to the Indexs base weights according to the schedule described in the prospectus. The chart and the product financial data displayed in Exhibit 7 show a DBE Energy ETF similar to that of other Energy ETFs. This can be motivated with the fact that the energy sector is highly concentrated in just a few names and therefore inducing us to favour low cost leaders such as DBE EFT. The energy sector is also tied to the larger credit cycle, and particularly the dollar, whose weaker trend in the last few years created an increase in dollar borrowing and inflation, which helped the boom in raw materials prices. On the flip side, central banks around the world are dropping their interest rates to historically low levels and governments are spending assertively on stimulus packages. Economists expect inflation to return in the not too distant future. Therefore in consideration of this agreed opinion as well as of the low number of commodities involving investors only in the most liquid commodity contracts in their respective sectors, we believe that the poor returns performance of the index displayed in Exhibit 8 will only be a temporary condition subject to a slow recovery in the next six months. Exhibit 7- DBE, the PowerShares DB Energy ETF Performance and Financial Data Splits:none Last Trade: 25.975 $ Trade Time: Dec 3 Change: 0.00 (0.00%) Prev Close: 25.975 Open: N/A Bid: N/A Ask: N/A 1y Target Est: N/A Days Range: N/A - N/A 52wk Range: 20.81 - 27.86 Volume: 0 Avg Vol (3m): 97,256.8 Market Cap: N/A P/E: N/A EPS : N/A Dividend: N/A$ Exhibit 8- DBE, the PowerShares DB Energy ETF RETURNS Year DBE, the PowerShares DB Energy ETF 2005 N.A. 2006 N.A. 2007 -1.06% 2008 +3.24% 2009 -1.95% Annualised returns of DBE, the PowerShares DB Energy ETF .Returns are to be intended until December 2nd, 2009. N.A. data in 2005 and 2006 Words count: 2,399 Words allowed: 1,400-2,400 WORKS CITED Amihud Yakov, Beni Lauterbach and Haim Mendelson, 2002. “The value of trading consolidation”. Evidence from the exercise of warrants. Working paper. New York University. Blume Marschall E., 2000.”The structure of U.S. equity markets”.Working paper. Wharton. 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