Exchange-Traded Funds (eBook)

Dr. A. Seddik Meziani is a tenured professor of finance at Montclair State University in New Jersey, USA, and former chair of the department of Economics, Finance, and Real Estate. He is also the Soliciting Editor of The Journal of Index Investing and a member of the Research Advisory Board of ETF Global, LLC, an independent advisory firm that offers investment decision support, research, and risk analytics focusing on exchange-traded funds. He previously worked for Standard & Poor’s and TIAA-CREF. He received a PhD from Rensselaer Polytechnic Institute and an MBA from New York University, USA.   Dr. Meziani’s expertise covers exchange-traded funds, micro- and small-caps and emerging/frontier markets. His extensive work on ETFs was acknowledged on a worldwide list of “Seventeen ETF Friendly Professors” compiled by Yahoo Finance. He has been regularly featured on the ETF speaking circuit since 2000 and has served as a speaker, panel moderator, and panellist on a wide range of ETF topics at several ETF conferences, both in the United States and internationally. He is extensively published in both academic and practitioner journals and is the author of two ETF books: Exchange-Traded Funds as an Investment Option (Palgrave-Macmillan, 2005) and Exchange-Traded Funds: Conceptual and Practical Investment Approaches (Risk Books, 2009).    

Dedication 6
Foreword 8
Preface 10
Acknowledgements 20
Contents 22
List of Figures 24
List of Tables 26
1: Evolution and Outlook of the ETF Market: From a Trickle to a Mighty Roar 28
Introduction 28
Brief Background History of ETFs 28
Equity Index Participations 29
Toronto Stock Exchange Index Participations 30
U.S. ETF Market 31
From a Trickle to a Mighty Roar 31
Main Characteristics of the ETF Market 35
The ETF Market Remains Monopolized by a Few 35
Assets of ETFs by Asset Category 36
Equity ETFs 37
Fixed-Income ETFs 37
Commodities and Real Estate ETFs 38
Currency and Multi-asset ETFs 38
Assets of ETFs by Geographical Region 39
ETF Outlook: The Economy Matters—A Lot 41
Summary 42
2: Characteristics of Exchange-Traded Funds: Weighting Myths and Realities 43
Introduction 43
Structure of ETFs 43
ETFs Started as Unit Investment Trusts 44
Most New ETFs Are Organized as Open-End Funds 48
Cash Dividends Can Be Reinvested 48
Other Structural Nuances 57
Securities Lending 58
Physical versus Synthetic Replication 58
Trading ETFs 59
ETFs and Arbitrage 59
Fair Pricing and Liquidity 61
The Creation and Redemption Process 61
Liquidity Is Determined by the Transparency of the Fund 63
ETF Liquidity and Pricing from an Academic Perspective 64
Myths and Realities: Take a Close Look Under the Hood 65
ETFs Are Diversified 65
Pay Attention to Your Fund’s Expense Ratio: Not All ETFs Are Low-Cost 66
Vignette 2.2: Rule 12(b)-1: A Rule Few Investors Understand 67
Just What Do These Fees Pay For? 67
How Can I Find Out the Charges and Uses at My Funds? 67
Are There Advantages in Having These Expenses Paid Out of Fund Assets? 68
Are There Disadvantages in Paying These Expenses Through 12b-1 Charges? 68
What’s the Prognosis for SEC Action? 68
The size of the ratio also depends on the size of the fund. Logically, the smaller the fund the larger the ratio, since the manager must cover the fund’s expenses from a limited asset base. That explains why investors in SPY or IVV benefit from a mu 66
Not All ETFs Are Tax-Efficient 70
Trading ETFs Results in Brokerage Fees 72
Dollar-Cost Averaging and ETFs 72
Summary 73
3: Exploring the Tax Advantages of Exchange-Traded Funds 75
Introduction 75
The Rebalancing Process 76
ETFs as a Non-Taxing Entity 78
Taxable Gain at the Inception of Investment 79
Redemption in Stock or in Cash 80
Tax Efficiency of Redemption 80
Tax-Free In-kind Redemption 83
Tax Consequences for ETF Shareholders 84
ETF as a Tax Pass-Through Entity 85
Individual Taxpayer 85
Corporate Taxpayer 86
Summary 87
4: Understanding the Complex Universe and Role of Fixed-Income Funds as Investment Vehicles 88
Introduction 88
Brief Review of the Factors Underlying Bonds’ Importance 89
Bonds Are Effective Instruments of Diversification 89
Factors Weighting on Bond Performance 91
The Global Economy is Still on the Mend 91
Panic Selling Could Easily Ensue 92
Yet Bonds Offer Security by Reducing Portfolio Volatility 92
Important Factors Impacting the Bond Market 92
Recent Trends in the Bond Markets 93
Measures of Bond Performance 94
Index Investing 94
Actively Managed Funds versus Index Funds 94
Vignette 4.1: Performance of Actively Managed Funds against Their Relevant S& P Index Benchmarks, Year-End 2013 Results, According to SPIVA
Summary Results 97
In spite of its modest showing, active management has predominated in the United States because of the buy-side and sell-side practices supported by the equity research desks of investment managers. Although both sides may have an ax to grind, the b 98
Expanding the Scope of Indexing 99
The Case for International Indexing: There Is a World of Choices 99
International Index Funds versus Actively Managed International Funds 99
Is the Bond Market Less Efficient Than the Stock Market? 100
Logistical Problems in Implementing a Bond Indexing Strategy 100
Issues Facing Bond Indexers 101
But There Is Still a Case for Bond Indexing 102
Some of the Factors Underlying the Importance of Bond Indexing 102
Other Potential Benefits of Bond Indexing: The Case of High-Yield Bonds 103
A Sample of Bond Indexes and their Investment Characteristics 103
Barclays Global Aggregate Index 104
Barclays US Aggregate Bond Index 105
Barclays Capital US Government Inflation-Linked Bond Index 105
Barclays Global High-Yield Index 107
Barclays Emerging Markets (EM) USD Aggregate Bond Index 109
Importance of the Underlying Index 110
Security Market Indexes Are Used as a Performance Criterion 110
Market Indexes as Proxy for Systematic Risk 110
Main Differentiating Characteristics of Market Indexes 111
Summary 113
5: Jumping on the Bond ETF Wagon 115
Introduction 115
Characteristics and Benefits of Bond ETFs 116
Overview of the ETF Bond Market 117
The 2002–2006 Period: The ETF Bond Market at Its Beginning 117
Bond ETFs Should Have Had a Propitious Start … 117
… But Instead Bond ETFs Had an Ominous Start 118
The Current Fixed-Income ETF Universe 120
Taking Stock of the Market 120
The ETF Bond Market Remains Consolidated 127
Bond ETF Performance 128
Assessment of the Fixed-Income ETF Market in Terms of Return Performance 128
Assessment in Terms of Risks and Risk-Adjusted Performance 133
Sharpe Ratio 138
Sortino Ratio 139
Information Ratio 139
Alpha and Beta 141
Correlations 142
Summary 151
6: Smart-Beta ETFs: Market Growth and Performance Trends 153
Introduction 153
Smart-Beta and the Modern Portfolio Theory 154
The Capital Asset Pricing Model 154
Extension of the CAPM: The Fama-French (FF) Three-­Factor Model 155
What Goes Up Must Come Down: The Momentum Factor 156
Minimum-Variance Portfolio 156
The CAPM and the Investment Industry: Moving Beyond Theory 157
Smart-Beta Investment Strategies and the ETF Market 159
Taking Stock of the Market 160
Market Evolution 163
Market Growth by Category of Smart-Beta ETFs 164
Smart-Beta ETFs and Market Performance 165
Return Performance Statistics 166
Risk Performance Statistics 171
Expense Ratio 172
Average Daily Trading Volume (ADTV) 172
Beta 172
Alpha 173
Sharpe Ratio 173
Summary 174
7: Managing Volatility Risk with Minimum-Volatility ETFs 176
Introduction 176
Setting the Stage: Market Volatility Has Increased 176
Review of the Literature 177
Factors Other than Volatility Explaining Cross-Sectional Differences 178
Volatility as a Source of Beta Risk 178
Minimum Volatility and the Investment Industry 179
Low-Volatility Portfolios and the ETF Market 180
Taking Stock of the Minimum-Volatility ETF Market 181
Market Evolution 183
Comparing the Two Largest Minimum-Volatility Funds: Simplicity Goes a Long Way with Investors 184
Performance Statistics 186
Return Performance Statistics 186
Risk Performance Statistics 190
Performance Assessment in Terms of Standard Deviation as a Measurement of Volatility 190
Performance Assessment in Terms of Beta as a Measurement of Systematic Risk 193
Measuring Diversification in Terms of Correlation to SPY 194
Comparison in Terms of Risk-Adjusted Returns 195
Review in Terms of Liquidity Statistics 196
Summary 197
8: Finding Value in Environmental, Social, and Governance ETFs 199
Introduction 199
An Overview of the History of ESG Investing 200
How ESG Came About 200
The Emergence of Environmental Conservation, Social Responsibility, and Ethical Behavior in ESG Investing 201
Exchange-Traded Funds and ESG Investing 204
The Emergence of ESG Investing in the ETF Market 204
Taking Stock of the Market 205
ESG ETFs: Performance Statistics 208
Return Performance 209
Risk Performance 212
Summary 217
9: Sailing Away with Emerging Markets ETFs 219
Introduction 219
Brief Review of the Emerging Markets Literature 220
What Drives the Appeal of Emerging Markets? 222
Emerging Markets and the ETF Industry 223
The Emergence of Emerging Markets in the ETF Market 223
Taking Stock of the Emerging Market ETF Landscape 229
Return Performance Statistics 233
Risk Performance Statistics 234
Alpha 251
Beta 252
Sharpe Ratio 252
Sortino Ratio 254
Summary 255
10: The Frontier Markets Story: Adapting to a New Landscape 257
Introduction 257
Spicing up a Portfolio with Frontier Markets 258
What Are They? 258
What Are Their Specificities? 261
Reasons to Consider Frontier Markets 261
Broaden the Scope of a Portfolio 262
Other Benefits 262
Index Characteristics 264
Index Concentration Is Substantial 265
Concentration in Terms of Sector Weights 265
Concentration in Terms of Country Weights 267
Other Risks Investors Should Be Aware Of 268
Bringing Frontier-Markets Growth Down to Scale 268
Assessing the Ease of Getting Out 269
Frontier-Markets ETFs 271
Overview of the Frontier-Markets ETFs 271
Return Performance 272
A Macro View 274
A Micro View 274
Risk Performance 275
Sharpe Ratio 276
Sortino Ratio 276
Treynor Ratio 277
Other Key Statistics 278
High Concentration 278
Low Average Daily Trading Volume 279
Wide Premiums and Discounts 279
High Expense and Turnover Ratios 281
Summary 281
11: Active ETFs: To Be or Not to Be? 283
Introduction 283
The Debate over Active versus Passive Management 284
The Academic Argument 284
The Practitioners’ Stance 286
Active Investing and the ETF Market 287
Active ETFs Were Off to a Quick Start in Germany 288
How Germany Bypassed the Specialist Issue 288
Circumstances Surrounding the Launch of Active ETFs in the U.S. 289
The SEC’s Transparency Challenge 289
The Mutual Fund Industry as Outsider 295
Other Issues Slowing Down the Growth of Active ETFs 295
The Specialists’ Issue 295
SEC’s Moratorium on the Use of Derivatives 295
The Impact of Smart-Beta ETFs 296
Taking Stock of the Active U.S. ETF Market 297
An Overview of the Active ETF Market 297
Active ETF Market by Asset Category 306
Market Performance of Active ETFs 309
Return Performance 309
Risk Performance 312
Alpha 312
Beta 314
Sharpe Ratio 315
Sortino Ratio 315
Treynor Ratio 316
Correlation Statistics 317
Summary 318
12: Building Fresh Tax-Advantaged Investment Strategies with ETFs 320
Investors Have Become More Tax-Aware 320
Harvesting Tax Losses 321
Beware of the Wash-Sale Rule 322
Tax-Loss Offset Strategies as They Apply to Investment Products Other Than ETFs 323
The Wash-Sale Rule and Stocks 324
The Wash-Sale Rule and Bonds 325
The Wash-Sale Rule and Mutual Funds 326
Tax-Loss Offset Strategies as they Apply to ETFs: Newer Twists on an Old Plot 326
Strategy 1: Harvesting Losses from a Stock while Maintaining Exposure to its Sector through a Sector ETF 326
Strategy 2: Harvesting Losses while Maintaining Exposure to the Sector of Choice 328
Strategy 3: Many ETFs Are Considered Similar Yet Are Certainly Not Identical 329
Strategy 4: Harvesting Losses from a Mutual Fund while Maintaining Exposure to the Market through a Broad-Based ETF 330
Strategy 5: Harvesting Losses from One ETF while Maintaining Market Exposure with Another 332
Strategy 6: Harvesting Losses within the Same Sector 333
Could Stocks and ETFs Be Possibly Construed as “Substantially Identical Securities”? 335
Section 1091(a) 335
But What if an ETF Is Construed as a Contract or Option to Acquire a Specific Stock? 336
Summary 336
13: The Long and Short of ETFs 338
Introduction 338
Essentials of Short Selling 339
Reasons for Short Selling 339
Vignette 13.1: Illustration of a Short Sale 340
Step 1: Short Sale Initiated 340
Step 2: Short Sale Covered 340
By taking a diametrically opposed position, short sellers have their own reasons to believe that the security is overvalued. It could be that they believe the stock’s issuer is a poorly run company or that the stock is priced above its intrinsic value. T 339
Short Selling as a Market Indicator 341
Short Selling with ETFs 341
Advantages over Stocks and Closed-End Funds 341
ETFs Are Increasingly Popular with Short Sellers 343
Reading Short Interest 349
Using Short Interest as a Sentiment Indicator 351
Interpreting the Numbers 351
Bringing It All Together 355
Practical Investment Strategies 357
Long/Short Investment Strategy Along Asset Classes 357
Long/Short Investment Strategy Along Market Capitalizations and Across Sectors 361
Long/Short Investment Strategies Along Styles 362
Shorting Interest-Sensitive Sectors 363
Long/Short Investment Strategies Along Countries 363
Summary 364
14: Other ETF Investment Strategies and Applications 366
Introduction 366
Futures Contracts on ETFs 367
Brief History 367
Overview of Characteristics 367
Differences in Terms of Trading Unit and Settlement Date 368
Other Major Differences 369
Investment Strategies with Futures Contracts 369
Adjusting Portfolios’ Systematic Risk 370
Hedging Strategy Using European ETF Futures 372
Commodity Futures 373
What Are Commodities? 373
Why Are Commodities an Important Asset Category? 374
Should the Current Commodity Slump Matter? 374
Commodities Futures Contracts 375
Margin Trading with ETFs 377
Characteristics of Margin Trading 378
Leverage in the Form of Options, Futures, and Swaps 378
The Basic Mechanics of Margin Trading 379
Portfolio Margining 383
Basic Facts Behind the Drive for Portfolio Margining 383
Rules Pertaining to Portfolio Margining Accounts 383
Greater Leverage Calls for Greater Equity 384
The Long and Short of “Barbelling” 384
What Is It? 385
Barbelling with Bond ETFs 385
Balancing Long-Term and Short-Term Bond ETFs 385
Balancing ETFs along Asset Classes 386
Summary 387
15: Investment Strategies Using Options on ETFs 389
Introduction 389
Basic Characteristics of Option Contracts 390
Option Contracts 390
American Options versus European Options 390
ETF Options versus Index Options 391
ETF Options Compared with Futures on ETFs 393
Other Characteristics 393
Call versus Put Options 394
Options Trading 394
What Determines the Price of an Option? 395
Synthetic Protective Put Option 401
Investment Strategies Using ETF Options 402
Investment Strategies Based on Buying Call Options 402
Investment Strategies Based on Selling Call Options 404
Other Option Strategies 405
Covered Call Position 406
Characteristics of a Covered Call Position 406
The Ins and Outs of a Covered Call with a Straightforward Illustration 407
Straddle 409
Options on Fixed-Income ETFS 412
Protective Put 412
Collars 413
Summary 414
Index 416