The Exchange-Traded Funds Manual

370 Pages·2010·4.374 MB·English

by  Gary L. Gastineau

The Exchange-
Traded Funds
Manual
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The Exchange-
Traded Funds
Manual
Second Edition
GARY L. GASTINEAU
John Wiley & Sons, Inc.
Copyright(cid:2)C 2010byGaryL.Gastineau.Allrightsreserved.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.
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LibraryofCongressCataloging-in-PublicationData
Gastineau,GaryL.
Theexchange-tradedfundsmanual/GaryL.Gastineau.–2nded.
p.cm.–(Wileyfinanceseries)
Includesbibliographicalreferencesandindex.
ISBN978-0-470-48233-9(hardback)
1.Exchangetradedfunds. 2.Stockindexfutures. I.Title.
HG6043.G372010
332.63(cid:3)27–dc22
2010010866
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
Contents
Preface ix
Acknowledgments xi
CHAPTER1
AnIntroductiontoExchange-TradedFunds 1
Exchange-TradedFundsWereIntroducedas
“SomethingtoTrade” 1
ShareholderProtection 3
TaxEfficiency 7
CostTransparencyIsDesirable,ButTrading
TransparencyIsCostly 9
IntradayETFTrading 10
ComparingETFandMutualFundEconomics 11
Conclusion 17
CHAPTER2
TheHistoryandStructureofExchange-TradedFunds—and
SomeofTheirCompetitors 19
SomeMajorFinancialMarketDevelopments(1975to2000) 19
DecliningTradingCostsIncreaseFinancialEngineering
Opportunities,andFinancialEngineeringReduces
TradingCostsintheNewMillennium 23
ABriefHistoryofETFs 25
OtherTradableBasketProducts 34
CHAPTER3
TheRegulatoryFrameworkandMechanicsoftheOpen-EndETF 43
U.S.FundRegulationHasPlayedaMajorRoleinthe
StructureofETFsIntroducedaroundtheWorld 43
TheInvestmentCompanyActof1940 45
ExemptionsfromtheInvestmentCompanyActof1940
HaveBeenGrantedtoPermitIssuanceofOpen-EndETFs 47
v
vi CONTENTS
ETFDevelopmentsOutsideNorthAmerica 50
ProposedRule33-8901andLimitationsonETF
TradingTransparency 53
TheMechanicsofETFCreationandRedemptionIn-Kind 53
CHAPTER4
TaxationofETFsandTheirShareholders 65
TaxationofInvestmentCompanies:SubchapterMand
RegulatedInvestmentCompany(RIC)Requirements 65
TheMechanicsofRICShareholderCapitalGainsTaxation 73
TheWashSaleRule 81
OtherPass-ThroughCollectiveInvestmentVehicles 82
TheRelativeTax-EfficiencyofMutualFunds,
Exchange-TradedFunds,andPortfolioBaskets 90
DeferralofLong-TermCapitalGains 93
OutlookforChangesinInvestmentCompanyTaxation 98
CHAPTER5
TheEconomicsofIndexing,TradingTransparency,and
Limited-FunctionActiveManagementofETFs 101
IndexingWorksBestWhenApproachedwith
CommonSense 102
TheContinuum:FromPassivetoActive 108
BenefitsfromaDeclineinETFTradingTransparency 110
HowTradingPlansBecomeTransparent 112
EffectofTransparencyCostsonFundPerformance 121
Silent(Nontransparent)Indexes 124
ABattleofContrastingIndexFundManagementStrategies 126
CHAPTER6
FundRatingsandRankings—TheEvaluationandSelectionof
ETFsandMutualFunds 131
AnIntroductiontoFundRatings 131
Wanted:AComprehensiveButEclecticApproachto
FundEvaluationandAnalysis 140
MeasuringandComparingFundPerformance 141
APerspectiveontheLimitationsofFundAnalysisToday 142
ElementaryFundEconomics 146
TheLargestCostforMostFundsIsNotReportedto
theFund’sInvestors 149
WhatIsTrackingError? 155
Contents vii
NetTrackingErrorasaFrameworkforFund
PerformanceEvaluation 161
Positive(Value-Added)Elements 168
eXtensibleBusinessReportingLanguage(XBRL):The
NewDataStandard 170
ThereIsaWideRangeintheQualityofFundTouts,
Tools,andTechniques 172
FundGovernance 179
CHAPTER7
HowWillFull-FunctionActivelyManagedETFsWork? 183
TheSECConceptReleaseandLimited-Function
ActivelyManagedETFs 183
CHAPTER8
HowtoMinimizeYourCostofTradingETFs 197
ETFTradingIsDifferentfromStockTrading 197
ETFIntradayNetAssetValue(NAV)Proxies 200
TheBraveNewWorldofHigh-FrequencyElectronicTrading 202
ETFTradingVolumeIsHuge,Growing,and
HighlyConcentrated 207
HowtoTradeETFsEfficiently 208
Market-on-Close(MOC)TransactionsinETFs 210
IntroducingNAV–BasedTradinginExchange-Traded
Funds 218
Conclusion 224
CHAPTER9
EconomicsandMarketEffectsofETFShortSelling 227
UnderstandingtheRisksofSellingETFsShort 227
TheImplicationsofETFShortSelling 231
ETFShortSellingforTraditionalInvestors 234
CHAPTER10
LeveragedLongandInverseExchange-TradedFunds 245
TradingSardines 245
HowLeveragedLongandLeveragedInverseETFs
ConstructTheirPortfolios 246
IsItUsefultoDescribeLeveragedFundReturnsasPath
Dependent? 254
LeveragedFundReturnPatterns 255
viii CONTENTS
TaxationandDistributionsfromLeveragedETFs 259
OtherIssuesAffectingLeveragedETFs 260
AnotherWaytoObtainLeverageWithoutBorrowing 261
TheBottomLineonLeveragedETFs 262
CHAPTER11
ETFApplicationsforIndividualInvestorsandtheAdvisors
WhoServeThem 263
Short-TermETFTradingSometimesMakesSense 265
ETFsasPortfoliosandasComponents 266
IntegratingDiverseFamilyAccounts 267
TaxManagement 268
OtherTaxIssues 270
ThinkingOutsidetheBox 274
MeasuringtheComparativeEconomicsofTradingand
HoldingDifferentComponentsofanIndex
ArbitrageComplex 275
CHAPTER12
ETFsforInvestorsLivingOutsidetheUnitedStates 279
SomeFeaturesoftheETFsDescribedinThisBookAre
NotUniversal 279
CHAPTER13
AFewThingsEveryoneShouldKnowaboutInvestment
ReturnsandRetirement 285
CHAPTER14
WheretoLookforHelpinUsingETFs 293
SourcesofProfessionalHelp 293
TheAdvisoryRelationship 296
SourcesofETFInformation 298
Bibliography 303
Glossary 313
AbouttheAuthor 351
Index 353
Preface
A
uthors try to accomplish a variety of things in prefaces. My objective
hereistohelpyougetwhatyouwanttogetfromthisbook.Ofcourse,
youarefreetochartyourownpath.
Theindividualchapterscoverspecifictopicsandtheyareroughlyinthe
ordersomeonenewtoexchange-tradedfundsmightapproachthetopic,but
thereisnoneedtoreadallofthemortoreadtheminorder.Inmostchapters
you will find footnotes and text references to other spots in the book and
tootherpublicationsandInternetmaterialthatwillgiveyoumoredetailon
the subject covered in the chapter or in a section of the chapter. If you are
lookingfordetailedcoverageofaparticulartopicyouwillprobablychoose
achapterandfollowitwhereitleadsyou.Areaderlookingforanoverview
will probably read straight through with little attention to footnotes and
citations.
If none of the chapter headings seems specific enough, I suggest you
look for your topic in the index. The index has an unusually large number
of cross-references by design. When you look up terms and topics in the
index they will frequently lead you to other references that may help you
exploremoreefficiently.
There are plenty of footnotes. I hope they provide supplementary in-
formationattherighttimeandsuggestnewpaths—alwaysatyouroption.
Also,aninterestinonetopicwilloftenbelinkedtoaninterestinarelated
topic. The bibliography is confined to works mentioned in the text or in
footnotes.Manyofthesereferencesareworthyourattentionifyouwantto
godeeperintoatopic.
Some ETF topics that are subjects of extensive current discussion are
(1)activelymanagedandothernon-transparentexchange-tradedfunds,(2)
securities structures similar to open-end exchange-traded notes that can
eliminate most counterparty credit risk and (3) ways to reduce the cost of
trading exchange-traded products. The next few years will also see major
changes in leveraged ETFs, currency and commodity products, improved
fixedincomeportfolios,andgreatlyimprovedequityindexfunds.
I have no illusions that the present volume will completely satisfy any
reader’s need for information about ETFs, but I hope this explanation of
whatIhavetriedtodowillhelpyounavigatethesepages.
ix
Acknowledgments
N
oonecanwriteabookofthisnatureandcomplexitywithoutagreatdeal
of help and support. I have had a lot of both from a number of terrific
people.Conversationswithandsuggestionsfromalargenumberoffriends
havecontributeddirectlytothecurrentvolumeandtomyunderstandingof
ETFsovertheyears.
IowespecialthankstoSethVarnhagenandEdwardHynesforextensive
comments on the manuscript from their viewpoint as advisors who exam-
ine ETFs as possible candidates for their clients’ portfolios. Ron DeLegge,
Dan Dolan, Matt Hougan, Todd Broms, Richard Keary, Jim Wiandt, and
Michael Dickerson also gave me useful comments and suggestions from a
numberofperspectives.RichardShapirohassharedhisinsightsintotheU.S.
tax code with me for many years, first on options and now on ETFs. His
analysishasalwaysbeenwell-reasonedandhiscommentshavealwaysbeen
sound.
A large number of friends contributed information and understand-
ing on one or more key topics. Among these are Jim Angel, Heather Bell,
Rebecca Cameron, Don Cassidy, Don Chance, Roger Edelen, Gary
Eisenreich,FrankFabozzi,BenFulton,DebraFuhr,MartinGruber,Richard
Harper, John Haslem, Dodd Kittsley, Mark Kritzman, Craig Lazarra,
Michael Lipper, Steven Lotz, Burton Malkiel, Albert Mandansky, Dan
McCabe, Kevin McNally, Richard Michaud, Kathleen Moriarty, Nathan
Most,JamesNovakoff,AnttiPetajisto,JimRoss,VijaySingal,RobertTull,
WayneWagner,andCliffordWeber.
My daughters, Gayle and Nicole, provided invaluable research assis-
tanceatvarioustimesandmywifeNancyhasbeenmorepatientthanIhad
arighttoexpectasthisbookoccupiedourtime.
I owe a particular debt of gratitude to my assistant, Rosemary Wieszt.
Without her extensive and intensive efforts, this book would not have
happened.
xi