EXCHANGE-TRADED FUNDS - ETFs

Exchange-traded funds (ETFs) are offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock. The first ETF was the “Spider,” a nickname for SPDR or Standard & Poor’s Depository Receipt, which is a unit investment trust holding a portfolio matching the S&P 500 index. Unlike mutual funds, which can be bought or sold only at the end of the day when NAV is calculated, investors could trade Spiders throughout the day, just like any other share of stock. Spiders gave rise to many similar products such as “Diamonds” (based on the Dow Jones Industrial Average, ticker DIA), Cubes (based on the Nasdaq 100 Index, ticker QQQ), and WEBS (World Equity Benchmark Shares, which are shares in portfolios of foreign stock market indexes). By 2000, there were dozens of ETFs in three general classes: broad U.S. market indexes, narrow industry or “sector” portfolios, and international indexes, marketed as WEBS. Table 4.3, Panel A, presents some of the sponsors of ETFs; Panel B is a sample of ETFs.

ETFs offer several advantages over conventional mutual funds. First, as we just noted, a mutual fund’s net asset value is quoted—and therefore, investors can buy or sell their shares in the fund—only once a day. In contrast, ETFs trade continuously. Moreover, like other shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.

ETFs also offer a potential tax advantage over mutual funds. When large numbers of mutual fund investors redeem their shares, the fund must sell securities to meet the redemptions. This can trigger capital gains taxes, which are passed through to and must be paid by the remaining shareholders. In contrast, when small investors wish to redeem their position in an ETF they simply sell their shares to other traders, with no need for the fund to sell any of the underlying portfolio. Moreover, when large traders wish to redeem their position in the ETF, redemptions are satisfied with shares of stock in the underlying portfolio. Again, a redemption does not trigger a stock sale by the fund sponsor.

The ability of large investors to redeem ETFs for a portfolio of stocks comprising the index, or to exchange a portfolio of stocks for shares in the corresponding ETF, ensures that the price of an ETF cannot depart significantly from the NAV of that portfolio. Any meaningful discrepancy would offer arbitrage trading opportunities for these large traders, which would quickly eliminate the disparity.

ETFs are also cheaper than mutual funds. Investors who buy ETFs do so through brokers,  rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses translates into lower management fees. For example, Barclays charges annual expenses of just over 9 basis points (i.e., .09%) of NAV per year on its S&P 500 ETF, whereas Vanguard charges 18 basis points on its S&P 500 index mutual fund.


There are some disadvantages to ETFs, however. Because they trade as securities, there is the possibility that their prices can depart by small amounts from NAV. As noted, this discrepancy cannot be too large without giving rise to arbitrage opportunities for large traders, but even small discrepancies can easily swamp the cost advantage of ETFs over mutual funds.

Second, while mutual funds can be bought for NAV with no expense from no-load funds, ETFs must be purchased from brokers for a fee. Investors also incur a bid–ask spread when purchasing an ETF. ETFs have to date been a huge success. Most trade on the Amex and currently account for about half of Amex trading volume. So far, ETFs have been limited to index portfolios.

A variant on large exchange-traded funds in a “built-to-order” fund, marketed by sponsors to retail investors as folios, e-baskets, or personal funds. The sponsor establishes several  model portfolios that investors can purchase as a basket. These baskets may be sector or broader-based portfolios. Alternatively, investors can custom-design their own portfolios. In either case, investors can trade these portfolios with the sponsor just as though it were a personalized mutual fund. The advantage of this arrangement is that, as is true of ETFs, the individual investor is fully in charge of the timing of purchases and sales of securities. In contrast to mutual funds, the investor’s tax liability is unaffected by the redemption activity of other investors. (Remember that in the case of mutual funds, redemptions can trigger the realization of capital gains that are passed through to all shareholders.) Of course, investors would similarly control their tax position using a typical brokerage account, but these basket accounts allow one to trade ready-made diversified portfolios. Investors typically pay an annual fee to participate in these plans.

Read More: EXCHANGE-TRADED FUNDS - ETFs

ETFs Avoid the Expense of Fund Managers

Most open-end mutual funds (which will be referred to simply as mutual funds throughout the rest of the book) are actively managed. This means that most funds have managers who pick which stocks to buy and sell, and when, according to their own judgments. Active managers generally keep their stock selections secret until they have finished making transactions for their own funds. In this way, they avoid having to compete in the market when placing transactions against free riders, who might want to copy the managers’ ideas.

In contrast, ETFs are passively managed. Passive management means that a predetermined set of rules is used to select the individual stocks that are held in each ETF. An ETF sponsor can update the selection of stocks in a passively managed portfolio, but only on dates that it specified in advance. Anybody who knows what the rules are can anticipate the changes that an ETF will be making to its portfolio on the dates specified for portfolio update. Because the rules for selecting a passively managed portfolio are available to everyone, it is unnecessary to hire a manager.

The fund sponsor for each passively managed ETF selects a set of rules that govern which stocks the ETF will hold. After these rules are in place, the ETF does not deviate. So, unlike the case with an actively managed fund, investors in a passively managed fund or ETF know at any time exactly which stocks are in the fund and when that portfolio is scheduled to change. (Although some actively managed ETFs are in development, passively managed ETFs are likely to dominate the landscape for the foreseeable future.) The accurate knowledge by individual fund investors of their funds’ holdings is called investment transparency. For many investors, this transparency is considered an advantage, because when you buy an ETF, you know exactly what you are getting.

Another term used to describe passive investment management is indexing. The connotation of a market index, in addition to being passively managed and enjoying the attendant advantages of low cost and transparency, is that it usually aims to represent the performance of a particular market sector. Broadly based indexes can represent the entire universe of publicly traded shares in the United States, or even in the world (such as the MSCI World Index). At the other end of the spectrum, a number of market indexes have been designed to represent the behavior of fairly narrow industry sectors, such as the S&P Select Homebuilders Industry Index. (The latter is tracked by an ETF, the SPDR Homebuilders ETF, whose ticker symbol is XHB.)
Read More : ETFs Avoid the Expense of Fund Managers

ETFs Are Traded on Exchanges

The big difference between ETFs and regular mutual funds is that as an individual investor, you buy ETFs on a stock exchange. You do not deal directly with the sponsoring mutual fund company, and you bear the full costs of every transaction you make. Whether this is an advantage to you depends on how you are using ETFs.

For example, when you purchase shares of a regular mutual fund, such as Vanguard’s S&P 500 Index Fund (VFINX), you send your money to Vanguard, and it creates new shares of its fund for you. The price per share is based on the value at the market close of the fund’s holdings on the date of your purchase. Conversely, if you want to redeem from a Vanguard fund, Vanguard eliminates your shares and sends you the cash value, again based on the value of the assets in the fund at the market close on that day.

With regular (open-end) mutual funds, buyers and sellers receive the same price for their shares on any given day, regardless of how the market behaved, and regardless of how many other shareholders in the fund might be buying or selling on that day. If you buy new shares, the mutual fund manager might be unable to put your money to work until the next day, when the fund will have the chance to purchase additional shares. If you redeem mutual fund shares, the fund manager might have to raise the cash you have requested by selling some of the fund’s holdings the next day. The necessity of engaging in such transactions to accommodate shareholder additions or redemptions might hurt the performance of the mutual fund, but it does not affect the price per share you pay or receive.

In contrast, when you purchase an ETF, you call or e-mail your stockbroker just as you would to buy stock in an individual company. When you purchase an ETF, you must pay a broker’s commission, similar to the charge you would incur to buy an individual stock. Note the difference between the likely size of a commission on the purchase of ETF shares and the sales charge on the purchase of a mutual fund with a sales load. Competition among brokers has driven the cost of buying ETF shares to low levels at many brokerage firms (including online brokerages and discount brokerages). However, the sales loads on mutual funds remain far larger than the cost of buying shares through a discount broker. Sales loads are generally as high as 5 percent of the assets you are investing.

You pay this sales charge either as a lump sum up front or over a period of years. When the sales charge is collected over a period of years (for example, 0.75 percent of assets per year for seven years in a typical class B load mutual fund share), you pay a “deferred sales charge” if you try to exit the fund before the full sales charge has been paid to the broker.

When you purchase shares of an open-end mutual fund, the number of outstanding fund shares increases because the fund company takes your cash and creates new shares that are delivered to your account. The mutual fund generally puts the cash it received from you to work by using it to buy stock. Similarly, when you redeem shares of an open-end mutual fund, the fund company takes your shares and eliminates them, thereby decreasing the number of outstanding shares. In return for your shares, the fund company places cash in your account. The mutual fund generally sells shares of stock it owns to raise the cash it has to give to you.

Unlike mutual funds, which need to create new shares to meet your purchases and to eliminate existing shares to meet your redemptions, when you buy or sell ETF shares, you conduct the transaction with another investor. You and the other investor exchange ETF shares for cash, but the number of outstanding ETF shares does not change as a result of your transaction. Only the list of shareholders changes.

As an example, let us compare what happens when an investor purchases 100 SPY at $127/share to what happens if the same investor instead purchases shares in an open-end S&P 500 Index Fund (ticker ABCDX) that sells for $50/share. The outline that follows compares the purchase of ETF shares to the purchase of shares in an open-end mutual fund.

Every transaction in an open-end fund for the entire day receives the same price. An order placed with a fund at 9:00 a.m. gets the same closing price for the day as one placed at 3:59 p.m. That closing price is set based on data from the market close at 4:00 p.m. Any order received at a mutual fund after 4:00 p.m.—even 4:01 p.m.— receives the next day’s closing price.

With ETFs, as with stocks, the price you get for your order can change throughout the day. Suppose that you buy an ETF early in the trading day (say, at 10:00 a.m.), and then at 11:00 a.m. some news comes out that drives the market higher. In this case, you will profit from the timing of your order. However, mutual fund purchasers will not. Of course, the reverse can also be true—namely, that the timing of your order can result in your getting a less favorable price than would have been the case if you had waited until the end of the trading day.

If you are a day trader, the ability to trade ETFs throughout the day makes them useful to you in a way that other mutual funds are not. Indeed, many hedge funds use ETFs specifically to be able to day-trade. If you trade more slowly, holding positions for days or weeks or longer, or if you are a long-term investor, the ability to trade during the day will probably not affect your investment performance one way or the other, on average.

For investors who utilize end-of-day trading strategies, ETFs have a big advantage that does not apply to individual stocks or mutual funds: Many ETFs trade until 4:15 p.m.—15 minutes after the regular market closes at 4:00 p.m. This allows you to wait until the market close to collect data and then use that data to decide which trades to execute on the same day.

In my experience, any trading model that utilizes daily data from the market close is likely to perform more poorly if trades are not executed on that same day. Investors who use mutual funds that allow unlimited trading (such as those offered by Rydex, Profunds, and Direxion that are designed to accommodate active trading) must submit their buy or sell orders to the mutual fund before the market closes. There is a chance that some trading decisions made before the close will turn out to be different from the decisions that would have been made if the final closing data had been known earlier.
Read More : ETFs Are Traded on Exchanges

ETF Investors Have Hidden Costs Through the Bid-Ask Spread

From the earlier discussion, you can infer that the price you pay for your ETF depends on the balance of supply and demand for that ETF at the time your order hits the trading floor. An ETF’s share price is usually slightly different from the market value of the fund’s underlying holdings. Moreover, the price a buyer pays is generally higher than the price a seller receives.

Selling a used car is a useful analogy. If you know how much you want for your car, you can sell it yourself. If a willing buyer sees your advertisement, he may take the car off your hands at a price you both feel is fair. However, you might not be able to locate a buyer. If that is the case, you might decide to sell your car to a dealer.

The dealer then pays a price low enough for him to expect to turn a profit when he resells your car. The dealer’s knowledge of the car’s value comes from observing the used-car market. Ideally (for the dealer), he would like to offer you as little as possible, but if the offer is too low for your liking, you will simply look for another dealer. On the other hand, if your demands are too high to leave room to profit, the dealer will let you walk.

If you accept the dealer’s offer on your car, he will try to resell it at a higher price. Suppose the dealer is extremely lucky—the second after you leave the lot, a buyer enters, looking for exactly the car you just sold. Naturally, the dealer will sell it at a profit. The same car on the same day was worth less to you, the seller, than it was to the buyer.

Trading ETFs on exchanges works much the same way. If you as an ETF buyer are offering the same price that a different seller is demanding, the stock exchange is supposed to match up the two of you so that each of your orders can be filled. (However, exchanges have not always functioned this way, giving rise to periodic scandals and investigations. As a result, you should pay attention to the quality of your trade execution.)

However, suppose you want to buy an ETF at a time when a willing seller is not around. In that case, a dealer or specialist in a stock exchange offers to fill your order. Just as with a car dealer, a stock dealer transacts with you only at a price that allows him to make a profit. With the advent of electronic trading, you (through your broker) can look for the best price available for the ETF you want on more than one exchange. This is analogous to shopping around for the best price at multiple car dealerships.

If the dealer sells you the shares you want, he immediately tries to repurchase them from someone else at a lower price. If you turn around and try to resell your shares to a dealer (or specialist, or market maker), you receive less than you paid, even if the market has not moved one iota in the interim.

The price you pay to buy shares at the lowest available price is called the asking price, or ask. The price you receive when you sell shares at the highest available price is the bid. As with cars, stock dealers stand ready at any time to sell you shares at the ask price or to buy shares from you at the bid price.

The difference between the price you have to pay to buy shares and what a seller would receive to sell shares is called the bid-ask spread. The bid-ask spread is no less a cost to you than a broker’s commission, despite being less visible. But to the unwary investor, the bid-ask spread is a hidden cost. Before you decide to buy an ETF, you should ask your broker for both the bid and ask so that you can get a feel for the cost per trade.
Read More : ETF Investors Have Hidden Costs Through the Bid-Ask Spread

Growth and Value ETFs

Other criteria are available with which to segregate groups of stocks besides market capitalization. An important category is the group of market indexes called value indexes, which represent the collective behavior of stocks that appear cheap compared to the overall market in terms of their current earnings, dividends, or value of the company’s underlying assets (called book value). Although in principle, any company’s stock could be a value stock if the share price dropped low enough, in practice, certain industries, such as banks, energy, and cyclical stocks, have been disproportionately represented in value indexes.

Complementing value indexes are growth indexes. Growth stocks generally appear expensive relative to the overall market in terms of their current earnings, dividends, or book values. Investors buy these stocks because the companies appear to have better future prospects than the typical company. Industries represented most heavily in growth stock indexes have included technology, health care, and consumer staples.

Indexes that do not attempt to separate growth and value stocks are called blend indexes. The S&P 500, composed of large-cap stocks, is an example of a large-cap blend index. The Russell 2000 Index is a small-cap blend index that consists of 2,000 small company stocks, again without regard to growth or value characteristics.

Over the long term, large-cap value has outperformed large-cap growth. However, as is the case with small- versus large-caps, growth and value stocks have done better at different times. As a general rule, when the stock market has been weak, large-cap value stocks have fared better than large-cap growth stocks. During strong market climates, large-cap growth has generally beaten large-cap value.

Small-cap growth and value have also fared differently from one another during different periods. However, it is hard to make a generic statement that small-cap value has generally done better than small-cap growth during bear markets. Certainly, from 2000–2003, small-cap value performed well compared to the other investment styles. However, during the bear market years of 1969–1970, smallcap growth actually held up better.

It turns out that the same strategy has been successful in guiding long-term asset allocation decisions between growth and value, whether using small- or large-cap ETFs.
Read More : Growth and Value ETFs

Are Risk Management Applications And Heavy ETF Share Trading Desirable For Fund Shareholder And Fund Advisors?

From the viewpoint of a fund shareholder who might want to trade fund
shares from time to time,15 the tighter the market spread and, other things
being equal, the more active trading in the fund shares becomes, the easier
and cheaper it will be to trade shares in the fund. However, significant
effects of a fund’s membership in an index arbitrage complex and trading
in different market centers competing to tighten trading spreads are still
confined to two funds: the S&P 500 SPDRs and the QQQs. Shareholders
in funds with at least $100 million in assets and a conscientious exchange
specialist are not likely to be at a significant trading cost disadvantage to
multibillion dollar funds with more trading activity, but no active futures
contract. Trading has to expand very dramatically before trading activity
per se has a significant effect on ETF trading costs.


Great popularity in the market for risk management instruments is
not necessarily an advantage to an ETF’s investment advisor. ETF short
sales supported by market-maker-share inventories held to lend to short
sellers have a positive effect on an ETF’s shares outstanding. These market
maker activities, in fact, foster the creation of lendable fund shares
that pay fees to the fund advisor, increasing the assets under management
and, together with the increase in trading activity, create an appearance
of success for the fund that might have the effect of attracting additional
assets. On the other hand, if the recent trend to less-covered lending by
specialists and other market makers, who create shares to lend them, and
more lending by other holders of ETFs becomes the dominant pattern,
short selling will reduce an ETF’s shares outstanding. A short seller needs
a buyer. If shares are easy to borrow, that buyer is likely to be a market
maker who will sell the shares back to the fund and shares outstanding
will decline. It matters very much to fund advisors whether shares are
created to lend or lending is an incidental activity of ETF investors and
replaces shares issued by the fund.

To put the impact of short selling ETFs in an economic perspective, if
all open short positions in the QQQs in December 2003 were covered by
share borrowing from traditional investors, the shares supplied by the
short sellers reduced the fund’s assets by approximately $12.5 billion. At
the fund’s 20 basis point expense ratio, this represents forgone fee revenue
of approximately $25 million annualized. There is little question that
the large benchmark ETFs are more actively traded as a result of risk
management applications. Short sellers can meet the needs of ETF buyers
with shares borrowed from traditional investors rather than shares created
to be loaned. This pattern is certainly not attractive to the fund’s
advisor. Of course, without the effect of active trading, the funds might be
much smaller, making the net effect of a large-short interest unclear.
Read More : Are Risk Management Applications And Heavy ETF Share Trading Desirable For Fund Shareholder And Fund Advisors?

What Is The Effect Of Short Selling And Risk Management Activity On ETF Trading Volume And Trading Costs?

The facts that QQQs are the most actively traded equity security in the
world (in terms of number of shares) and that SPDRs are the most actively
traded securities (in terms of trading value) are not the result of frenetic
trading by the average investor in these fund shares. That the total number
of SPDR and QQQ shares outstanding turns over every few weeks
simply reflects that these ETFs have become extremely popular risk management
instruments, and have taken significant risk management market
share from futures contracts. The effect of these hedging applications on
trading spreads and share volume makes the nature of the markets in a
few actively traded ETFs with large short interests very different from the
markets in less active ETFs and more traditional securities.

At first thought, widespread use of ETFs in risk management applications
should not have a material effect on the quality of the markets
in the ETF shares. Other things being equal, the bid/asked spread that
an investor or trader faces in an ETF should be largely a function of
spreads in the markets for the underlying basket of securities that make
up the ETF portfolio. However, if the ETF’s portfolio becomes a standard
portfolio or basket trade and if ETF market makers experience a

high level of trading activity in the ETF shares, they may trade the ETF
at a tighter spread than an investor trading in a similar basket or less
active ETF would experience. A benchmark index portfolio basket,
whether for the S&P 500, the QQQs or the Russell 2000, is a standard
basket and will trade more cheaply as a basket than an investor or
trader can trade the individual securities separately. If an ETF is
extraordinarily active like the SPDRs and QQQs, a consistent high level
of trading activity in the ETF shares may further reduce trading costs.

Tight spreads on these baskets and on some of the related ETFs are
not just the result of a large number of orders interacting. In today’s markets,
the presence of a number of market centers—on exchanges, on NASDAQ,
and on the trading books of a variety of electronic communication
networks (ECNs)—permits some market participants who can access multiple
market centers to trade the most active ETF shares at very low cost.

The interaction of multiple ETF market places with futures contracts
on the ETFs themselves and, more importantly, with futures contracts on
the indices underlying the ETFs, leads to active trading in what we call an
index “arbitrage complex” that facilitates active trading on tight spreads
for online traders and traders at hedge funds and broker-dealers. As the
pattern of growth and decline in capitalization reflected in the shares outstanding
for each of the 10 largest ETFs listed in Exhibit 4.2 illustrates, the
number of shares an ETF has outstanding is not stable. Short selling and
other risk-management-related ETF activity varies greatly in importance
depending, in large measure, on how widely the underlying index for the
ETF is used in risk management applications. Ultra-tight trading spreads
from the interaction of competing markets and competing instruments
have had a major effect only on the S&P 500 SPDRs and the QQQs. The
growing short interests for the DIAMONDS, based on the Dow Jones
Industrial Average, and the iShares Russell 2000 fund suggest that these
funds might ultimately experience some similar trading effects.

Two funds based on the same underlying index—the S&P 500 SPDR,
the largest ETF in terms of assets, and the iShares 500 ETF, the third largest
ETF in terms of assets—vary greatly in trading activity, and in the absolute
and relative size of the funds’ short interests. This particular case is
interesting because the iShares 500 has a very slightly lower expense ratio
than the 500 SPDR. Also, the two funds have had very similar performance
for most of the period they have competed, with the SPDRs showing the
better performance earlier and the iShares 500 fund having done a little

better more recently. Trading activity and the short interest are concentrated
in the S&P 500 SPDR, probably because it was the first ETF on the
market and its trading and risk management applications are better established.
The short interest in the 500 SPDRs is worth nearly twice as much
as the value of all shares outstanding in the iShares 500 fund.

As Exhibit 4.2 illustrates, short interest, a good indicator of risk
management applications for an ETF, varies considerably over funds and
indices and over time. Substantial differences in short interests also will
be found among smaller ETFs. In smaller ETFs, measurements like the
short interest or the percentage of institutional ownership may be determined
by a few large shareholders or large short sellers. For example, it
is theoretically possible for securities lending and relending to lead to a
short interest in excess of the share capitalization of a fund. Furthermore,
in at least one case, (the iShares MSCI Taiwan Fund) institutional
ownership reported under rule 13-F once accounted for more than 100%
of the shares outstanding as a result of securities lending among a few
large institutional investors combined with dealer trading facilitation.
Read More : What Is The Effect Of Short Selling And Risk Management Activity On ETF Trading Volume And Trading Costs?

What Are The Most Important Safety Features Protecting ETF Short Sellers?

Exchange-traded funds are a unique hybrid of closed-end and open-end
investment companies. ETF shares trade like common stocks or closedend
funds during market hours and can be purchased or redeemed like
open-end funds with an in-kind deposit or withdrawal of portfolio securities
at each day’s market close. In the United States, ETFs offer a unique
level of capital gains tax efficiency and in most markets they offer a high
level of intra-day liquidity and relatively low operating costs.

The trading flexibility and open-endedness of ETFs offer unusual
protection to short sellers.
1. It is essentially impossible to suffer a short squeeze in ETF shares. In
contrast to most corporate stocks where the shares outstanding are
fixed in number over long intervals,1 shares in an ETF can be greatly
increased on any trading day by any Authorized Participant.2 Creations
or redemptions in large ETFs like the S&P 500 SPDRs and the NASDAQ
100 QQQ’s are occasionally worth several billion dollars on a
single day. The theoretical maximum size of the typical ETF, given this
in-kind creation process, can be measured in hundreds of billions or
even trillions of dollars of market value. The open-ended capitalization
and required diversification of ETFs takes them out of the extreme risk
category. As a practical matter, “cornering” an ETF market is unimaginable.

The upside risk in a short sale is still theoretically greater than
the downside risk in a long purchase, but even that risk is modified by
the way ETF short selling is used to offset other risks.

2. Most ETF short sales are made to reduce, offset, or otherwise manage
the risk of a related financial position. The dominant risk management/
risk reduction ETF short sale transaction offsets long market risk with
a short or short equivalent position. Unlike the aggressive skier or
surfer, the risk manager who sells ETF shares short is nearly always
reducing the net risk of an investment position. In contrast to extreme
athletes, the risk managers selling ETFs short are more like the ski
patrol or lifeguards: They sell ETFs short to reduce total risk in a portfolio.


3. Most serious students of markets consider the uptick rule an anachronism
(at best). Requiring upticks for short sales is certainly unnecessary
and inappropriate for ETFs that compete in risk management applications
with sales of futures, swaps, and options—risk management instruments
that have never had uptick rules.

Read More : What Are The Most Important Safety Features Protecting ETF Short Sellers?

How Do ETFs Work In Risk Management Applications?

Existing ETFs are all based on benchmark indices. While there are
important benchmarks and there are unimportant benchmarks, benchmark
index derivatives are widely used in risk management applications.

For example, an investor with an actively managed small-cap
portfolio might feel that superior stock selection reflected in the portfolio
will provide good, relative returns over the period ahead, but that
most small-cap stocks might still perform poorly. The investor can
hedge the portfolio’s exposure to small-caps while capturing its stock
selection advantage by hedging the small-cap risk with a short position
in a financial instrument linked to the Russell 2000 small-cap benchmark
index. Available risk management tools for this application range
from futures contracts and equity swap agreements—to the shares of a
small-cap exchange-traded fund.

Derivative contracts have limited lives. Equity index futures contracts
will usually be rolled over about four times a year in longer-term risk management
applications. While risk managers could take futures positions
with more distant settlements, liquidity is usually concentrated in the nearest
contracts. Consequently, risk managers typically use the near or next
contract and roll the position forward as it approaches expiration. Similar
expiration provisions apply to most swap agreements, leaving the typical
derivative transaction with considerable “roll” risk—risk of adverse market
impact from rolling the hedge forward to the next expiration.

If a hedger uses ETF shares instead of futures, a risk management position
can be held indefinitely without roll risk. Of course, the open-end
nature of an ETF risk management or hedging position has other differences
from futures and swaps. There is an implied cost associated with the
expenses of the fund that may make the ETF a better short hedge, and there
may be tracking error between the ETF portfolio and the benchmark index,
but these are usually small considerations relative to fluctuating roll risk
and recurring transaction costs in a longer-term rolling derivatives hedge.

Exhibit 4.1 illustrates two snapshot cost analyses of long stock
index futures versus long ETF shares as one-year portfolio replication
positions. When these analyses were prepared (at different times), they

indicated that the ETF was the low-cost replication instrument of choice
for an investor who expected the position to stay in place for a year. The
assumptions used in these analyses were appropriate at the times they
were prepared, but any investor or hedger should evaluate current market
conditions before choosing between futures or swaps and ETFs.

More importantly, the risk manager needs to convert the analyses of
Exhibit 4.1 from a long-side to a short-side cost comparison with specific
data for the organization managing the risk. The reason the examples
in Exhibit 4.1 show long positions in futures versus long positions
in ETFs is that the expected costs and trading frictions associated with a
long position are about the same for nearly everyone on the long side.

On the short side, the management fee works in favor of the ETF short
seller, but, more importantly, the net cost of borrowing ETF shares varies
over time and among risk managers. In fact, a number of the costs
change over time and among market participants.

In estimating the net share borrowing cost or loan premium for a
short ETF position, we will not spend much time discussing the fund
management fee. Lenders who buy ETF shares to lend them will sometimes
be the marginal share lenders in the ETF market and when they are
the marginal lenders they should be able to recoup the management fee
as part of their securities lending revenue. When the marginal lender is
an ordinary investor, the ETF loan premium will be unaffected by the
management fee. The fact that the existence of the management fee
favors the short seller may stimulate ETF share lending efforts by thirdparty
securities lending agents working with brokerage firms and custodians.

“Recapturing” the management fee should effectively increase the
lending revenue on which agency lending fees are calculated. Generally,
the larger component of the securities loan premium is the net interestrate-
linked spread which the share borrower pays. For ETF share loans,
the total loan premium can range from near 10 basis points in a very low
interest rate environment to a maximum of about 30 basis points if there
is management fee recapture built into the loan premium. If the loan premium
rises above that level, ETF short sellers will begin to switch to
futures contracts and some investors will create ETF shares to lend.

The low end of this range is determined by the minimum administrative
costs of setting up a large securities lending program and implementing
only very large intermediate- and longer-term securities loans in this very
liquid and relatively transparent market. The high end of the range in this
particular market will probably be determined by the economics of persuading
large pension funds with index portfolios to switch from direct
ownership of indexed portfolios—with few individual stock lending opportunities—
to, say, SPDRs with substantial and relatively consistent lending
opportunities. In fact, an astute S&P 500 index manager will probably

handle this transaction for its pension plan clients at no extra charge. A
30-basis point lending fee might cover the expense ratio of the ETF, any
performance penalty associated with the way the ETF is managed,3 an offset
for any index outperformance the pension plan’s index manager was
obtaining and administrative costs.4 The works of Gastineau,5 Blume and
Edelen,6 and Quinn and Wang7 help us understand how these costs can
aggregate to as much as 30 basis points for an S&P 500 portfolio. The
maximum lending fee might be larger for smaller cap funds if fund shares
are created to lend, perhaps as much as 100–150 basis points for a Russell
2000 ETF because a good pension plan index manager should beat the
Russell 2000 by a substantial margin. At a loan premium in this range,
futures will be the short risk management tool of choice.

A more efficient8 underlying large cap index than the S&P 500 could
theoretically lead to a lower maximum lending fee and a tighter spread if
the index were as widely accepted as the S&P 500. For now, a 20 basis
point spread between low- and high-borrowing costs is as tight as it is
likely to get, but smaller lenders and borrowers will often see significantly
wider spreads and higher loan premiums. To see the short-side perspective
on an ETF versus stock index futures comparison, the reader should modify
the numbers in Exhibit 4.1 for a short ETF position by reversing the
effect of the management fee (the management fee is the same as the
fund’s expense ratio in most ETFs) and adding an annual loan premium
in the 10 to 30 basis point range to the cost of the ETF transaction.
Read More : How Do ETFs Work In Risk Management Applications?

Who Owns ETF Shares?

In contrast to the obvious relevance of this question when it is asked
about a common stock in the context of short selling, who owns the
ETF shares outstanding should not matter very much to the ETF investor
or to the risk manager who would sell ETF shares short. The opportunity
to increase ETF shares outstanding, literally at a moment’s notice,
makes current ETF shares outstanding largely irrelevant from a trading
or risk management perspective. Nonetheless, knowing something
about the composition of the shareholder population and the effect of
short sales on share ownership can help traders better understand the
ETF market and ETF share-borrowing and -trading costs.

A typical large-capitalization common stock without significant
insider holdings may show institutional investors accounting for 70% to
80% of its share capitalization. This institutional shareholder data can
be accumulated from 13-F reports and similar filings with the Securities
and Exchange Commission. The institutional share of ETF ownership
varies widely among the funds, but most ETF 13-F summaries show
institutional shareholdings in the 20–40% of ETF capitalization range,
far below the institutional holdings in most of the U.S. common stocks
held by the typical ETF.

When the ETF institutional shareholder numbers are viewed relative
to the typical large ETF’s short interest, the relatively low ETF institutional
ownership is almost surprising. With the short interest running
about 2% of shares outstanding in the average common stock, it is not
important that 2% of shares may be reported twice because one institution
has lent its shares to a short seller and the shares have been purchased
by another reporting institution. With a two percent short
interest, double counting all or part of the short interest in the 13-F
reports does not affect the reported institutional ownership of most
common stocks very much because the short interest is such a negligible
part of the total stock capitalization. However, the large short interest
in many ETFs affects the reports considerably because all shares that
have been sold short appear as long positions in two investor portfolios.

Consequently, the ETF institutional ownership percentage reflected in
the 13-F reports is overstated as a percentage of total shares. For example,
if the short interest is reported at, say, 55% of capitalization, the
number of shares shown on the books of all holders of the ETF’s shares
will total 155% of the number of shares outstanding. If the 13-F reports
show that institutions hold 45% of the shares outstanding in the ETF,

that is actually 45% out of 155% or only about 29% of the shares that
all investors combined show long in their accounts.

Huge ETF short interests also mean that short sellers play important
roles in the size of an ETF’s assets and in its trading activity. Specialists and
other market makers have frequently maintained significant inventories of
ETF shares to lend to short sellers. These market makers hedge their positions
and obtain a fee from the securities lending operation, making creation
of ETF shares for securities lending a modestly profitable business
activity at times. In the summer of 2003, many market makers substantially
reduced these ETF lending positions, apparently because interest rates were
so low that ETF share lending was no longer profitable for them.

The departure of some dealers from the business of buying and
hedging ETF shares for the securities lending market has not led to a
shortage of shares available to short sellers.11 As the increase in many of
the short interest percentages (SIPs) in the largest ETFs listed in Exhibit
4.2 suggests, the ETF share borrowing needs of short sellers have been
readily accommodated by institutional ETF holders, by brokerage firms
carrying retail margin accounts and by other dealers. When market
makers reduced their participation in the ETF share-lending business,
they redeemed the shares they had been lending. This reduced the funds’
shares outstanding, but had no negative effect on the short interest that
actually grew in most large ETFs. In fact, the same lower interest rates
that reduced the attractiveness of ETF share lending to market makers
also reduced the effective cost of ETF borrowing and short selling by
risk managers. The reduction in the cost of borrowing ETF shares made
ETF short sales more attractive relative to short futures positions in
comparisons like those illustrated in Exhibit 4.1. Consequently, short
ETF positions gained risk management market share from short-stock
index futures positions.

With or without market makers’ ETF-lending portfolios, substantial
numbers of ETF shares have been made available to short sellers by
institutions and by brokerage firms from their retail investor accounts–
which typically exceed the size of institutional ETF holdings. Broker-

dealers, both in their roles as market makers and for their own risk
management operations, are also substantial holders, lenders and short
sellers of ETF shares. There is little published data to help us quantify
all these participations.
Read More : Who Owns ETF Shares?

Will It Always Be Possible To Borrow ETF SHARES At Low-Cost For Risk Management Applications?

Clearly, when short-term interest rates increase from 2003 levels, the
attractiveness of securities lending should increase for dealers who create
and hold hedged positions in ETFs while lending the ETF shares to
short sellers. Their activity should assure a supply for ETF share borrowers.

However, an interesting change in the U.S. Federal Tax Code
will certainly change the dynamics of ETF securities lending and short
selling even if it does not change the economics very much.
The 2003 Tax Act, formally the Jobs and Growth Tax Relief Reconciliation
Act of 2003, cut the tax rate for individual investors on qualified
dividends from certain equity securities (including most ETFs) to
15%. The Internal Revenue Code distinguishes between various kinds
of dividend and interest income, on the one hand, and payments in lieu
of such dividend and interest income, on the other hand. This distinction
can be significant for municipal bonds, for example, where payments
in lieu of municipal interest are not exempt from federal and
certain state income taxes, while the actual interest payment or an interest
passthrough from municipal bond funds will qualify fully for tax
exemption. Similar provisions apply to Treasury interest, which is generally
exempt from state income taxes, but payments in lieu of Treasury
interest on securities lent out do not qualify for tax exemption.

Under the 2003 Tax Act, dividends can be affected by a similar distinction
between actual or passed-through dividends and payments in lieu
of dividends. Corporations have had to exercise care that the “dividends”
they have received on common and preferred stocks have qualified for
the tax code’s corporate tax dividend-received deduction by being actual
dividend payments or pass-throughs rather than payments in lieu. Most
individual investors have not had to worry about the character of such
payments until now. For 2003, the new tax act provides that as long as
an individual investor has no reason to believe that what he or she is
receiving is a payment in lieu, the taxpayer can assume dividend payments
from a brokerage firm or other custodian that holds the taxpayer’s
stocks, equity mutual funds or equity ETF shares are qualified dividends.

New Treasury rules dictate that financial intermediaries report dividend

qualification status for 2004 and subsequent years. Payments in lieu of
ETF dividends from securities lenders will not qualify for the special dividend
tax rate in 2004 and later years. While some observers have suggested
that the lower dividend tax rate for individuals may increase the
cost of borrowing dividend-paying securities, it is more likely that there
will be a modest change in where the shares will be borrowed.

Some current ETF share lending may dry up. For example, brokers
carrying ETFs in individual investor’s accounts will not be able to certify
the ETF dividends as eligible for the 15% tax rate if they lend out the
shares. Institutional investors may have a more complex tax calculation to
make. Mutual funds, for example, often use ETFs to equitize small cash
balances. In fact, mutual funds probably account for a substantial fraction
of reported ETF institutional ownership.13 Some mutual funds may not be
willing to loan their ETF shares as freely in 2004 and later years because
any payment in lieu of dividends that they receive from the borrower will
not be distributable as qualifying dividends to their taxpaying individual
shareholders. However, the provisions of Internal Revenue Code § 854
will govern the eligibility of fund dividend distributions for the 15% tax
rate. This section was written to cover eligibility of dividends for the dividend-
received deduction and it, in effect, applies nonqualifying income to
expenses first, leaving qualified dividends to be distributed. Assuming the
same treatment under the new law, only funds with very low expense
ratios or very large share lending programs, will risk distributing payments
in lieu of dividends when they loan out ETF shares.

Any tax-exempt account will lend shares readily. Lending opportunities
might draw in the pension plans we described as potential ETF lenders in
the previous section. Long ETF positions held by a broker-dealer in its risk
management activities will be lendable because the broker-dealer cannot
take advantage of the special 15% dividend tax rate. Long positions held
by a dealer to hedge an equity swap transaction where the broker-dealer
pays the return on an ETF as a swap payment in return for receiving the
return on a stock position should also be lendable without incurring disadvantageous
tax treatment. The swap payments are already payments in lieu
and, hence, the position held by the dealer would be lendable without disturbing
any individual investor’s receipt of a qualified dividend.

The net effect of this provision of the tax law on who lends ETF
shares and under what circumstances or with what promises as to the

nature of the cash flows involved, may not be as great as the economic
effect of interest rate changes on securities lending. In most recent interest
rate environments, lending ETF shares created specifically for the
purpose of lending has been a moderately attractive business opportunity
for specialists and other market makers. As short-term interest rates
move up from recent extremely low levels, ETF share lending could
become an attractive business activity for dealers once again. Of course,
the need for more extensive record keeping to meet requirements the
Treasury may impose could affect the economics of short selling and
securities lending in unpredictable ways. Pension plan ETF share lenders
should be able to avoid most such record-keeping costs.

As an aside, the QQQs—with their 55% of capitalization short
interest in December 2003—pay only a tiny dividend. Ironically, however,
the new dividend tax treatment has encouraged many firms to
begin paying dividends or to increase their dividends, so the possibility
of a larger QQQ’s dividend cannot be ignored. Realistically, any QQQ’s
dividend is not likely to be large enough to affect the lending of QQQ
shares anytime soon.
Read More : Will It Always Be Possible To Borrow ETF SHARES At Low-Cost For Risk Management Applications?