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ETF Liquidity Explained

Paul Daley, Phil Dorencz and Dan Bargerstock


The Impact Of Market Models On Liquidity
Lisa Dallmer
Fragmentation In The European ETF Market
Bart Lijnse and Christiaan Scholtes
Share Lending And ETFs In Europe
Leonard Welter
Plus European ETFs on the cusp, alpha in indexes, financial bubbles, target date indexes and more!
www.journalofindexes.com

Vol. 13 No. 2

features
ETF Liquidity Explained
By Paul Daley, Phil Dorencz and Dan Bargerstock 10
A guide to discerning sufficient liquidity in ETFs.
The Impact Of Market Models On Liquidity
By Lisa Dallmer 18
The role of liquidity providers.
The Fragmentation Of The European ETF Market
By Bart Lijnse and Christiaan Scholtes 22
Lack of unified market hurts ETF volumes in Europe.
A Big Bang In European ETF Trading?
By Keshava Shastry 26
Is Europe’s ETF market reaching a tipping point?
No Shortage Of Share Lending 10
By Leonard Welter 28
Securities lending with ETFs in Europe.
Talking Indexes: Bubble Decisions
By David Blitzer 30
How do you know if the market is in a bubble?
Can Indexes Generate Alpha?
By David Blanchett 32
Indexes aren’t necessarily just beta.
The Future Of Fund Ratings, Part Three
By Gary Gastineau 38
A look at freely available investor tools.
Creating A Better Target Date Benchmark
By Grant Gardner and Mary Fjelstad 42
A methodology for comparing families rather than funds.
Fixing The Flaws With Target Date Funds
By Navaid Abidi and Dirk Quayle 46
Renovating the target date concept. 18
The ETFs Of 2010
By Dave Nadig 68
What’s in store for unsuspecting ETF investors in 2010?

news
Lead Stories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Indexing Developments . . . . . . . . . . . . . . . . . . . . 56
Around The World Of ETFs . . . . . . . . . . . . . . . . . 58
Back To The Futures . . . . . . . . . . . . . . . . . . . . . . 61
Know Your Options . . . . . . . . . . . . . . . . . . . . . . . 61
From The Exchanges . . . . . . . . . . . . . . . . . . . . . . 61
On The Move . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

data
Selected Major Indexes . . . . . . . . . . . . . . . . . . . . 62
Returns Of Largest U.S. Index Mutual Funds . . . . 63 42
U.S. Market Overview In Style . . . . . . . . . . . . . . . 64
U.S. Industry Review . . . . . . . . . . . . . . . . . . . . . . 65
Exchange-Traded Funds Corner . . . . . . . . . . . . . . 66

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www.journalofindexes.com March/April 2010 1


Contributors

David Blanchett is a full-time MBA candidate at the University of Chicago Booth


School of Business. Previously, he was employed by Unified Trust Company in
David Blanchett

Lexington, Ky., and Hilliard Lyons in Louisville, Ky. Blanchett holds an M.S. in
financial services through The American College and a BBA in finance and eco-
nomics from the University of Kentucky. He is also an Accredited Investment
Fiduciary Analyst and a Chartered Financial Analyst charterholder.

Paul Daley is a senior managing director of sales and trading at Fox River
Execution. He is the product manager for Fox Spotlight, Fox River’s agency block
ETF trading platform. Daley’s primary responsibilities include ensuring best
execution of orders for all of the company’s customers, new product develop-
Paul Daley

ment initiatives and business development with new customers. He holds a B.A.
in economics and an MBA in finance from the University of Chicago.

Lisa Dallmer is executive vice president of global index services and exchange-
traded products for NYSE Euronext. Her primary responsibilities are the global
expansion of trading and listing services for exchange-traded products, and
Lisa Dallmer

developing multiple marketplaces in which the company is expanding. Dallmer


also oversees the expansion and marketing of NYSE Euronext’s index-related
operations. She holds an MBA from the University of Chicago.

Gary Gastineau is a managing member of Managed ETFs LLC and ETF


Consultants LLC; and a partner in Skyhawk Management, LLC, the adviser to a
market-neutral hedge fund that buys ETFs and sells them short. A new edition
Gary Gastineau

of his book, “The Exchange-Traded Funds Manual,” was released by Wiley in


February. Gastineau is a frequent contributor to the Journal of Indexes.

Bart Lijnse is managing director of arbitrage trading firm Nyenburgh in


Amsterdam. He is part of the firm’s board of directors and holds final respon-
sibility for the firm’s arbitrage trading and IT. Prior to Lijnse’s appointment at
Nyenburgh in 2000, he worked for several years as a derivatives and structured
products trader at MeesPierson. Lijnse holds a master’s degree in mathematics
Bart Lijnse

and computer science.

Keshava Shastry is a director and the head of markets looking after trading of
iShares ETFs within BlackRock. Prior to joining iShares nearly three years ago,
he worked at Citigroup for four years as an FX and interest rate trader. Shastry
has a master’s degree in mathematics and computer science from Imperial
Keshava Shastry

College (London) and is also a Chartered Financial Analyst charterholder.

Leonard Welter is chief technology officer of Data Explorers. He joined Data


Explorers in October 2008 from Morgan Stanley, where he was an executive
director. At Morgan Stanley, Welter was responsible for the global develop-
ment of new securities lending analytic tools and trading systems. He was also
responsible for European securities lending portfolio pricing and trading of
Leonard Welter

equities and ETFs. Welter holds an MBA from the London Business School.

2 March/April 2010
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representation regarding the advisability of investing in such product(s).
Jim Wiandt
Editor
FREE subscRiption oFFER! jim_wiandt@journalofindexes.com
Dorothy Hinchcliff
Managing Editor
dorothy_hinchcliff@journalofindexes.com
The Journal of Indexes is the premier source for financial index Matt Hougan
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Editorial Board
Company
David Blitzer: Standard & Poor’s
Lisa Dallmer: NYSE Euronext
Address Deborah Fuhr: BlackRock
Gary Gastineau: ETF Consultants
City State Zip
Joanne Hill: ProShares ETFs and ProFunds
John Jacobs: The NASDAq Stock Market
Lee Kranefuss: BlackRock
Phone Fax Kathleen Moriarty: Katten Muchin Rosenman
Jerry Moskowitz: FTSE
E-mail Don Phillips: Morningstar
John Prestbo: Dow Jones Indexes
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Delva, Gary Eisenreich, Richard Evans, Jeffrey
Do you personally sell, recommend or manage investments, work in the index Feldman, Gus Fleites, Bill Fouse, Christian
industry or advise clients on investment and/or asset management? Gast, Thomas Jardine, Paul Kaplan, Joe Keenan,
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Wayne Wagner, Peter Wall, Brad Zigler
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(5) q $10 million - $24.9 million (6) q Under $10 million
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4 March/April 2010
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Editor’s Note

Indexes And Trading:


A Modern Marriage

I
ndex investing has long had a bit of an awkward relationship with trading. Good index
fund management has always been to some degree about controlling trading costs, be
they commissions, spreads or market impact costs. After all, the point of good index
Jim Wiandt fund management is to minimize friction, and trading is the primary friction between an
Editor index investor and obtaining the performance of an index.
ETFs—and now ETNs, ETCs and other ETPs—have complicated that equation even
more. ETFs are, as the acronym suggests, exchange-traded funds, bringing index funds
into tradable units. Add to that the myriad new ways to trade—through electronic trad-
ing networks, exchanges, off the floor and around the back—and you’ve got a complex
mix that any investor who wants to preserve something approaching market returns has
to figure out.
We’re excited about this issue because we’ve got some top-notch articles covering an
array of trading issues—with the balance tilted toward Europe—where we’ll be hosting
our first Inside ETFs Europe event, in Amsterdam on April 12-13. If trading is complicated
in the U.S., it’s a thicket of briars at midnight in Europe, where only a small percentage
of trading happens publicly.
Leading with the U.S. part of the trading issue are Paul Daley, Phil Dorencz and Dan
Bargerstock, with a very strong submission that looks at the rather complicated issue of
understanding how liquid an ETF really is (hint—the daily trading volume in the ETF is
not your best metric).
Next, Bart Lijnse and Christiaan Scholtes weigh in from across the pond with an out-
standing analysis of some of the complications of the fragmented European markets.
They are followed by Keshava Shastry’s column asserting that the European ETF industry
might be just about to turn the corner to find an ocean of trading liquidity. Wrapping
up the trading and liquidity portion of this issue, Leonard Welter offers a window on the
fascinating world of share lending in Europe.
Rounding out the lineup are David Blitzer with a sharply insightful piece on bubbles;
David Blanchett on alpha-generating indexes; Gary Gastineau with his final installment on
fund evaluation methods; two retirement/target date pieces—one from Grant Gardner
and Mary Fjelstad, and the other from Navaid Abidi and Dirk Quayle; and Dave Nadig with
a zany take on where the ETF industry is headed.
Like it or not, trading and indexes are forever married. You can remain in denial, or
find yourself a good counselor. This month the Journal of Indexes is board-certified to help
you work things out.

Jim Wiandt
Editor

Jim Wiandt
Editor

8 March/April 2010
Thoroughbreds perform better with blinders on.
Investors don’t.

In today’s economy, many people feel like they’re investing in the dark. So it’s time someone shed a little light on
the matter. With State Street, you can choose from a stable of over 80 SPDR ® ETFs. Which means it’s easy to precisely
match your investments to your investment strategy. Interested in Fixed Income? Gold? High-dividend stocks? Whatever
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Before investing, consider the funds’ investment objectives,


risks, charges and expenses. To obtain a prospectus or summary
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1.866.787.2257 or visit www.spdrs.com. Read it carefully.
ETFs, such as SPDR® S&P 500,® MidCap SPDR,® and Diamonds® trade like stocks, are subject to investment risk and will fluctuate in market value.
There is no assurance or guarantee an ETF will meet its objective. SPDR S&P 500, MidCap SPDR, and Diamonds are issued by SPDR Trust, MidCap
SPDR Trust, and Diamonds Trust respectively.
The “SPDR®” trademark is used under license from The McGraw-Hill Companies, Inc. (“McGraw-Hill”). No financial product offered by State Street
Global Advisors, a division of State Street Bank and Trust Company, or its affiliates is sponsored, endorsed, sold or promoted by McGraw-Hill.
Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; and inflation risk.
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Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street
may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors,
Inc., a registered broker-dealer, is distributor for SPDR S&P 500, MidCap SPDR and Dow Diamonds, all unit investment trusts and Select Sector SPDRs.
IBG-0311
ETF Liquidity Explained
A framework for the ETF trader

By Paul Daley, Phil Dorencz and Dan Bargerstock

10 March/April 2010
E
xchange-traded funds have enjoyed tremendous growth really heat up. 1999 was the year that the Nasdaq-100 QQQs
over the past decade, whether you measure that by became known as the proxy for technology stocks. With the
daily trading volume, the number of annual new fund Internet stock bubble at full inflation, investors could not get
issuances or assets under management. enough of the QQQs. For ETF issuers, an entire new market
Assets under management have grown during the past was discovered: the day trader. Issuers responded to the new
decade from less than $100 billion to nearly $800 billion. demand with a then-record 57 new fund launches in 2000 (see
Trading volume has soared as well: In 2009, the value of ETFs Figure 1).
traded on U.S. exchanges surpassed $18 trillion, and ETFs The next wave of growth centered on expanding the asset
regularly accounted for 30 percent or more of all dollar volume types embedded in this unique structure. The first fixed-
traded on U.S. exchanges. Meanwhile, over the past four years, income funds were introduced in 2002, commodities followed
we have seen between 100 and 200 net new funds per year. in 2004 and currencies in 2006. By creating an entire invest-
Despite all this growth, flaws in the understanding of ment palette, once again an entire new market of ETF users
how these vehicles trade—and the best manner in which to was created: The registered investment adviser community
trade them—remain. A variety of heuristics exist for deter- soon recognized that with a full suite of products available,
mining which funds can be safely traded and which are too they could focus their pursuit of alpha at a more strategic
expensive for practical trading, but nearly all of these rules of level. Rather than picking individual securities, they could
thumb are flawed at best and dead wrong at worst. focus on sectors and asset types. The benefits of doing so
One of the most common assertions is that investors should were many, from greater tax efficiencies to less-specific risk
avoid any funds with fewer than $100 million in assets and and lower overall trading costs.
average daily trading volume of fewer than 100,000 shares. 2006 also saw the entrance of a new innovation that has
This paper will show that there is virtually no correlation driven significant increases in ETF trading volume: The first
between those two factors and the true liquidity of an ETF. leveraged and inverse ETFs opened the market to more
For purposes of this paper, Fox River Execution defines the aggressive risk takers. While not without some controversy,
true liquidity of the ETF to be the combination of the ETF’s day trading as well as medium- and long-term investment in
average daily trading volume and the average daily trading these instruments has driven big volume gains.
volume of the underlying securities. The combination of these Beyond issuance of new products, the second driver of
two factors explains the real-world experience of traders mov- growth has been volatility. Invariably in times of high uncer-
ing significant sums of money into and out of funds. tainty and stress in the market, investors seek out what they
Most of the detailed examples reviewed in this paper understand most, and risk managers gravitate toward simple
involve ETFs with U.S. equity underlying securities because ways to broadly manage risk. ETFs, with their full holdings
there are fewer variables to interfere with the precision of transparency and broad market coverage, fit the bill.
the calculations. However, as shown, this general framework As a result, it is not altogether surprising that trading vol-
can be used to both analyze and understand the trading ume in SPY is closely correlated with the CBOE Volatility Index,
patterns of ETFs based on currencies, commodities, fixed better known as the VIX. This was demonstrated most recently
income and international equities. in the credit-crisis-driven events of 2007 and 2008 (see Figure
2). Every spike in the VIX Index is almost immediately fol-
Brief History Of ETF Growth lowed by a spike in SPY trading volume. It is also interesting
The story of the growth of the ETF market has been one of that while overall market volume spikes, the spread between
innovation meeting opportunity repeatedly, but not neces- SPY volume growth and overall market growth continues to
sarily immediately. It often takes a high-stress period in the expand throughout the period. This suggests that those who
market for investors to realize that there are new ways to use find uses for ETFs in times of stress do not abandon them
the tools at hand. when the stress is relieved.
On Jan. 29, 1993, State Street Global Advisors brought to Another significant contributor to ETF volume growth that
market the first ETF—the SPDR S&P 500 (NYSE Arca: SPY)— Figure 1
to almost no fanfare. On its second anniversary, SPY was
trading 50 percent less volume than it did in its first month ETF Market Growth
of existence, and even that was not that impressive. It was
Net New ETFs
not until late 1995 that it began its uninterrupted march to 250
trading volume leadership.
200
One theory as to why volume was so light is that the
applications State Street envisioned for the product did not 150
resonate with investors or traders. Their sales pitch included
100
asking S&P 500 Index fund managers to replace their 500
stocks with a single security. That was not an appealing pros- 50
pect to managers, as it represented an effective outsourcing
0
of their fund management responsibilities (with a resulting ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09
second level of fees charged to the end investor).
It was not until 1999 that the market for ETFs began to Source: IndexUniverse.com

www.journalofindexes.com March/April 2010 11


is not often talked about is the options market. The CBOE lists value of a stock is its current market price.
options on 229 ETFs, which had a combined trading volume in ETFs derive their value from the value of the securities
2009 of over 1 billion contracts. For every option contract that that underlie them. While those underlying securities have
trades, some number of ETF shares need to trade for market values determined in an outright market, the ETF’s value can
makers to hedge their positions. While that volume is down only be expressed in relation to them. In this way there is
2 percent from 2008, it is a slightly deceptive statistic given an arbitrage that exists between the ETF and its underlying
that volatility in the fourth quarter of 2008 hit 80 percent and securities. Any deviation from the arbitrage-free price in the
drove option usage temporarily higher. Additionally, with the ETF represents an opportunity for guaranteed profit to those
recovery in the stock market in 2009, it is likely that the dollar nimble enough to take advantage of the opportunity.
value of options traded actually increased. Therefore ETFs do not trade like stocks. They trade like
the sum of the stocks that comprise them. For this reason,
ETFs Do Not Trade Like Stocks: The Difference the average daily volume of an ETF is often a meaningless
Between Outright And Arbitrage Markets statistic, as it is the average daily volume of the underlying
Q: What is your house worth? securities that determine the real trading characteristics of
A: What someone else will pay for it. the ETF. To truly understand the liquidity of the ETF, then, it
Q: What is a share of IBM worth? is critically important to understand that arbitrage process.
A: What someone else will pay for it.
Q: What is an ETF worth? Understanding The ETF Arbitrage Process
A: Where someone else can hedge it. The ETF arbitrage process is made possible by the cre-
A review of ETF sponsor Web sites yields the following ation/redemption process that is a basic property of the
quotes about the trading characteristics of ETFs: “ETFs … open-ended fund structure of an ETF.
combine the trading flexibility of individual stocks with the For all ETFs, certain market participants called autho-
diversification benefits of mutual funds;” “with the trading rized participants, or APs, are able to “create” or “redeem”
flexibility and continual pricing of individual stocks and (destroy) shares of the fund: literally swelling or shrinking the
bonds;” “ETFs employ all of the same trading flexibility as number of shares outstanding in the market to accommo-
stocks.” Web sites that purport (are designed?) to educate date rising or falling demand for the fund. This differs from
ETF traders follow a similar theme: “ETFs trade like individual individual stocks, where the number of shares is typically
securities on stock exchanges;” “traded on stock exchanges, fixed, and can only be increased or decreased through direct
much like stocks or bonds.” corporate actions such as secondary offerings.
These statements are correct as far as they go, but they APs can create new shares of an ETF by turning in a pre-
miss a critical nuance. There are important distinctions defined basket of securities to the ETF sponsor in exchange
between the way stocks trade and the way ETFs trade, derived for an equivalent value of newly created fund shares.
from the fact that additional shares of stock cannot be created Alternatively, the AP can turn in ETF shares and receive the
by market participants, while additional shares of ETFs can. same predefined basket of securities in exchange. This cre-
Stocks are said to trade in an outright market and ETFs ates the truest form of arbitrage because all of these transac-
are said to trade in an arbitrage or derivative market. The tions occur at the fund’s net asset value (NAV). If at any time
value of a stock is determined by the aggregate opinion of the fund shares are trading at a discount to the NAV, an AP
the outright value of the related company. That opinion gets need only buy the basket (at NAV) and short the fund shares
expressed by the price discovery process wherein supply and (above NAV) at the same time. The AP can then exchange the
demand are equated at a market-clearing price. The correct basket for fund shares at the end of the day to cover its short
Figure 2

A Brief History: SPY Growth

10 Lehman Bankruptcy, Bank Failures 90


Fed Creates Financials Short Sale Ban, Hit 16-Year High, AIG Debt
9 TAF, TSLF, PDCF; Supports AMLF, TARP, CPFF, TLGP, Restructured, TALF II 80
GSEs and AIG, JPM MMIFF, CPP, RMBSF, CDOF, TALF
8 MoneyMarkets 70
7 “Dislocate,” Quant
Meltdown I & II 60
Growth Rate

VIX Index

6
50
5 Bear Stearns
Suspends Credit HF 40
4
Redemption 30
3
2 20
1 10
0 0
April Oct April Oct April Oct April Oct
2006 2006 2007 2007 2008 2008 2009 2009
■ SPY Volume ■ US Equity Volume ■ VIX

Sources: Bloomberg data, Federal Reserve Bank of St. Louis

12 March/April 2010
position and lock in a guaranteed profit. The process works Figure 3
in reverse for redemptions.
Of course, there are costs to executing these trades iShares Russell 2000 (IWM) Mispricing: By Percent Of Day
(bid/ask spreads, commissions, taxes, clearing fees, market
35%
impact, etc.) that create a band around the NAV within which
30%
arbitrage is not profitable. But outside of these bands there
is free money to be made, and it is made all day, every day by 25%

market participants with the infrastructure to do so. 20%

Individual investors do not need to perform these arbi- 15%


trage trades themselves to secure good executions when 10%
trading ETFs. It is only necessary to know where the arbi- 5%
trage is at, how it functions and how to use this knowledge 0%
<$0.01 $0.01 - 0.03 $0.03 - 0.05 >$0.05
to effectively process trades in any particular ETF.
Source: Fox River Execution
Premium Or Discount: A Critical Factor Figure 4
When Trading ETFs
One of the most important factors in determining what is Asymmetry
a fair price at which to trade an ETF is the extent to which
the ETF deviates from its NAV. While the arbitrage described iShares Russell 2000 (IWM)
57.80
above suggests that this should theoretically never happen,
57.70
in the real world—and for a variety of reasons—it does.
57.60
During the month of December 2009, for instance, our
57.50
research identified 50 U.S. equity ETFs that averaged more
57.40 Asymmetry:
than 5 cents of mispricing; an additional 27 ETFs were mis- Closer to bid
than offer
priced between 3 and 5 cents per share, on average. While 57.30
some of these were lightly traded vehicles, there is often 57.20
no correlation between trading volume and mispricing. 57.10
8:41:04 AM 8:41:54 AM 8:42:44 AM 8:43:34 AM 8:44:29 AM 8:45:20 AM
A regression of AUM to premium/discount yields an R2 of
only 0.00095. For example, the iShares Russell 2000 Index ■ NAV Ask ■ IWM Ask ■ IWM Bid ■ NAV Bid

Fund (NYSE Arca: IWM) is the third-most-actively traded ETF Source: Fox River Execution
in the U.S. based on dollar volume, behind only SPY and
QQQQ. Due in part to the difficulty of trading some of the dition exists, the ETF often fluctuates between prices that
small-cap stocks within it, however, it can be a problematic are bound by the arbitrage bands: APs are unable to directly
fund for APs to hedge. As a result, in spite of its enormous arbitrage the ETF within this band, since the cost of assem-
trading volume in December 2009, IWM was mispriced by bling the underlying basket of securities is higher than the
at least 5 cents per share for an average of 22.6 percent of bid/ask spread of the ETF itself. Understanding when and
each trading day—or almost one and a half hours of each where this can happen is important for those trading ETFs,
six-and-a-half-hour trading session (see Figure 3). because when there is asymmetry in the arbitrage market
Investors can gain a first-level approximation of whether an for a given ETF, large buy orders will have a different level
ETF is trading at a premium or discount to NAV by comparing of impact on the ETF market than large sell orders.
the ETF’s share price with the indicative NAV (iNAV) as published For example, in December 2009, IWM had an average
by a number of data providers. There are some weaknesses to bid/ask spread of $0.010 per share. During the same period,
this approach though. For one, iNAVs are only updated every 15 the underlying basket of securities in IWM had a combined
seconds and are based on last price rather than bids and offers average bid/ask spread of $0.122 per share. This twelvefold
in the underlying securities. As bid/ask spreads on the underly- difference creates a vast amount of space for IWM to trade
ing securities become wider, and critically—if those underlying within before arbitrage becomes profitable.
securities are not trading on a regular basis —iNAV values can Figure 4 is a 10-minute snapshot of the IWM bid/ask spread
move away from a more real-time view of the fair value of an and the bid/ask spread of its NAV on December 2009.
ETF. This is particularly a problem as one moves down the Investors should be able to drive most trades in ETFs
market-cap spectrum. Specialists, APs and dedicated ETF liquid- within the channel suggested by the NAV bid/ask spread.
ity providers will perform calculations based on the real-time But within that channel, large buy and sell orders can
bid/ask spreads of the underlying components, to create a more and will drive the price of the ETF toward the top or the
real-time approximation of the true value of the ETF. bottom of the channel.

Asymmetry And Arbitrage Channels In ETF Trading Impact In The Underlying Vs. Impact In The ETF
Asymmetry in the arbitrage process typically occurs when Pre-Trade Model Examples
the bid-offer spread for the underlying constituents is wider When determining how difficult a stock is to trade, most
than the bid offer spread for the ETF itself. When this con- traders rely on pre-trade impact cost estimate models pro-

www.journalofindexes.com March/April 2010 13


vided by their brokers. Upon examination, these models are pants). This yields a more realistic 0.016 percent.
typically built on three factors: trade size as a percentage of Two conclusions can be drawn. First, mathematical mod-
average daily volume (ADV), stock intraday volatility and bid/ els are tuned to handle “normal” settings for their inputs.
offer spread. On deeper examination, it is really ADV that They tend to break down when extreme values are used.
drives the calculation. That explains both the magnitude and the spread in the JKD
This point was driven home at the end of 2007. With the impact numbers in Figure 5. When looking at a trade rep-
credit crisis in full bloom and restrictions in place on shorting resenting more than 2x ADV, the models move into an area
financial shares, bid/offer spreads on stocks rose significantly which they were not built to explain.
while intraday volatility was at near-term highs. At the same Second, empirical results are more valuable to under-
time, volume spiked as investors fled the stock market for standing how ETFs trade when true liquidity is factored into
more certain investments. Trading stocks was clearly more the analysis. Using true liquidity, Fox River Execution calcu-
difficult and more expensive than prior to the crisis. lates the impact to be 0.0077 percent, less than half of what
Wider bid/ask spreads and higher volatility make securi- even the basket model predicts.
ties more difficult and more costly to trade, while higher
volume typically makes it easier and cheaper. With two of IVV vs. SPY
the three factors that pre-trade models rely on suggesting Another interesting illustration is to examine the results
trades should cost more to execute, it came as a surprise that for IVV and SPY. IVV is the iShares S&P 500 Index Fund. SPY
pre-trade cost models suggested trade costs would be lower. is the SPDR Trust Series 1. Both ETFs track the performance
Clearly the models are highly dependent on ADV. of the S&P 500 Index.
Using pre-trade cost models to either predict the expect- It comes as no surprise then that their underlying bas-
ed outcome of an ETF trade or to determine which ETFs are kets are virtually identical, with all of the same holdings
safer to trade than others can be problematic, because the and weightings differences that are only discernible at the
ADV of the ETF is only one part of the “true liquidity” of the hundredth of a percent level (and often at the thousandth of
ETF. Most popular trade impact models today do not take a percent level). The only obvious difference between these
into consideration the liquidity of the underlying securities two is their trading volume: IVV traded an average of 3.4
in an ETF, and therefore miss the fund’s true liquidity. million shares per day in December 2009, while SPY traded a
whopping 131 million per day over the same period.
Case Study: JKD A simple comparison of their respective volumes would
JKD is the iShares Morningstar Large Core Index ETF. The suggest that one should be cheaper to trade than the other,
underlying stocks are 78 of the largest, most liquid in the but given that they hold the same underlying securities, why
U.S. market, including names like Johnson & Johnson, Procter should this necessarily be? Whether one is trading a basket
& Gamble and IBM. By any objective measure, JKD’s underly- of 500 stocks or a certificate representing the 500 stocks,
ing stocks have a high degree of liquidity with a low degree the costs should be nearly identical. Therefore, from a cost
of trading costs. perspective, it should not matter whether a trader is trading
In December 2009, its ADV was 21,826 shares, or approxi- one certificate or another. Predictably, however, pre-trade
mately $1.4 million. Using four different pre-trade impact models continued to be fooled by the volume disparity. Using
models, we are led to believe that the cost of quickly trading the most conservative model, we get an estimated impact for
50,000 shares (the minimum creation size) will be between 1 million shares of SPY traded with high urgency of 0.057 per-
1.47 and 16.1 percent. The absurdity of these numbers cent. The same size and urgency in IVV results in an estimated
illustrates the point nicely. It is ridiculous to think that the impact of 2.32 percent. Of course, they both taste like chicken
cost of trading approximately $3 million of the world’s most to the arbitrage community, so the real impact of trading IVV
liquid stocks should be as high as 16 percent. will be identical to the impact of trading SPY. There were, in
To further illustrate the point, one can feed in the basket fact, three trades in IVV of greater than 1 million shares in
of stocks that comprise the 50,000 shares of JKD to one of December 2009. The average size was 2,953,000 shares and
the models and find out what the true cost to the arbitrageur the average impact (defined as distance from the midpoint of
would be (and therefore, the true cost to all market partici- the bid/offer spread) was 0.032 percent.

Figure 5 More Complex ETFs: Imperfect Hedges


So far we have only dealt with ETFs that had relatively
JKD Pre-Trade Impact Models
simple-to-calculate underlying baskets. There are a multitude
of ETFs that do not fall into this category. Some U.S. equity
JKD Impact Underlying Impact
ETFs with less liquid underlyings—including virtually all
Broker A 4.57 % fixed-income, commodity, currency and international ETFs—
Broker B 5.86 % 0.016 % are more problematic to hedge and also more problematic to
price. Arbitrageurs use a variety of techniques when deter-
Broker C 16.10 %
mining how to hedge their trades. These imperfect hedges
Non-Broker 1.47 %
lead to wider arbitrage bands, but they do not make the ETF
Source: Bloomberg impossible to trade. With a greater understanding of the

14 March/April 2010
techniques and some robust tools for analysis, our research hedge for the least liquid instruments.
and market experience suggests that solid price and size dis- In all of the cases listed above, there is a basis risk
covery in less-trafficked-in ETFs is very achievable. involved in the hedge. Basis risk is when the hedge does
not perform exactly the way the instrument being hedged
Optimized Baskets performs. This leads to wider bid/offer spreads, but does not
Managers of small-capitalization index funds learned necessarily decrease the depth of the market or mean that
long ago that it is not always necessary to own every stock large trades cannot be moved through. Often the correlated
in the index to produce performance with little tracking instruments are more liquid than the underlying of the ETF
error to the index. A variety of optimization techniques are they are hedging, which can lead to situations where arbitra-
employed. While the objective function has factors designed geurs are willing to make bigger (albeit wider) markets in the
to replicate the characteristics of the broad universe, it ETF than in the instrument the ETF tracks.
almost always also contains a trade-cost-minimizing objec-
tive that is designed to create a replicating basket with the Event Risk Hedges
lowest cost of implementation and maintenance. Many of the correlated hedges described above can
Arbitrageurs employ the exact same techniques when also be put in the category of event risk hedges. This is
operating in the ETF market, which creates an interesting particularly the case with using ADRs or domestic equi-
opportunity for traders. These optimized baskets are always ties to hedge international equity ETFs. As investors have
subsets of the entire index. Because one of the optimization expanded their investment horizons to include internation-
factors is trade cost (often represented by the width of the al investing (whether that is non-U.S. investors investing in
bid/offer spread), it is likely that the bid/offer spread of the the U.S. or vice versa), correlations among markets around
optimized basket is narrower than the bid/offer spread of the the world have grown. Most large-cap companies already
entire universe. It is also likely that there will be some asym- have significant businesses overseas, further boosting cor-
metry in the spreads of the respective basket. The more opti- relations. For these reasons, domestic events and news
mized baskets there are and the more asymmetry there is in have an impact on foreign markets just as news abroad has
the baskets, the better it is for the market as a whole. This is an impact here. In the absence of pre-market news that will
because the best bid and the best offer are unlikely to come affect the open of trading in the U.S., we often take our lead
from the same optimized basket, making the overall market from the markets in Asia and Europe. If they trade higher,
tighter than if all participants were using the same basket to we tend to do likewise. When news in the U.S. creates a
hedge. This is at least part of the reason (though not all) that big impact on our markets, trading in Asia and Europe is
IWM trades with a 1 cent bid/offer spread, while the underly- similarly affected the next day.
ing basket trades with a 12 cent bid/offer spread. Because of higher correlations across markets, the big risk
when trading after markets close is news risk or event risk,
Correlated Instruments since it can affect all markets. This actually makes it easier
One special challenge for arbitrageurs is how to hedge to make markets in ETFs with foreign underlying long after
ETF positions when the underlying securities held by the their markets are closed. Arbitrageurs may not be able to lay
fund are not trading. This is not an issue for most domestic off their specific risk until some time the next day, but they
equity or fixed-income funds, but for international equity can lay off their event risk immediately by using an ETF or
or fixed-income securities, and certain commodity markets, related security that is already trading in the U.S. market.
the underlying securities may not trade during the U.S. That way, if there is a significant event related to geopolitics,
market day. For instance, the Asian equity and debt markets
are closed during all of the U.S. trading day, and European Figure 6
markets only overlap U.S. market hours in the morning.
In these situations, arbitrageurs use correlated instru- ETF Trading: The Value Of Knowledge
How do you know where to set the limit? Different techniques. Different results.
ments to hedge their ETF trades. Correlated instruments
can include futures, options, physical commodities, curren- iShares Russell 2000 (Growth)
cies and a vast array of fixed-income securities. [Correlated
instruments can and are used to hedge domestic ETFs as Begin Sweep
56.92
well, in situations where the correlated instruments are more Begin Sweep
liquid or efficient than the underlying in the ETF itself.] 56.87 Post
Filled 72,600
For international markets, for instance, American deposi-
tary receipts (ADRs) or even domestic instruments may be 56.82
used to hedge. For commodities, futures or physical assets
can be used as a hedge. It is more likely that futures will 56.77
Filled 43,800
be used because of their easy access, exchange listing and
56.72 
favorable margin requirements. Physical commodities pres- 12:35:00 PM 12:37:09 PM 12:39:05 PM 12:41:04 PM 12:42:50 PM 12:44:30 PM
ent problems with financing, transportation and storage that NAV Ask ■ IWO Ask ■ IWO Bid NAV Bid
are typically, but not always, avoided. For fixed-income ETFs,
sometimes the most liquid ETFs are used as a correlated Sources: Fox River Execution, Bloomberg

www.journalofindexes.com March/April 2010 15


earnings at multinational companies, exchange rates, credit growth stocks. It has very similar trading characteristics to
markets or any of dozens of other potential risks, the arbitra- the broader IWM. The graph covers one 10-minute period
geur has at least a broad level of protection. that contained two significant trades in IWO: one for 72,600
A secondary effect of this type of hedging activity is that shares and one for 43,800 shares. The two trades were
seemingly unrelated ETFs can begin to exhibit correlation executed differently, and as a result, experienced different
at the intraday level while not being highly correlated at the levels of impact on the market. But before getting into the
interday level. The MSCI EAFE Index is an index of developed costs, let’s review some features of the graph.
markets in Europe, Australia and the Far East. In December The dotted lines are the arbitrage bands as represented
2009, the daily returns of this index had a correlation to the by the bid and offer of the NAV. At the time of this snapshot,
daily returns of the S&P 500 of 0.4267. Those correlations they were approximately 10 cents apart, while the ETF itself
are measured based on closing prices for the indexes. The traded between 1 and 2 cents wide.
iShares MSCI EAFE Index Fund (NYSE Arca: EFA) tracks the Figure 6 shows many of the features discussed earlier.
MSCI EAFE Index. Yet its intraday correlation (as measured There is asymmetry in the pricing, in that more often
by one-minute returns) to the SPY was 0.8434. One possible than not, the IWO bid is closer to the NAV bid than the
reason for this extraordinarily high intraday correlation is IWO offer is to the NAV offer. For that reason, a large
when APs are hedging trades they do in EFA, they might use sell should have less impact than a large buy: IWO does
the SPY. This is more likely to occur when the local markets not have to travel as far to make the arbitrage profitable.
the EAFE index covers are closed. The Australia and Far East Another way to express this asymmetry is to measure from
components are never open during U.S. trading hours, and the midpoint of each respective spread. Based on that
Europe is only open for a small portion of the U.S. market measurement, IWO can actually be said to be trading at
hours (typically 15-30 percent). a discount to NAV during this time period, with the same
logical implication that a large sell should have less impact
The Cost Of Failing To Understand ETF Trading than a large buy. Because small trades can be done at the
The cost of failing to understand ETF trading can be large, IWO bid and offer, they will have similar impact of one-
both in terms of real and opportunity costs. half the bid offer spread.
As demonstrated, pre-trade price models dramatically The first trade is for 72,600 shares and is executed over
overestimate the impact of pushing large trades through a one-minute span beginning just after 12:35:00 p.m. The
funds like JKD or IVV. This may dissuade some investors from trade begins with a sweep of the market, which sold all the
considering these and other small-volume ETFs, limiting shares on the national best bid and offer from a price of
their opportunity set without reason. $56.89 down to $56.84. The remaining shares that needed
And for those investors who do trade ETFs, the real-life to be sold were posted with a limit order of $56.84. The
costs of failing to understand the ETF arbitrage mechanism price where the trade would stop sweeping the book and
can be large. post the remaining shares as a limit order was chosen
Figure 6 illustrates a real-life example using the iShares based on knowledge of two things: where the arbitrage
Russell 2000 Growth Index Fund (NYSE Arca: IWO). Fund was given the bid of the NAV and the likelihood that there
holds the subset of the Russell 2000 Index that contains was an optimized basket with a better bid than the NAV.

Figure 7

Trading: How Do I Trade Size At The Close?  

(Spread cost 0.005, Impact cost 0.0218)


iShares Russell 3000 (IWV)
53.50 350,000

290,000 300,000
53.45
250,000
53.40
Volume

200,000
Price

53.35
150,000
53.30
100,000
53.25 50,000

53.20 0
2:45:03 PM

2:46:03 PM

2:47:03 PM

2:48:03 PM

2:49:03 PM

2:50:03 PM

2:51:03 PM

2:52:03 PM

2:53:03 PM

2:54:03 PM

2:55:03 PM

2:56:03 PM

2:57:03 PM

2:58:03 PM
2:58:18 PM

2:59:03 PM

■ Volume ■ IWV Bid ■ IWV Ask NAV Bid NAV Ask

Sources: Fox River Execution, Bloomberg

16 March/April 2010
The total impact on the market for this trade was 5 cents of information any trader or investor should have before
(average impact being less), with only a penny or two of attempting to use ETFs in appreciable size. It has been the
reversion after the trade. goal of this article to supply that level of understanding.
The second trade is for 43,800 and is executed over a Beyond an understanding of the structure and market
span of seconds less than 10 minutes after the first trade. structure of ETFs, it can be very handy to have a quantita-
The trade began with a sweep at $56.87 and that sweep tive, real-time assessment of the factors impacting pricing
continued until 43,800 shares were sold; the trade is com- while trading. It is this piece that can be harder to come by.
pleted at $56.75. A post was never attempted for this trade. Most APs are happy to tell you where they would trade an
While Fox River Execution was not party to the specifics ETF, but it is only a few brokers who can first tell you where
of this trade, one can imagine that the trader or algorithm they should trade an ETF. Knowing the “should” before find-
executing it did not take into account the arbitrage value ing out the “would” can lead to much more pleasant out-
of the NAV when deciding fair pricing for the ETF. The total comes as well as minimizing instances of buyer’s remorse.
impact on the market for this trade was 12 cents, with an A final real-world example can drive this home. Figure 7
almost immediate reversion of 7 cents, suggesting 5 cents shows how an enormous trade can be pushed through an
would have been a fair price impact. ETF with minimal price impact.
The difference in impact between these trades of approx- The chart shows the minute-by-minute trading volume in
imately 7 cents is the real cost of failing to understand how the iShares Russell 3000 Index Fund (NYSE Arca: IWV). The
ETFs trade based on the arbitrage relationship between the fund trades throughout the day, but the size of the trades
ETF and its NAV. That does not adjust for the fact that it was are small. Then, a trade for 290,000 shares was executed 90
the larger trade that experienced the smaller impact. seconds before the market close. This volume was equal to
48 percent of all the shares that had traded in the first 6.5
How To Use Information hours of the day. Yet the impact of the trade was only 2.18
For More Effective Trading cents from the midpoint of the bid/offer spread at the time
Since the first markets were formed, it has always been the market was entered.
the more informed trader that has an advantage over the IWV is a relatively liquid ETF to begin with, but the same
trader with less information. So it is with ETFs. rules apply to less liquid products as well. If you know
An understanding of the structure of ETF arbitrage and how where to trade, and why, enormous positions can be moved
it translates into prices in the market is the minimum amount through the market with relatively little impact.

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www.journalofindexes.com March/April 2010 17


The Impact Of Market
Models On Liquidity
The case for lead market makers in ETF markets

By Lisa Dallmer

18 March/April 2010
E
xchange-traded funds have revolutionized investing and “Paying for Market Quality,” by Anand, Tanggaard and
markets in ways we never could have imagined. ETFs Weaver published in the Journal of Financial and Quantitative
fill the investing pages of the Wall Street Journal and Analysis (JFQA) in April 2008 reports on the benefits of liquid-
stream across the ticker line on CNBC all day long. With all of ity providers (referred to as “LPs” in our European markets,
the attention ETFs have received, however, few investors truly which are akin to our U.S. LMMs): “… price discovery during
understand the complexity of what goes on behind the scenes the continuous trading period of the trading day increases
with ETF trading and market making. There is a diverse array significantly following the start of LP services.” Another white
of players in the market that is truly the key for making ETFs paper, titled “The Value of the Designated Market Makers,”
the efficient windows into market liquidity that they are. by Venkataraman and Waisburd published in the JFQA in
To understand how the market for ETFs works, let’s take September 2007, indicates that: “A dealer enhances market
a step back and talk about how an ETF works. ETFs are effec- quality by simply maintaining a regular market presence.”
tively mutual funds that trade like stocks. But unlike stocks, The research goes on to say that a market maker “reduces
where price discovery is a function of supply and demand price risk that equilibrium values may shift between order
throughout the day (i.e., scarcity of shares and opinions), an submission and execution.”
ETF is a collection of securities whose underlying valuation
can be calculated as a result of the portfolio’s transparency. The Lead Market Maker’s Role
This transparency, coupled with the ETF’s creation redemp- Overall, the LMM’s core function is to provide publicly
tion process, creates a constant loop of pricing information displayed limit orders, resulting in the formation of price
that is used to create an arbitrage opportunity should the discovery. LMMs trade using their own proprietary software
fund’s price get out of line with its expected underlying to connect to the exchange and establish two-sided markets
net asset value (NAV). As the supply and demand for an ETF for the products they’ve been allocated. To establish competi-
goes up and down, authorized participants exchange the tive quotes, LMMs use real-time data, firm capital and their
basket of underlying securities for the shares of the ETF to knowledge of ETF markets as well as the transparent-known
increase or decrease the ETF shares available in the market- basket of securities underlying each ETF. These quotes result
place. Thus, generally the price discovery of the ETF is not in trades that are consistent with arbitrage principles and
affected by long-term supply and demand, because the size in line with the underlying value of the ETF’s portfolio. For
of a fund’s assets under management can grow and shrink example, the offer on a particular ETF is largely defined as the
according to demand. collective price at which the LMM could assemble the basket
and access a creation unit in order to sell the ETF into the sec-
Sources Of Liquidity ondary marketplace. If trading international products, LMMs
There are a variety of exchanges and trading venues that also must have access to non-U.S. markets to get international
can be generally characterized as 1) the listed exchange uti- data feeds, foreign stock holdings and foreign clearing costs,
lizing either the lead market maker (LMM) arranged by the and need to develop relationships with brokers who can man-
exchange (U.S. approach) or arranged by the issuer (common age off-hours market risk. LMMs have an obligation to make
European approach); 2) multilateral trading facilities (MTFs) the bid and ask as relevant as possible to a fund’s underlying
with unlisted trading activity; and 3) alternative liquidity value, net of the cost of assembling the basket to quote, ulti-
aggregation venues, often called “dark pools,” that do not mately reducing costs for individual investors who would find
expose an order to a public quote. Liquidity providers and it expensive to assemble such baskets. To do so, they need
liquidity takers meet on these trading venues in a process technology, knowledge of the underlying markets and access
known as price discovery. The basic idea is that through to those underlying markets.
price discovery, liquidity providers are fundamental to ensur- In addition to maintaining continuous two-sided quotes,
ing that ETFs trade at values close to their expected NAVs, LMMs must meet minimum performance requirements that
throughout the trading day. But regardless of who is provid- include, for each ETF, a percentage of the time that the LMM
ing the liquidity, understanding the finer points of exactly quotes are at the national best bid and offer (NBBO), an aver-
how that liquidity provision is introduced to the exchange is age displayed size and an average quoted spread. An exchange
key to understanding how this market functions. should set the appropriate performance requirements for
At the heart of the exchange model, these players are known each individual security (based on its price and other trading
as lead market makers. LMMs are akin to designated market characteristics). LMMs fulfill these quote and execution obliga-
markers (formerly known as specialists) in the floor-based tions by electronically interacting with the market in displayed
trading system. Operating in a fully electronic market model, order types and through their willingness to algorithmically
LMMs support displayed limit order trading because they are provide price improvement to incoming orders without seeing
obligated to quote narrow, two-sided markets throughout the the actual orders in advance. The incentive to act as an LMM is
trading day. LMMs are responsible for maintaining share depth, driven by the scalability of trading systems to ETFs and lower
tight quoted spreads, and using publicly displayed limit orders transaction pricing that is reserved for the LMM.
to generate the opportunity for price improvement. The LMMs
enhance market quality and supplement natural liquidity from Opening And Closing Auctions
the collective broker-dealer community. The LMM is also involved in two of the most critical
Academic research supports this point. An article titled single moments of the trading day: the open and the close.

www.journalofindexes.com March/April 2010 19


Figure 1

Quoting Quality For NYSE Arca Listed Domestic ETFs: First Half 2009

Spread Depth % NBBO Market Share

CADV NYSE NYSE NYSE NYSE


Quintile Nasdaq Nasdaq Nasdaq Nasdaq
Range Arca Arca Arca Arca

1st 641,625-
208,989,995 0.05% 0.05% 21,252 20,543 87.80% 89.18% 26.60% 33.40%
2nd 110,208-
625,584 0.13% 0.18% 1,891 1,984 80.97% 68.41% 28.60% 21.60%
3rd 28,624-
109,562 0.25% 0.50% 2,428 2,101 74.80% 50.92% 35.00% 16.30%
4th 9,671-
27,572 0.58% 0.90% 1,889 1,455 74.54% 49.80% 37.60% 13.30%
5th 400-9,602
ADV 0.42% 1.06% 1,989 1,438 79.11% 51.23% 45.30% 12.80%

Source: Arcavision.com

Figure 2

Quoting Quality Statistics For NYSE Arca-Listed International And Non-U.S. Treasury/Agency Fixed-Income ETFs: First Half 2009

Spread Depth % NBBO Market Share

CADV NYSE NYSE NYSE NYSE


Quintile Nasdaq Nasdaq Nasdaq Nasdaq
Range Arca Arca Arca Arca

1st 211,350-
75,975,042 0.06% 0.08% 12,087 10,781 91.34% 88.44% 34.60% 22.40%
2nd 72,122-
209,190 0.38% 2.16% 2,256 1,519 78.48% 38.22% 44.00% 6.90%
3rd 18,697-
72,050 0.62% 3.77% 2,164 972 81.50% 21.29% 47.50% 4.80%
4th 5,982-
18,423 0.76% 4.95% 2,215 694 86.56% 19.93% 54.40% 5.30%
5th 2-5,825 1.13% 7.05% 1,999 655 89.52% 16.51% 65.70% 4.90%

Source: Arcavision.com

To open and close the trading day as a means of creating Any participating trading firm can offset the imbalance, but
the primary market print, exchanges use an auction. In the the LMM must be there to partially offset the indicative imbal-
U.S. and Europe, a commonly used method is a single-price ance. All trading firms, including LMMs, have access to the
Dutch auction, which matches buy and sell orders at a price indicative match price and are able to analyze the valuation of
to maximize the amount of tradable stock. Using the NYSE that underlying portfolio to assess any arbitrage opportunities.
Arca exchange as an example, a requirement of the LMM is The LMM will use the same arbitrage pricing mechanics during
to support these market opening and closing auctions. So at the core trading session and at the auctions to effectively set
these 9:30 a.m. and 4 p.m. single-price auctions, the LMM displayed prices. Both the opening and closing auction are the
must be present in the formation of the price discovery, and official opening and closing prices of the primary market.
to help offset any buy or sell imbalances. These types of transparent auctions have been successful
As a part of the auction process, the indicative match price, at focusing liquidity for a given point in time. Most exchanges
indicative match volume and the auction imbalance are con- retain a high percentage of market share during their open
tinually calculated and disseminated. This facilitates real-time and closing auctions in part because institutional and retail
price discovery and supports market transparency. Indications traders often want the primary listed exchange print for the
are calculated and broadcast through the Internet and via first and last trade of the day. Slippage—the percentage
market-data feeds to subscribers leading up to the auction. difference of that closing auction price against the volume-
This process allows any market participant—institutional, weighted average price (VWAP) of the last two minutes of
sell-side or retail, as well as the LMMs—to not only gauge the the core trading session—with such auctions is minimal, at
price, and the size at which to place orders so that they will approximately 20 basis points; illustrating that the market
get executed, but how to help offset any imbalances. prices as the day draws to a close are well represented by the

20 March/April 2010
Figure 3

Lyxor ETF Cac40

Spread (bps) Depth (euro per side) Volume (€)

NYSE NYSE NYSE


BATS Chi-X BATS Chi-X BATS Chi-X
Euronext Euronext Euronext

Jun-09 8.69 5.22 4.18 356,153 412,818 599,313 4,930,739 35,681,134 972,285,808
Jul-09 10.02 5.62 4.46 170,342 207,000 613,889 1,905,503 13,101,820 937,853,935
Aug-09 9.17 5.02 3.53 110,389 155,633 372,015 3,030,697 32,192,172 662,337,670

Source: Bloomberg

Figure 4

Lyxor ETF Euro Stoxx 50

Spread (bps) Depth (euro per side) Volume (€)

NYSE NYSE NYSE


BATS Chi-X BATS Chi-X BATS Chi-X
Euronext Euronext Euronext

Jun-09 10.79 5.64 5.38 345,147 423,234 506,534 10,568,733 67,609,939 726,355,233
Jul-09 13.92 6.22 5.69 201,812 217,028 315,127 11,863,689 29,844,952 727,930,507
Aug-09 12.58 5.15 5.13 225,206 225,860 402,887 21,045,685 48,840,082 543,124,322

Source: Bloomberg

auction price and the LMM’s participation.1 on indexes holding only listed U.S. equities securities and
In return for fulfilling such obligations, for each order places them into quintiles that are sorted by first-half 2009
that adds liquidity to the book, the LMM is paid a “liquid- consolidated average daily volume (CADV). The top quintiles
ity execution” rebate that is an incremental rebate to what have tighter median spreads across the board, and although
basic broker-dealer order firms could obtain. Only when a the spreads for the bottom quintiles widen, they are much
firm removes liquidity from the book is it charged a transac- tighter at the LMM-driven NYSE Arca than observed for the
tion fee, and for the LMMs, this transaction fee is lower as same symbols traded on Nasdaq, where an LMM is not pres-
a result of the quoting obligations and price discovery they ent. Even if the product has little secondary trading volume,
perform in the marketplace. For the LMMs on NYSE Arca, the NYSE Arca LMM is required to make a continuous two-
there is no advance knowledge of incoming orders to the sided quote and maintain a specified spread requirement.
central limit order book. Secondary trading volume is an indicator of the traction and
general demand for trading the ETF, which is in part influ-
What Liquidity Really Means In ETFs enced by the issuer’s brand and overall appeal for the invest-
The popular press has often misstated the relationship ment theory set out in the ETF. As products grow in second-
between ETFs with low trading volumes (volume being an ary trading volume, the pool of general liquidity providers
indicator of activity), and those ETFs with wide quoted expands, and the quoted spreads may tighten to levels that
spreads (where spread is an indicator of ease of pricing and are narrower than the cost of assembling the basket of the
desire to trade). The key driver of an ETF’s spread is both underlying securities. This observation regarding the knock-
the liquidity of the ETF at the NBBO at the time of trading, on effects of higher trading volume is also consistent with
and the liquidity and volatility of the underlying portfolio, the depth statistics displayed in Figure 1. Figure 2 groups
since the ETF shares themselves can be created and offered all international equity ETFs and non-U.S. Treasury/agency
for sale in the secondary market. For example, an ETF may fixed-income ETFs in quintiles by volume.
have a low level of secondary volume (an activity indicator) Overall, liquidity begets liquidity in the interconnected sys-
but reasonably tight quoted spreads as a result of the ease tems of trading, but it’s useful to observe the tangible results of
of pricing the basket. On the contrary, the LMM’s cost of obligated LMM participation, particularly in thinly traded ETFs.
quoting is higher for ETFs that hold international equities as
compared with domestic equities. An ETF with a higher cost ETFs In Europe
of quoting results in a wider quoted spread. The major European exchanges also trade on fully elec-
To highlight this example, Figure 1 looks at ETFs based continued on page 53

www.journalofindexes.com March/April 2010 21


ing an ETF, and in some case, are cheaper than borrowing. If the tively higher cost should diminish if more institutions make
memory of Lehman Brothers fades over the course of the year, the their ETFs available to borrow. The increase in supply could
demand that European ETFs saw in 2009 may begin to fade. come about as more ETF owners realize that they can offset
An increase in the supply of European ETFs could, in turn, the ETF management fee by putting them into a securities
lead to an increase in demand. As additional supply comes lending program. This lending activity can help offset the
into the market, the advantages that swaps have over short- inherent tracking risk, which may make owning European
ing ETFs will continue to diminish. The risk of recall and rela- ETFs more attractive.

Endnotes
1 ETF Landscape Industry Preview Year End 2009, BlackRock Global ETF Research & Implementation Strategy Team
2 Source: Data Explorers
3 Ibid.

Dallmer continued from page 21


quality advantages the exchange-appointed LP model pro-
tronic order-driven market models with opening and closing vides in terms of tighter spreads and deeper markets.
auctions, central limit order books and valuation price feeds.
Similar to the U.S. LMM model, the European ETFs Conclusion
benefit from a multiliquidity provider model that results Overall, one can easily understand how liquidity provision,
in remarkable market depth and competitive spreads. encouraged on a level playing field of fair access, can result
For each ETF, there is at least one liquidity provider (LP), in better expected market quality for a given symbol. In the
generally appointed by the issuer, that agrees to provide popular press, there is a large belief that all ETFs are created
continuous quotes, minimum market depth and maximum equal—meaning that due to their transparency, the pricing
spreads through the exchange’s trading session. Monitored of any ETF is without costs and will be priced efficiently.
by the exchange, so long as they are meeting their pres- In principle this might be true; however, in practice, just
ence, size and spread requirements, LPs may receive incen- because an ETF can be efficiently priced doesn’t mean some-
tives from the exchange for providing liquidity in the form one actually wants to do it at all times. An exchange model
of discounted transaction fees. Auctions are supported by that supports the role of a lead market maker or liquidity
the LPs through their obligation to provide consistently dis- provider with performance obligations is well-positioned in
played liquidity during the opening to the closing auction. principle to meet this ideal more often than not.
The number of LPs in Europe has increased significantly in
recent months following the implementation of a new trad- DISCLAIMER:
ing technology and faster data feeds, improving the overall This article is intended for investment professionals only and
tool kit for all traders. The increasing diversity of partici- solely for informational and educational purposes. It should not
pants trading ETFs (buy-side, sell-side, retail, etc.) ultimately be relied upon for any investment decisions. The article is based
leads to more efficient markets, and with the LP activity, we on data obtained as of Aug. 30, 2009 (unless otherwise noted
observe the quoted spreads of several ETFs are now tighter herein), which, although believed reliable, may not be accurate
than those of the underlying indexes, and others reached or complete and should not be relied on as such. The author
their lowest ever. does not recommend or make any representation as to possible
Although this is a deep dive into only two ETFs (see Figures benefits from any securities, investments, products or services.
3 and 4), a comparison to BATS and Chi-X—nonexchange Investors should undertake their own due diligence regarding
multilateral trading facilities (MTFs)—illustrates the market- securities and investment practices.

Endnote
1. Source: NYSE Euronext research databases

Shastry continued from page 27


Endnotes
1Amery, P., Inside ETFs Conference 2010: A Focus on Trading, www.indexuniverse.eu/blog/7127.
2Fuhr, D. op. cit.
3ibid.
4ibid.
5London Stock Exchange and SIX Swiss Exchange require their members to trade-report their OTC activity in funds that are listed on those venues.
6Source: Euronext, LSE, BlackRock.
7Amery, P., op. cit.

www.journalofindexes.com March/April 2010 53


The Fragmentation Of
The European ETF Market
How does it impact liquidity?

By Bart Lijnse and Christiaan Scholtes

22 March/April 2010
T
he worldwide exchange-traded fund market has Examples Of Fragmentation
gained significant momentum since the launch of The fragmentation in Europe is caused by two factors:
the first ETF in the United States, in 1993. The first 1) Competition between issuers; and 2) inefficiencies in the
ETF in Europe, the iShares DJ Euro Stoxx 50 (EUN2), was structure of the European financial markets. Combined,
launched only seven years later, in April 2000. Since then, these have fractured the ETF market with significant
the European exchange-traded product market has grown impacts on end investors.
rapidly to include 1,1031 ETFs and exchange-traded com- For example, consider the Dow Jones Euro Stoxx 50
modities, with over 3,000 separate listings, at the end of Index (“SX5E”). Widely popular, SX5E is tracked by the
2009. European ETP assets under management rose to most liquid European index futures contract (listed on
$223 billion2 by the same date (see Figure 1). Eurex), as well as some of the largest and most liquid ETFs
In terms of average daily trading volume, Europe lags in Europe.
behind the U.S. considerably. European average daily But as of December 2009, there were 78 different
turnover was $2.3 billion in 2009, compared with $45.8 listings for ETFs tracking the SX5E (see Figure 3). This
billion in the U.S. (see Figure 2). excludes numerous structured delta-1 notes listed on plat-
forms like Scoach.
Figure 1
Fragmentation Caused By
European ETF And ETC AUM Growth Competition Between Issuers
250 1,000 Unlike the U.S., the European market is not one single
Number of Listed ETFs market (although some politicians are working very hard
200 800
to make it that way). Banks still have some weak form of
AUM (U.S. $Billions)

150 600 monopoly in their home markets and are used to charging
high fees to their clients. Given this background, the key
100 400 issue for ETF asset growth in Europe is still distribution.
ETFs compete against a variety of products, including mutu-
50 200
al funds and structured products from those same banks,
0 0 and therefore the accessibility of ETFs and their visibility to
2002 2003 2004 2005 2006 2007 2008 2009
potential clients is very important.
ETF commodity assets Fixed income ETF equity assets
Any ETF issuer will have to reach potential investors in
Number of ETFs Number of ETPs
order to gain AUM. Any U.S. ETF provider seeking brand
Sources: Bloomberg; BlackRock ETF Landscape, Year End 2009 awareness can advertise on a national level; for instance,
during the Super Bowl or another high-profile event, or
Figure 2
alternatively, advertise in a national business newspaper like
U.S. Vs. European ETF Average Daily Trading Volumes
the Wall Street Journal. By contrast, European ETF provid-
ers need to advertise in a variety of magazines, papers, TV
120 channels, Web sites and so on, throughout multiple different
Trading Volume (U.S. $Billions)

European countries, to achieve the same results as their U.S.


100
counterparts. Furthermore, there are simple information
80 faults and language confusion, as well as a home-trading bias
among investors in certain countries: Italian retail investors
60
will have a very hard time finding prices for London-listed
ETFs, and the typical German retail investor will probably
40
never trade on a foreign exchange. Most issuers therefore
20 choose to list their ETFs on several exchanges, increasing
the visibility for investors but fracturing the overall liquidity.
0
Dec Dec Dec Dec Dec Dec Dec Dec In addition, buying ETFs outside an investor’s home market
’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09
can prove to be quite costly, as banks typically charge higher
U.S. Europe commissions for transactions outside domestic markets.
Sources: Factset, Bloomberg, Goldman Sachs. All data as of December 2009 In response to banks fishing for each other’s customers
(by listing on exchanges outside their home market), we
One of the major differences between the European and increasingly see what we call the “defensive” or “me-too”
the U.S. ETF markets is that, in the U.S., there are only one ETF providers. Defensive ETF providers only start issuing
or two ETFs tracking each given index, whereas in Europe, ETFs when they lose too many fee-paying clients to interna-
one index is tracked by 78 separate ETF listings, and many tional ETF providers. These defensive ETF providers typically
others have multiple listings as well. originate from the asset management division of local banks
In this article, we will examine the reasons for this and anxiously try to keep competition (like market makers
fragmentation, and the effect it has on the liquidity of or high-frequency traders) out of their products and keep
ETFs in Europe. the profits in-house. In our opinion, these ETF providers will

www.journalofindexes.com March/April 2010 23


Figure 3

SX5E-Related ETFs Across All European Exchanges

Issuer Regular Inverse Leveraged Leveraged Inverse Total Listings

BBVA 1 – – – 1
CASAM 1 1 1 – 3
Comstage 2 2 2 – 6
dbx-trackers 9 5 – – 14
Easy ETF 5 – – 2 7
ETFS – – 4 4 8
ETFlab 1 – – – 1
HSBC 1 – – – 1
iShares 10 – – – 10
Lyxor 8 2 6 3 19
Source 2 – – – 2
UBS 6 – – – 6
Total 78

Sources: Bloomberg; BlackRock ETF Landscape, Year End 2009

Figure 4

Average Daily Exchange Turnover (20 Days), Selected Exchanges And Issuers (U.S. $Millions)

Issuers Exchange

Domestic Borsa NYSE


Issuer LSE SWX Xetra
Exchange Italiana Euronext

db x-trackers Xetra 37.4 22.0 9.7 12.7 246.2


ETFS LSE 40.3 85.9 5.1 — 19.0
Lyxor NYSE Euronext 170.4 2.8 271.7 13.2 95.3
Xmatch SWX 2.3 — — 45.8 0.8

Sources: Bloomberg; Nyenburgh research

not profit from economies of scale in the long run, and will use an intensive one-on-one sales approach and marketing
either retreat from the ETF business, or merge with their campaign to drive interest.
larger international competitors. As ETF providers typically experience the distribution
In response to this, some banks have decided to share issues detailed above, assets and trading volume tend to be
the costs and their distribution networks, and have teamed concentrated in the country of origin of the ETF provider.
up in ETF consortia. There are currently two such consortia Figure 4 illustrates this.
in Europe: This fragmentation of trading volume impacts the quality
of the order book. Figure 5 contains an example of a reason-
• Source (Morgan Stanley, Goldman Sachs, Merrill Lynch, ably liquid ETF, the db x-trackers DJ Euro Stoxx 50. As can be
Nomura) seen, the order book is filled with bids and offers, and the
• ETF Exchange (ETF Securities, RaboBank, CitiGroup, Merrill spread is about 7 basis points (2 euro cents vs. a midprice of
Lynch) 29.07, using the best available bid and offer).
ETFs with large trading volume attract market makers and
It is very difficult for ETF providers without a strong distri- high-frequency trading firms, creating a full order book. In
bution network to autonomously grow assets under manage- contrast to the listing on Xetra, the absence of a customer
ment. The one exception in Europe would be ETF Securities base in the U.K. makes for an empty market and a wider
(ETFS), which was founded by ETC pioneer Graham Tuckwell, spread of approximately 20 basis points in the LSE listing.
and which recently reached $16 billion in AUM. ETFS has
reached this level by focusing only on ETCs and without any Issues Caused By Fragmentation
distribution power at the first launch. ETFS’ strategy was to Again, unlike the U.S., the European clearing and settle-
list their ETCs on multiple exchanges in Europe, and then ment system is not a homogenous entity. Every exchange

24 March/April 2010
Figure 5

Order Book For db X-trackers DJ Euro Stoxx 50 ETF: Xetra Vs. LSE Listing

Xetra Listing Currency: Euro Last Trade 29.09 Volume 593,610

Total Bid Total Size Bid Ask Size Order Total Ask
50,000 1 50,000 29.06 29.08 30,000 1 30,000
80,000 1 30,000 29.05 29.09 70,000 3 100,000
100,000 1 20,000 29.04 29.10 2,000 1 102,000
102,000 1 2,000 29.03 29.11 2,000 1 104,000
132,000 1 30,000 29.02 29.12 2,000 1 106,000
162,000 1 30,000 29.00 29.13 3,000 3 109,000
163,000 1 1,000 28.95 29.17 60,000 2 169,000
173,000 1 10,000 28.89 29.30 10,000 1 179,000
173,100 1 100 28.60 29.58 6,528 1 185,528
176,701 1 3,601 28.58 29.61 3,645 1 189,173

LSE Listing Currency: Pence Last Trade 2,553.00 Volume 5,000

5,000 1 5,000 2,540 2,545 5,000 1 5,000

Source: Bloomberg

has its own central counterparty (CCP) and central securi- listing, including the listings that do not trade (they also
ties depository (CSD), and therefore every listing settles have to maintain inventory to prevent buy-ins). For some
in a different place. In order to balance positions between ETFs, this can lead to maintaining inventory and bid/offer
settlement venues, ETFs need to be transferred from one prices for more than nine listings.
location to another, which costs money and can take sev- In the end, all individual quotes are typically smaller in
eral days. This is only the start of a whole range of issues size than they would have been if there were one single list-
arising from different settlement locations, including: ing. In contrast to other issuers, Source has chosen to list its
ETFs on only one exchange, thereby preventing these effects.
• Different settlement cycles (T+2, T+3) Its goal is to concentrate all liquidity in its products in one
• Prime brokers and clearinghouses might use an omnibus single place. Moreover, unlike Reg NMS, the European MiFID
account at the CSD. Consequently, ETFs can effectively be regulation does not enforce true best execution. Brokers can
loaned out by the clearinghouse to another trading firm, choose to route all flow to one exchange, completely ignor-
without prior knowledge and/or approval from the owner ing better prices on other exchanges.
of the position. Once loaned, the ETFs cannot be trans-
ferred. (It is very difficult to transfer shares that are not Impact On Liquidity
actually in your account.) In the end, all client orders are spread over many differ-
• The LSE has a 30-day settlement period, which basically ent listings, therefore effectively reducing the liquidity of
means that settlements can take up to 30 days. This lee- the investment product. End-investors almost always have
way is frequently misused by hedge funds and trading to cross the bid/offer spread, and working an order against
firms. Again, it is very difficult to transfer an ETF that is other investor flow is very difficult. Another consequence is
not “settled long.” that a significant proportion of the trading volume in ETFs in
• Monte Titoli (Borsa Italiana) does not net-off trades, so a Europe is traded over the counter (OTC); some even estimate
short sale followed by a cover buy will not be netted off. that OTC trading represents more than 50 percent of the total
You first need to buy somewhere else and then transfer to trading volume. A precise number is hard to determine, as no
Italy for this trade to settle. obligation exists under the MiFID regulation to report OTC
• Some CSDs do not connect to each other, so ETFs must be trades. Brokers who trade off-screen use the appearance of
transferred using a third country, which takes extra time low screen-based liquidity to promote themselves as alterna-
and costs extra money. tive liquidity pools. Although an order might easily have been
executed on-screen, a larger order is usually done OTC. This
European exchanges have a policy of forcing a buy-in is the case for most orders above €10 million, and sometimes
when ETF trades don’t settle, imposing penalties of up to even much smaller orders are traded OTC.
100 percent of the notional value of the trade. This practice
further reduces liquidity, as market makers and other liquid- Solutions
ity providers are limited in their short-selling capabilities. What can be done to make European ETFs more liquid?
Liquidity providers are obligated to put quotes in for every continued on page 55

www.journalofindexes.com March/April 2010 25


acceptable formal governance ratings highly questionable. should also be possible. The fact that a case involving fund
To illustrate the scope for differences of opinion along the fees has reached the Supreme Court suggests far-from-uni-
“fee” dimension, Wallison and Litan15 present a strong argu- versal agreement on fund fee issues.
ment that requiring fund directors to approve a fund’s invest- If a fund service insists on taking a stance on fund gov-
ment management fee discourages price competition among ernance, it should consider any specific governance issue it
investment managers. The stickiness of fees in the face of deems relevant to a fund and either accept the governance
heavy emphasis on expense ratios in fund comparisons sug- and ethical standards at a fund company and not discuss
gests that Wallison and Litan have a point. It would certainly them or reject them entirely with a full explanation of the
not harm investors in existing funds to permit managers of reasons behind the rejection. Either a question or problem
new funds to experiment with a fund’s fee structure. As long is serious enough to encourage investors to avoid the fund
as disclosure of the possible range of fees is adequate from or it is not important enough or definitive enough to affect
the first day the fund is offered to investors, changes in fees an investment decision. Beyond a statement of the facts of
by these new funds and adoption of fee structures that are a situation, complexity in fund governance analysis and rela-
different from the fulcrum performance fees now required tive governance ratings will rarely be either fair or useful.

Endnotes
1 The early status of the Investment Company Institute XBRL Initiative is summarized in McMillan, Karrie, “Remarks at XBRL International Conference,” Vancouver, British Columbia,
Dec. 4, 2007. The timing of further XBRL implementation is difficult to forecast but the ICI seems to be the fund industry’s organization of choice for this effort. You can see where
the SEC stands on XBRL by starting at http://www.sec.gov/spotlight/xbrl.shtml. There is even a rudimentary mutual fund viewer that lets you create a simple fund comparison report
for two or three funds. A visit will impress you with both the potential for improved fund data and with how far the process has to go.
2 See Cox, Christopher, “Disclosure from the User’s Perspective,” CFA Institute Conference Proceedings Quarterly, September 2008, pp. 10-15.
3 In fairness to iShares, the cost of licensing a wide range of indexes just for this application would probably be prohibitive.
4 Chua, David B., Mark Kritzman and Sébastien Page, “The Myth of Diversification,” The Journal of Portfolio Management, Fall 2009, vol. 36, No. 1, pp. 26-35 provides a useful look
at the asymmetry of diversification.
5 Cremers, Martijn and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure that Predicts Performance,” Review of Financial Studies, September 2009, vol. 22,
No. 9, pp. 3329-3365.
6 In calculating active share, it is often useful to make the calculation relative to a number of benchmark indexes. While the S&P 500 and the Russell 1000 are highly correlated, a closet
indexer using the Russell 1000 as a fund template might have a greater active share measured against the S&P 500 than measured against the (more relevant for this fund) Russell 1000.
Cremers and Petajisto measured active share against a variety of major indexes and assumed the benchmark was the index that showed the lowest active share, (p. 3340).
7 Cremers and Petajisto, p. 3332.
8 Ibid, pp. 3354-3355.
9 Ibid, pp. 3350-3353.
10 Wright, Christopher, “Cleaning Closets,” CFA Magazine, September/October 2008, vol. 19, No. 5, pp. 20-21.
11 Gastineau, Gary L., Andrew R. Olma and Robert G. Zielinski, “Equity Portfolio Management,” Chapter 7, in Maginn, John L., Donald L. Tuttle, Jerald E. Pinto and Dennis W.
McLeavey, “Managing Investment Portfolios: A Dynamic Process,” pp. 407-476. John Wiley & Sons, Hoboken, New Jersey, 2007.
12 Ertugrul, Mine and Shantaram Hegde, “Corporate Governance Ratings and Firm Performance,” Financial Management, vol. 38, No. 1, Spring 2009, pp. 139-160.
13 Wellman, Jay and Jian Zhou, “Corporate Governance and Mutual Fund Performance: A First Look at the Morningstar Stewardship Grades,” Unpublished Working Paper, March
18, 2008.
14 Haslem, John A., “Mutual Funds,” Wiley, 2010, p. 312.
15 Wallison, Peter J. and Robert E. Litan, “Competitive Equity: A Better Way to Organize Mutual Funds,” The AEI Press, Washington, D.C., 2007.

Lijnse continued from page 25


The distribution problem is something politicians have been to be allowed to be sold. The issue of Europe’s fragmented
working on for 50 years by trying to form the European clearing and settlement system could be solved by having
Union. Unfortunately, as long as Europe remains divided, one central or several linked CSDs, much like the Depository
issuers will have to spend more time, effort and money on Trust & Clearing Corporation in the U.S., in combination with
marketing in each individual country. A good start would stricter regulations on best execution. Finally, an obligation
be to ease regulations that require ETFs to be listed locally to report OTC trades would increase transparency.

Endnotes
1 Source: DB Index Research, Weekly ETF reports—Europe, January 21, 2010

2 Source: BlackRock ETF Landscape Year End 2009

References
BlackRock Advisors, ETF Landscape, Industry Preview, Year End 2009
Bloomberg
DB Index Research, Weekly ETF reports—Europe, January 21, 2010

www.journalofindexes.com March/April 2010 55


Europe In Focus

A Big Bang In European


ETF Trading?
Some think 2010 could be a turning point

By Keshava Shastry

T
he growth of exchange-traded funds in Europe over the the European market is fundamentally different from the U.S.
past 10 years has been remarkable. However, with ETF one, where ETFs are responsible for roughly one-third of the
assets under management worldwide recently surpass- total activity in the equity market and where 17 years after the
ing the $1 trillion milestone, a question comes to mind about inception of the first ETF, assets have surpassed $700 billion,
the ETF industry—particularly if we consider the global eco- with more than $50 billion changing hands every day.3
nomic upheaval of the past 18 months. What’s next? This last figure about ETF turnover might actually hold
What are the arguments indicating further dynamic the key to explaining where growth will come from, and
growth and, perhaps even more importantly, what conditions points clearly to where the main difference lies between
need to be met for this growth to materialize? the U.S. and European markets.4 It is the deficit of liquidity,
It may surprise some to hear a view expressed that, or to be more precise, the deficit of visible liquidity, that
despite the significant growth of the past two years or so has impacted the development of ETF markets in Europe.
in the European exchange-traded product market, the real Even in the eyes of those who have always understood the
breakthrough in Europe is only now about to happen. primary market creation/redemption mechanism for ETFs,
Clearly it would be an oversimplification to point toward this apparent deficit of liquidity has led to the misconcep-
a single driver as being capable of changing the market, yet tion that ETFs are investment vehicles accessible only to
it cannot pass unnoticed that there is a general consensus institutional clients who are able to trade over-the-counter
forming about this year being one of trading in ETFs.1 (OTC) with specialized ETF brokers.
What is fueling this popular belief? A lot can be said about the origins of this preconception.
The fact that OTC transactions have been excluded from the
A False View Of Liquidity scope of the MiFID (Markets in Financial Instruments) direc-
One does not need to be a skeptic to observe that there tive has done the market no favors, as it has pushed the bulk
is an end to all things, and it is no small wonder that there of activity in ETFs into a gray zone of unreported trading.
might be some people who think a 56.8 percent rise in assets Similarly, the multitude of exchanges and trading venues
under management in European ETFs in 2009 could be dif- alongside currency cross-listings means that the visible pool
ficult to replicate in 2010 and coming years.2 of liquidity is further fragmented and can be confusing. All in
One cannot deny that at least part of this impressive all, the final impression is that of a market with erratic activ-
growth came as a result of unique market circumstances. ity levels and high trading costs.
Investor concerns about counterparty risk, compounded This is not a fair reflection of the market. On the contrary,
by plunging financial markets, moved investor interest into when looking at market structure and trends over the last
financial products such as ETFs, while the subsequent rally of two years, it is clear that there are increasing signs indicating
late 2009 helped to achieve the strong asset growth figures the time is approaching for the big trading bang to happen.
witnessed by European ETF providers. One obvious indicator is the continuing growth of trading
Still, with 215 new ETFs launched in 2009, it is clear there volumes. Although the 0.9 percent increase in on-exchange
remains considerable room for growth in the ETF market into trading activity might not seem particularly impressive, when
2010 and beyond. Indeed, there are no reasons to assume that we include all the OTC flows that are “printed back” onto

26 March/April 2010
trade reporting facilities, a truer picture emerges. decision about their trading strategies. After all, it is not just
What is striking about this jump of more than 100 per- reality but perception that needs to change if 2010 is really
cent year-on-year is what it suggests about the real size of to be remembered as the year of trading in European ETFs.
the OTC market in Europe. Given that trade reporting of In this battle of perceptions, progress is being made.
ETFs in Europe is mostly voluntary, it is primarily limited First of all, ETFs are an established phenomenon in the
to the entities that have automated infrastructure in place European market, and the efforts made by issuers into
to report their MiFID-compliant cash market activity.5 As the education of investors is paying off with the actual
such, specialized ETF trading houses, which are respon- usage and trading of ETFs increasing.7 Equally important,
sible for the bulk of trading volumes, remain largely in the increased competition between exchanges has forced them
shadows, with the broker-to-broker market almost entirely to simplify their requirements and lower trading costs,
veiled from external observers. Still, the fact that the trade- making it easier to compare actual execution costs. Finally,
reported segment of the market more than doubled in size the arrival of multilateral trading facilities (MTFs) and their
last year shows both the potential for greater transparency appetite for a share of the ETF market translates into future
among market participants and the increased understand- opportunities for growth.
ing of the benefits that this might bring. In this context, one of the most widely discussed concepts
Whereas it is clear that liquidity generates liquidity, it is is that of a European consolidated order book—something
nevertheless important to remember that there are also other that would enable a client to access all venues where a
criteria that need to be met in order to pass the trading “big particular instrument trades through a single connection to
bang” threshold point. For market participants to treat the one platform. The trade order routing facility that has been
trading of ETFs as an extra opportunity, at least three other recently offered by some MTFs, and that now includes some
preconditions must be met: lower trading costs, a deep order ETFs, is one of several attempts to provide a remedy to the
book and ease of comparison between trading venues. problem of the fragmentation of liquidity that has historically
For the first two preconditions, it is possible to show that beset the European ETF market.
2009 was a year that marked a step in the right direction. It As with all forecasts, it is not easy to claim with certainty
should also be of no particular surprise that a drop in trad- that 2010 will indeed be a “big bang” year for trading European
ing costs usually comes as a result of deeper order books, as ETFs. There is much evidence that would seem to point toward
increased competition between market makers forces pro- such a development, and the general sentiment in the market
viders to accept limited margins and decrease their spreads. seems to reinforce it. Nevertheless, it is quite clear that things
In terms of trading costs associated with investing in are ripe for change and chances are high that once such a shift
ETFs, there is hardly an exchange in Europe where the happens, it will transform the market quite rapidly.
average spread a client needs to pay to trade a fund has Still, it is very important to realize that, even now, the
not decreased throughout 2009. Taking Euronext as an ETF market in Europe is in a state of rapid progress. The
example, the median spread of all listed ETFs was 34.36 real question is not whether it will develop, but how quickly.
bps in December 2009, down from 71.03 bps in December For the rapid growth recently witnessed to continue, there
of 2008. Over the same time period, figures for the needs to be an improvement in visible liquidity, which in turn
London Stock Exchange (LSE) show a drop from 87.58 bps should work as a magnet to attract the attention of inves-
to 52.33 bps, while for Deutsche Boerse it is 46.64 bps and tors. One crucial variable is the potential legal changes that
25.46 bps, respectively.6 might bring ETFs within the scope of the MiFID directive.
As powerful as the above-mentioned statistics are, it is Nonetheless, before this happens, it is still possible to see
worth remembering that looking at the spread figure as the the continued growth of the European market into spring
only indicator of trading performance might be misleading, and beyond. And who would mind spring, after the winter
especially when aggressive quotes are not backed by a deep we experienced this past year?
order book. To ensure easy and cost-effective execution, it continued on page 53
is almost as important to be able to rely on more than one Figure 1
market maker quoting any given product. Again, the figures European ETF Volume Reported Back
here are encouraging. Whereas in January 2009 iShares ETFs To Trade Reporting Facilities
were on average traded by just under two official exchange
Trade Reported Volume (€mil)
liquidity providers, the equivalent figure jumped to nearly
30,000
three in December 2009.
25,000
Aside from efforts by the provider, there is also a clear
increase of interest among high-frequency traders—espe- 20,000
cially those who run successful franchises in the U.S.—who 15,000
are keen to move into Europe early to benefit from a widely
10,000
anticipated surge in trading activity.
While tighter spreads and a deeper order book create a 5,000

more favorable environment for clients interested in trading 0


2008 2009
ETFs, it is equally important for them to be able to correctly
assess those parameters and make a conscious and educated Source: Bloomberg

www.journalofindexes.com March/April 2010 27


ing an ETF, and in some case, are cheaper than borrowing. If the tively higher cost should diminish if more institutions make
memory of Lehman Brothers fades over the course of the year, the their ETFs available to borrow. The increase in supply could
demand that European ETFs saw in 2009 may begin to fade. come about as more ETF owners realize that they can offset
An increase in the supply of European ETFs could, in turn, the ETF management fee by putting them into a securities
lead to an increase in demand. As additional supply comes lending program. This lending activity can help offset the
into the market, the advantages that swaps have over short- inherent tracking risk, which may make owning European
ing ETFs will continue to diminish. The risk of recall and rela- ETFs more attractive.

Endnotes
1 ETF Landscape Industry Preview Year End 2009, BlackRock Global ETF Research & Implementation Strategy Team
2 Source: Data Explorers
3 Ibid.

Dallmer continued from page 21


quality advantages the exchange-appointed LP model pro-
tronic order-driven market models with opening and closing vides in terms of tighter spreads and deeper markets.
auctions, central limit order books and valuation price feeds.
Similar to the U.S. LMM model, the European ETFs Conclusion
benefit from a multiliquidity provider model that results Overall, one can easily understand how liquidity provision,
in remarkable market depth and competitive spreads. encouraged on a level playing field of fair access, can result
For each ETF, there is at least one liquidity provider (LP), in better expected market quality for a given symbol. In the
generally appointed by the issuer, that agrees to provide popular press, there is a large belief that all ETFs are created
continuous quotes, minimum market depth and maximum equal—meaning that due to their transparency, the pricing
spreads through the exchange’s trading session. Monitored of any ETF is without costs and will be priced efficiently.
by the exchange, so long as they are meeting their pres- In principle this might be true; however, in practice, just
ence, size and spread requirements, LPs may receive incen- because an ETF can be efficiently priced doesn’t mean some-
tives from the exchange for providing liquidity in the form one actually wants to do it at all times. An exchange model
of discounted transaction fees. Auctions are supported by that supports the role of a lead market maker or liquidity
the LPs through their obligation to provide consistently dis- provider with performance obligations is well-positioned in
played liquidity during the opening to the closing auction. principle to meet this ideal more often than not.
The number of LPs in Europe has increased significantly in
recent months following the implementation of a new trad- DISCLAIMER:
ing technology and faster data feeds, improving the overall This article is intended for investment professionals only and
tool kit for all traders. The increasing diversity of partici- solely for informational and educational purposes. It should not
pants trading ETFs (buy-side, sell-side, retail, etc.) ultimately be relied upon for any investment decisions. The article is based
leads to more efficient markets, and with the LP activity, we on data obtained as of Aug. 30, 2009 (unless otherwise noted
observe the quoted spreads of several ETFs are now tighter herein), which, although believed reliable, may not be accurate
than those of the underlying indexes, and others reached or complete and should not be relied on as such. The author
their lowest ever. does not recommend or make any representation as to possible
Although this is a deep dive into only two ETFs (see Figures benefits from any securities, investments, products or services.
3 and 4), a comparison to BATS and Chi-X—nonexchange Investors should undertake their own due diligence regarding
multilateral trading facilities (MTFs)—illustrates the market- securities and investment practices.

Endnote
1. Source: NYSE Euronext research databases

Shastry continued from page 27


Endnotes
1Amery, P., Inside ETFs Conference 2010: A Focus on Trading, www.indexuniverse.eu/blog/7127.
2Fuhr, D. op. cit.
3ibid.
4ibid.
5London Stock Exchange and SIX Swiss Exchange require their members to trade-report their OTC activity in funds that are listed on those venues.
6Source: Euronext, LSE, BlackRock.
7Amery, P., op. cit.

www.journalofindexes.com March/April 2010 53


No Shortage Of
Share Lending
An overview of securities lending and ETFs in Europe

By Leonard Welter

28 March/April 2010
S
ince their inception over nine years ago, the assets of easily, by borrowing the underlying constituents of the ETF
European-listed exchange-traded funds have grown to and delivering them to the creation agent in return for ETF
a record $223 billion.1 The rapid recent growth of the units, which could then be lent to the market. This cost of
European ETF market indicates that ETFs have obtained accep- creation is generally low, which means that the “borrow to
tance as an asset allocation tool by institutional as well as retail create” (or “create to lend”) ETF transaction is a viable source
investors. The securities lending market for European-listed of supply. In Europe, on the other hand, stamp taxes and divi-
ETFs also saw an increase in 2009, with loan values recovering dend costs make the “borrow to create” transaction prohibi-
from their spring lows. The lending market also saw an increase tively expensive to the short seller and lending agents.
in the breadth of trading throughout 2009, and by December Demand has historically also been an issue for the European
there were more than 300 different ETFs with securities lend- ETF securities lending market. Hedge funds and proprietary
ing activity in Europe.2 Could this be the year the securities trading desks can easily substitute a trade that involves the
lending market for European ETFs really takes off? shorting of an ETF by entering into a swap contract. A swap can
be structured to give the same performance of a short ETF posi-
What Is Securities Lending tion and has been seen to be a less expensive and more stable
And Why Is It Important To ETFs? alternative to borrowing ETFs. The recall risk when borrowing
Securities lending is a global market with more than $1 tril- ETFs can be significant, as the general lack of supply mean’s
lion worth of equity assets out on loan.3 The main purpose of that a hedge or directional short could be forced to close due
the market is to facilitate the practice of short selling—a short to the lender requiring the return of borrowed shares.
seller is required to borrow the security in order to make
onward delivery to the market. The lender of the security Has The Market Changed?
negotiates the price to borrow, with this price generally being The overall dollar value of loans made in European ETFs is
quoted as an annual percentage of the value of the loan, while still below the peak that was hit in February 2008, but as shown
retaining the right to recall the loaned security at any time. in Figure 1, demand has recovered from the March 2009 lows. A
The loans are collateralized with either cash or securities and more significant signal of change in demand is the fact that the
are governed by standard agreements. overall number of ETFs with lending activity has more than dou-
The securities lending market is relatively complex and bled from 113 in March 2009 to 305 in December (Figure 2).
the majority of transactions take place over the counter
(OTC). The supply of securities that are made available to Figure 1
the lending market comes from beneficial owners, such as
pension funds, who make their shares available to lend via European ETFs Value On Loan
agents such as custodian banks. The demand to borrow is $2.5
fueled by hedge funds and proprietary trading desks that use
either internal trading desks or prime brokers to source and $2.0
manage their borrowing requirements.
In the United States, the lending and borrowing of ETFs has $1.5
USD Billions

been well established for many years. ETFs such as SPY and
QQQQ are very easily borrowed by short sellers who are taking $1.0
directional views on the market or are using them as a relatively
cheap and easy way to manage a hedge. It can be argued that $0.5
the activity of short sellers in the ETF market helps to provide
market liquidity and trade volume for the largest ETFs in the $0
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
U.S. market. There is an additional benefit to the underlying ’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09
holder of loaned ETFs, as the lending revenue can offset some,
or all, of the management charge of the fund, which reduces Source: Data Explorers

their tracking error to the benchmark of the ETF.


In Europe, the securities lending market has seen much Part of this increase in securities lending for European ETFs
slower growth when compared with the U.S. The slow can be attributed to the 2008 collapse of Lehman Brothers.
growth has been due to several factors, all of which come The collapse highlighted the significant counterparty risk of
down to the classic problem of “which came first: the chick- swap transactions. With a swap, the buyer is tied to the party
en or the egg?” or, in the case of lending European ETFs, that sold them. Swaps cannot be easily transferred and may
“which came first: supply or demand?” not be able to be closed during a period of market turmoil.
Supply has historically been an issue for ETF securities lend- An ETF, on the other hand, trades on an exchange, and short
ing, as the traditional lenders such as custodian agents either did positions can be transferred to another bank/prime broker or
not have accounts holding ETFs or they did not understand the quickly closed in the market if necessary.
structure and nature of ETFs and therefore did not lend them. Another explanation for the increase in the demand for
Another disadvantage European ETFs have when compared ETFs could also be due to the change in the supply situa-
with their U.S. counterparts is the structural cost of creation. tion. The value of European ETFs made available to borrow
In the U.S., ETF supply for lending could be created relatively continued on page 52

www.journalofindexes.com March/April 2010 29


Welter continued from page 29 seen in 2008, the strong run-up since June 2009 is an indica-
Figure 2 tion that the value of supply will continue to grow in 2010.
This upward trend in lendable value is also mirrored in
Number Of European ETFs Out On Loan the number of European ETFs that are being made available
350 to borrow. As illustrated in Figure 4, the number increased
significantly at the tail end of 2009, from roughly 200 in April
300
to more than 300 by the end of December.
250

200
The Top 10 European ETFs Of 2009, By Loan Value
The ETFs that saw the highest 2009 average U.S. dollar
150 loan value were predominantly iShares funds. The iShares
100 FTSE 250 consistently saw the highest level of demand, fol-
lowed by the Lyxor Euro Stoxx 50 ETF.
50
In terms of lending revenue, the average lending rate for the
$0 top 10 ETFs in most cases exceeded the ETF management fee.
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09 In fact, the lending rate was also in excess of the rates charged
Source: Data Explorers Figure 5

Figure 3 Securities Lending Top Ten European ETFs

European ETF Lendable Value Avg


Avg Total Wholesale
$16 Name
Balance Lending Rate
$14 (Fee)

$12 iShares FTSE 250 GBP $79mm 2.70%


Lyxor ETF DJ Euro Stoxx 50 ETF $43mm 1.65%
$10
USD Billions

db x-trackers MSCI USA TR Index ETF $41mm 0.30%


$8
iShares FTSE 100 GBP $40mm 1.00%
$6
iiShares DAX (DE) $34mm 1.50%
$4
iShares DJ Euro Stoxx 50 (DE) $23mm 1.50%
$2 Lyxor ETF CAC 40 $20mm 2.00%
$0 Xact OMXS30 $20mm 0.65%
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09
UBS-ETF DJ Euro Stoxx 50 A $15mm 2.00%
Source: Data Explorers iShares MSCI Japan USD $12mm 1.85%

Figure 4 Source: Data Explorers

Number of European ETFs Made Available to Borrow for the underlying basket of securities. Some of this premium
350
could be put down to the structural cost of creating ETFs to
lend, such as stamp tax for U.K. equities, but the rates do imply
300 that the market is willing to pay for the convenience of bor-
250 rowing a single security. Another explanation for the premium
could be that the securities lending market for European ETFs is
200
still far from mature. While the number and value of European
150 ETFs in securities lending is increasing, it is still far below the
100 levels seen in the U.S. market. In the U.S., the lendable value
for the ETF market is in excess of $55.8 billion, with a value
50 on loan of $23 billion. This depth of supply results in much
$0 lower lending rates for U.S. ETFs. The average rate is close to,
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09 or marginally below, the management fee of the ETF. However,
the higher level of demand means the absolute value of revenue
Source: Data Explorers
from lending ETFs is higher than in Europe.
by lenders such as custodian banks saw a marked decrease
in the autumn of 2008 (Figure 3). Part of this decline can be 2010: What Does The Future Hold?
attributed to the drop in global equity values, and part is due While the data points to a strong lending market for
to the fact that some market participants suspended lending European ETFs in 2010, there are still areas of weakness.
during the extreme market conditions of 2008 and 2009. On the demand side, while swaps have a significant element of
While the value of the supply ended 2009 below the highs counterparty risk, they do not have the same recall risk as borrow-

52 March/April 2010
ing an ETF, and in some case, are cheaper than borrowing. If the tively higher cost should diminish if more institutions make
memory of Lehman Brothers fades over the course of the year, the their ETFs available to borrow. The increase in supply could
demand that European ETFs saw in 2009 may begin to fade. come about as more ETF owners realize that they can offset
An increase in the supply of European ETFs could, in turn, the ETF management fee by putting them into a securities
lead to an increase in demand. As additional supply comes lending program. This lending activity can help offset the
into the market, the advantages that swaps have over short- inherent tracking risk, which may make owning European
ing ETFs will continue to diminish. The risk of recall and rela- ETFs more attractive.

Endnotes
1 ETF Landscape Industry Preview Year End 2009, BlackRock Global ETF Research & Implementation Strategy Team
2 Source: Data Explorers
3 Ibid.

Dallmer continued from page 21


quality advantages the exchange-appointed LP model pro-
tronic order-driven market models with opening and closing vides in terms of tighter spreads and deeper markets.
auctions, central limit order books and valuation price feeds.
Similar to the U.S. LMM model, the European ETFs Conclusion
benefit from a multiliquidity provider model that results Overall, one can easily understand how liquidity provision,
in remarkable market depth and competitive spreads. encouraged on a level playing field of fair access, can result
For each ETF, there is at least one liquidity provider (LP), in better expected market quality for a given symbol. In the
generally appointed by the issuer, that agrees to provide popular press, there is a large belief that all ETFs are created
continuous quotes, minimum market depth and maximum equal—meaning that due to their transparency, the pricing
spreads through the exchange’s trading session. Monitored of any ETF is without costs and will be priced efficiently.
by the exchange, so long as they are meeting their pres- In principle this might be true; however, in practice, just
ence, size and spread requirements, LPs may receive incen- because an ETF can be efficiently priced doesn’t mean some-
tives from the exchange for providing liquidity in the form one actually wants to do it at all times. An exchange model
of discounted transaction fees. Auctions are supported by that supports the role of a lead market maker or liquidity
the LPs through their obligation to provide consistently dis- provider with performance obligations is well-positioned in
played liquidity during the opening to the closing auction. principle to meet this ideal more often than not.
The number of LPs in Europe has increased significantly in
recent months following the implementation of a new trad- DISCLAIMER:
ing technology and faster data feeds, improving the overall This article is intended for investment professionals only and
tool kit for all traders. The increasing diversity of partici- solely for informational and educational purposes. It should not
pants trading ETFs (buy-side, sell-side, retail, etc.) ultimately be relied upon for any investment decisions. The article is based
leads to more efficient markets, and with the LP activity, we on data obtained as of Aug. 30, 2009 (unless otherwise noted
observe the quoted spreads of several ETFs are now tighter herein), which, although believed reliable, may not be accurate
than those of the underlying indexes, and others reached or complete and should not be relied on as such. The author
their lowest ever. does not recommend or make any representation as to possible
Although this is a deep dive into only two ETFs (see Figures benefits from any securities, investments, products or services.
3 and 4), a comparison to BATS and Chi-X—nonexchange Investors should undertake their own due diligence regarding
multilateral trading facilities (MTFs)—illustrates the market- securities and investment practices.

Endnote
1. Source: NYSE Euronext research databases

Shastry continued from page 27


Endnotes
1Amery, P., Inside ETFs Conference 2010: A Focus on Trading, www.indexuniverse.eu/blog/7127.
2Fuhr, D. op. cit.
3ibid.
4ibid.
5London Stock Exchange and SIX Swiss Exchange require their members to trade-report their OTC activity in funds that are listed on those venues.
6Source: Euronext, LSE, BlackRock.
7Amery, P., op. cit.

www.journalofindexes.com March/April 2010 53


Talking Indexes

Bubble Decisions

How do you deal with a pernicious cycle?

By David Blitzer

T
he market’s major innovation of the last decade or slowly, giving people time to develop arguments about what
two is the return of the bubble. While banks, brokers might be happening. Bubbles can be big and explosive or
and others were hard at work developing new ways small and seemingly unchanging; they can switch from mod-
to make money in the investment markets, the market itself est price increases that slightly stretch valuations to booms
introduced the most powerful, and frustrating, innovation of and busts that threaten economies. They can make the tran-
all: short, steep boom-and-bust cycles better known as bub- sition in a year or a week.
bles. Some of the bubbles we’ve seen include tech stocks (and A defense against bubbles would be welcome. Currently
Nasdaq-listed stocks in general) in 2000, home prices in 2005- most regulators—who should be protecting us from such
2008 (in the U.S., the U.K. and Spain, among other places) and things—argue that in the middle of a bubble, one can’t tell
Chinese A-shares at various times in the last decade. that you’re in a bubble, and further efforts to control the
Few if any of the investment ideas of the last 20 years pro- bubble would slow the economy or collapse stock prices.
vided half as many gains as the bubbles took away. After all, Neither regulators nor investors are quite so powerless.
the S&P 500 opened 2010 lower than where it closed 2000, Forecasting with 100 percent accuracy may not be possible,
or for that matter, 1997. True, some people made money but that hasn’t stopped people from making and acting on
through the decade of the 2000s, but they were few in num- forecasts of bubbles or other market events. The worrisome
ber; the idea that one could participate in overall economic thing about trying to control bubbles is that policies to
growth by owning stocks just didn’t work. control a bubble, if applied when there is no bubble, might
Bubbles weren’t new in the 21st century—they’ve been indeed—as those regulators suggest—slow the economy
around since at least the 17th century, when there were tulip or end a bull market. While many of the myriad books and
bulbs in Holland. But they have returned with a vengeance. articles dissecting the financial crisis offer estimates of the
One of the most unfortunate things about bubbles is that costs of controlling bubbles or tools to predict bubbles, the
they don’t usually come with large warning signs reading big question is, how do we decide when to attack the bubble?
“Entering the Bubble Zone.” Rather, they seem to creep up A little crude analysis may help.

Figure 1

Bubble Damage Decision Analysis

True Market Condition

Bubble No Bubble
Market Condition Bubble 600 300
Regulators See No Bubble 1,000 0

30 March/April 2010
What we have, essentially, is a decision problem. If we’re maximum loss is 600. Taking the smaller of 1,000 and 600,
in a bubble, steps such as restricting trading, increasing the approach is a policy that assumes a bubble is occurring
margin requirements, or raising interest rates and trading and seeks to limit the damage, even though this would be
costs can rein in the boom before prices reach extremes. But costly if there is no bubble. Without arguing that the rela-
if these actions are taken and there is no bubble, regulators tive damages make sense, this is not what the Fed and other
will have killed off a bull market for no reason—not a popu- regulators did in 2005-2007.
lar action. On the other hand, if regulators assume there is However, this suggests that regulators should see
no danger and the bubble bursts, the resulting bear market bubbles everywhere they look and always attack bull mar-
and recession could be nasty. A diagram with some damage kets. This is not a very attractive policy—we can do better.
figures can sort this out (see Figure 1). While we can’t know for certain if we’re in a bubble until
The markets are either in a bubble or not. The two col- after the fact, we should be able to estimate the prob-
umns on the right represent the actual market condition: ability we’re in a bubble. For example, if the probability of
Bubble or No Bubble. The two rows represent the regula- being in a bubble is 30 percent and the probability of no
tors’ point of view: They either believe there is, or is not, a bubble is 70 percent, we can calculate the expected loss of
bubble. The numbers in the four boxes represent the dam- each policy choice. The expected loss of the bubble policy
ages caused by each case. (first row) is 30 percent of 600 plus 70 percent of 300, or
Starting in the upper left number box, if there is a bubble an overall loss of 390; the expected loss of the no-bubble
and the regulators guess correctly, the damage is 600; if the policy is 300 (30 percent of 1,000 plus 70 percent of zero).
regulators are wrong—they don’t see the bubble but it is In this case, the regulators should take the “we’re not in a
there—the damages are 1,000. Now suppose that there is bubble” approach because the expected loss is less. With a
no bubble (extreme right-hand column). If regulators are cor- little experimentation, providing that our loss numbers and
rect, the damage is zero (bottom right), while if the regula- probabilities make some sense, we can figure out (using
tors invoke policies to control a bubble that isn’t there, the our theoretical loss numbers) that if the probability of a
policy of tight money or trading restrictions still leads to bubble is greater than 43 percent, regulators should attack
damages of 300. (All these figures are just for illustration and the bubble. Different damage costs will lead to a different
are not based on real data or estimates.) number than the 43 percent. The higher the damage from
This little diagram, borrowed from statistical decision an unrecognized bubble, the lower the probability thresh-
analysis, can help people decide what to do. The standard old for attacking a bubble. Double the 1,000 figure, leave
approach to solving this kind of problem—called minimax the other loss estimates unchanged, and the 43 percent
in the literature—seeks to minimize the maximum loss that becomes 17 percent.
could be suffered. Although this sounds a bit pessimistic— Finding the necessary probability and loss data isn’t
expect the worst and limit its severity—it has been shown to impossible. Andrew Smithers, an investment analyst based in
be successful. For each choice the regulators could make— London, in a recent book, “Wall Street Revalued,” describes
bubble or no bubble—we find the maximum damage. Then measures that could be used to estimate the probability of
we choose the policy—bubble or no bubble—with the small- being in a bubble. Damage figures appear in many of the
est loss. Looking at the numbers here, the maximum loss if analyses of the recent financial crisis. Whether regulators,
we assume there is no bubble is 1,000 (bubble bursts and or investors, are willing to step into the markets and try to
we’re not expecting it), while if we expect the bubble, the manage bubbles remains to be seen.

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www.journalofindexes.com March/April 2010 31


Can Indexes Generate Alpha?
Comparing index providers

David Blanchett

32 March/April 2010
T
here are an increasing number of passive investing are invested in large cap, given that it is generally defined as
strategies available for investors, each offering a the largest 70 percent of securities based on market capital-
slightly different market exposure. While we would ization, it is somewhat surprising that such a large portion is
expect indexes with the same general market exposure (e.g., invested in a single style: large blend.
domestic large value) to have similar returns, past research Figure 1 includes the rolling three-year annualized perfor-
by Israelsen [2007], among others, has noted that the returns mance for the large blend indexes from each of the six different
of indexes can vary widely, even over prolonged time peri- index methodologies (S&P uses the same blend methodology
ods. Comparing indexes on returns alone, though, does not for both its regular and pure indexes, so the return for the S&P
account for risk. It could be that a large growth index from 500 has only been included once) from July 1997 to June 2009.
one family outperformed another during a historical period Note that rolling three-year periods were selected because the
just because it was less “large” or more “growth.” regression analysis in the following section is based on rolling
Therefore, the best way to compare indexes from different historical three-year periods (i.e., 36 months).
providers is to do so on a risk-adjusted basis, i.e., determine As shown in Figure 1, while the rolling annualized three-year
their respective alphas. While indexes are beta investments returns for the large blend indexes varied across providers, the
by definition—not alpha investments—given their varying returns were relatively similar, although significant differences
returns and construction methodologies, we would expect did exist at varying points in time. The maximum range in
some to outperform others on a risk-adjusted basis. This three-year returns during the entire test period for the six large
“alpha” component of seven different index methodologies blend indexes was the three-year period ending September
(and almost as many providers)—including the Dow Jones, 2001, where the Morningstar large blend index outperformed
Dow Jones Wilshire, Morningstar, MSCI, Standard & Poor’s, the MSCI large blend index by 7.51 percent (per year, +6.70
Standard & Poor’s Pure and Russell index families—will be percent vs. -0.81 percent, respectively), while the minimum
explored in this paper, where alpha is determined using a four- range was in September 2000, where the Dow Jones large
factor regression model (i.e., Carhart model) consisting of the blend outperformed the S&P large blend index by 1.28 percent
three Fama/French factors and momentum. (per year, +17.72 percent vs. +16.44 percent, respectively).
Figure 2 includes the annualized returns of the indexes for
Indexes each style from July 1997 to June 2009, or a 12-year period.
Investors choose to invest in an index, or really an invest- Note that these returns were calculated by compounding the
ment that tracks an index such as a mutual fund or ETF, in order monthly returns obtained from Morningstar Direct, based on
to capture the return associated with that market exposure the same values used to create Figure 1.
without the variability (and often costs) associated with active The annualized performance differences may not appear
management. While the major index providers have similar large among the indexes in Figure 2, but they are material
methodologies for their domestic equity indexes (see Appendix given the time period (12 years). For example, the annualized
I for a summary of the methodologies for the index providers performance difference between the best-performing large-
included in the study), there are differences among them. These cap blend index (Morningstar at 2.78 percent) and the worst-
differences impact the performance and risk attributes for each performing large-cap blend index (MSCI at 0.15 percent) may
index, yet make it difficult for the average investor to compare be only 2.63 percent, but over 12 years this would result in a
the relative strengths and weaknesses of each strategy. difference of approximately 36 percent (with the investment
As a shortcut, many investors simply seek out the most in the Morningstar large-cap blend being 36 percent larger,
well-known index for investing purposes. For example, ignoring contributions). What is less clear, though, is what
according to the 2009 Investment Company Factbook, 58 the true “alpha” of the strategies is after accounting for their
percent of all assets invested in domestic equity index mutual
funds were tracking the S&P 500, despite the fact that many Figure 1
other indexes exist with similar market exposures. A better Rolling Three-Year Performance: Large Blends
approach would be to see which indexes actually outperform July 1997–June 2009
on a risk-adjusted basis, yet little research has been devoted 25%
to this topic. While one may expect that indexes would not 20%
3-Year Performance
Rolling Annualized

generate alpha using traditional risk-adjusted measures (i.e., 15%


10%
four-factor alpha), the research conducted for this paper sug- 5%
gests otherwise. 0%
-5%
-10%
Index Investing Today -15%
As of June 30, 2008, more than 70 percent of assets in -20%
-25%
index mutual funds and ETFs invested within the nine domes- Jun Oct Mar Jul Dec Apr Aug
tic equity styles boxes (defined as Investment Category by ‘00 ‘01 ‘03 ‘04 ‘05 ‘07 ‘08
3-Year Period Ending
Morningstar) were invested in the large blend category, fol-
lowed by 7 percent in large growth and 5 percent in large ■ Dow Jones ■ Morningstar ■ S&P
■ DJ Wilshire ■ MSCI ■ Russell
value (making the total large-cap allocation approximately 82
percent). While it is not surprising that the majority of assets Source: Morningstar

www.journalofindexes.com March/April 2010 33


varying market exposures. Using the previous example, it using the three Fama/French factors, as well as momentum.
may be that the outperformance of the Morningstar large All data for the beta factors, as well as the risk-free rate, was
blend index over the MSCI large blend index is entirely due obtained from Kenneth French’s Web site, and all return data
to the Morningstar index having a higher market weight (i.e., for the indexes was obtained from Morningstar Direct.
higher beta factor), and once this is adjusted for the differ- The excess return of the index (which is defined as the return
ence (or relative alpha), it could become negative. This is of the index for the month minus the risk-free rate for the
what will be explored in the analysis section of the paper. month) is regressed against a market beta factor (defined as the
return on the market minus the risk-free rate), a value factor (or
Analysis HML, defined as the return on value stocks minus the return on
While it is impossible to know which index group (or really growth stocks), a size factor (or SMB, defined as the return on
which methodology) will outperform on a risk-adjusted basis small stocks minus the return on big stocks), and a momentum
in the future, a review of the historical risk-adjusted attributes factor (based on the six value-weight portfolios formed on size
of each methodology should provide insight as to which and prior return, the average return on the two high prior-return
methodology does a better job capturing outperformance portfolios minus the average return on the two low prior-return
relative to its market exposure. To determine the “alpha” or portfolios). The four-factor regression equation is:
risk-adjusted outperformance for each index methodology, Rindex – Rf = αindex + βindex (Rmarket – Rf) + βSMB(SMB) +
a four-factor (i.e., Carhart) regression analysis is performed βHML(HML) + βMOM(Momentum) + εasset

Figure 2

Annualized Return: July 1997-June 2009

Category Dow Jones DJ Wilshire Morningstar MSCI S&P S&P Pure Russell

Large Growth -1.25% 1.18% -1.74% -0.22% 1.36% 4.82% 0.73%


Large Blend 1.42% 2.35% 2.78% 0.15% 2.05% 2.05% 2.41%
Large Value 2.74% 3.15% 2.61% 0.28% 2.10% 4.54% 3.30%
Mid-Cap Growth 3.11% 3.14% 1.93% 2.86% 9.45% 9.51% 3.41%
Mid-Cap Blend 4.96% 5.12% 4.82% 3.92% 7.34% 7.34% 5.48%
Mid-Cap Value 5.87% 5.70% 5.54% 6.75% 5.28% 6.08% 5.79%
Small Growth 2.66% 2.75% 0.37% 4.02% 5.01% 6.64% 0.96%
Small Blend 5.02% 4.79% 6.52% 4.19% 5.28% 5.28% 3.41%
Small Value 5.09% 6.11% 6.06% 3.47% 5.35% 6.67% 5.22%
Average 3.29% 3.81% 3.21% 2.82% 4.80% 5.88% 3.41%

Source: Morningstar
Figure 3

Rolling Three-Year Four-Factor Regression Annualized Alphas: July 1997-June 2009

Category Dow Jones DJ Wilshire Morningstar MSCI S&P S&P Pure Russell

Large Growth -0.91% 0.40% -0.65% -0.62% 0.68% 3.54% 0.70%


Large Blend -0.55% 0.00% 1.32% -1.84% -0.07% -0.07% 0.17%
Large Value 0.41% -0.21% -0.41% -2.48% -0.73% -1.42% -0.08%
Mid-Cap Growth 2.68% 1.14% 2.21% 0.49% 5.15% 5.66% 2.62%
Mid-Cap Blend 1.81% 0.97% 1.31% -0.10% 2.72% 2.72% 1.56%
Mid-Cap Value 1.50% 0.92% 1.11% 2.18% 0.77% 1.14% 1.48%
Small Growth 0.02% -0.87% -0.18% 0.75% 0.59% 1.67% -3.42%
Small Blend 0.75% -0.67% 2.23% -0.69% -0.45% -0.45% -2.76%
Small Value -0.65% -0.16% -0.33% -2.07% -1.34% -2.31% -1.60%
Average 0.56% 0.17% 0.74% -0.49% 0.81% 1.16% -0.15%
Std Dev 1.16% 0.69% 1.08% 1.42% 1.88% 2.39% 1.94%
t stat 1.45% 0.74% 2.05% -1.03% 1.29% 1.46% -0.23%
Weighted -0.22% 0.06% 1.12% -1.52% 0.18% 0.34% 0.10%

Sources: Morningstar, Kenneth French

34 March/April 2010
Where Rindex is the return on the index, Rf is the risk-free rate, index funds and ETFs as of June 30, 2009. This number
αindex is the alpha of the index, βindex is the index’s beta with reflects how investors actually invest in index funds at the
respect to the market, Rmarket is the return of the market, βSMB is total asset level, versus the simple average that is used for
the index’s beta with respect to the “large” factor (SMB), βHML statistical significance purposes for each methodology.
is the index’s beta with respect to the “value” factor (HML), Among the seven methodologies, five had positive average
βMOM is the index’s beta with respect to the “momentum” alphas (Dow Jones, Dow Jones Wilshire, Morningstar, S&P and
factor (MOM), and εasset is the error term. All monthly alpha S&P Pure), and S&P’s Pure methodology had the highest alpha,
estimates are annualized for comparative purposes. For those at 1.16 percent, although only Morningstar had an average alpha
readers not familiar with four-factor regression approach, see that was statistically significant (with an average alpha of 0.74
Fama and French [1993] and Carhart [1997]. percent and a t statistic of 2.05). On a weighted basis, five meth-
Cremers, Petajisto and Zitzewitz [2008] have noted that the odologies had positive alphas: Dow Jones Wilshire, Morningstar,
standard Fama-French (three-factor) and Carhart (four-factor) S&P, S&P Pure and Russell, with Morningstar having the highest
regression models can produce statistically significant nonzero weighted alpha, of 1.12 percent, which could largely be attrib-
alphas for passive indexes primarily from the disproportionate uted to the alpha of its large blend index (1.32 percent).
weight the Fama-French factors place on small value stocks The range of outperformance decreases on a risk-adjusted
(which have performed well). While Cremers et al. introduce basis (Figure 3) when compared with the raw outperformance
regression factors that outperform standard models in their (Figure 2), to 3.57 percent from 4.28 percent, respectively.
paper, the traditional four-factor estimates are used for this There were also some changes in relative outperformance
research, due to their widespread use and acceptance. While the when viewed on a risk-adjusted basis. For example, over the
reader may contend that an index (i.e., a broad, well-diversified 12-year test period the Dow Jones Wilshire Small Growth
and passive portfolio) should not have an alpha component by Index outperformed the Dow Jones Small Growth Index by
definition, using a method that is widely employed to determine 0.09 percent (on an annualized basis, 2.75 percent and 2.66
alpha for active managers (the four-factor Carhart approach with percent, respectively); however, on a risk-adjusted basis, the
the traditional Fama-French factors) can in fact generate one. Dow Jones Small Growth Index outperformed the Dow Jones
For the analysis, regressions are based on rolling three- Wilshire Small Growth Index by .89 percent (on an annual-
year periods, which consist of 36 months of historical data. ized basis, 0.02 percent and -0.87 percent, respectively).
Rolling periods are used versus a single period to account The respective alpha estimates for the various indexes
for potential changing market exposures of the indexes over were quite consistent during the test period, both on a
time, as well as to make the analysis less dependent on the relative and absolute basis. Figure 4 provides an example; it
period studied. For example, if an index methodology did very includes the rolling three-year four-factor regression alphas
well the first and last months of the test look-back period, it for the large blend indexes included in the analysis.
may appear that it generated alpha during the entire study, As shown in the graph, while the absolute numbers fluctu-
despite the fact it dramatically under-performed the months in ate over time, the relative rankings change very little during
between. Also, the average implied holding period for equity the test period. In the aggregate, when viewed at the ranked
mutual funds is approximately three years based on a cur- index level, Dow Jones, Dow Jones Wilshire, Morningstar,
rent redemption rate of 30 percent per year [ICI 2009], which S&P and S&P Pure tended to have relatively consistent rank-
makes the rolling three-year regression method more relevant ings that were slightly above average, while MSCI and Russell
to how investors actually invest in equity mutual funds. had rankings that tended to be significantly below average
Seven different index methodologies are considered for (they also were the two methodologies with negative aver-
the analysis: Dow Jones, Dow Jones Wilshire, Morningstar, age alphas). The persistence in alpha should not be that
MSCI, Standard & Poor’s, Standard & Poor’s Pure and Russell,
with the actual underlying tested indexes listed in Appendix Figure 4
II. The time period for the analysis is from July 1997 until Rolling Three-Year Four-Factor Regression Annualized
June 2009, which is the longest period for which data was Alphas For Large Blend Indexes: July 1997-June 2009
available for the different indexes (all nine domestic styles for 8%
each of the seven different providers). Using the same period 6%
for all methodologies allows for a more relative comparison
4-Factor Alpha

4%
than using the entire period of data available for each index. 2%
The total number of three-year test periods is 109.
0%
-2%
Results
-4%
The average four-factor regression alphas for each of the
-6%
idexes for each style are included in Figure 3, as well as the Jun Oct Mar Jul Dec Apr Aug
average alpha across styles, standard deviation of alphas 00 01 03 04 05 07 08

across styles and the average alpha across the styles’ t sta- 3-Year Period Ending

tistics for each methodology. Information on the weighted ■ Dow Jones ■ Morningstar ■ S&P
outperformance is also included, where the respective alphas ■ DJ Wilshire ■ MSCI ■ Russell

are weighted by the total net assets invested in all passive Sources: Morningstar, Kenneth French

www.journalofindexes.com March/April 2010 35


surprising, given the fact the factor estimates for the indexes while an investor would typically like to invest in an index family
were relatively constant over time (they are indexes, after that generates positive risk-adjusted alpha, an active manager
all). Combined, these findings suggest that it is likely that would typically like an index that generates a negative risk-
some methodologies are likely to persistently generate posi- adjusted alpha, since it should be an easier benchmark to out-
tive/negative alphas relative to their peers in the future. perform. Interestingly, the most popular benchmarking meth-
odology, Russell, had the second-lowest alpha among the meth-
Key Takeaways odologies tested (with an average of -15 bps and a t statistic of
There are a number of important takeaways from the analy- -0.23, only MSCI’s was lower, and they specifically build indexes
sis. First, while the S&P methodology had a positive average to “better reflect the investment process of asset managers”).
alpha for all nine of its indexes, the alpha for the S&P 500 was This suggests, ignoring the potential qualitative benefits/aspects
negative (-0.07 percent, although not statistically significant). of Russell’s methodology, that Russell is an easier “hurdle” to
This has important implications, because the vast majority of overcome than most of the other indexes studied.
large blend assets that are indexed are invested in a product
that attempts to replicate the S&P 500. The only large blend Conclusion
index with a statistically significant positive alpha was the The analysis conducted for this paper introduces a simple
Morningstar Large Core Index (with an average alpha of 1.32 methodology to determine the optimal indexes with which to
percent and a t statistic of 7.82), and the only other index with invest, both at the individual style level and the overall meth-
a positive alpha for large blend was the Russell 1000 (with an odology level, after controlling for risk. Four-factor alphas
alpha of 0.17 percent and t statistic of 1.90). Investors looking varied considerably across providers during the time period
for positive risk-adjusted returns in the large blend space would tested. Five methodologies had positive average alphas (Dow
appear to be best off investing in these two methodologies. Jones, Dow Jones Wilshire, Morningstar, S&P and Russell),
Second, there can be a tremendous amount of variance and while S&P Pure had the highest average alpha at 1.16
(i.e., a high standard deviation) among the alpha estimates percent, only Morningstar’s methodology was statistically
across the categories within a methodology, with S&P and significant (with an average of 0.74 percent with a t statistic
Russell having the highest alpha standard deviation and Dow of 2.07). Morningstar also had the highest-weighted alpha, of
Jones Wilshire and Morningstar the lowest. This is important 1.12 percent, based on how monies were invested in index
when considering the fact that some investors choose to index mutual funds and ETFs as of June 30, 2009 (although this was
certain styles and not others, although they generally prefer to largely a result of the alpha of its large blend index).
utilize a provider’s entire suite of indexes (e.g., use all Russell) The S&P 500 had a negative alpha (-0.07 percent, although
versus combining different methodologies. For example, an not statistically significant), which is important given the large
investor would have fared relatively poorly if they had used amount of assets that track it (58 percent of all indexed assets).
large-cap active managers and indexed small cap with Russell- Russell, arguably the most common index for benchmarking
based index funds; however, they would have done much bet- purposes, had the second-lowest average alpha across method-
ter had they done the reverse. The ideal index methodology ology (-15 bps, although not statistically significant), suggesting
for implementation purposes across all styles would be one that it represents a relatively low hurdle for active managers to
with a positive alpha and a low standard deviation, attributes overcome compared with the other methodologies considered
in both Dow Jones and Morningstar methodologies. for the analysis. In closing, the results of this study suggest that
Third, different investors have different goals, and the goal some index providers, do, in fact, generate alpha, both on an
can have dramatic impact on the “ideal” index. For example, absolute basis and relative to their peers.

Appendix I: Index Provider Methodologies


Dow Jones: The Dow Jones U.S. Index and its subindexes are constructed and maintained according to a transparent, rules-based methodology. The indexes are weighted based on float-
adjusted market capitalization and are calculated in real time. They are rebalanced quarterly (style indexes semiannually), and in addition are reviewed on an ongoing basis to account for
mergers, acquisitions and other extraordinary events affecting index components. The large-cap and mid-cap indexes measure the top 70 percent and next 20 percent of stocks by market
capitalization. The small-cap index represents the next 5 percent of stocks, excluding the smallest companies based on market capitalization and turnover. The Dow Jones U.S. Style Indexes
measure growth stocks and value stocks. Companies determined to be style-neutral are excluded from the indexes. The style classifications are determined using a multifactor model that
accounts for projected price-to-earnings ratio (P/E), projected earnings growth, price-to-book ratio, dividend yield, trailing P/E and trailing earnings growth. (www.djindexes.com)
Dow Jones Wilshire: Dow Jones Wilshire U.S. Style Indexes are constructed by separating the Dow Jones Wilshire 5000 universe of stocks into four capitalization groups using full
market capitalization and then splitting the capitalization groups into growth and value stocks. The resulting 10 indexes are float-adjusted and market-capitalization weighted.
Instead of 12 subindexes there are 10 style benchmarks because the smallest capitalization group, microcap stocks, is not split into growth and value. Large cap is defined as the 750
largest stocks by market capitalization, small cap is the next 1,750 largest stocks from 751 to 2,500, mid cap is a combination of 500 large and small stocks from the 501st largest
to the 1,000th largest, and micro cap is all stocks in the bottom half of the Dow Jones Wilshire 5000 Index (below the 2,501st largest). The Dow Jones Wilshire style methodology
uses six intuitive fundamentals to define a company as growth or value: next year’s price-to-earnings ratio, forecast long-term earnings growth, price-to-book ratio, dividend yield,
trailing revenue growth for the previous five years, trailing earnings growth for the previous 21 quarters. (www.wilshire.com)
Morningstar: Large cap is defined as the largest 70 percent of investable securities by free-float market capitalization, mid cap is the next 20 percent by market capitalization (70th to 90th
percentile), and small cap is the next 7 percent (90th to 97th percentile). Within each capitalization class, index constituents are assigned to one of three style orientations—value, growth
or core—based on the stock’s overall style score. A stock’s value orientation and growth orientation are measured separately using related but different variables. Value factors: price/
projected earnings (50.0 percent), price/book (12.5 percent) price/sales (12.5 percent), price/cash flow (12.5 percent), dividend yield (12.5 percent). Growth factors: long-term projected
earnings growth (50.0 percent), historical earnings growth (12.5 percent), sales growth (12.5 percent), cash flow growth (12.5 percent), book value growth (12.5 percent). Morningstar
rebalances constituent shares and weights of its indexes quarterly in March, June, September and December (on the Monday following the third Friday). Immediate rebalancing occurs if
two constituents merge or a company’s free-float changes by 10 percent or more. The indexes are reconstituted twice annually, in June and December. (www.morningstar.com)
MSCI: MSCI’s domestic indices are subsets of the MSCI US Investable Market 2500, which are the Large Cap 300, Mid Cap 450 and Small Cap 1750 indexes. Market capitalization is based
on a free-float adjustment. Indexes are reviewed quarterly and rebalanced semiannually. MSCI employs a “buffer zone” approach among size and value/growth dimensions to reduce

36 March/April 2010
turnover and to better reflect the investment process of asset managers. Eight different variables (three for value and five for growth) are used to better represent value and growth styles.
Value attributes are: book value to price ratio, 12-months forward earnings to price ratio, and dividend yield. Growth attributes are: long-term forward earnings per share (EPS) growth
rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, long-term historical sales per share growth trend. (www.mscibarra.com)
Standard & Poor’s: Standard & Poor’s U.S. indexes are maintained by the U.S. Index Committee, which meets monthly and comprises eight full-time professional members of
Standard & Poor’s staff. Unadjusted market capitalization of $3 billion or more for the S&P 500 (approximately 75 percent of U.S. equities), $750 million to $3.3 billion for the
S&P Mid Cap 400 (approximately 7 percent of U.S. equities), and $200 million to $1.0 billion for the S&P Small Cap 600 (approximately 3 percent of U.S. equities). The market cap
of a potential addition to an index is looked at in the context of its short- and medium-term historical trends, as well as those of its industry. Adequate liquidity and reasonable
price—the ratio of annual dollar value traded to market capitalization—should be 0.3 or greater. Various domicile requirements; public float of at least 50 percent of the stock;
rules to minimize turnover. Changes to the U.S. indexes are made as needed, with no annual or semiannual reconstitution.
The Style index series divides the complete market capitalization of each parent index approximately equally into growth and value indexes. This series covers all stocks in the parent
index universe, and uses the conventional, cost-efficient market-cap-weighting scheme. The style indexes measure growth and value along two separate dimensions, with three factors
used to measure growth and four factors used to measure value. Growth factors: five-year earnings per share growth, five-year sales per share growth rate and five-year internal growth
rate (IGR). Value factors: book value to price ratio, cash flow to price ratio, sales to price ratio, and dividend yield. A growth score for each company is computed as the average of the
standardized values of the three growth factors. Similarly, a value score for each company is computed as the average of the standardized values of the four value factors.
Style Index Series: This series divides the complete market capitalization of each parent index approximately equally into growth and value indexes while limiting the num-
ber of stocks that overlap between them. This series is exhaustive (i.e., covering all stocks in the parent index universe) and uses the conventional, cost-efficient, market-
capitalization-weighting scheme.
Pure Style Index Series: The pure style index series identifies approximately one-third of the parent index’s market capitalization as pure growth and one-third as pure value.
There are no overlapping stocks, and these indexes do not have the size bias induced by market-capitalization weighting; rather, stocks are weighted in proportion to their
relative style attractiveness. (http://www2.standardandpoors.com/)
Russell: U.S. common stocks are ranked from largest to smallest based on free-float market capitalization at each annual reconstitution date, which is May 31. The largest 1,000 stocks
become the Russell 1000 Index, the largest 800 stocks in the Russell 1000 become the Russell Mid Cap Index and the next largest 2,000 stocks (after the largest 1,000 stocks) become
the Russell 2000 Index. Style is determined by ranking each stock by two variables: the book to price ratio and the I/B/E/S forecast long-term growth mean. The variables are combined
to create a composite value score (CVS) for each stock. The stocks are then ranked by their CVS, and a nonlinear probability algorithm is applied to the distribution to determine style
membership weights. Roughly 70 percent are classified as all value or all growth and 30 percent are weighted proportionately to both value and growth. (www.russell.com)

Appendix II: Benchmark Indices


Dow Jones Dow Jones Wilshire
Large Growth DJ Style US Growth Large Cap DJ US TSM Large Cap Growth
Large Blend DJ US Large Cap DJ US TSM Large Cap
Large Value DJ Style US Value Large Cap DJ US TSM Large Cap Value
Mid-Cap Growth DJ Style US Growth Mid Cap DJ US TSM Mid Cap Growth
Mid-Cap Blend DJ US Mid Cap DJ US TSM Mid Cap
Mid-Cap Value DJ Style US Value Mid Cap DJ US TSM Mid Cap Value
Small Growth DJ Style US Growth Small Cap DJ US TSM Small Cap Growth
Small Blend DJ US Small Cap DJ US TSM Small Cap
Small Value DJ Style US Value Small Cap DJ US TSM Small Cap Value

Morningstar MSCI
Large Growth Morningstar Large Growth MSCI US Large Cap Growth
Large Blend Morningstar Large Core MSCI US Large Cap 300
Large Value Morningstar Large Value MSCI US Large Cap Value
Mid-Cap Growth Morningstar Mid Growth MSCI US Mid Cap Growth
Mid-Cap Blend Morningstar Mid Core MSCI US Mid Cap 450
Mid-Cap Value Morningstar Mid Value MSCI US Mid Cap Value
Small Growth Morningstar Small Growth MSCI US Small Cap Growth
Small Blend Morningstar Small Core MSCI US Small Cap 1750
Small Value Morningstar Small Value MSCI US Small Cap Value

S&P S&P Pure


Large Growth S&P 500/Citi Growth S&P 500/Citi Pure Growth
Large Blend S&P 500 S&P 500
Large Value S&P 500/Citi Value S&P 500/Citi Pure Value
Mid-Cap Growth S&P MidCap 400/Citi Growth S&P MidCap 400/Citi Pure Growth
Mid-Cap Blend S&P MidCap 400 S&P MidCap 400
Mid-Cap Value S&P MidCap 400/Citi Value S&P MidCap 400/Citi Pure Value
Small Growth S&P SmallCap 600/Citi Growth S&P SmallCap 600/Citi Pure Growth
Small Blend S&P SmallCap 600 S&P SmallCap 600
Small Value S&P SmallCap 600/Citi Value S&P SmallCap 600/Citi Pure Value

continued on page 67

www.journalofindexes.com March/April 2010 37


Blanchett continued from page 37
Appendix II: Benchmark Indices continued
Russell
Large Growth Russell 1000 Growth
Large Blend Russell 1000
Large Value Russell 1000 Value
Mid-Cap Growth Russell Mid Cap Growth
Mid-Cap Blend Russell Mid Cap
Mid-Cap Value Russell Mid Cap Value
Small Growth Russell 2000 Growth
Small Blend Russell 2000
Small Value Russell 2000 Value

Works Cited
“2009 Investment Company Fact Book.” Investment Company Institute. http://www.icifactbook.org/.
Carhart, Mark M. 1997. “On Persistence in Mutual Fund Performance,” Journal of Finance, vol. 52: No. 1, 57-82.
Cremers, Martijn, Antti Petajisto, and Eric Zitzewitz. 2008. “Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation.” Working paper version July 31, 2008.
Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Bonds and Stocks,” Journal of Financial Economics, vol. 33: 3-53.
French, Kenneth R., http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Israelsen, Craig. 2007. “Variance Among Indexes.” Journal of Indexes, May/June: 26-29

Gardner continued from page 45


true of any returns-based performance metric. This fact must primary goal of target date funds is creating wealth at a
be kept in mind in interpreting the Russell TDM: It is a mea- certain fixed “cash-out” point in the future. Performance en
sure of performance over a given time period, not a predictor route to that final number is important because of how it
of future performance. influences that end result.
• Takes into account the timing of cash flows as a typical
Conclusion investor saves for retirement.
During June and July 2009, Congress held hearings and • Determines the value over a given performance period
heard testimony regarding the performance of target date by differences in the returns of the funds in the family
funds. This reflects how important these investment vehicles and the benchmark returns. A returns-based measure
have become and how great the need is for credible perfor- will capture the performance differentials that are due
mance measures. The industry needs a measure that: to glide path structure, asset mix and active/passive
• Provides a valid estimate of the true value for a given implementation, the three key components of target
family of funds, using fund returns over a limited evalu- date fund performance differences.
ation period. • Measures performance relative to a passive investable
• Reflects the relative importance of each fund’s posi- alternative.
tion on its glide path: Returns of funds near their • Can be used to meaningfully compare the performance
target dates have more influence on retirement wealth of any two families of funds over a common perfor-
than returns of more distant funds. This is because the mance period.

References
Christopherson, J.A., D.R. Cariño and W.E. Ferson (2009). “Portfolio Performance Measurement and Benchmarking,” McGraw-Hill.
Gardner, G. and A. Sirohi (2009). “The Russell Target Date Performance Metric: Description of Methodology,” Russell Research, August.
Goodwin, T. (1998). “The Information Ratio,” Financial Analysts Journal. July/August, pp. 34-43.
Maxie, D. (2009). “Getting Personal: Target date funds find ways to cut costs.” Wall Street Journal, August 3.
Spaulding, D. and J.A. Tzitzouris, ed. (2009). “Classics in Investment Performance Measurement,” The Spaulding Group.

Endnotes
1Maxie (2009).
2For calculation specifications, see Gardner and Sirohi (2009).
3The total return of global equity as measured by the 67 percent/33 percent mix of the Russell 3000 and Russell Global ex-U.S. Indexes minus the return of the Barclays Capital U.S Aggregate
Bond Index.

Disclosures
Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a subsidiary
of The Northwestern Mutual Life Insurance Company.

www.journalofindexes.com March/April 2010 67


The Future Of
Fund Ratings
Bringing mutual fund and ETF evaluations into the 21st century
Part Three

By Gary Gastineau

38 March/April 2010
I
n Parts One and Two of this article series, I examined speech, Chairman Cox actually applied the “don’t try this at
how reported fund expenses and less readily measurable home” admonition (which he attributed to reports describ-
expenses like transaction costs reduce fund returns. I sug- ing one of Harry Houdini’s feats) to the difficulty of extract-
gested using the definition of index tracking error commonly ing useful fund data from SEC reports without XBRL. On my
used by ETF analysts and advisers to organize the analysis of Scouts’ honor, the Mr. Wizard story in Part Two of this article
the elements that determine how well or how poorly a fund and the rest of this discussion of XBRL was part of a draft
performs. In this third and final article, I describe XBRL, the before the former Chairman made his speech.
key to the availability of accurate fund data and to the devel- XBRL is an open standard. It carries no royalty or licens-
opment of improved fund evaluation software that investors ing fees. The availability of clean data in a standard format
and advisers will use to improve fund selection. I also adress from most funds will permit an adviser or even a committed
some specialized tools that are useful in examining and individual investor to analyze funds with more reliable data
evaluating important fund features. than the best fund services have today. In addition to data
assembly and analytical macros provided by financial Web
Extensible Business Reporting Language: The New sites, a wide range of analysts and market pundits will be
Data Standard For Corporate And Fund Reporting able to produce custom analyses at low cost. Questions that
So far, fund industry use of XBRL consists of a few over- are rarely asked because the data to answer them has been
publicized SEC filings of risk/return summary information inaccessible will be asked and answered with ease. Everyone
from a small number of mutual fund prospectuses. The who cares will have free access to a better fund database
published information includes a few details of the funds’ than any fund service could assemble today. The fund rating
investment objectives, costs and historical performance. organizations will be competing with developers of new fund
The applicability of XBRL to a full range of financial data is analysis and evaluation software. Investors and their advisers
illustrated by the fact that it is now mandatory for many cor- will be the beneficiaries of this competition.
porate filings with the SEC. With required use of XBRL, the The downside to the XBRL story is that a full XBRL report-
accuracy of available corporate financial data has improved ing standard is not yet mandatory for funds. Some funds may
dramatically. The Investment Company Institute (ICI) has cre- decide not to use XBRL for all data, including important non-
ated XBRL categories and templates for mutual fund filings.1 financial data. It is impossible to predict the pace at which
When this project is fully operational, funds will report to the the XBRL standard will be rolled out and the data from it roll
SEC using the XBRL format, and fund analysts and advisers in. If most of the major fund companies submit a full range
will be able to use XBRL to assemble data for a full range of of XBRL data, the pressure on other funds to conform will be
fund analyses and comparisons. powerful. Realistically, however, a critical mass of funds is
The significance of full XBRL fund reporting is that ana- unlikely to submit full data without a mandatory standard.
lysts will be able to access specified elements of data, ana- The “financial crisis” of 2008 diverted attention from
lyze data from an individual fund or do comparative analyses the SEC’s normal operations and, unfortunately, diverted
of competitive funds. Most of the analyses illustrated in Part attention from XBRL, of which former Chairman Cox was a
Two will be performed using spreadsheets and macros or major advocate. Chairman Schapiro is as fully attuned to the
formal programs for periodic reports and comparisons. The regulatory needs of fund investors as anyone, but she and
key underlying change will be standardization and tagging of her colleagues at the SEC have far too many issues that need
fund data elements so that the data everyone uses will be the their attention. Fortunately, the case for XBRL fund data is
data the fund files with the SEC. compelling. The advantages of XBRL data from funds are so
To understand the potential significance of compre- great that the XBRL rollout will provide data necessary to
hensive XBRL data, one need only read the descriptions of reduce other elements of the commission’s workload.
gathering, “cleaning” and screening mutual fund data in the
academic studies of funds that have been undertaken over There Is A Wide Range Of Quality
the past 20 years. Mutual fund data extraction has moved In Fund Touts, Tools And Techniques
from handwritten ledgers to manual copying of poorly for- After an adviser and investor have worked together for a
matted hard copy SEC filings to special-purpose text search reasonable period of time, the investor might understand the
methods that extract data from eclectic electronic reports adviser’s thinking process well enough that a simple recom-
filed with the SEC. Today changing formats, missing data mendation to buy or sell a specific ETF might be accepted
items and confusing aggregations of fund family data that at once in the context of a specific investment application.
differ in format from one period to the next make data col- Obviously, that level of acceptance will only be possible after
lection the hardest part of any comparative analysis of funds. the investor is thoroughly familiar with the adviser’s deci-
Different fund services often publish different numbers for sion-making processes and has no specific questions about
the same fund. The adoption and widespread use of XBRL for the proposed transaction. The investor will know that if he
fund data will not eliminate fund data problems overnight, has a question, the adviser will have the answer and, from
but it promises to revolutionize most fund comparisons. The experience, that the answer will be fully satisfactory.
best description of the advantages XBRL brings to fund data An investor might develop a high degree of confidence
analysis that I have seen is in a speech former SEC Chairman in the analysis and recommendations of a published fund
Cox gave to a group of financial analysts in late 2008.2 In his evaluation or rating service; but most published recommen-

www.journalofindexes.com March/April 2010 39


dations either (1) are based on one or a very small number way than the iShares folks have in mind. Accept the limita-
of fund characteristics; (2) proceed from a complex weight- tion to iShares ETFs and compare one or more iShares ETFs
ing of factors that is not thoroughly revealed and that may to appropriate mutual funds. If you determine that an iShares
vary considerably from one recommendation to another in a ETF looks better than any of the mutual funds, use another
way that makes it difficult for the investor to understand the method to compare the iShares ETF(s) to other ETFs.
recommender’s “thinking” process; or (3) appear without any A number of stand-alone fund evaluation tools and tech-
context or substantiation. Common sense suggests that an niques are worthy of investor and adviser attention. I do
investor should try to understand what is behind any recom- not suggest these tools as comprehensive methods of fund
mendation. Be skeptical and ask questions. If you can’t get selection, but they can offer useful insights, particularly
your questions about a recommendation fully answered, you when used in combination or in conjunction with a more
should look for another source of investment advice. comprehensive analysis along the lines of the tracking error
Some of the data available from the fund rating services breakdown illustrated in Part Two. Unfortunately, one of the
can be very useful, particularly data that is organized to greatest problems in using tools provided on fund Web sites
answer the kinds of questions an investor or adviser might is that many of them are thoroughly “lawyered,” reducing
ask. However, much fund data aggregation and commentary their usefulness and, in many cases, reducing the access of
does not explain the data assembly or analytical process, investors to the tools. A number of ETF and other fund Web
and many recommendations are just hanging in space with sites have two levels of access: one for “investors” and anoth-
no visible means of support. er for “professionals.” The professional level often has the
One of the most frustrating and least useful practices is best and most robust information. Standards as to what kind
publication of recommended lists of mutual funds and/or of information can be made available to most investors and
ETFs from a person without obvious credentials, an anony- what can be provided only to advisers are not consistently
mous webmaster, or one or more “staff” members. It is not applied over all Web sites, but there do not appear to be any
unusual to find an unrevealed bias in the recommendations requirements that you prove you are an adviser.
from one of these sources. I came across a list of recom-
mended ETFs on a popular Web site that included no funds Portfolio Return Correlation Tools
from one of the largest ETF providers. When I examined the The most important reason to hold a diversified portfolio
funds on the recommended list, they were uncomfortably is that financial instrument returns are not perfectly corre-
similar to the funds that advertised on the Web site. lated. Diversification is usually the easiest and lowest-cost
We buy one fund rather than another because we expect way to improve the risk-adjusted return of a portfolio. Risk,
the chosen fund to deliver a better return. Even if we believe defined as the variability of returns, is almost automatically
securities returns proceed from a random process, the fund reduced by sensible diversification. If all securities are fairly
that holds the securities does not have random costs and priced relative to their risk and return contribution to the
random quirks. There is certainly scope for fund analysis and market portfolio, diversification toward the market portfo-
evaluation even if you believe that security selection is use- lio’s composition should improve an investor’s risk-adjusted
less. Accepting and acting on what may be, at best, a random results. In the context of diversification, most asset allocation
fund recommendation is not a sound investment policy. discussions focus at one point or another on the correlations
between and among baskets of assets or asset classes.
Looking For Useful Tools The arguments for diversification emphasize the risk-
Free tools abound on the Internet. Free is a great price, offsetting effect of imperfect correlation among the posi-
but we have to understand the reason something is free and tions that are combined to create a portfolio. Useful data for
consider how that reason affects how we can safely use the any fund being evaluated includes correlations to standard
tool. In short, we need some criteria to screen tools before indexes and frequently used combinations of indexes.
we use the tools to screen funds. Some of the better ETF Web sites provide correlation
I happen to like a relatively new fund comparison tool information and even correlation tools. The best of the tools
that is available on the iShares Web site. It is simple, clear I have seen are on the Sector SPDR Web site, www.spdrsin-
and it offers relevant (if not comprehensive) comparisons of dex.com, and the iShares Web site at www.ishares.com. The
up to five mutual funds and ETFs. The tool is designed to latter provides index correlations only with indexes used by
permit advisers (or investors) to construct a comparison of an iShares products, but (in the spirit of using tools in the way
iShares ETF with mutual funds and other iShares ETFs. The they are most useful to us) it is possible to calculate correla-
graphics are attractive, and most of the comparisons made tions between an iShares index or fund and a competitor’s
are relevant to the selection of one fund over another. The ETF that is based on the index of interest.3 Limited rolling
usefulness of the tool is limited by the fact that the only ETFs historical correlation calculations are possible with both
that can be used for cross-fund comparisons are iShares ETFs. the iShares and the Sector SPDRs correlation tools, but they
I can certainly understand the thinking behind restricting the are not always easy to set up, and the period covered by
usable ETFs to your own funds, but comparison software that historic data for some of these correlations is pretty short.
permitted use of a wide range of competitive ETFs would Another excellent correlation tool available on the Internet
certainly be more useful. I like this tool, but I would suggest is Asset Correlations (www.assetcorrelations.com), which
using it as part of your fund selection process in a different allows comparison of funds from multiple providers.

40 March/April 2010
The reason for measuring correlation over a sequence with a high active share shows indications of being a truly
of periods is that correlations that may be low in normal actively managed fund—at least relative to the index used as
markets are often high in bear markets. This is most often a benchmark.6 The active share can be a useful measure of
observed in cross-border equity markets where low correla- the intensity of the fund manager’s effort to deliver an active
tion in bull markets is replaced by near-perfect correlation management return. A fund with a low active share suggests
in bear markets—the precise time when lack of correlation the manager’s lack of confidence in an active investment pro-
or, even better, negative correlation is most valuable.4 The cess or, simply, inability to deliver active management.
absence of a simple, comprehensive and highly flexible cor- Some “enhanced” index funds attempt to provide only
relation tool illustrates the greatest problem with the largely modest deviations from the benchmark and keep tracking
free but limited—function tools available to fund investors error (standard deviation definition) low relative to the
on the Internet: A good correlation tool is inherently costly benchmark index. This is a reasonable investment strat-
to maintain because it requires (1) a database of historical egy, and failure to achieve a substantial active share is not
returns for a large number of financial instruments, including necessarily an indictment of an enhanced index fund man-
proprietary indexes; and (2) the capability to combine finan- ager whose mandate includes a standard deviation tracking
cial instruments and portfolio products in a variety of combi- constraint. However, a small active share does suggest a
nations and weightings over a number of time intervals. relatively modest effort at return enhancement and should
command a relatively modest active management fee.
Active Share The greatest significance of active share is that Cremers
Active security selection is undertaken to create a portfolio and Petajisto found that funds with higher active shares have
that is different from a fund’s benchmark index in ways that tended to deliver significantly better performance. The best
are expected to improve investor returns. A useful measure single explanation for that result is that the managers of
of portfolio differentiation relative to a benchmark index is a funds with low active share measures were closet indexers
calculation called active share. This calculation is described with active management fees. In that context, it is certainly
and developed extensively by Cremers and Petajisto.5 Active worth looking at an active share calculation as an indication
share measures the extent to which a portfolio differs from a of the nature of a fund’s investment process.
benchmark index. To calculate a fund’s active share relative The magnitude of a fund’s tracking error (standard devia-
to a particular index, the easiest procedure is to calculate the tion definition) has no apparent effect on performance, sug-
percentage composition of the index, security by security, gesting that individual stock selection is more likely to be a
and perform a similar percentage composition calculation for successful fund management strategy than factor bets.7 An
the portfolio being evaluated to measure the correspondence above-average prior-year return combined with a large active
between the portfolio and the index. To the extent that the share tends to presage further above-average performance.8
same security appears on both lists, the smaller percentage Average tracking error (standard deviation definition) has
for that security in either the index or the fund portfolio is little correlation with performance.9 An active share over 80
listed in the Correspondence column and the percentages combined with a modest tracking error (standard deviation)
in that column are summed as illustrated in the calculation suggests careful risk management and a serious attempt to
in Figure 1. If the correspondence percentage or overlap deliver value for investors.
between the index and the portfolio sum to 65 percent, the There is an important caveat to bear in mind when con-
active share—that is the difference in portfolio composition sidering the implications of active share. Like many other
as a result of the fund’s active investment process—is 100 variables that are measured, the act of measuring active
percent minus 65 percent, or a 35 percent active share. share may cause its significance to change. That the act of
The greater the active share, the greater the divergence measurement can change the characteristics of the item
of the fund portfolio from the benchmark index and, pre- measured is a maxim in such diverse disciplines as quan-
sumably, the more “active” the investment process. A fund tum physics and monetary policy. If active share becomes
a popular calculation, a closet indexer might create an
Figure 1
artificially high active share by systematically increasing
Percentage Holdings a portfolio’s composition differences relative to an index
without even attempting to improve the fund’s return. The
possibility of gaming a solitary active share measure is a
Stock Fund Index Correspondence strong argument for the proposition that no single fund
A 35% 20% 20%
evaluation measure should stand alone.
B 40% 20% 20%
Statistical Measures Of Active Manager Performance
C 20% 35% 20% In addition to correlation and active share calculations,
D 5% 25% 5% a number of other tools and calculations are available to
Total 100% 100% 65% permit investors to measure the nature of the management
Active Share = = 100% minus Correspondence process and the effectiveness of the manager. Beta can pro-
= 100% - 65% = 35%
vide a measure of the extent to which the portfolio manager
continued on page 54

www.journalofindexes.com March/April 2010 41


Gastineau continued from page 41 fund. Sometimes this occurs because a specific group of
is increasing or reducing the risk in the portfolio, usually to investors finds that selling an ETF short is easier, less costly
reflect increased bullishness or bearishness on the overall or better meets their objectives than the purchase of an
market and on the portfolio’s specific components. Analysis inverse fund (e.g., some of the “short” funds or exchange-
of Sharpe ratios, information ratios and return-based perfor- traded notes offered by Direxion, ProShares, Rydex and
mance analysis are additional tools that fund performance Barclays Capital) or using an index derivative like a futures
analysts can bring to bear on the analysis of active manage- contract to take a short equivalent position. A large short
ment efforts. For information on some of these tools, see interest can sometimes suggest an inefficient index or an
Wright10 and Gastineau, Olma and Zielinski.11 ineffective investment manager. These latter possibilities are
among the reasons to consider the possible negative implica-
Tax Efficiency tions of an unusually high short-interest percentage.
Some of the tax efficiency comparisons provided by exist-
ing fund services are acceptable—as far as they go—but Fund Governance
some attempts to rank funds by tax efficiency are seriously The mutual fund scandals of 2003-2004 and various efforts
misleading. Two measures of different aspects of expected to mandate fund governance changes have led some fund
and actual tax efficiency are appropriate for most funds, be services to offer evaluations of fund governance. The ethics,
they conventional mutual funds or ETFs. The first and most reputation and business practices of the manager of a fund are
important of these measures is capital gains overhang. Capital certainly appropriate concerns for an investor and an adviser
gains overhang is a fund portfolio’s net unrealized gains less who are considering ownership of shares in the fund. It is
any accumulated realized losses carried forward. It is usually also appropriate for a fund service to provide information and
measured as a percentage of the fund’s assets. Capital gains even basic analysis of various aspects of governance includ-
overhang can be calculated from fund shareholder reports ing the relative independence of the board, the nature and
as of the end of any fund reporting period for which balance timing of any regulatory investigations or settlements with
sheet and gain and loss information is reported. the SEC or state attorneys general, etc. On the other hand,
Another calculation that is useful in assessing a fund’s tax complex relative evaluations of governance practices at funds
efficiency (and the portfolio manager’s attention to detail) are of doubtful value as long as the fund’s practices comply
is the percentage of any eligible dividend distribution that with relevant laws and regulations. Ertugrul and Hegde12
is qualified for the reduced qualified dividend tax rate— found that corporate governance ratings (which have been
percentage of eligible dividends qualified. While some fund around far longer than fund governance ratings) have been
“dividend” distributions—e.g., short-term capital gains and of little value in predicting company operating and stock
distributions from real estate investment trusts (REITs) and market performance. In a very short-term study of fund gov-
bonds—are not eligible for treatment as qualified dividends, ernance ratings, Wellman and Zhou13 found that the initial
fund shareholders should be able to count on most eligible Morningstar governance ratings were more closely correlated
dividends being delivered to them as qualified dividends. with performance before the ratings were published than with
Simple percentages for capital gains overhang and percent- subsequent performance. Nearly all of the “predictive” value
age of eligible dividends qualified for several recent years for Morningstar’s post-ratings performance was in two (board
will provide an investor with all the information needed to quality and fees) of the five components of the overall ratings.
estimate the probable future tax efficiency of most funds. The For some reason, Morningstar has doubled the weighting of
temptation to translate these simple and useful percentage “Corporate Culture,”14 which Wellman and Zhou found to have
numbers into proprietary relative ratings should be firmly no significant performance predictive value.
resisted. These numbers are most useful in a simple percent- Codifying regulatory actions by the SEC, state securities
age format. Giving them different names and calculating differ- commissioners, or other regulators or law enforcement orga-
ent relationships simply confuses investors and advisers who nizations can be a useful service, but fund rating services have
use more than one source of fund information. no obvious qualifications that make them more appropriate
commentators on fund governance issues than anyone else.
Short Interest The notion of turning largely nonquantitative information into
Some exchange-traded funds regularly have short inter- a governance rating is a stretch. The publication of a formal
est percentages in excess of 100 percent. A 100 percent adverse governance rating tends to discourage investors and
short interest percentage means that a fund with 1 million advisers from examining the facts and making their own con-
shares issued by the fund has 2 million shares carried long in sidered decisions based on their personal circumstances and
accounts held by various investors. A short interest over 100 values. Furthermore, a numerical rating lets a fund governance
percent indicates that some financial intermediaries have analyst act as judge and jury, perhaps without adequate disclo-
loaned and reloaned securities to other firms to facilitate sure of the full story behind the rating.
short sales in the ETF shares. To the extent that the securi- Differences in investor values are behind the fact that
ties trading and lending process turns into a round robin, it both sin funds and SRI (socially responsible investing) funds
is not at all difficult to have an ETF with a short interest of find investor constituencies. That there is less-than-universal
several hundred percent; that is, where the shares held long agreement on a number of governance issues suggests that
in accounts are a multiple of the actual shares issued by the differences in personal values make the notion of universally

54 March/April 2010
acceptable formal governance ratings highly questionable. should also be possible. The fact that a case involving fund
To illustrate the scope for differences of opinion along the fees has reached the Supreme Court suggests far-from-uni-
“fee” dimension, Wallison and Litan15 present a strong argu- versal agreement on fund fee issues.
ment that requiring fund directors to approve a fund’s invest- If a fund service insists on taking a stance on fund gov-
ment management fee discourages price competition among ernance, it should consider any specific governance issue it
investment managers. The stickiness of fees in the face of deems relevant to a fund and either accept the governance
heavy emphasis on expense ratios in fund comparisons sug- and ethical standards at a fund company and not discuss
gests that Wallison and Litan have a point. It would certainly them or reject them entirely with a full explanation of the
not harm investors in existing funds to permit managers of reasons behind the rejection. Either a question or problem
new funds to experiment with a fund’s fee structure. As long is serious enough to encourage investors to avoid the fund
as disclosure of the possible range of fees is adequate from or it is not important enough or definitive enough to affect
the first day the fund is offered to investors, changes in fees an investment decision. Beyond a statement of the facts of
by these new funds and adoption of fee structures that are a situation, complexity in fund governance analysis and rela-
different from the fulcrum performance fees now required tive governance ratings will rarely be either fair or useful.

Endnotes
1 The early status of the Investment Company Institute XBRL Initiative is summarized in McMillan, Karrie, “Remarks at XBRL International Conference,” Vancouver, British Columbia,
Dec. 4, 2007. The timing of further XBRL implementation is difficult to forecast but the ICI seems to be the fund industry’s organization of choice for this effort. You can see where
the SEC stands on XBRL by starting at http://www.sec.gov/spotlight/xbrl.shtml. There is even a rudimentary mutual fund viewer that lets you create a simple fund comparison report
for two or three funds. A visit will impress you with both the potential for improved fund data and with how far the process has to go.
2 See Cox, Christopher, “Disclosure from the User’s Perspective,” CFA Institute Conference Proceedings Quarterly, September 2008, pp. 10-15.
3 In fairness to iShares, the cost of licensing a wide range of indexes just for this application would probably be prohibitive.
4 Chua, David B., Mark Kritzman and Sébastien Page, “The Myth of Diversification,” The Journal of Portfolio Management, Fall 2009, vol. 36, No. 1, pp. 26-35 provides a useful look
at the asymmetry of diversification.
5 Cremers, Martijn and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure that Predicts Performance,” Review of Financial Studies, September 2009, vol. 22,
No. 9, pp. 3329-3365.
6 In calculating active share, it is often useful to make the calculation relative to a number of benchmark indexes. While the S&P 500 and the Russell 1000 are highly correlated, a closet
indexer using the Russell 1000 as a fund template might have a greater active share measured against the S&P 500 than measured against the (more relevant for this fund) Russell 1000.
Cremers and Petajisto measured active share against a variety of major indexes and assumed the benchmark was the index that showed the lowest active share, (p. 3340).
7 Cremers and Petajisto, p. 3332.
8 Ibid, pp. 3354-3355.
9 Ibid, pp. 3350-3353.
10 Wright, Christopher, “Cleaning Closets,” CFA Magazine, September/October 2008, vol. 19, No. 5, pp. 20-21.
11 Gastineau, Gary L., Andrew R. Olma and Robert G. Zielinski, “Equity Portfolio Management,” Chapter 7, in Maginn, John L., Donald L. Tuttle, Jerald E. Pinto and Dennis W.
McLeavey, “Managing Investment Portfolios: A Dynamic Process,” pp. 407-476. John Wiley & Sons, Hoboken, New Jersey, 2007.
12 Ertugrul, Mine and Shantaram Hegde, “Corporate Governance Ratings and Firm Performance,” Financial Management, vol. 38, No. 1, Spring 2009, pp. 139-160.
13 Wellman, Jay and Jian Zhou, “Corporate Governance and Mutual Fund Performance: A First Look at the Morningstar Stewardship Grades,” Unpublished Working Paper, March
18, 2008.
14 Haslem, John A., “Mutual Funds,” Wiley, 2010, p. 312.
15 Wallison, Peter J. and Robert E. Litan, “Competitive Equity: A Better Way to Organize Mutual Funds,” The AEI Press, Washington, D.C., 2007.

Lijnse continued from page 25


The distribution problem is something politicians have been to be allowed to be sold. The issue of Europe’s fragmented
working on for 50 years by trying to form the European clearing and settlement system could be solved by having
Union. Unfortunately, as long as Europe remains divided, one central or several linked CSDs, much like the Depository
issuers will have to spend more time, effort and money on Trust & Clearing Corporation in the U.S., in combination with
marketing in each individual country. A good start would stricter regulations on best execution. Finally, an obligation
be to ease regulations that require ETFs to be listed locally to report OTC trades would increase transparency.

Endnotes
1 Source: DB Index Research, Weekly ETF reports—Europe, January 21, 2010

2 Source: BlackRock ETF Landscape Year End 2009

References
BlackRock Advisors, ETF Landscape, Industry Preview, Year End 2009
Bloomberg
DB Index Research, Weekly ETF reports—Europe, January 21, 2010

www.journalofindexes.com March/April 2010 55


Creating A Better
Target Date Benchmark
Looking for an innovative performance measure

By Grant Gardner and Mary Fjelstad

42 March/April 2010
T
arget date funds are becoming increasingly important ferent the glide paths—the dynamic allocation to equity and
as investment solutions for retirement savings plans. In bonds—can be from one fund family to another.
2007, the U.S. Department of Labor recognized target
date funds as a possible suitable choice as the default investment Conventional Performance Measures
option for defined contribution plans, and subsequently there Do Not Work For Target Date Funds
has been a surge of assets into these funds. As of April 2009, Traditional fund performance measures use time-weight-
assets under management in target date funds are estimated to ed portfolio returns over various periods—one month, one
be close to $314 billion.1 Investment managers have responded year, three years, etc. They group similar funds into a per-
with new products and redesigns of existing products. formance universe, comparing them against each other and
For the individual investor, investment adviser or plan spon- against a passive market index benchmark.
sor, selecting from among the variety of target date products is These measures work well for typical single-asset-class
a formidable task. One of the fundamental problems is the lack funds and can be adapted to evaluate multi-asset-class funds
of an objective, returns-based measure of performance that is with static asset allocations. However, they have serious
appropriate for evaluating target date funds. While investment shortcomings when applied to target date funds.
decisions should never be based solely on past performance, For one, the choice of a benchmark portfolio for a given
any investor choosing among families of target date funds target date fund is problematic. Over any evaluation period,
(whether an individual investor, personal investment adviser, performance will differ among the target date funds in a
plan sponsor or plan participant) is going to ask: “How have fund family, because each fund has a different asset alloca-
they performed? Have they done better than some simple tion. It seems sensible that each target date fund should
but reasonable benchmark? How has the family of funds I am have its own benchmark. For example, the return of a 2035
considering done relative to peers?” Over time, the investor fund could be compared with the return of a weighted com-
will also need to know: “How will I be able to tell if my fund is posite of stock and fixed-income indexes that is appropriate
doing what the investment manager said it would do?” for 2035 funds. This date-specific return would be based
In this article, we provide an introduction to target date upon the performance of a “benchmark” target date fund
funds and identify the key determinants of differences in that evolves along a benchmark glide path. Calculation of
performance across target date fund families. We elucidate this benchmark return, however, necessitates assumptions
why the traditional approach to benchmarking and perfor- about the glide path (the structure of the changing alloca-
mance analysis, which has long been tested for single-asset- tions to stocks and bonds over the life of the target date
class and static-mix investment products, fails to meet the fund) and the asset mix within the stock and bond asset
needs of target date fund performance measurement. We classes. Existing target date fund index providers employ
identify the desirable properties such a measure would have differing complex glide path and asset mix assumptions and
and introduce a measure that meets those requirements. different methodologies regarding glide path construction.
There is also no metric for a fund family’s aggregate
How Do Target Date Funds Work? performance. Even if benchmark portfolios for individual
Although target date funds are offered by many invest- target date funds are available to produce performance
ment managers with varying investment philosophies, they numbers on a fund-by-fund basis, using such benchmarks
nonetheless share common features. The investor chooses a can lead to poor choices. Comparing funds across differ-
fund with a target date close to his or her retirement—for ent target dates is problematic. Consider this example:
example, Target Date Fund 2040—and makes regular contri-
Figure 1
butions. The fund manager selects appropriate asset classes,
specifies an allocation among them that evolves over the life Glide Paths
of the fund, and devises the best investment strategy within
each asset class. Thus, there are three major components to % Equity
target date fund performance: 1) the glide path (the evolu- 100%
tion of the mix between equity and fixed income; 2) the 90%
allocation among the sectors of the broad equity and fixed-
80%
income asset classes; and 3) implementation through active
and/or passive vehicles within each asset class. While all of 70%

these components determine performance, the glide path 60%


is the most important determinant of the risk and return 50%
characteristics of a target date fund.
40%
The glide paths of target date funds have a common Retirement at “0”
feature: The allocation to equity declines as the fund 30%
45 40 35 30 25 20 15 10 5 0
approaches the target date. Younger investors in funds with
Years
distant target dates therefore will have a higher allocation
� Fund A � Fund B � Fund C � Fund D
to equity than older investors in funds with nearby target
dates. Despite this common framework, there is no com- This hypothetical example is for illustration only and is not intended to reflect
monly accepted glide path. Figure 1 demonstrates how dif- any actual investment.

www.journalofindexes.com March/April 2010 43


Suppose that Fundco’s 2020 fund has a higher one-year • The benchmark portfolio must be based on a transpar-
return than SaveMore’s 2020 fund and that the funds’ rank- ent and investable glide path structure and asset mix.
ings are reversed for their 2040 funds. Current approaches • It must measure the performance of a family of target
in performance evaluation would say that Fundco’s 2020 funds.
performed better than SaveMore’s, and that its 2040 per- • The measurement must be made relative to the primary
formed worse. But this is unhelpful, since both of these investment goal of building retirement wealth.
Fundco funds are, after all, simply different aspects of • It must capture the impact of the timing of cash flows
the same target date strategy. Even if it were feasible to and returns.
choose specific target date funds from among different
providers—say, the 2020 from Fundco and the 2040 from An Innovative Approach
SaveMore—over time (20 years, in this example), the 2040 To meet these new needs, a new metric has been devel-
SaveMore would evolve into the 2020 SaveMore. In this oped that will combine the monthly returns of a fund fam-
sense, when you buy one target date fund from a family, ily’s suite of target date funds to generate a performance
you are buying all of that family’s funds, since they all move measure over a specified period. The Russell Target Date
along the same glide path. Furthermore, since you cannot Metric (TDM) is the ratio of retirement wealth generated by
feasibly mix target date fund selections between providers, a fund family to the wealth generated by investing in a set
no actionable information for participants or plan sponsors benchmark over the same period.
is contained in this comparison. The intuition behind the TDM is simple. The longest-dat-
Finally, traditional approaches do not meaningfully mea- ed target date funds typically have about 45 years until the
sure a target date fund in terms of meeting its invest- target date. If we had 45 years (540 months) of return data
ment goal. Traditional time-weighted returns are purposely for a given target date fund and for the benchmark fund, and
designed to remove the effects of the timing of cash flows. a path of 540 monthly contributions, it would be possible to
This is appropriate for measuring the performance of an calculate the “true value” of the TDM and measure success.2
equity or bond manager who faces cash inflows and out- That true value would be the ratio of ending wealth gener-
flows that are beyond his or her control. Yet the essential ated by the target date fund to the ending wealth generated
purpose of a target date fund is to take a stream of cash by the benchmark fund. By construction, it would take into
flows over time and create wealth. To measure the success account the entire glide path and the timing of cash flows.
of target date funds in a manner consistent with the primary Unfortunately, 45 years is a long time to wait to measure
investment purpose, it is necessary to incorporate both the performance. We need something that gives us useful infor-
size and the timing of cash flows. Time-weighted returns mation about the target date fund over shorter periods, such
assume away a critical aspect of target date performance. In as three months, year-to-date, and one, three and five years,
particular, time-weighted returns ignore the fact that returns that are typical of performance measures.
in the final few years before the target date have much more Constructing this performance measure based on limited
impact on the retirement wealth of a typical investor than do periodic returns means that certain assumptions about target
returns in the early years. Thus, Russell believes an appropri- date funds must be made. These assumptions should reflect
ate performance metric for target date funds should give empirical realities of the actual products in the marketplace
greater importance to returns nearer the target date. and the behavior of investors. Unfortunately, there is limited
evidence on many of the needed assumptions. When there
Essential Characteristics is limited evidence and divergence of opinion, it’s often best
Of A Target Date Performance Metric to start with the simplest assumptions. As this marketplace
Regardless of what type of fund is being evaluated, we matures, these assumptions may change, and the methodol-
believe that a performance metric should have the following ogy of any new target date metric can evolve as well.
characteristics: The current assumptions employed in the TDM are:
• It should allow comparison with a benchmark portfolio • The glide paths for target date funds begin 45 years before
that is an investable alternative strategy. the target date. This is based on the observation that few
• It should allow the construction of a performance universe fund families currently have target dates beyond 2050.
of similar funds that provides a fair, objective comparison. • For each fund family, target date funds exist at five-year
• It should be based on actual fund returns. intervals. If there are gaps in the fund lineup, the returns
• It should measure the fund’s success in performing an of the missing funds are generated either by taking the
investment “task” over a specified period. average return of the funds with next highest and next
Traditional time-weighted returns satisfy these standards lowest target dates, or, if no fund with a higher target
when applied to conventional equity and fixed-income funds date exists, by making a linear projection based on the
and to balanced funds with static allocations. In developing two funds with the closest target dates.
a performance metric for target date funds, these same stan- • $1 is deposited at the beginning of each month for
dards should be met. 45 years (540 periods). This assumption is made for
For target date funds, additional requirements need simplicity. While conventional wisdom and empirical
to be met: evidence suggest that defined contribution plan par-

44 March/April 2010
ticipants’ contributions increase as the target date gets Performance Universe Example
closer, estimates of the growth in contributions vary. Figure 2 shows TDM calculations for nine randomly
• A simple and feasible (if primitive) benchmark is a selected actual fund families over various performance
constant allocation of 40 percent Russell 3000®, 20 intervals ending in June 2009. This table illustrates a basic
percent Russell Global ex-U.S. Index and 40 percent performance universe.
Barclays Capital U.S. Aggregate Bond Index. This The essential requirement of a performance universe is to
benchmark reflects the returns to a balanced fund provide an unambiguous rank ordering of the universe mem-
with a constant allocation mix to stocks and bonds, bers over a specified return history. This ordering creates a
and as such, is a transparent, investable alternative single number that represents the overall performance of all
to target date funds. target date funds in a family. Moreover, as just discussed,
Using these assumptions, we calculate a periodic bench- the TDM quantifies the magnitude by which each fund fam-
mark over a specific evaluation horizon that is a valid esti- ily outperforms the benchmark, as well as the magnitude by
mate of the true value of the target date metric. which one family outperforms another universe member.
From Figure 2 we observe:
Interpreting The TDM • Family 1 is the only one that outperforms the bench-
The TDM is the ratio of the wealth generated by a family mark over the one- and two-year periods.
of target date funds to the wealth generated by the bench- • Over the most recent quarter, all fund families have
mark fund over a specific time period. If a fund family’s TDM outperformed the benchmark; Family 1 comes in sev-
over a three-month period is 105, that indicates that the enth out of nine over the quarter.
fund family generated 5 percent more in target date wealth While every aspect of a fund family’s investment pro-
over those three months than did the benchmark portfolio. cess—the glide path, allocations among sectors of the
Each evaluation horizon—three months, one year, three fixed-income and equity asset classes, the use and success of
years, etc.—will have its own value of the TDM. active management, etc.—influences the returns and hence
The TDMs of different families over the same evaluation the TDM, it is possible to determine some general character-
period can be compared directly with each other, meaning that istics of the investment policy and the return environment
conventional performance universes can be constructed at the that drive universe ranking.
family-of-funds level. For example, suppose that for this three- The primary drivers are the overall equity/fixed-
month period, the TDM for the Fundco target date funds was income allocation along the glide path and the relative
110, while the competitor SaveMore target date funds had a returns to equity and fixed income over an evaluation
TDM of 121. These values mean that over these three months: interval. Generally, fund families with higher overall
• Fundco’s target date funds added 10 percent more to equity allocations will rank higher than those with lower
retirement wealth than the benchmark portfolio, while equity allocations in periods when stocks outperform
SaveMore’s target date funds added 21 percent more. bonds. This characteristic seems obvious, and would be
• SaveMore’s funds outperformed Fundco’s funds— trivial if the families’ glide paths never “crossed.” That is
SaveMore’s funds added 10 percent more to retire- to say, if for any possible pair of glide paths in the uni-
ment wealth than did Fundco’s (121 is 10 percent verse, one family had a higher allocation to equity than
larger than 110). the other family at every point on the glide path, then
the family with the consistently higher equity allocation
Figure 2 would likely have a higher TDM than the other over
evaluation periods when stocks outperformed bonds.
TDM For Periods Ending
June 30, 2009
However, glide paths of families do indeed cross, and it
is important to consider an overall measure of relative
Family
3 1 2 3 performance for this very reason.
Months Year Year Year The sample universe in Figure 2 gives a sense of the
Family 1 114.1 100.3 105.0 92.1 range of values in a TDM performance universe. Note
Family 2 125.2 86.3 76.4 74.6 that for every evaluation period except the most recent
Family 3 110.4 80.0 75.9 74.3
quarter, bonds outperformed stocks by a significant mar-
gin. The distinct difference between the performance of
Family 4 142.2 73.5 64.8 66.5
Family 1 and the other members of the universe suggests
Family 5 112.8 73.0 68.4 63.2 that Family 1 may have a generally higher bond exposure
Family 6 123.2 69.0 70.8 63.0 than the other families. Family 9’s performance over the
Family 7 131.0 65.0 63.6 60.0 different periods suggests a high equity allocation. This
Family 8 125.6 74.6 62.7 53.9 sample universe demonstrates that the TDM captures
Family 9 133.6 50.2 45.2 42.9
the impact on performance of notable differences among
target date fund products.
TDM Equity – Bond Return3 19.2% –33.8% –49.1% –40.8%
Performance ranking is sensitive to time period. This is
Sources: Russell, Barclays Capital, Morningstar continued on page 67

www.journalofindexes.com March/April 2010 45


Blanchett continued from page 37
Appendix II: Benchmark Indices continued
Russell
Large Growth Russell 1000 Growth
Large Blend Russell 1000
Large Value Russell 1000 Value
Mid-Cap Growth Russell Mid Cap Growth
Mid-Cap Blend Russell Mid Cap
Mid-Cap Value Russell Mid Cap Value
Small Growth Russell 2000 Growth
Small Blend Russell 2000
Small Value Russell 2000 Value

Works Cited
“2009 Investment Company Fact Book.” Investment Company Institute. http://www.icifactbook.org/.
Carhart, Mark M. 1997. “On Persistence in Mutual Fund Performance,” Journal of Finance, vol. 52: No. 1, 57-82.
Cremers, Martijn, Antti Petajisto, and Eric Zitzewitz. 2008. “Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation.” Working paper version July 31, 2008.
Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Bonds and Stocks,” Journal of Financial Economics, vol. 33: 3-53.
French, Kenneth R., http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Israelsen, Craig. 2007. “Variance Among Indexes.” Journal of Indexes, May/June: 26-29

Gardner continued from page 45


true of any returns-based performance metric. This fact must primary goal of target date funds is creating wealth at a
be kept in mind in interpreting the Russell TDM: It is a mea- certain fixed “cash-out” point in the future. Performance en
sure of performance over a given time period, not a predictor route to that final number is important because of how it
of future performance. influences that end result.
• Takes into account the timing of cash flows as a typical
Conclusion investor saves for retirement.
During June and July 2009, Congress held hearings and • Determines the value over a given performance period
heard testimony regarding the performance of target date by differences in the returns of the funds in the family
funds. This reflects how important these investment vehicles and the benchmark returns. A returns-based measure
have become and how great the need is for credible perfor- will capture the performance differentials that are due
mance measures. The industry needs a measure that: to glide path structure, asset mix and active/passive
• Provides a valid estimate of the true value for a given implementation, the three key components of target
family of funds, using fund returns over a limited evalu- date fund performance differences.
ation period. • Measures performance relative to a passive investable
• Reflects the relative importance of each fund’s posi- alternative.
tion on its glide path: Returns of funds near their • Can be used to meaningfully compare the performance
target dates have more influence on retirement wealth of any two families of funds over a common perfor-
than returns of more distant funds. This is because the mance period.

References
Christopherson, J.A., D.R. Cariño and W.E. Ferson (2009). “Portfolio Performance Measurement and Benchmarking,” McGraw-Hill.
Gardner, G. and A. Sirohi (2009). “The Russell Target Date Performance Metric: Description of Methodology,” Russell Research, August.
Goodwin, T. (1998). “The Information Ratio,” Financial Analysts Journal. July/August, pp. 34-43.
Maxie, D. (2009). “Getting Personal: Target date funds find ways to cut costs.” Wall Street Journal, August 3.
Spaulding, D. and J.A. Tzitzouris, ed. (2009). “Classics in Investment Performance Measurement,” The Spaulding Group.

Endnotes
1Maxie (2009).
2For calculation specifications, see Gardner and Sirohi (2009).
3The total return of global equity as measured by the 67 percent/33 percent mix of the Russell 3000 and Russell Global ex-U.S. Indexes minus the return of the Barclays Capital U.S Aggregate
Bond Index.

Disclosures
Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a subsidiary
of The Northwestern Mutual Life Insurance Company.

www.journalofindexes.com March/April 2010 67


Fixing The Flaws With
Target Date Funds
Mitigating risk and adding value through a new index framework

By Navaid Abidi and Dirk Quayle

46 March/April 2010
S
electing the appropriate target date fund (TDF) is a Risk Of Bundled Services
challenge for even the most sophisticated profession- The TDF manager’s bundling of four methodologies into a
als. As evidenced over the past two years, there can single product can mask the embedded risks associated with
be a wide disparity in the performance of TDFs, making the poor choices at any of the four steps. Major differences in
risk of picking a single provider significant. This paper pres- asset allocation exist but are not always obvious. For example,
ents a new TDF index based on a dynamic market average, some TDFs have high-yield bonds, TIPS and emerging market
thereby avoiding risks associated with a single provider’s investments in their asset class models; others don’t. A poorly
methodology. This paper also presents a methodology designed retirement methodology may not provide young
framework that can be used to build custom target date investors with enough market risk to grow their capital, or
solutions based on different market assumptions. The TDF may expose late-stage workers to excessive market risk. A poor
index mitigates asset allocation and retirement methodol- investment manager selection in any one of the tracker funds
ogy risks while allowing an institution/adviser to add value for asset classes could result in overly concentrated portfolios,
based on investment selection. The index’s methodology excess turnover with high tracking error and high manage-
framework allows an institution to create a customized ver- ment fees. Some TDFs in 2008 were caught with illiquid fixed-
sion of a target date index based on its specific needs. income securities that had been characterized as low-risk cash
TDFs are designed to automatically manage inves- equivalents. Lastly, a poorly designed rebalancing algorithm
tor assets with an age-appropriate investment strategy can result in high tracking error to the target asset allocation,
that becomes more conservative as the target date is or might not reinvest the dividends on a timely basis.
approached. Target date funds can provide a good option
for plan sponsors and advisers looking for an automated Existing Target Date Industry Indexes
way to maintain appropriate diversification over time, but Standard indexes are created in order to measure market
selecting the appropriate target date funds has been a performance by providing a reference point for peer invest-
challenge for even the most sophisticated professionals. ment funds managers. In addition, standard indexes provide
This is because TDFs bundle investment management with an alternative for investors to implement using low-cost
retirement advice to combine four methodologies that mutual funds and ETFs. The TDF indexing market is more
result in a single package that is easy to use, but difficult complex since there are multiple types of risk embedded
to decipher. in the target date market. Defining the market is the first
Four methodologies bundled by TDF managers: step. Firms such as Dow Jones and Morningstar have created
1. an asset allocation methodology that specifies a set of target date benchmark index series based on proprietary
efficient portfolios methodologies (see Figure 3). These firms derive and pres-
2. a retirement methodology that determines a glide path ent an index series for advisers and investment managers to
with a changing portfolio allocation track and benchmark against. But since most asset managers
3. a fund selection methodology that tracks asset class believe they are equally or more qualified to derive asset allo-
benchmarks cations and glide paths, Dow Jones and Morningstar indexes
4. a rebalancing methodology of funds that tracks the can be classified in the same category as any asset manager:
target asset allocation They are third-party methodologies encapsulating the index
As was apparent in 2008 and 2009, making active decisions creators’ own unique proprietary views and risks. Investable
about four contributing methodologies that apply to TDFs
provides many opportunities for performance divergence. Figure 1

2007 Performance Of TDF Managers


Target Date Funds: Risks Exposed
TDFs experienced their first real test during the market
turmoil of the past two years, and to some degree, they 2007 Return
failed. Consider three 2010 funds from Oppenheimer, Oppenheimer 2010 Fund +7.16%
Wells Fargo and Fidelity. Figure 1 shows what an investor
Fidelity Freedom 2010 Fund +7.43%
would have seen had they looked at the 2007 performance
Wells Fargo Advantage 2010 Fund +7.10%
of each fund before making a TDF investment decision at
the beginning of 2008. Source: Morningstar
The returns look similar enough. Yet Figure 2 shows how Figure 2
the investor would have done in 2008 and 2009.
That was an incredible performance range for funds tar- 2008-09 Performance Of TDF Managers
geting an imminent retirement date in two years. With that
short time horizon, it was logical to assume a consistent, 2008 Return 2009 Return
conservative risk/return profile across the industry, but that Oppenheimer 2010 Fund -41.20% 23.80%
clearly wasn’t the case. This performance variance highlights
Fidelity Freedom 2010 Fund -25.30% 24.82%
the difficulty for investing professionals expected to effec-
tively analyze and select a fund/methodology initially, and Wells Fargo Advantage 2010 Fund -10.75% 12.76%
then monitor with rigor in the future. Source: Morningstar

www.journalofindexes.com March/April 2010 47


Figure 3

Existing TDF Benchmark Indexes

Morningstar DJ Real
Methodology S&P TD Index
Lifetime Index Return TD Index

Prescriptive: MPT, constant lifetime


Theory Descriptive: Holdings style Prescriptive: Risk targeting
market portfolio targeting, through
analysis for industry consensus. real returns.
estimation of human capital.
Peer average of holdings of manag- Methodology Unclear.
MPT combined with human capital
ers that meet AUM criteria. Index Target level of total equity alloca-
Glide Path Methodology theory-based glide path with LDI
calculation excludes 10% extreme tion gliding down from 90% to
targeting.
outliers of asset allocation. about 30% at retirement.

To date target. Investor liquidates


Through date target. Investor
Terminal portfolio 3 years after funds at retirement. Capital accu-
Maturity Treatment spends down capital through
retirement year. mulation during early years, real
retirement based on income fund.
inflation hedge near retirement.

2045 - 90% 2045 - 90% 2045 - 90%


Equity Allocation
2010 - 40% 2010 - 47% 2010 - 30%
Number of Asset Classes 9 9 (+8) 5 (+4)
Reconstitution Annually Annually Semiannually
Rebalancing Annually Quarterly Semiannually

Source: Index providers

TDF solutions based on these TDF indexes pose the same MarketGlide Target Date Index Series
risks of a single provider as discussed above. The MarketGlide Target Date Index (MGI) Series is a set of
The only major benchmark that is market based is the portfolios that track the consensus asset allocation of the tar-
S&P Target Date Index Series, which is constructed through get date industry in five-year increments for investors retiring
an annual survey of the holdings of target date funds in the in 2010 through 2050 (see Figure 4).
industry. The index series provides a fixed perspective of the The MGI is based on an equally weighted statistical esti-
TDF industry’s asset allocation based on S&P’s chosen asset mate of the asset allocation glide path of each TDF manager
class index benchmarks. with at least $100 million in assets under management (AUM)
Another approach to creating a market index is to analyze and at least 24 months of returns history. MGI is constructed
the behavior of the actual investments. One of the fundamen- using a set of asset class indexes that provide coverage of the
tal assumptions of modern financial asset pricing theory is general investable risk exposure of the TDF industry.
that the expected returns of investment funds are driven by The asset allocation glide path developed by any TDF man-
how the investments behave relative to systematic risk factors ager is based on two primary sets of assumptions: (1) a set of
and not by what they hold. The new MarketGlide Target Date capital market assumptions; and (2) the profile of a representa-
Index Series is the first behavior-based target date indexing tive investor’s savings and retirement requirements. The specific
methodology, and tracks the average performance of target choices within these two sets of assumptions provide significant
date managers more closely than any other index. opportunity for TDF investment performance disparities. As a
Figure 4 result, TDFs can have significantly different asset class portfolios
with respect to target date. A particular TDF manager will have
MarketGlide Asset Allocation Glide Path superior returns to peers only to the extent that the random
100% realization of financial markets returns most closely align with
90% the manager’s particular allocation strategy and security selec-
80%
70%
tion. MarketGlide estimates the custom asset allocation glide
60% path of each TDF family using a new statistical technique that
50% calibrates the systematic risk factors exposure by target date.
40%
30%
The MarketGlide index series reflects the collective methodol-
20% ogy assumptions of the major public TDF families, and results
10% in asset allocations that have robust performance in the face of
0%
40 35 30 25 20 15 10 5 0 -5 extreme financial market co-movements, in part because they
Years To Maturity avoid the idiosyncrasies or timing errors that are associated
■ Cash ■ TIPS ■ US Bonds ■ High Yield ■ REIT ■ Emerg Eq ■ Int  Dev Eq with individual managers.
■ US Small Cap ■ US Large Value ■ US Large Growth
Figure 5 shows how the out-of-sample monthly performance
Sources: Business Logic; Morningstar     of MGI Series portfolios closely tracks the average returns of

48 March/April 2010
the TDF managers. The tracking error is asymmetrical in up and Figure 5
down markets. MGI results include a 25-basis-point manage- Average Monthly Tracking Error Of MarketGlide
ment fee to put it on similar footing as a low-cost index fund. Index Vs. TDF Managers
Figure 6 shows the annual and cumulative performance of
the MarketGlide 2010 and 2040 indexes compared with the 2005-09 Target Date Funds
performance mean and range of the industry from 2005 through MGI
2010 2020 2030 2040
2009. MGI achieves its stated goal of closely tracking the indus- TDF Manager
try’s average annual returns performance. MGI outperforms the MGI Avg 0.08% 0.06% 0.04% 0.03%
average manager’s cumulative return over the five-year period Tracking Error
due to the asymmetrical tracking error in down markets.
Up Market -0.13% -0.10% -0.11% -0.14%
Months Error
Methodology Behind The MGI
Down Market 0.50% 0.40% 0.38% 0.39%
Months Error
Glide Path Style Analysis
MGI relies on a new technique—glide path style analysis Sources: Business Logic; Morningstar
(GPSA)—that optimizes an asset allocation glide path and
thereby recovers the systematic risk behavior of a TDF family. TDFs. RBSA assumes that the style of a manager is constant
The technique assumes TDFs are long-term investments with through time and cannot be used for analysis of investments
a stable asset allocation glide path policy that is consistent such as TDFs, which change their asset allocation over time.
across different dated funds of a given family. Generally, TDFs It is a common industry practice to use a “rolling window”
are fully invested, do not employ leverage and are likely to hold RBSA to check for shift in investment style over time. For
diversified investments reflective of broad asset class exposure example, Figure 7 depicts 18-month rolling windows used
of equities and fixed income, and the asset allocation changes to analyze the historical behavior of the TDF 2010 and 2040
slowly over time as the TDF gets closer to the target date. fund members for a family. As expected, the funds changed
GPSA extends returns-based style analysis (RBSA) to cover their asset allocation over time, but there is also a significant
Figure 6

Performance Of MarketGlide Target Date Index Series

MarketGlide 2010 Index versus TDF Industry (a) MarketGlide 2010 Index versus TDF Industry (b)
40% 40%
30% 30%
Cumulative Return

20% 20%
Annual Return

10%
10%
0%
0%
-10%
-10%
-20%
-30% -20%
-40% -30%
Year Year
-50% -40%
2009 2008 2007 2006 2005 2009 2008-2009 2007-2009 2006-2009 2005-2009
Max 31.5% -10.8% 9.5% 14.4% 6.3% Max 31.5% 5.6% 13.5% 23.3% 25.0%
Min 12.8% -41.2% 2.9% 3.3% 1.4% Min 12.8% -27.2% -22.0% 1.1% 6.7%
Mean 22.7% -23.8% 6.2% 9.5% 4.5% Mean 22.7% -6.7% -1.0% 9.6% 14.9%
MarketGlide 21.5% -19.0% 6.5% 10.2% 4.8% MarketGlide 21.5% -1.6% 4.8% 15.5% 21.1%

MarketGlide 2040 Index versus TDF Industry (c) MarketGlide 2040 Index versus TDF Industry (d)
50% 50%
40% 40%
30%
Cumulative Return

30%
Annual Return

20%
10% 20%
0% 10%
-10% 0%
-20%
-10%
-30%
-40% -20%
Year Year
-50% -30%
2009 2008 2007 2006 2005 2009 2008-2009 2007-2009 2006-2009 2005-2009
Max 40.6% -31.2% 11.0% 18.3% 9.1% Max 40.6% -11.2% -5.4% 6.2% 14.2%
Min 26.1% -41.3% 1.8% 4.7% 2.9% Min 26.1% -22.4% -17.8% -6.3% 1.8%
Mean 31.8% -37.4% 6.9% 14.4% 7.1% Mean 31.8% -17.7% -11.9% 0.2% 7.3%
MarketGlide 32.1% -35.4% 7.4% 15.3% 7.0% MarketGlide 32.1% -14.6% -8.3% 5.7% 13.1%

■ Max ■ Min ● Mean ■ MarketGlide

Sources: Business Logic; Morningstar      

www.journalofindexes.com March/April 2010 49


Figure 7

Rolling Window Style Analysis Of TDF Family A 2010 And 2040 Funds

100% 100%
90% 90%
80% 80%
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 0%
1999 2001 2003 2005 2007 2009 2001 2002 2003 2004 2005 2006
2010 fund 2040 fund
■ Cash ■ TIPS ■ US Bonds ■ High Yield ■ REITS ■ Emerg Eq ■ Int  Dev Eq ■ US Small Growth ■ US Large Value ■ US Large Growth

Sources: Business Logic; Morningstar   

amount of noise. As can be seen from the rolling style analy- has five parameters that dictate its shape: a starting value
sis results of TDF Family A 2040 fund, the fund had above a asymptotic allocation, ending asymptotic allocation, time of
90 percent allocation to stocks in 2002 and that allocation maximum rate of allocation change, the maximum growth rate
seemed to shift slightly toward bonds after 2003, while the of allocation/year, the last parameter that dictates asymmetry
TDF 2010 fund shows a much more significant and growing of the curve. When GPSA performs the function fit, it assumes
exposure to bonds. the TDF manager followed a consistent asset allocation glide
Each window RBSA provides an estimate of the asset alloca- path across all funds within the same TDF family. As can be
tion around the midpoint time of the window used. This insight seen in Figure 9, different values of the S-curve parameters can
is crucial to the GPSA method. GPSA transforms these rolling generate shapes of equity glide paths that span a wide range
window results into a common time-based measure by subtract- of plausible investment policy choices of TDF managers.
ing the midpoint time period of the RBSA window from the tar- The curve-fitting problem for the entire asset allocation
get date of the fund. The center of each time window provides glide path is solved using a hierarchical nonlinear least-
an estimate of the fund manager allocation based on the length squares fit algorithm that first fits the equity/fixed split of
of time from target date. This common time unit allows GPSA to the manager, and then traverses down to fit more granular
consolidate all the rolling windows style analysis (RWSA) results asset classes. The last aggregate cumulative portfolio is
for all the funds from a particular target date family. The aggre- assumed to sum to a 100 percent allocation at each point in
gate results for TDF Family A in Figure 8 provides new clarity to the glide path. The algorithm requires specification of the
the funds’ behavior. From this, it is apparent that a TDF family’s hierarchical tree structure of the grouping of the asset class
asset allocation style becomes more conservative as each fund benchmarks. Specifying this asset class hierarchy ensures
gets closer to its target date. that the GPSA algorithm partitions the analysis so that it
To address the RWSA measurement noise, the GPSA meth- first focuses on the macro view, and iteratively zooms in to
od performs a nonlinear least-squares fit of a multivariate func- fit the micro view. The resulting glide paths quickly become
tion to filter the noise in portfolio transitions over time. The stable at the equity/fixed level and are further refined by
“S-curve” function family is chosen because its shape naturally tuning the finer details with arrival of new returns data. The
fits the shape of an asset allocation glide path. This function entire process is embedded within a model simplification
algorithm to build the most statistically powerful model
Figure 8
with the fewest asset classes that explain the largest per-
Family A Asset Allocation Glide Path centage of returns variance of the TDF manager.
GPSA validation can be performed using results based on
100% leading TDF families that resemble actual industry reference
90%
80%
points. The estimated glide path is then used to create a
70% custom TDF benchmark for each target date fund of the fam-
60% ily. The performance of each fund can be measured against
50%
40%
this benchmark. The GPSA-based custom TDF benchmarks
30% account for more than 99.9 percent of the variance of the
20% idealized TDFs and fit the asset allocation portfolios to with-
10%
0%
in 0.1 percent. These adjusted R-squared statistics reflect
40.5 33.5 28.5 23.5 18.5 13.5 8.5 3.5 -1.5 -6.5 the average for each of the funds of a TDF family. The results
Years to Maturity validate that the GPSA algorithm can reverse-engineer glide
■ Cash ■ TIPS ■ US Bonds ■ High Yield ■ REITS ■ Emerg Eq paths of known TDF families and can be applied to the real
■ Int  Dev Eq ■ US Small Cap ■ US Large Value ■ US Large Growth
world with confidence.
Sources: Business Logic; Morningstar     The MGI selection criteria for TDF managers is that they

50 March/April 2010
Figure 9 managers who generally invest in well-diversified broad asset
S-Curve-Generated Sample Equity Allocation Glide Paths classes and have a stable asset allocation glide path policy. The
results also indicate that TDF managers with lower adjusted-
R-squared statistics violate some assumptions of our simple
1 five-asset-class GPSA analysis validation test. One major reason
0.9
is that the five-asset-class benchmarks set used for this basic
0.8
GPSA validation test did not span all the risk factors invested
0.7
0.6 in by the other half of the selected TDF managers.
0.5 In an effort to achieve higher adjusted R-squared statistic
0.4 results, the GPSA analysis was performed again with a set of
Defensive
Conservative 0.3 10 asset class benchmarks (Appendix A) that better reflect
Moderate
Aggressive
0.2 the general investment risk taken within the TDF industry.
0.1 The worst adjusted R-squared result for the previously unex-
0
40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -2 -4 -6
plained TDF manager shows significant improvements, from
Years To Maturity
92 percent to above 96 percent. The improved TDF manag-
ers require a more granular asset allocation glide path for
Source: Business Logic    GPSA to explain these managers’ behavior. The improvement
of fit is especially important for managers with significant
are publicly traded, have over $100 million in AUM and have allocations into nontraditional asset classes such as emerging
24 months of publicly available returns history for institutional markets, REITs, TIPS and high yield.
share class investments. The GPSA process was first performed
with a simple set of five broad asset classes including U.S. Summary
large and small cap, international equities, U.S. bonds and The target date fund market has the potential to simplify
short-term T-bills. Of the selected TDF managers, four manag- investor behavior for a large segment of the retirement mar-
ers had average family adjusted R-squared statistics over 99 ket, but it has experienced significant growing pains with
percent, half of the managers had values above 98 percent and wide performance disparities that have been difficult to pre-
all had values above 92 percent. The model fit was validated dict due to the complexity of underlying building blocks. New
and revealed valuable information about the TDF industry. index approaches are required to offer better insight into the
About half of all the TDF families are nearly perfectly repli- target date market and thereby reduce target date methodol-
cated by our simple GPSA five-asset-class model; these are ogy risk for investment professionals and investors.

References
Black, F., Jensen, M.C., and Scholes, M. (1972). “The Capital Asset Pricing Model: Some Empirical Tests,” in “Studies in the Theory of Capital Markets.”
Bodson, L., Hübner, G., and Coën, A. (2008). “Dynamic Hedge Fund Style Analysis with Errors-in-Variables.”
Fama, E.F. and French, K.R. (1992). “The Cross-section of Expected Stock Returns.”
Jukic, D. and Scitovski, R. (2003). “Solution of the Least-Squares Problem for Logistic Function,” Journal of Computational and Applied Mathematics.
Lucas, L. and Riepe, M.W. (1996). “The Role of Returns-Based Style Analysis: Understanding, Implementing, and Interpreting the Technique,” Working Paper, Ibbotson Associates.
Pizzinga, A., Vereda, L., Atherino, R. and Fernandes, C. (2008). “Semi-strong dynamic style analysis with time-varying selectivity measurement,” Applied Stochastic Models in
Business and Industry.
Roll, R. and Ross, S.A. (1984). “The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning,” Financial Analysts Journal.
Sharpe, W.F. (1992). “Asset Allocation: Management Style and Performance Measurement,” Journal of Portfolio Management.
Swinkels, L.A.P. and van der Sluis, P.J. (2002). “Return-Based Style Analysis with Time-Varying Exposures.”

Appendix A: Asset Class Benchmark Indexes


Benchmark Index
U.S. Large Cap Growth Russell 1000 Growth
U.S. Large Cap Value Russell 1000 Value Index
U.S. Small Cap Russell 2000 Index
International Developed Equities MSCI EAFE Index
Emerging Market Equities MSCI Emerging Markets Index
U.S. REIT MSCI US REIT Index
High-Yield Bonds Barclays High Yield Index
U.S. Bonds Barclays U.S. Aggregate Gov/Credit Index
Cash Citigroup 3-Month T-Bills Index
U.S. TIPS Barclays US TIPS Index

www.journalofindexes.com March/April 2010 51


Welter continued from page 29 seen in 2008, the strong run-up since June 2009 is an indica-
Figure 2 tion that the value of supply will continue to grow in 2010.
This upward trend in lendable value is also mirrored in
Number Of European ETFs Out On Loan the number of European ETFs that are being made available
350 to borrow. As illustrated in Figure 4, the number increased
significantly at the tail end of 2009, from roughly 200 in April
300
to more than 300 by the end of December.
250

200
The Top 10 European ETFs Of 2009, By Loan Value
The ETFs that saw the highest 2009 average U.S. dollar
150 loan value were predominantly iShares funds. The iShares
100 FTSE 250 consistently saw the highest level of demand, fol-
lowed by the Lyxor Euro Stoxx 50 ETF.
50
In terms of lending revenue, the average lending rate for the
$0 top 10 ETFs in most cases exceeded the ETF management fee.
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09 In fact, the lending rate was also in excess of the rates charged
Source: Data Explorers Figure 5

Figure 3 Securities Lending Top Ten European ETFs

European ETF Lendable Value Avg


Avg Total Wholesale
$16 Name
Balance Lending Rate
$14 (Fee)

$12 iShares FTSE 250 GBP $79mm 2.70%


Lyxor ETF DJ Euro Stoxx 50 ETF $43mm 1.65%
$10
USD Billions

db x-trackers MSCI USA TR Index ETF $41mm 0.30%


$8
iShares FTSE 100 GBP $40mm 1.00%
$6
iiShares DAX (DE) $34mm 1.50%
$4
iShares DJ Euro Stoxx 50 (DE) $23mm 1.50%
$2 Lyxor ETF CAC 40 $20mm 2.00%
$0 Xact OMXS30 $20mm 0.65%
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09
UBS-ETF DJ Euro Stoxx 50 A $15mm 2.00%
Source: Data Explorers iShares MSCI Japan USD $12mm 1.85%

Figure 4 Source: Data Explorers

Number of European ETFs Made Available to Borrow for the underlying basket of securities. Some of this premium
350
could be put down to the structural cost of creating ETFs to
lend, such as stamp tax for U.K. equities, but the rates do imply
300 that the market is willing to pay for the convenience of bor-
250 rowing a single security. Another explanation for the premium
could be that the securities lending market for European ETFs is
200
still far from mature. While the number and value of European
150 ETFs in securities lending is increasing, it is still far below the
100 levels seen in the U.S. market. In the U.S., the lendable value
for the ETF market is in excess of $55.8 billion, with a value
50 on loan of $23 billion. This depth of supply results in much
$0 lower lending rates for U.S. ETFs. The average rate is close to,
Jan Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec
’08 ’08 ’08 ’08 ’08 ’08 ’09 ’09 ’09 ’09 ’09 ’09 or marginally below, the management fee of the ETF. However,
the higher level of demand means the absolute value of revenue
Source: Data Explorers
from lending ETFs is higher than in Europe.
by lenders such as custodian banks saw a marked decrease
in the autumn of 2008 (Figure 3). Part of this decline can be 2010: What Does The Future Hold?
attributed to the drop in global equity values, and part is due While the data points to a strong lending market for
to the fact that some market participants suspended lending European ETFs in 2010, there are still areas of weakness.
during the extreme market conditions of 2008 and 2009. On the demand side, while swaps have a significant element of
While the value of the supply ended 2009 below the highs counterparty risk, they do not have the same recall risk as borrow-

52 March/April 2010
ing an ETF, and in some case, are cheaper than borrowing. If the tively higher cost should diminish if more institutions make
memory of Lehman Brothers fades over the course of the year, the their ETFs available to borrow. The increase in supply could
demand that European ETFs saw in 2009 may begin to fade. come about as more ETF owners realize that they can offset
An increase in the supply of European ETFs could, in turn, the ETF management fee by putting them into a securities
lead to an increase in demand. As additional supply comes lending program. This lending activity can help offset the
into the market, the advantages that swaps have over short- inherent tracking risk, which may make owning European
ing ETFs will continue to diminish. The risk of recall and rela- ETFs more attractive.

Endnotes
1 ETF Landscape Industry Preview Year End 2009, BlackRock Global ETF Research & Implementation Strategy Team
2 Source: Data Explorers
3 Ibid.

Dallmer continued from page 21


quality advantages the exchange-appointed LP model pro-
tronic order-driven market models with opening and closing vides in terms of tighter spreads and deeper markets.
auctions, central limit order books and valuation price feeds.
Similar to the U.S. LMM model, the European ETFs Conclusion
benefit from a multiliquidity provider model that results Overall, one can easily understand how liquidity provision,
in remarkable market depth and competitive spreads. encouraged on a level playing field of fair access, can result
For each ETF, there is at least one liquidity provider (LP), in better expected market quality for a given symbol. In the
generally appointed by the issuer, that agrees to provide popular press, there is a large belief that all ETFs are created
continuous quotes, minimum market depth and maximum equal—meaning that due to their transparency, the pricing
spreads through the exchange’s trading session. Monitored of any ETF is without costs and will be priced efficiently.
by the exchange, so long as they are meeting their pres- In principle this might be true; however, in practice, just
ence, size and spread requirements, LPs may receive incen- because an ETF can be efficiently priced doesn’t mean some-
tives from the exchange for providing liquidity in the form one actually wants to do it at all times. An exchange model
of discounted transaction fees. Auctions are supported by that supports the role of a lead market maker or liquidity
the LPs through their obligation to provide consistently dis- provider with performance obligations is well-positioned in
played liquidity during the opening to the closing auction. principle to meet this ideal more often than not.
The number of LPs in Europe has increased significantly in
recent months following the implementation of a new trad- DISCLAIMER:
ing technology and faster data feeds, improving the overall This article is intended for investment professionals only and
tool kit for all traders. The increasing diversity of partici- solely for informational and educational purposes. It should not
pants trading ETFs (buy-side, sell-side, retail, etc.) ultimately be relied upon for any investment decisions. The article is based
leads to more efficient markets, and with the LP activity, we on data obtained as of Aug. 30, 2009 (unless otherwise noted
observe the quoted spreads of several ETFs are now tighter herein), which, although believed reliable, may not be accurate
than those of the underlying indexes, and others reached or complete and should not be relied on as such. The author
their lowest ever. does not recommend or make any representation as to possible
Although this is a deep dive into only two ETFs (see Figures benefits from any securities, investments, products or services.
3 and 4), a comparison to BATS and Chi-X—nonexchange Investors should undertake their own due diligence regarding
multilateral trading facilities (MTFs)—illustrates the market- securities and investment practices.

Endnote
1. Source: NYSE Euronext research databases

Shastry continued from page 27


Endnotes
1Amery, P., Inside ETFs Conference 2010: A Focus on Trading, www.indexuniverse.eu/blog/7127.
2Fuhr, D. op. cit.
3ibid.
4ibid.
5London Stock Exchange and SIX Swiss Exchange require their members to trade-report their OTC activity in funds that are listed on those venues.
6Source: Euronext, LSE, BlackRock.
7Amery, P., op. cit.

www.journalofindexes.com March/April 2010 53


Gastineau continued from page 41 fund. Sometimes this occurs because a specific group of
is increasing or reducing the risk in the portfolio, usually to investors finds that selling an ETF short is easier, less costly
reflect increased bullishness or bearishness on the overall or better meets their objectives than the purchase of an
market and on the portfolio’s specific components. Analysis inverse fund (e.g., some of the “short” funds or exchange-
of Sharpe ratios, information ratios and return-based perfor- traded notes offered by Direxion, ProShares, Rydex and
mance analysis are additional tools that fund performance Barclays Capital) or using an index derivative like a futures
analysts can bring to bear on the analysis of active manage- contract to take a short equivalent position. A large short
ment efforts. For information on some of these tools, see interest can sometimes suggest an inefficient index or an
Wright10 and Gastineau, Olma and Zielinski.11 ineffective investment manager. These latter possibilities are
among the reasons to consider the possible negative implica-
Tax Efficiency tions of an unusually high short-interest percentage.
Some of the tax efficiency comparisons provided by exist-
ing fund services are acceptable—as far as they go—but Fund Governance
some attempts to rank funds by tax efficiency are seriously The mutual fund scandals of 2003-2004 and various efforts
misleading. Two measures of different aspects of expected to mandate fund governance changes have led some fund
and actual tax efficiency are appropriate for most funds, be services to offer evaluations of fund governance. The ethics,
they conventional mutual funds or ETFs. The first and most reputation and business practices of the manager of a fund are
important of these measures is capital gains overhang. Capital certainly appropriate concerns for an investor and an adviser
gains overhang is a fund portfolio’s net unrealized gains less who are considering ownership of shares in the fund. It is
any accumulated realized losses carried forward. It is usually also appropriate for a fund service to provide information and
measured as a percentage of the fund’s assets. Capital gains even basic analysis of various aspects of governance includ-
overhang can be calculated from fund shareholder reports ing the relative independence of the board, the nature and
as of the end of any fund reporting period for which balance timing of any regulatory investigations or settlements with
sheet and gain and loss information is reported. the SEC or state attorneys general, etc. On the other hand,
Another calculation that is useful in assessing a fund’s tax complex relative evaluations of governance practices at funds
efficiency (and the portfolio manager’s attention to detail) are of doubtful value as long as the fund’s practices comply
is the percentage of any eligible dividend distribution that with relevant laws and regulations. Ertugrul and Hegde12
is qualified for the reduced qualified dividend tax rate— found that corporate governance ratings (which have been
percentage of eligible dividends qualified. While some fund around far longer than fund governance ratings) have been
“dividend” distributions—e.g., short-term capital gains and of little value in predicting company operating and stock
distributions from real estate investment trusts (REITs) and market performance. In a very short-term study of fund gov-
bonds—are not eligible for treatment as qualified dividends, ernance ratings, Wellman and Zhou13 found that the initial
fund shareholders should be able to count on most eligible Morningstar governance ratings were more closely correlated
dividends being delivered to them as qualified dividends. with performance before the ratings were published than with
Simple percentages for capital gains overhang and percent- subsequent performance. Nearly all of the “predictive” value
age of eligible dividends qualified for several recent years for Morningstar’s post-ratings performance was in two (board
will provide an investor with all the information needed to quality and fees) of the five components of the overall ratings.
estimate the probable future tax efficiency of most funds. The For some reason, Morningstar has doubled the weighting of
temptation to translate these simple and useful percentage “Corporate Culture,”14 which Wellman and Zhou found to have
numbers into proprietary relative ratings should be firmly no significant performance predictive value.
resisted. These numbers are most useful in a simple percent- Codifying regulatory actions by the SEC, state securities
age format. Giving them different names and calculating differ- commissioners, or other regulators or law enforcement orga-
ent relationships simply confuses investors and advisers who nizations can be a useful service, but fund rating services have
use more than one source of fund information. no obvious qualifications that make them more appropriate
commentators on fund governance issues than anyone else.
Short Interest The notion of turning largely nonquantitative information into
Some exchange-traded funds regularly have short inter- a governance rating is a stretch. The publication of a formal
est percentages in excess of 100 percent. A 100 percent adverse governance rating tends to discourage investors and
short interest percentage means that a fund with 1 million advisers from examining the facts and making their own con-
shares issued by the fund has 2 million shares carried long in sidered decisions based on their personal circumstances and
accounts held by various investors. A short interest over 100 values. Furthermore, a numerical rating lets a fund governance
percent indicates that some financial intermediaries have analyst act as judge and jury, perhaps without adequate disclo-
loaned and reloaned securities to other firms to facilitate sure of the full story behind the rating.
short sales in the ETF shares. To the extent that the securi- Differences in investor values are behind the fact that
ties trading and lending process turns into a round robin, it both sin funds and SRI (socially responsible investing) funds
is not at all difficult to have an ETF with a short interest of find investor constituencies. That there is less-than-universal
several hundred percent; that is, where the shares held long agreement on a number of governance issues suggests that
in accounts are a multiple of the actual shares issued by the differences in personal values make the notion of universally

54 March/April 2010
acceptable formal governance ratings highly questionable. should also be possible. The fact that a case involving fund
To illustrate the scope for differences of opinion along the fees has reached the Supreme Court suggests far-from-uni-
“fee” dimension, Wallison and Litan15 present a strong argu- versal agreement on fund fee issues.
ment that requiring fund directors to approve a fund’s invest- If a fund service insists on taking a stance on fund gov-
ment management fee discourages price competition among ernance, it should consider any specific governance issue it
investment managers. The stickiness of fees in the face of deems relevant to a fund and either accept the governance
heavy emphasis on expense ratios in fund comparisons sug- and ethical standards at a fund company and not discuss
gests that Wallison and Litan have a point. It would certainly them or reject them entirely with a full explanation of the
not harm investors in existing funds to permit managers of reasons behind the rejection. Either a question or problem
new funds to experiment with a fund’s fee structure. As long is serious enough to encourage investors to avoid the fund
as disclosure of the possible range of fees is adequate from or it is not important enough or definitive enough to affect
the first day the fund is offered to investors, changes in fees an investment decision. Beyond a statement of the facts of
by these new funds and adoption of fee structures that are a situation, complexity in fund governance analysis and rela-
different from the fulcrum performance fees now required tive governance ratings will rarely be either fair or useful.

Endnotes
1 The early status of the Investment Company Institute XBRL Initiative is summarized in McMillan, Karrie, “Remarks at XBRL International Conference,” Vancouver, British Columbia,
Dec. 4, 2007. The timing of further XBRL implementation is difficult to forecast but the ICI seems to be the fund industry’s organization of choice for this effort. You can see where
the SEC stands on XBRL by starting at http://www.sec.gov/spotlight/xbrl.shtml. There is even a rudimentary mutual fund viewer that lets you create a simple fund comparison report
for two or three funds. A visit will impress you with both the potential for improved fund data and with how far the process has to go.
2 See Cox, Christopher, “Disclosure from the User’s Perspective,” CFA Institute Conference Proceedings Quarterly, September 2008, pp. 10-15.
3 In fairness to iShares, the cost of licensing a wide range of indexes just for this application would probably be prohibitive.
4 Chua, David B., Mark Kritzman and Sébastien Page, “The Myth of Diversification,” The Journal of Portfolio Management, Fall 2009, vol. 36, No. 1, pp. 26-35 provides a useful look
at the asymmetry of diversification.
5 Cremers, Martijn and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure that Predicts Performance,” Review of Financial Studies, September 2009, vol. 22,
No. 9, pp. 3329-3365.
6 In calculating active share, it is often useful to make the calculation relative to a number of benchmark indexes. While the S&P 500 and the Russell 1000 are highly correlated, a closet
indexer using the Russell 1000 as a fund template might have a greater active share measured against the S&P 500 than measured against the (more relevant for this fund) Russell 1000.
Cremers and Petajisto measured active share against a variety of major indexes and assumed the benchmark was the index that showed the lowest active share, (p. 3340).
7 Cremers and Petajisto, p. 3332.
8 Ibid, pp. 3354-3355.
9 Ibid, pp. 3350-3353.
10 Wright, Christopher, “Cleaning Closets,” CFA Magazine, September/October 2008, vol. 19, No. 5, pp. 20-21.
11 Gastineau, Gary L., Andrew R. Olma and Robert G. Zielinski, “Equity Portfolio Management,” Chapter 7, in Maginn, John L., Donald L. Tuttle, Jerald E. Pinto and Dennis W.
McLeavey, “Managing Investment Portfolios: A Dynamic Process,” pp. 407-476. John Wiley & Sons, Hoboken, New Jersey, 2007.
12 Ertugrul, Mine and Shantaram Hegde, “Corporate Governance Ratings and Firm Performance,” Financial Management, vol. 38, No. 1, Spring 2009, pp. 139-160.
13 Wellman, Jay and Jian Zhou, “Corporate Governance and Mutual Fund Performance: A First Look at the Morningstar Stewardship Grades,” Unpublished Working Paper, March
18, 2008.
14 Haslem, John A., “Mutual Funds,” Wiley, 2010, p. 312.
15 Wallison, Peter J. and Robert E. Litan, “Competitive Equity: A Better Way to Organize Mutual Funds,” The AEI Press, Washington, D.C., 2007.

Lijnse continued from page 25


The distribution problem is something politicians have been to be allowed to be sold. The issue of Europe’s fragmented
working on for 50 years by trying to form the European clearing and settlement system could be solved by having
Union. Unfortunately, as long as Europe remains divided, one central or several linked CSDs, much like the Depository
issuers will have to spend more time, effort and money on Trust & Clearing Corporation in the U.S., in combination with
marketing in each individual country. A good start would stricter regulations on best execution. Finally, an obligation
be to ease regulations that require ETFs to be listed locally to report OTC trades would increase transparency.

Endnotes
1 Source: DB Index Research, Weekly ETF reports—Europe, January 21, 2010

2 Source: BlackRock ETF Landscape Year End 2009

References
BlackRock Advisors, ETF Landscape, Industry Preview, Year End 2009
Bloomberg
DB Index Research, Weekly ETF reports—Europe, January 21, 2010

www.journalofindexes.com March/April 2010 55


News
Global ETF Assets
At All-Time High
investing seen in the past five years.
His new firm, SummerHaven Index
not a complete stranger to the ETP
world: It is the issuer of the GS Connect
Global exchange-traded product Management, in December launched S&P GSCI Enhanced Commodity ETN
assets hit $1.14 trillion, a new all-time the Summerhaven Dynamic Commodity (NYSE Arca: GSC), which has more than
high, according to a new report from Index. The index is designed to avert the $60 million in assets, a reasonably siz-
BlackRock. That figure was up 48 per- more disastrous effects of contango and able amount for an ETN.
cent from the close of 2008. other pitfalls of passive commodities Both firms are looking to follow other
Total ETP listings rose as well, albeit investment strategies. SummerHaven big financial services names into the now-
more slowly, from 2,103 to 2,508. described it as “the first long-only active established ETF industry. The leap has
The bulk of the ETP assets at the end benchmark for commodity investors.” already been made by such luminaries as
of November 2009 were in U.S.-listed Each month, SDCI picks 14 commodi- Charles Schwab, Old Mutual and Pimco.
ETFs, which held $754 billion, up 39 ties from a pool of 27 based on funda- With assets under management of $366
percent from the end of 2008. At the mental indicators, weighting the selected billion and $871 billion, respectively, T.
end of November 2009, there were 896 commodities equally in the portfolio. Rowe and Goldman are clearly equipped
U.S.-listed ETPs, up from 834 at the Eligible commodities must have active to play with the big dogs—the real ques-
start of the year. and liquid futures markets on exchanges tion is whether any of these firms will be
In Europe, the story was more dra- in developed markets, with the contracts able to mount a serious threat to estab-
matic, with assets surging 58 percent, denominated in U.S. dollars. lished ETF issuers like iShares, Vanguard
from $150 billion to $237 billion. The The index has been licensed by U.S. and State Street Global Advisors.
number of listings jumped from 756 Commodity Funds to underlie the firm’s
to 969, an increase of 28 percent. The first nonenergy-related ETF. BlackRock Completes
region is clearly still in a period of BGI Acquisition
heavy growth in ETFs and other ETPs. T. Rowe, Goldman Sachs It’s official: The merger between
Asia Pacific (ex-Japan) is still in the ear- To Enter ETF Industry BlackRock Inc. and Barclays Global
liest stages of its growth, with total assets During the last quarter of 2009, two Investors was completed as of Dec. 1.
in the region of just $39 billion. That major players in the financial services The new company is operating under
belies overall ETF use, however, as many industry tossed their hats into the ETF the BlackRock name, but the iShares
institutional investors in the region have ring, as both T. Rowe Price and Goldman brand—BGI’s exchange-traded funds
significant money in U.S.-listed ETFs. Sachs filed 40-APP forms with the business—will be retained.
In Japan, ETF assets were actually Securities and Exchange Commission. BlackRock has some $3.2 trillion in
down 11 percent from the end of 2008, 40-APP filings clear the regulatory way assets under management and it holds
to roughly $24 billion, even though their for a firm to launch an ETF, and are the the title of the world’s largest institutional
numbers increased slightly, from 61 to first steps in launching an ETF family. money management firm. The mega-merg-
67. Other ETP assets were up just about 8 In early December, T. Rowe Price er was announced back in June and it came
percent, to $370 million in just five sepa- asked the SEC for approval to launch a with a price tag of some $13.5 billion.
rate products, one of which was added family of actively managed ETFs, includ- BlackRock’s board of directors is absorb-
during the first 11 months of 2009. ing U.S. equity, global equity and fixed- ing Barclays PLC’s Chief Executive John
income funds. That bombshell was fol- Varley and President Robert Diamond Jr.
‘Father’ Of Commodity Investing lowed by a Christmas Eve filing from Following the acquisition, BlackRock
Launches New Index Goldman Sachs that requested broad will continue to serve as the marketing
Yale University professor K. Geert relief from the SEC to launch a variety agent for the iPath family of exchange-
Rouwenhorst, one of the “fathers” of of funds, including equity, fixed-income traded notes, which are offered by
broad-based commodity investing, has and blended portfolios. Barclays Capital.
co-founded a new firm and is launching a Although both firms are known for
new generation of commodity indexes. their actively managed strategies, only INDEXING DEVELOPMENTS
Rouwenhorst is best known for his T. Rowe indicates that it will be focusing Russell Launches
2004 paper with Gary Gorton, “Facts and on actively managed funds—Goldman’s Global SMID Index
Fantasies about Commodity Futures,” filing only mentions index-based ETFs. Russell Investments recently rolled
which kicked off the surge of commodity However, unlike T. Rowe, Goldman is out a benchmark covering what the

56 March/April 2010
firm calls the global “SMID” segment. els, but remained more than 92 percent the Real Return series adds in TIPS, com-
The new index covers the middle below 2007 levels. Similarly, information modities and real estate securities.
chunk of the market and then a little technology saw a boost of 121 percent in
more—from the upper ranks of the the quarter, snagging a 30 percent slice S&P And BGCantor
small-cap segment to the bottom ech- of all buybacks in the period. Announce Treasury Indexes
elons of the large-cap segment. The By contrast, energy sector buybacks In December, S&P said it had entered
premise of the index seems to be dropped 15 percent quarter-over-quarter. into an agreement with market data
that investment managers recognize provider BGCantor Market Data LP to
that the largest companies don’t have DJI Adds New Index collaborate with each other in the cre-
a lot of significant growth ahead of To Target Date Family ation of a new family of U.S. Treasury
them, while the very smallest compa- In January, Dow Jones Indexes updated indexes. BGCantor is a subsidiary of
nies often have significant risk factors, its Dow Jones Target Date and Real Return BGC Partners and specializes in fixed-
especially in emerging markets; SMID index series with the addition of the Dow income and derivatives data.
might be the happy medium. Jones U.S. Target Date 2050, Dow Jones The indexes will be calculated by S&P
The SMID index covers nearly 4,000 Global Target Date 2050 and Dow Jones based on data provided by BGCantor;
stocks ranging in size from $370 mil- Real Return 2050 indexes. At the same S&P’s announcement said that the index-
lion to $5.3 billion, and can be broken time, DJI phased out the Dow Jones Target es would launch in the first quarter of
down into multiple subindexes cover- 2005, Dow Jones U.S. Target 2005 and 2010. According to S&P, the benchmarks
ing different styles or regions, such as Dow Jones Real Return 2005 indexes. were created with custom requirements,
emerging markets. DJI’s target date indexes cover target liability-driven investing and portfolio-
years set at five-year intervals within a building strategies in mind.
S&P 500 Buybacks Jump In 3Q 40-year span, with indexes retired five The initial launch will include 11
Standard & Poor’s said in December that years after they have reached their tar- indexes:
third-quarter stock buybacks for the S&P get date. The multi-asset indexes gener- • S&P/BGCantor 0-3 Month U.S.
500 were up 44 percent from Q2, when ally shift more weight into fixed income Treasury Bill Index
they hit the lowest level ever recorded and cash, thereby reducing risk levels, as • S&P/BGCantor 3-6 Month U.S.
since S&P started keeping record in 1998. they move along their respective glide Treasury Bill Index
Third-quarter buybacks reached paths. The U.S. and Global index families • S&P/BGCantor 6-9 Month U.S.
$34.8 billion, up from $24.2 billion in track combinations of stocks, bonds and Treasury Bill Index
Q2. By comparison, third-quarter totals cash, while the global family includes • S&P/BGCantor 9-12 Month U.S.
remained more than 61 percent below an international component. Meanwhile, Treasury Bill Index
the results seen in the third quarter of
2008, and nearly 80 percent lower than
levels seen in the period two years ago.
Howard Silverblatt, senior index ana-
In January, Dow
lyst at S&P Indices, noted in a press release Pull Quote
Jones Indexes Pull Quote Pull Quote
updated
that companies cautiously increased buy- its DowPull Quote
Jones Pull Quote Pull Quote
Target
backs as the market recovery continued,
while keeping an eye on expenditures. PullReal
Date and Quote Pull Quote Pull Quote
Return
Silverblatt projected that stock buybacks
could jump another 10 percent in the
Index series.
next quarter, but going into 2010, overall
buybacks should remain well below peak
2007 levels, as these kinds of expendi-
tures are “highly correlated to the recov-
ering economy,” he said.
From a sector standpoint, financial
sector buybacks jumped 80 percent in
the third quarter from second-quarter lev-

www.journalofindexes.com March/April 2010 57


News
• S&P/BGCantor 0-1 Year U.S. set standards for weightings and diversifi- ensure that the index is investable.
Treasury Bond Index cation within a portfolio. S&P has also launched a series of
• S&P/BGCantor 1-3 Year U.S. At the same time, S&P provided a subindexes that break the main index
Treasury Bond Index list of commodity indexes that would down into various maturities: 1-3 year,
• S&P/BGCantor 3-5 Year U.S. be calculated going forward in real 3-5 year, 5-7 year, and 10+ years.
Treasury Bond Index time in euros: the S&P GSCI All Metals According to ETFWorld, the euro-
• S&P/BGCantor 7-10 Year U.S. Capped Commodity Index, the S&P zone is the world’s second largest gov-
Treasury Bond Index GSCI Agriculture Capped Component ernment bond market, and is about half
• S&P/BGCantor 10-20 Year U.S. Index, the S&P GSCI Light Energy Index the size of the U.S. market.
Treasury Bond Index and the S&P GSCI Non-Energy Index.
• S&P/BGCantor 20+ Year U.S. FTSE, EDHEC Collaborate
Treasury Bond Index Nasdaq Re-Ranks On Index Launch
• S&P/BGCantor U.S. TIPs Index Nasdaq-100 Components Index provider FTSE Group and the
The Nasdaq OMX Group’s annu- EDHEC-Risk Institute jointly created a
Russell Creating al re-ranking of the securities in its new series of indexes that launched in
Factor-Based Indexes Nasdaq-100 Index and Nasdaq Q-50 mid-January.
Russell Investments has teamed up Index took effect Dec. 21. The FTSE EDHEC-Risk Efficient index
with Axioma Inc., a provider of portfo- The seven new names entering the series draws its components from FTSE All
lio optimization and risk analysis tools, Nasdaq-100 Index included Vodafone World equity indexes. However, the new
to create a family of indexes built Group, Mattel Inc., BMC Software indexes constituents are weighted by their
around risk factors used in Axioma’s Inc., Mylan Inc., Qiagen N.V., SanDisk Sharpe ratio rather than by the traditional
proprietary risk models. Corporation and Virgin Media Inc. The method of market capitalization.
The indexes will be based on Russell’s companies removed from the index The Sharpe ratio is a measure of
existing market-cap-weighted indexes, included Akamai Technologies Inc., excess return per unit of risk, with
but will incorporate Axioma’s risk mod- Hansen Natural Corp., IAC/InterActive risk defined as the standard deviation
els; the new indexes will be designed Corp., Liberty Global (Class A), (volatility) of returns.
to minimize turnover and factor track- Pharmaceutical Product Development Professor Noël Amenc, director of
ing error, maximize exposure to the Inc., Ryanair Holdings plc and Steel the EDHEC-Risk Institute, noted, “The
specified risk factor and provide neutral Dynamics Inc. methodology minimizes excessive con-
exposure to nontarget risk factors. The Nasdaq-100 Index tracks the 100 centration of risk and affords investors
The first group of indexes will target largest U.S. and international nonfinancial the ability to benefit from the maxi-
momentum and include the Russell- companies listed on the Nasdaq stock mum Sharpe ratio portfolio.”
Axioma U.S. Large Cap Momentum market based on market capitalization. The indexes are designed to exploit
Index, the Russell-Axioma U.S. Small More than $20 billion in U.S.-listed the fact that higher returns are generally
Cap Momentum Index and the Russell- ETF assets, including geared funds, is tied linked to higher risk levels, while lower-
Axioma U.S. Momentum Index. The to the performance of the Nasdaq-100. risk stocks generally see lower returns.
new indexes will be derived from the
Russell 1000, Russell 2000 and Russell New Eurozone Bond AROUND THE WORlD Of ETfs
3000 indexes, respectively. Index Debuts From S&P Palladium, Platinum ETFs Launch
Index provider Standard & Poor’s ETF Securities launched new ETFs in
S&P Adds To Commodity tossed its hat into the eurozone bond early January, providing U.S. investors with
Index Lineup arena recently with the launch of the S&P easy access to physical platinum and palla-
In December, S&P rolled out a vari- Eurozone Government Bond Index. The dium for the first time. The ETFS Platinum
ety of commodities indexes. market-value weighted index measures Trust (NYSE Arca: PPLT) and ETFS Palladium
The main index to debut was the S&P the performance of the government Trust (NYSE Arca: PALL) both hold physical
GSCI All Metals Index, which combines debt of 11 of 16 eurozone countries, bullion in a vault as their sole asset.
the precious metals and industrial met- with Italy, Germany, France and Spain The funds quickly attracted attention
als subindexes of the S&P GSCI. In con- receiving the largest weightings in the from investors, gathering more than
junction with that index’s rollout, S&P index. A number of smaller and newer $100 million in new creations on their
also introduced the S&P GSCI All Metals members of the eurozone are excluded first day and trading in large volumes.
Capped Commodity Index as well as the from the index, which targets the more In fact, the funds may be attracting
S&P GSCI Agriculture Capped Component developed countries in Europe. too much attention: Both the platinum
Index. The “Capped” indexes are designed The index excludes inflation-linked, and palladium markets are notoriously
to underlie investments complying with floating-rate and zero-coupon bonds, tight, and there is some concern that
the European Union UCITS III rules, which and has liquidity screens in place to the two ETFs will create a shortage in

58 March/April 2010
those markets. To mitigate those con- (Nasdaq: VCIT)
cerns, ETF Securities placed limits on • Vanguard Long-Term Corporate
how large the funds could grow: PPLT, Bond Index Fund (Nasdaq: VCLT)
for example, is limited to just 7 percent • Vanguard Mortgage-Backed Securities
of net platinum demand each year. Index Fund (Nasdaq: VMBS)
Shortly after its launch, that trans- The ETFs each represent a separate
lated into $750 million in assets, while share class of a traditional index mutual
PALL (which has similar limitations) had fund. Each ETF charges an expense
an asset cap of around $500 million. ratio of 15 basis points.
Should the two funds hit their limits,
they would likely trade to a premium BGI Launches Its First Active ETF
above net asset value while regula- In mid-November, iShares launched
tors consider whether to allow them the iShares Diversified Alternatives Trust
to expand. The two funds charge 0.60 (NYSE Arca: ALT), its first actively man-
percent in annual expenses. aged ETF and one of the first managed
futures products to hit the market.
Old Mutual Debuts ALT’s portfolio comprises exchange-
Fee-Free ETF Teaser traded futures contracts on everything
Old Mutual followed Charles Schwab from commodities, currencies and inter-
into the ETF market in early December est rates to stock and bond indexes, as
with the launch of the GlobalShares FTSE well as foreign currency forward con-
Emerging Markets Fund (NYSE Arca: GSR). tracts. The fund’s overall investment
The fund debuted with an expense strategy looks at relative value; it capital- tary receipts of companies with market
ratio of zero. However, as of Jan. 31, izes on the spread between assets and caps of at least $150 million. Additionally,
2010, GSR’s price tag was set to rise to 39 asset categories that deviate from the each company needs to generate at least
basis points. The firm also said the price norm. To achieve this—and in an effort 50 percent of its revenues from gold
tag could go up earlier if the assets hit $1 to minimize volatility—it takes both long and/or silver mining to be included in
billion before that date. (They didn’t.) and short positions in correlated assets. the index. The index is heavily weighted
GSR tracks the FTSE Emerging Index, Ultimately, ALT will use a combina- toward small-cap companies.
which covers mid- and large-cap stocks tion of strategies to capitalize on various GDXJ comes with a net expense ratio
in 22 emerging markets. spread opportunities, including techni- of 60 basis points.
Old Mutual, an established player in cal and fundamental strategies as well as
the mutual fund market, has another yield and futures curve arbitrage. Claymore Liquidates Four ETFs
four ETFs—all with an international Its portfolio targets an annualized Claymore Securities liquidated four
flavor—currently in registration. return volatility of 6 to 8 percent. “lightly followed” ETFs at the end of 2009:
ALT charges an annual expense ratio • Claymore/Morning-star Manufac-
Vanguard Expands of 0.95 percent. turing Super Sector Index ETF
Fixed-Income Offerings (NYSE Arca: MZG)
In late November, Vanguard launched New Van Eck ETF • Claymore/Morningstar
seven new bond ETFs, nearly doubling Tracks Junior Gold Miners Information Super Sector Index
its offerings in the ETF bond space, The Market Vectors Junior Gold ETF (NYSE Arca: MZN)
an area that saw significant inflows Miners ETF (NYSE Arca: GDXJ) debuted • Claymore/Morningstar Services
throughout 2009. in November, offering targeted access Super Sector Index ETF (NYSE
The funds include the following: to a range of small- to mid-cap gold- Arca: MZO)
• Vanguard Short-Term Government mining and -producing companies for • Claymore U.S.-1-The Capital Market
Bond Index Fund (Nasdaq: VGSH) the first time in an ETF. Index ETF (NYSE Arca: UEM)
• Vanguard Intermediate-Term Van Eck Global, the issuer, is also the All together, they represented less
Government Bond Index Fund creator of the large-cap-focused Market than 0.7 percent of the company’s
(Nasdaq: VGIT) Vectors Gold Miners ETF (NYSE Arca: roughly $2.5 billion in ETF assets at the
• Vanguard Long-Term Government GDX), which launched in 2006 and cur- time of the announcement.
Bond Index Fund (Nasdaq: VGLT) rently has some $5.6 billion in assets. While the company has never been
• Vanguard Short-Term Corporate GDXJ tracks the Market Vectors Junior hesitant about closing under-perform-
Bond Index Fund (Nasdaq: VCSH) Gold Miners Index, a rules-based, modi- ing funds, these are the first to go
• Vanguard Intermediate-Term fied market-cap-weighted, float-adjusted following Guggenheim Partners’ acqui-
Corporate Bond Index Fund index comprising securities and deposi- sition of Claymore Group mid-October.

www.journalofindexes.com March/April 2010 59


News
The move could reflect the beginning of trading on Dec. 28, 2009. Shareholders Morgan Stanley and Nomura are the swap
a product rationalization by the firm. of record on that date received cash providers, and Nyenburgh, All Options,
Trading of these funds was halted payments equal to the full net asset Banca IMI, IMC Group, Flow Traders and
Dec. 11 and liquidation of shares con- value of the trusts, minus expenses. UniCredit are the key market makers.
cluded between Dec. 14 and Dec 18. MacroMarkets said that the trusts According to the Dec. 24 Deutsche Bank
Investors were paid the full net asset were being liquidated because they ETF Liquidity Trends report, Source had
value of each fund in cash. failed to accrue at least $50 million in €2.13 billion in exchange-traded product
assets under management. Launched in assets under management, ranking the issu-
12-Month Natural June, the trusts had a combined $20.8 er twelfth amongst European providers.
Gas ETF Debuts million in assets as of Dec. 22, 2009.
United States Commodity Funds’ lat- This is not the first time that db x-trackers Hedge Fund
est ETF, the U.S. 12-Month Natural Gas MacroMarkets has shut down its unique ETF Hits $1 Billion
Fund (NYSE Arca: UNL), began trading exchange-traded fundlike products: Two European ETF issuer db x-trackers
on Nov. 18. The fund is designed to previous sets of products were terminat- reported in mid-December that its
lessen the impact of contango, which has ed on previous occasions. With its third hedge fund ETF had reached $1 billion
dragged down another USCF fund, the set of products failing to thrive and no in assets under management.
U.S. Natural Gas Fund (NYSE Arca: UNG). additional products trading, it’s unclear The db x-trackers db Hedge Fund
Instead of only buying the front-month what lies in store for MacroMarkets. Index ETF replicates hedge fund per-
natural gas futures contracts as UNG formance by investing in a group of
does, UNL purchases an equally weighted Source Unveils U.S. Sector ETFs funds operating on Deutsche Bank’s
basket of futures contracts with delivery In January, Source announced the launch managed account platform. The ETF
dates in each of the next 12 months. Two of nine new U.S. equity sector ETFs for trad- charges 0.90 percent per annum in
weeks from rollover time, the fund sells ing on the London Stock Exchange. management fees and is listed in the
the front-month contract and buys the The ETFs track new versions of S&P’s U.K., Germany and Switzerland.
one 12 months out, essentially pushing Select Sector indexes, with individual The index tracked by the ETF con-
the basket forward in time. constituent weights capped at 20 per- sists of five subindexes, each tracking
This methodology should protect the cent in order to ensure compliance a different sector of the hedge fund
latter somewhat from contango’s vicious with Europe’s UCITS regulations. The universe. The percentage weightings
sting, although it won’t insulate it entirely. covered sectors include consumer dis- allocated to these subindexes reflect
UNL charges an expense ratio of cretionary, consumer staples, energy, the predominance of each hedge fund
0.75 percent. financials, health care, industrials, strategy group in worldwide hedge
materials, technology and utilities. fund assets under management, as
MacroShares Terminated—Again The new funds carry a total expense measured by Hedge Funds Research
MacroMarkets LLC announced in late ratio of 0.30 percent per annum. They (HFR). This results in nearly 80 percent
December that the MacroShares Major use swap-based replication to track their of the ETF’s assets being devoted to the
Metro Housing Up (NYSE Arca: UMM) underlying benchmarks. Source operates “equity hedge” and “event-driven” cat-
and MacroShares Major Metro Housing an “open architecture” platform, under egories. The underlying subindexes are
Down (NYSE Arca: DMM) would cease which BofA Merrill Lynch, Goldman Sachs, proprietary indexes owned by Deutsche
Bank, the issuer of the db x-trackers.

Xetra Launches ETNs


Xetra, the Deutsche Boerse trading
With its third set of platform, expanded its product range in
December with the launch of the iPath
products failing to S&P 500 VIX Short-Term Futures Index
thrive and no additional exchange-traded note and the iPath
S&P 500 VIX Mid-Term Futures Index
products trading, it’s ETN in Europe. The ETNs track the S&P
unclear what lies in 500 short-term and mid-term futures
indexes, that respectively replicate a
store for MacroMarkets. rolling position in short- and mid-term
implied volatility futures on the S&P
500 equity index.
In the U.S., iPath launched a pair of
similar ETNs in January 2009, and those

60 March/April 2010
products quickly attracted more than KNOW YOUR OPTIONS BACK TO THE FUTURES
$1 billion in assets. CBOE 2009 Volumes CME Group ADV Down In 2009
The two Xetra-listed ETNs carry an Over 1 Billion CME Group, the world’s largest deriva-
annual management fee of 0.89 percent. The Chicago Board Options tives exchange, saw volumes rise 13 per-
Exchange’s total 2009 volume was down cent year-over-year in December 2009,
Watson Wyatt Questions 5 percent from 2008 to 1.13 billion con- but the ADV for 2009 overall fell to 10.3
ETF Attractiveness tracts, but last year was nevertheless million, down 20 percent from 2008.
European consultancy firm Watson the second consecutive year for which In particular, the ADV for equity
Wyatt has cast doubt on the appeal the exchange’s total contracts traded index contracts as a group was down
of exchange-traded funds, calling them exceeded 1 billion. Average daily vol- 20 percent to 2.9 million. Interestingly,
an “unattractive long-term investment ume was 4.5 million contracts, down in 2008, equity index contracts rep-
option for most institutional investors.” from 4.7 million in 2008. resented roughly 28 percent of the
According to the consultant, while Equity options had a great year, with exchange’s total ADV, and that percent-
ETFs have opened up a world of poten- volumes up 5 percent; however, index age held steady in 2009.
tially interesting market exposures, and ETF options were the chief drags
they “generally have higher fees than on the exchange’s total volume. Index FROM THE EXCHANGES
many institutional index products; may options saw their ADV and total vol- Nasdaq Rolls Out
have tax implications that require spe- umes decline 14 percent to 884,000 and Leveraged Nasdaq-100
cialist advice; and often contain coun- 223 million, respectively; meanwhile, In November, Nasdaq OMX Group, Inc.
terparty risks which investors may not ETF options volumes fell 16 percent to introduced the Nasdaq-100 Leveraged
be compensated for.” an ADV of just over 1 million and a total Index. The new index magnifies the
The criticism of unrewarded counter- 2009 volume of 277 million. daily returns of the widely followed
party exposures within ETFs is not new. The most actively traded of the ETF Nasdaq-100 index by 200 percent, but
A year ago at a conference at the London and index options were those on the also incorporates the financing costs
Stock Exchange, Chris Sutton, senior S&P 500 Index (SPX), Standard & Poor’s associated with achieving such exposure
consultant at Watson Wyatt, described Depositary Receipts (SPY), PowerShares in a portfolio into its returns.
securities lending as “picking up pennies QQQ Trust (QQQQ), CBOE Volatility The index could prove particularly
in front of a steamroller.” Sutton was Index (VIX) and iShares Russell 2000 useful to investors in the ProShares
chief executive of iShares Europe and a Index Fund (IWM). Ultra QQQ (NYSE Arca: QLD), which
director of parent company BGI before offers 200 percent leveraged exposure
joining the consultancy firm in 2007. CBOE Plans S&P 500 to the Nasdaq-100.
However, Watson Wyatt’s assertion Dividend Index Options
that “most investment strategies can also The CBOE announced in December ON THE MOVE
be implemented more cheaply and effi- that the SEC had cleared it to launch Management Shake-Up At Stoxx
ciently using index funds, index futures options on the S&P 500 Dividend Index European index provider Stoxx has
or swaps,” calls ETFs’ attractiveness into (DVS), though no listing date was given announced changes in its senior man-
question at a more fundamental level. at the time. agement.
Furthermore, the consultant argues The underlying index tracks the accu- Dr. Hartmut Graf, previously head
that most (non-ETF) passive funds have mulated ex-dividend amounts of the of the index business at the German
been structured with clearly defined S&P 500’s component securities during stock exchange, Deutsche Boerse, joins
tax positions for institutional investors, a quarterly accrual period. The options Stoxx as chief executive officer, replac-
whereas the treatment of ETFs is much contracts will be useful for investors ing Ricardo Manrique, who is leaving
more variable, which typically neces- who want to hedge the differences the company. Patrick Valovic, who was
sitates tax advice. between expected and actual ex-divi- previously director of business opera-
“Where the ETF industry has dend amounts, the CBOE said. Also, the tions at Stoxx, becomes CFO.
engaged in product proliferation, we dividend index’s calculation methodol- In November 2009, Deutsche Boerse
would rather press for genuine inno- ogy is very similar to that of the S&P 500 and SIX Swiss Exchange announced the
vation in the investment content of (same components, divisor, shares out- acquisition of Dow Jones’ one-third share
index products. If investors are look- standing, and weighting methodology), in the index provider, with Deutsche
ing for more efficient market expo- so it can easily be used in trading strate- Boerse acquiring a controlling stake.
sures, their first step should be to gies involving other S&P 500 options. A new board of directors has also
review the indices underlying their The European-style contract is the been appointed, with two members
existing investments with a view to first of its kind to be listed in the joining from the SIX group, one from
seeing if there are better alterna- U.S., according to the CBOE, which has Deutsche Boerse and one from Swiss
tives,” said Sutton. exclusive listing rights on the index. law firm Lenz & Staehelin.

www.journalofindexes.com March/April 2010 61


Global Index Data
Selected Major Indexes Sorted By 2009 Returns March/April 2010
Total Return % Annualized Return %
Index Name 2009 2008 2007 2006 2005 2004 2003 2002 3-Yr 5-Yr 10-Yr 15-Yr Sharpe Std Dev
MSCI Sri Lanka* 184.15 -62.09 -15.15 42.78 30.70 7.81 42.09 29.76 -2.95 11.27 10.09 0.47 0.10 48.02
Citigroup ESBI Brady 139.18 -60.81 -3.32 23.86 5.95 11.50 31.68 4.98 -3.23 3.53 7.88 - 0.10 43.06
MSCI Brazil* 121.25 -57.64 75.35 40.52 49.96 30.49 102.85 -33.78 18.01 28.20 15.08 11.23 0.57 40.29
MSCI BRIC* 88.79 -60.27 56.12 52.87 39.81 13.63 84.18 -15.18 5.41 20.14 11.04 - 0.28 37.34
MSCI EM 78.51 -53.33 39.39 32.17 34.00 25.55 55.82 -6.17 5.11 15.51 9.78 - 0.26 32.80
ML Global High Yield 61.98 -27.86 3.06 13.47 1.48 12.42 30.71 -1.14 6.39 6.75 6.94 - 0.32 17.89
Barclays Global High Yield 59.40 -26.89 3.18 13.69 3.59 13.17 32.42 4.13 6.34 7.21 8.61 9.40 0.32 17.54
NASDAQ 100 54.61 -41.57 19.24 - - - - - 2.51 - - - 0.14 23.81
Credit Suisse HY 54.22 -26.17 2.65 11.92 2.26 11.95 27.94 3.10 5.33 5.99 7.07 7.74 0.27 15.76
MSCI EAFE Small Cap 46.78 -47.01 1.45 19.31 26.19 30.78 61.35 -7.82 -7.59 3.50 - - -0.24 26.63
S&P 500 Equal Weighted 46.31 -39.72 1.53 15.80 8.06 16.95 40.97 -18.18 -3.62 2.30 5.14 10.05 -0.11 24.91
S&P MidCap 400/Citi Growth 41.08 -37.61 13.50 5.81 14.39 15.79 37.32 -19.71 -0.03 3.87 5.70 - 0.03 23.74
S&P Midcap 400 37.38 -36.23 7.98 10.32 12.56 16.48 35.62 -14.53 -1.83 3.27 6.36 11.66 -0.04 23.84
Russell 1000 Growth 37.21 -38.44 11.81 9.07 5.26 6.30 29.75 -27.88 -1.89 1.63 -3.99 6.87 -0.10 20.01
Russell 3000 Growth 37.01 -38.44 11.40 9.46 5.17 6.93 30.97 -28.03 -2.06 1.58 -3.79 6.66 -0.10 20.31
Wilshire 4500 Completion 36.99 -39.03 5.39 15.28 10.03 18.10 43.84 -17.80 -4.16 2.23 1.76 8.60 -0.15 23.78
Russell 2000 Growth 34.47 -38.54 7.05 13.35 4.15 14.31 48.54 -30.26 -4.00 0.87 -1.37 4.99 -0.12 25.20
MSCI EAFE Value 34.23 -44.09 5.96 30.38 13.80 24.33 45.30 -15.91 -7.35 3.36 3.53 6.41 -0.25 25.54
Barclays EM 34.23 -14.75 5.15 9.96 12.27 11.89 26.93 12.16 6.36 8.24 10.57 11.78 0.35 14.94
Russell Top 200 Growth 34.01 -36.06 12.15 8.56 2.88 3.74 26.63 -27.98 -1.32 1.42 -4.83 6.77 -0.09 18.58
S&P MidCap 400/Citi Value 33.73 -34.87 2.65 14.62 10.80 17.19 33.81 -9.51 -3.67 2.57 6.92 - -0.12 24.32
MSCI EAFE 31.78 -43.38 11.17 26.34 13.54 20.25 38.59 -15.94 -6.04 3.54 1.17 4.92 -0.23 23.91
S&P 500/Citi Growth 31.57 -34.92 9.13 11.01 1.14 6.97 27.08 -28.10 -2.24 0.96 -3.57 8.03 -0.14 18.60
MSCI EAFE Growth 29.36 -42.70 16.45 22.33 13.28 16.12 31.99 -16.02 -4.78 3.65 -1.31 3.32 -0.19 22.86
Russell 1000 28.43 -37.60 5.77 15.46 6.27 11.40 29.89 -21.65 -5.36 0.79 -0.49 8.23 -0.27 20.33
S&P SmallCap 600/Citi Growth 28.35 -32.94 5.60 10.54 7.02 24.27 38.43 -16.57 -3.14 1.46 5.52 - -0.09 24.71
Russell 3000 28.34 -37.31 5.14 15.72 6.12 11.95 31.06 -21.54 -5.42 0.76 -0.20 8.13 -0.27 20.61
JPM EMBI Global 28.18 -10.91 6.28 9.88 10.73 11.73 25.66 13.11 6.66 8.10 10.52 12.32 0.41 12.44
Russell Micro Cap 27.48 -39.78 -8.00 16.54 2.57 14.14 66.36 -16.10 -10.95 -3.33 - - -0.39 25.97
FTSE NAREIT All REITs 27.45 -37.34 -17.83 34.35 8.29 30.41 38.47 5.22 -13.10 -0.92 10.18 9.35 -0.24 37.35
S&P 1500 27.25 -36.72 5.47 15.34 5.66 11.78 29.59 -21.31 -5.30 0.69 -0.20 8.31 -0.27 20.27
Russell 2000 27.17 -33.79 -1.57 18.37 4.55 18.33 47.25 -20.48 -6.07 0.51 3.51 7.73 -0.20 25.19
S&P 500 26.46 -37.00 5.49 15.79 4.91 10.88 28.68 -22.10 -5.63 0.42 -0.95 8.04 -0.30 19.91
JP Morgan EMBI 25.95 -9.70 6.45 10.49 11.86 11.77 28.83 14.24 6.58 8.39 10.94 12.79 0.41 12.12
S&P Smallcap 600 25.57 -31.07 -0.30 15.12 7.68 22.65 38.79 -14.63 -4.79 1.36 6.35 - -0.15 25.07
Russell Top 200 24.21 -36.07 5.89 15.53 3.77 8.31 26.68 -23.36 -5.61 0.16 -2.26 7.64 -0.32 19.03
S&P SmallCap 600/Citi Value 22.85 -29.51 -5.54 19.57 8.33 21.06 39.09 -12.93 -6.48 1.16 7.02 - -0.21 25.76
DJ Industrial Average 22.68 -31.93 8.88 19.05 1.72 5.31 28.28 -15.01 -3.12 1.95 1.30 9.24 -0.19 18.48
S&P 100 22.29 -35.31 6.12 18.47 1.17 6.43 26.25 -22.59 -5.66 0.12 -2.34 8.04 -0.32 18.88
S&P 500/Citi Value 21.18 -39.22 1.99 20.80 8.71 15.03 30.36 -16.59 -9.10 -0.27 1.20 - -0.41 22.25
Russell 2000 Value 20.58 -28.92 -9.78 23.48 4.71 22.25 46.03 -11.43 -8.22 -0.01 8.27 9.87 -0.28 25.98
Russell 3000 Value 19.76 -36.25 -1.01 22.34 6.85 16.94 31.14 -15.18 -8.91 -0.24 2.88 8.94 -0.42 21.65
Russell 1000 Value 19.69 -36.85 -0.17 22.25 7.05 16.49 30.03 -15.52 -8.96 -0.25 2.47 8.93 -0.43 21.40
DJ UBS Commodity 18.91 -35.65 16.23 2.07 21.36 9.15 23.93 25.91 -3.83 1.96 7.13 6.23 -0.14 23.23
Dow Jones Transportation Average 18.58 -21.41 1.43 9.81 11.65 27.73 31.84 -11.48 -1.86 2.99 4.63 8.63 -0.02 25.88
Barclays US Credit 16.04 -3.08 5.11 4.26 1.96 5.24 7.70 10.52 5.74 4.67 6.64 7.15 0.46 8.06
Russell Top 200 Value 14.59 -36.09 0.25 22.99 4.60 13.34 26.75 -18.02 -9.79 -1.14 0.37 8.15 -0.50 20.34
S&P GSCI 13.49 -46.49 32.67 -15.09 25.55 17.28 20.72 32.07 -6.95 -3.00 5.05 4.91 -0.14 31.06
Barclays Municipal 12.91 -2.47 3.36 4.84 3.51 4.48 5.31 9.60 4.41 4.32 5.75 6.14 0.39 6.00
Dow Jones Utilities Average 12.47 -27.84 20.11 16.63 25.14 30.24 29.39 -23.38 -0.84 7.31 7.40 9.76 -0.09 16.83
Barclays Global Aggregate 6.93 4.79 9.48 6.64 -4.49 9.27 12.51 16.52 7.05 4.56 6.49 6.67 0.65 7.64
Barclays US Aggregate Bond 5.93 5.24 6.97 4.33 2.43 4.34 4.10 10.25 6.04 4.97 6.33 6.80 0.91 4.17
ML Global Govt 0.44 14.35 10.41 4.59 -6.01 8.43 11.68 17.05 8.24 4.51 6.08 6.22 0.74 8.30
ML US Treasury Bill 3 Mon 0.21 2.06 5.03 4.83 3.06 1.33 1.15 1.78 2.41 3.02 2.99 3.77 1.14 0.64
Barclays US Government -2.20 12.39 8.66 3.48 2.65 3.48 2.36 11.50 6.10 4.87 6.17 6.59 0.79 5.02
Barclays Treasury -3.57 13.74 9.01 3.08 2.79 3.54 2.24 11.79 6.14 4.84 6.15 6.56 0.72 5.65
NCREIF Property -15.07 -6.46 15.84 16.59 20.06 14.48 8.99 6.74 -1.29 6.16 7.83 9.08 - -
Barclays US Treasury 20+ Yr -21.40 33.72 10.15 0.93 8.57 8.99 1.80 17.00 5.00 4.87 7.57 8.14 0.25 16.55
Citigroup STRIPS 20-25 Year -28.56 43.67 11.02 -1.09 16.04 15.99 0.42 21.22 4.45 5.51 9.34 10.46 0.21 24.20
Citigroup STRIPS 25+ Year -42.88 77.10 12.71 4.09 17.82 16.33 -0.95 21.53 4.47 6.94 10.05 11.08 0.22 30.58
Source: Morningstar. Data as of December 31, 2009. All returns are in dollars, unless noted. 3-, 5-, 10- and 15-year returns are annualized. Sharpe is 12-month Sharpe ratio.
Std Dev is 3-year standard deviation. *Indicates price returns. All other indexes are total return.

62 March/April 2010
Index Funds U.S. Style Overview XXXX –XXXX, 2010
Morningstar
Largest U.S. Index Mutual Funds Sorted By Total Net Assets In $US Millions March/April 2010

Total Return % Annualized Return %


Fund Name Ticker Assets Exp Ratio 3-Mo 2009 2008 2007 3-Yr 5-Yr 10-Yr 15-Yr P/E Std Dev Yield
Vanguard Tot Stk VTSMX 58,004.0 0.18 5.85 28.70 -37.04 5.49 -5.10 0.91 -0.27 8.05 16.7 20.53 1.88
Vanguard 500 Index VFINX 48,312.8 0.18 6.03 26.49 -37.02 5.39 -5.66 0.34 -1.03 7.97 16.7 19.90 2.05
Vanguard Inst Idx VINIX 44,401.0 0.05 6.06 26.63 -36.95 5.47 -5.57 0.45 -0.91 8.10 16.7 19.90 2.17
Vanguard 500 Idx Adm VFIAX 28,379.9 0.09 6.06 26.62 -36.97 5.47 -5.58 0.43 -0.96 8.02 16.7 19.91 2.15
Vanguard Tot Stk Adm VTSAX 27,762.3 0.09 5.84 28.83 -36.99 5.57 -5.02 1.00 -0.20 8.10 16.7 20.55 1.96
Vanguard Total Intl Stk VGTSX 26,043.7 0.34 3.17 36.73 -44.10 15.52 -4.07 5.26 2.29 - 13.8 26.09 2.39
Vanguard Inst Idx InstPl VIIIX 24,767.0 0.03 6.06 26.66 -36.94 5.50 -5.55 0.48 -0.89 8.12 16.7 19.90 2.19
Vanguard TtlBdMkt2IdxInv VTBIX 20,431.8 0.19 0.24 - - - - - - - - - -
Vanguard Total Bd Idx VBMFX 19,554.9 0.22 0.07 5.93 5.05 6.92 5.97 4.90 6.06 6.57 - 4.22 4.07
Vanguard Total Bd Idx Ad VBTLX 17,932.2 0.14 0.10 6.04 5.15 7.02 6.07 5.00 6.13 6.62 - 4.22 4.17
Fidelity Spar US EqIx FUSEX 17,406.7 0.10 6.01 26.51 -37.03 5.43 -5.65 0.38 -1.04 7.90 17.6 19.92 1.98
Vanguard 500 Index Signal VIFSX 16,590.2 0.09 6.06 26.61 -36.97 5.47 -5.58 0.40 -1.00 7.99 16.7 19.91 2.15
Vanguard Tot Stk Inst VITSX 16,047.0 0.06 5.88 28.83 -36.94 5.56 -4.99 1.04 -0.15 8.15 16.7 20.52 1.97
Vanguard Total Bd Idx In VBTIX 15,692.5 0.08 0.11 6.09 5.19 7.05 6.11 5.04 6.19 6.69 - 4.22 4.22
T. Rowe Price Eq Idx 500 PREIX 11,082.3 0.35 6.00 26.33 -37.06 5.18 -5.79 0.19 -1.19 7.76 16.7 19.88 1.71
Vanguard Tot Stk InstPls VITPX 10,520.3 0.03 5.90 28.92 -36.89 5.62 -4.93 1.10 - - 16.7 20.56 1.96
Fidelity U.S. Bond Index FBIDX 10,383.0 0.32 0.17 6.45 3.76 5.37 5.19 4.43 6.08 6.58 - 3.82 3.73
Schwab S&P 500 In Sel SWPPX 9,382.5 0.09 6.01 26.25 -36.72 5.50 -5.54 0.43 -1.01 - 14.6 19.83 1.41
Vanguard TotBdMkt Idx Sig VBTSX 8,450.1 0.14 0.11 6.04 5.15 7.02 6.07 4.97 6.09 6.60 - 4.22 4.17
Vanguard Em Mkt Idx VEIEX 7,765.4 0.39 8.22 75.98 -52.81 38.90 4.87 14.53 9.82 8.22 15.4 33.21 1.21
Vanguard Total Bond Mkt II Inst Cl VTBNX 7,076.0 0.07 0.23 - - - - - - - - - -
Fidelity Spar 500 Adv FSMAX 6,904.0 0.07 6.03 26.54 -37.03 5.46 -5.63 0.40 -1.02 7.89 17.6 19.92 2.03
Vanguard Mid Cap Idx VIMSX 6,788.8 0.27 6.52 40.22 -41.82 6.02 -4.72 2.28 6.13 - 16.8 24.24 1.11
Fidelity Spar 500 Idx FSMKX 6,697.0 0.10 6.03 26.50 -37.05 5.43 -5.66 0.37 -1.03 7.89 17.6 19.92 2.00
Vanguard Eur Stk Idx VEURX 6,423.9 0.29 2.25 31.91 -44.73 13.82 -6.03 3.88 1.99 8.44 12.4 26.41 3.79
Vanguard Mid Cap Idx Ins VMCIX 5,960.1 0.09 6.58 40.51 -41.76 6.22 -4.56 2.45 6.30 - 16.8 24.27 1.25
Fidelity 100 Index FOHIX 5,926.0 0.20 5.74 22.14 -35.44 - - - - - 17.2 - 2.27
Vanguard SmCp Idx NAESX 5,913.3 0.28 4.07 36.12 -36.07 1.16 -4.16 1.80 4.36 8.67 16.9 26.16 1.00
Vanguard Gr Idx VIGRX 5,770.5 0.28 7.88 36.29 -38.32 12.56 -1.82 1.63 -2.75 8.12 18.6 19.79 1.03
Vanguard Inst DevMktsIdx VIDMX 5,767.8 0.13 1.61 28.17 -41.42 11.04 -5.88 3.65 - - 13.4 24.70 1.08
Fidelity Spar US Eq Adv FUSVX 5,574.4 0.07 6.03 26.55 -37.01 5.46 -5.62 0.40 -1.03 7.91 17.6 19.91 2.00
Fidelity Spar Intl Index FSIIX 5,555.1 0.10 2.14 28.48 -41.43 10.72 -5.90 3.63 1.03 - 11.4 24.82 2.20
Fidelity Spar Tot Mkt Ix FSTMX 5,388.6 0.10 5.80 28.39 -37.18 5.57 -5.22 0.95 -0.32 - 17.5 20.50 1.79
Vanguard Sh-Tm Bd Idx VBISX 5,282.9 0.22 0.24 4.28 5.43 7.22 5.64 4.45 5.09 5.65 - 2.62 2.81
Vanguard Sh-Tm Bd Sgnl VBSSX 5,080.0 0.14 0.28 4.38 5.51 7.28 5.72 4.50 5.12 5.67 - 2.62 2.91
Vanguard TotStMkt Idx Sig VTSSX 4,757.4 0.09 5.87 28.85 -36.99 5.55 -5.02 0.97 -0.24 8.08 16.7 20.53 1.96
Schwab 1000 In Inv SNXFX 4,542.3 0.29 6.06 27.68 -37.28 5.76 -5.39 0.68 -0.65 7.97 14.7 20.03 1.75
Vanguard ExtMktIdx VEXMX 4,309.3 0.30 5.05 37.43 -38.73 4.33 -4.23 2.06 1.71 8.69 17.4 24.75 1.00
Vanguard SmCp Idx Ins VSCIX 4,161.7 0.09 4.11 36.40 -35.98 1.29 -4.01 1.96 4.52 8.81 16.9 26.16 1.17
Vanguard Inst Tot Bd Idx VITBX 4,148.7 0.05 0.14 6.06 5.05 7.01 6.04 4.97 - - - 4.24 4.23
Vanguard REIT Index VGSIX 3,763.2 0.26 9.05 29.58 -37.05 -16.46 -12.00 0.59 10.40 - 29.5 39.98 4.31
Fidelity Spar Tot Mkt Adv FSTVX 3,697.2 0.07 5.82 28.43 -37.16 5.60 -5.19 0.98 -0.31 - 17.5 20.49 1.82
ING LB US Aggt Bd Idx I ILBAX 3,501.0 0.45 0.22 5.88 - - - - - - - - 2.26
Vanguard ExtMktIdx Instl VIEIX 3,494.1 0.09 5.12 37.69 -38.58 4.51 -4.04 2.25 1.89 8.83 17.4 24.76 1.19
Vanguard Intm Bd Idx VBIIX 3,478.8 0.22 -0.03 6.79 4.93 7.61 6.44 4.98 6.83 7.12 - 6.87 4.43
ING Stock Indx I INGIX 3,476.4 0.26 6.02 26.22 -37.12 5.28 -5.81 0.19 - - 16.7 19.96 0.60
Vanguard Bal Idx VBINX 3,430.8 0.25 3.55 20.05 -22.21 6.16 -0.29 2.87 2.64 7.87 16.7 12.93 2.66
Vanguard Val Idx VIVAX 3,356.9 0.26 4.41 19.58 -35.97 0.09 -8.49 0.05 1.23 7.97 15.0 21.06 2.73
Vanguard SmCp Vl Idx VISVX 3,279.1 0.28 3.79 30.34 -32.05 -7.07 -6.29 0.80 7.69 - 15.1 26.91 1.88
Vanguard Dev Mkts Idx VDMIX 3,123.9 0.29 1.67 28.17 -41.62 10.99 -6.00 3.50 - - 13.4 24.76 1.14
VALIC I Stock VSTIX 3,111.8 0.39 6.03 26.16 -37.21 5.13 -5.92 0.10 -1.28 7.69 17.6 20.05 2.15
Vanguard Pac Stk Idx VPACX 3,079.2 0.29 0.47 21.18 -34.36 4.78 -5.89 2.73 -0.68 0.37 16.6 22.12 2.64
Vanguard SmCp Gr Idx VISGX 3,017.6 0.28 4.37 41.85 -40.00 9.63 -2.28 2.56 4.84 - 18.9 26.33 0.29
Vanguard EmgMkts Idx Admr VEMAX 2,984.8 0.27 8.26 76.18 -52.76 39.09 5.00 14.63 9.87 8.25 15.4 33.23 1.31
Vanguard Gr Idx Instl VIGIX 2,913.1 0.09 7.94 36.50 -38.19 12.73 -1.66 1.79 -2.62 8.24 18.6 19.79 1.20
Vanguard Bal Idx Instl VBAIX 2,869.1 0.09 3.60 20.18 -22.10 6.34 -0.15 2.99 2.76 7.95 16.7 12.92 2.81
Vanguard Value Index Is VIVIX 2,812.3 0.09 4.46 19.79 -35.88 0.21 -8.35 0.19 1.36 8.07 15.0 21.07 2.89
Fidelity Spar Ext Mkt Ix FSEMX 2,583.6 0.10 4.95 36.65 -38.45 5.38 -3.94 2.38 1.75 - 17.0 23.80 1.15
Vanguard Intm Bd Idx Adm VBILX 2,508.4 0.14 0.00 6.89 5.01 7.70 6.53 5.06 6.89 7.17 - 6.87 4.53
Dreyfus S&P 500 Index PEOPX 2,381.3 0.50 5.96 26.04 -37.28 5.03 -6.01 -0.02 -1.41 7.51 17.6 19.90 1.64
Source:
Source:Morningstar.
Morningstar. Data
Data as
as of
of December
XXXXXXXX 31, 2009. Exp Ratio is expense ratio. 3-, 5-, 10- and 15-yr returns are annualized. P/E is price-to-earnings ratio.
Source: Morningstar. Data as of 2/29/08
Std Dev is 3-year standard deviation. Yield is 12-month.

www.journalofindexes.com March/April 2010 63


Morningstar U.S. Style Overview Jan. 1 – Dec. 31, 2009
Trailing Returns % Morningstar Market Barometer YTD Return %
3-Month YTD 1-Yr 3-Yr 5-Yr 10-Yr Value Core Growth
Morningstar Indexes
US Market 10.40 28.45 28.45 –5.01 1.09 –0.11
US Market 17.95 25.96 43.00
Large Cap 9.77 24.76 24.76 –5.30 0.63 –1.88 28.45
Mid Cap 12.34 39.03 39.03 –4.48 2.33 4.50
Small Cap 11.20 37.75 37.75 –4.35 1.61 5.68

Large Cap
US Value 6.66 17.95 17.95 –9.41 –0.12 3.58
US Core 10.32 25.96 25.96 –3.54 1.79 2.21 24.76 11.38 21.52 44.37
US Growth 14.61 43.00 43.00 –2.25 1.20 –6.26

Mid Cap
Large Value 5.12 11.38 11.38 –10.82 –0.94 1.77
Large Core 9.59 21.52 21.52 –3.27 1.65 0.48 39.03 36.05 38.94 42.05
Large Growth 15.19 44.37 44.37 –1.94 0.60 –8.19

Small Cap
Mid Value 10.27 36.05 36.05 –6.26 1.76 8.06
Mid Core 12.36 38.94 38.94 –4.60 1.84 6.78 37.75 40.28 39.86 32.98
Mid Growth 14.58 42.05 42.05 –2.96 3.09 –1.21

Small Value 12.26 40.28 40.28 –4.14 2.13 10.22 –8.00 –4.00 0.00 +4.00 +8.00
Small Core 11.80 39.86 39.86 –5.48 1.69 8.79
Small Growth 9.44 32.98 32.98 –3.89 0.65 –1.44

Sector Index YTD Return % Industry Leaders & Laggards YTD Return % Biggest Influence on Style Index Performance
YTD Constituent
Hardware 65.01 Broadcasting - Radio 400.00 Return % Weight %
Best Performing Index
Software 52.65 Long Distance Carriers 348.55 Large Growth 44.37

Media 43.27 Auto Manufacturers - Major 336.68 Apple Inc. 146.90 4.14
Microsoft Corp. 60.50 8.39
Business Services 34.08 Copper 204.82
Google Inc. Cl A 101.52 4.00
Industrial 33.79 Semiconductor - Memory 191.54 Cisco Systems Inc. 46.87 5.23
Goldman Sachs Group Inc. 102.54 1.84
Consumer Services 30.24 Online Retail 155.22

Consumer Goods 23.52 –6.91 Grocery Stores Worst Performing Index


Large Value 11.38
Healthcare 21.29 –8.93 Regional - Pacific Banks
JPMorgan Chase & Co. 34.36 4.71
Energy 19.46 –12.09 Regional - Midwest Banks
Ford Motor Co. 336.68 0.21
Financial Services 16.58 –15.56 Regional - Southeast Banks Merck & Co. Inc. 26.73 2.57
Morgan Stanley 87.93 0.62
12.67 –16.14 Regional - Mid -Atlantic Banks
Dow Chemical Co. 89.96 0.56
Utilities 11.74 –35.87 Photographic Equipment & Supplies

1-Year 3-Year 5-Year


Value Core Growth Value Core Growth Value Core Growth
Large Cap

Large Cap

Large Cap

11.38 21.52 44.37 –10.82 –3.27 –1.94 –0.94 1.65 0.60


Mid Cap

Mid Cap

Mid Cap

36.05 38.94 42.05 –6.26 –4.60 –2.96 1.76 1.84 3.09


Small Cap

Small Cap

Small Cap

40.28 39.86 32.98 –4.14 –5.48 –3.89 2.13 1.69 0.65

–20 –10 0 +10 +20 –20 –10 0 +10 +20 –20 –10 0 +10 +20

Source: Morningstar. Data as of Dec. 31, 2009.


Notes and Disclaimer: ©2009 Morningstar, Inc. All Rights Reserved. Unless otherwise noted, all data is as of most recent month end. Multi-year returns are annualized. NA: Not Available. Biggest Influence on Index Performance lists
are calculated by multiplying stock returns for the period by their respective weights in the index as of the start of the period. Sector and Industry Indexes are based on Morningstar's proprietary sector classifications. The information
contained herein is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
?

64 March/April 2010
Dow JonesU.S.U.S.
Exchange-Traded
Dow Jones Industry
Industry Review Review
Funds Corner
Performance
Index Name Weight 1-Month 3-Month 1-Year 3-Year 5-Year 10-Year
Dow Jones U.S. Index 100.00% 2.65% 6.05% 28.79% -4.98% 1.06% -0.39%
Dow Jones U.S. Basic Materials Index 3.33% 2.42% 9.92% 65.51% 2.64% 5.95% 4.87%
Dow Jones U.S. Consumer Goods Index 10.07% 1.30% 6.07% 23.86% 0.32% 3.43% 5.05%
Dow Jones U.S. Consumer Services Index 11.51% 3.55% 6.83% 33.68% -4.96% -0.76% -2.26%
Dow Jones U.S. Financials Index 15.52% -0.05% -1.30% 17.11% -21.79% -9.47% -0.51%
Dow Jones U.S. Health Care Index 12.13% 2.61% 8.66% 21.71% 0.60% 3.34% 3.42%
Dow Jones U.S. Industrials Index 12.53% 2.41% 6.01% 26.07% -4.70% 0.65% -0.19%
Dow Jones U.S. Oil & Gas Index 10.88% -0.22% 4.63% 17.26% 0.52% 10.83% 10.41%
Dow Jones U.S. Technology Index 17.31% 6.47% 10.73% 64.48% 2.83% 4.34% -6.21%
Dow Jones U.S. Telecommunications Index 2.78% 5.10% 7.04% 9.85% -6.76% 1.27% -7.42%
Dow Jones U.S. Utilities Index 3.95% 5.69% 6.84% 12.58% -2.58% 5.28% 6.17%

Risk-Return
5%
Technology Basic Materials
0% Consumer Goods Health Care Oil & Gas
3-Year Annualized Return

Utilities
-5% Composite Consumer Services Industrials
Telecommunications

-10%

-15%

-20%
Financials

-25%
14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34%

3-Year Annualized Risk

Industry Weights Relative to Global ex-U.S. Asset Class Performance


U.S. [85.79] Global ex-U.S. [89.68] Commodities [88.94]
Basic Materials -8.30%
REITs [64.39] Infrastructure [99.32]

Consumer Goods -2.23% 160

Consumer Services 4.58%


140
Financials -9.58%
120
Health Care 6.22%

Industrials 0.03% 100

Oil & Gas 0.41%


80

Technology 12.27%
60
Telecommunications -2.57%

Utilities -0.83% 40

-15% -10% -5% 0% 5% 10% 15%


20
Underweight <= U.S. vs. Global ex-U.S. => Overweight 12/06 3/07 6/07 9/07 12/07 3/08 6/08 9/08 12/08 3/09 6/09 9/09 12/09

Chart compares industry weights within the Dow Jones U.S. Index to industry weights within the Dow Jones U.S. = Dow Jones U.S. Index | Global ex-U.S. = Dow Jones Global ex-U.S. Index
Global ex-U.S. Index Commodities = Dow Jones-UBS Commodity Index | REITs = Dow Jones U.S. Select REIT Index
Infrastructure = Dow Jones Brookfield Global Infrastructure Index

© Dow Jones & Company, Inc. 2009. All rights reserved. "Dow Jones", "Dow Jones Indexes", "Dow Jones U.S. Index", "Dow Jones Global ex-U.S. Index" and "Dow Jones U.S. Industry Indexes" are service marks of Dow Jones & Company, Inc. "UBS" is a registered trademark of UBS AG. "Dow Jones-UBS Commodity Index" is a service
mark of Dow Jones & Company, Inc. and UBS. "Brookfield" is a service mark of Brookfield Asset Management Inc. or its affiliates. The "Dow Jones Brookfield Infrastructure Indexes" are published pursuant to an agreement between Dow Jones & Company, Inc. and Brookfield Asset Management. Investment products that may be based
on the indexes referencedare not sponsored, endorsed, sold or promoted by Dow Jones, and Dow Jones makes no representationregarding the advisability of investing in them. Inclusion of a company in these indexes does not in any way reflect an opinion of Dow Jones on the investment merits of such company. Index performance is for
illustrative purposes only and does not represent the performance of an investment product that may be based on the index. Index performance does not reflect management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

The Dow Jones U.S. Index, the Dow Jones Global ex-U.S. Index and the Dow Jones U.S. Industry Indexes were first published in February 2000. The Dow Jones Brookfield Infrastructure Index was first published in July 2008. To the extent this document includes information for the index for the period prior to its initial publication date,
such information is back-tested (i.e., calculations of how the index might have performed during that time period if the index had existed). Any comparisons, assertions and conclusions regarding the performance of the Index during the time period prior to launch will be based on back-testing. Back-tested information is purely hypothetical
and is provided solely for informational purposes. Back-tested performance does not represent actual performance and should not be interpreted as an indication of actual performance. Past performance is also not indicative of future results.

Data as of December 31, 2009


Source: Dow Jones Indexes Analytics & Research

For more information, please visit the Dow Jones Indexes Web site at www.djindexes.com.

www.journalofindexes.com March/April 2010 65


Exchange-Traded Funds Corner
Largest New ETFs Sorted By Total Net Assets In $US Millions Selected ETFs In Registration
Covers ETFs and ETNs launched in 2009.
Claymore Corporate Bond 2020
Fund Name Ticker ER 1-Mo 3-Mo Launch Date Assets Claymore Wilshire 5000 Eq-Wtd
iPath S&P 500 VIX Mid ETN VXX 0.89 -15.42 -31.85 1/29/2009 795.5 Direxion Nasdaq-100 Bull 3x
JPMorgan Alerian MLP Index ETN AMJ 0.85 6.75 16.06 4/2/2009 713.3 Emerging Global Shares INDXX Brazil Mid Cap
Market Vectors Brazil Small-Cap BRF 0.73 5.01 24.18 5/12/2009 699.2 Global X Finland
Market Vectors Junior Gold Miners GDXJ 0.60 -5.45 - 11/10/2009 660.8 Global X United Arab Emirates
Vanguard FTSE All-Wld ex-US SmCp VSS 0.38 1.95 3.57 4/2/2009 343.6 HTE Global Relative Value
ETFS Physical Swiss Gold SGOL 0.39 -7.21 8.57 9/9/2009 331.3 IQ International Canada Small Cap
ProShares Short 20+ Year Treasury TBF 0.95 6.29 6.88 8/20/2009 262.4 iShares MSCI ACWI ex US Utilities
SPDR Barclays Capital Convertible Bond CWB 0.40 2.39 5.34 4/14/2009 232.0 JETS Contrarian Opportunities
WisdomTree Dreyfus Emerging Currency CEW 0.55 0.13 1.98 5/6/2009 223.4 Market Vectors Latin America Small-Cap
Market Vectors Indonesia IDX 0.71 3.61 5.25 1/15/2009 201.6 McDonnell Core Taxable Bond
PIMCO 1-3 Year U.S. Treasury TUZ 0.09 -0.63 0.08 6/1/2009 175.3 Old Mutual FTSE Developed Markets ex US
ProShares UltraPro Short S&P 500 SPXU 0.95 -6.28 -20.14 6/23/2009 158.0 PowerShares Industrial Corporate Bond
ETFS Silver SIVR 0.30 -8.66 1.20 7/24/2009 155.5
PowerShares S&P SmallCap Healthcare
Direxion Daily Real Estate Bull 3x DRN 0.95 21.87 19.79 7/16/2009 149.3
ProShares Ultra Swiss Franc
PIMCO 1-5 Year U.S. TIPS STPZ 0.20 -0.58 2.18 8/20/2009 139.4
Rydex 2x Energy Investing
SPDR BarCap Short-Term International Treasury BWZ 0.35 -4.49 -1.84 1/15/2009 137.4
SPDR S&P India
iShares S&P/Citi International Treasury IGOV 0.35 -5.31 -3.14 1/21/2009 134.1
WCM / BNY Mellon Focused Growth ADR
iShares S&P/Citi 1-3 Yr International Treasury ISHG 0.35 -4.73 -2.45 1/21/2009 124.9
WisdomTree Commodity Currency
Market Vectors High-Yield Municipal HYD 0.35 1.11 -1.81 2/4/2009 119.7
WisdomTree Israel Total Dividend
iShares MSCI All Peru Capped EPU 0.63 -0.81 1.65 6/19/2009 110.5
Source: Morningstar. Data as of December 31, 2009. ER is expense ratio. 1-Mo is 1-month. 3-Mo is 3-month. Source: IndexUniverse.com's ETF Watch

Largest U.S.-listed ETFs Sorted By Total Net Assets In $US Millions


Total Return % Annualized Return %
Fund Name Ticker Assets Exp Ratio 3-Mo 2009 2008 2007 3-Yr 5-Yr Mkt Cap P/E Std Dev Yield
SPDRs (S&P 500) SPY 84,908.0 0.09 6.11 26.31 -36.70 5.12 -5.63 0.41 44,056 17.6 19.79 1.95
SPDR Gold Trust GLD 40,223.0 0.40 8.56 24.03 4.92 31.10 19.49 19.63 - - 21.87 -
iShares MSCI Emerg Mkts EEM 39,209.2 0.72 7.49 68.77 -48.87 33.11 4.73 14.89 22,806 5.9 32.38 1.40
iShares MSCI EAFE EFA 35,207.1 0.35 2.00 26.88 -41.00 9.94 -6.29 3.25 28,840 11.4 24.96 2.60
iShares S&P 500 IVV 21,729.2 0.09 6.04 26.61 -37.00 4.92 -5.77 0.42 44,074 17.6 19.81 1.93
Vanguard Emerging Markets VWO 19,445.3 0.27 7.84 76.29 -52.54 37.32 4.73 - 17,639 15.4 32.40 1.33
PowerShares QQQQ QQQQ 18,560.4 0.20 8.47 54.67 -41.72 19.13 2.40 3.16 38,949 25.8 23.89 0.46
iShares Barclays Capital TIPS Bond TIP 18,489.7 0.20 1.80 8.95 -0.53 11.93 6.65 4.52 - - 8.89 3.90
Vanguard Total Stock Market VTI 13,442.6 0.09 5.85 28.89 -36.97 5.36 -5.05 1.03 23,218 16.7 20.49 1.96
iShares Russell 2000 IWM 13,081.2 0.24 4.07 28.53 -34.15 -1.76 -5.96 0.54 739 16.0 24.62 1.15
iShares iBoxx $ Inv Grade Corp Bond LQD 12,840.6 0.15 -0.64 8.58 2.44 3.76 4.89 4.01 - - 12.16 5.50
iShares Russell 1000 Growth IWF 11,350.9 0.20 8.07 36.73 -38.21 11.48 -1.98 1.45 36,198 19.3 20.03 1.39
iShares Barclays Capital Aggregate AGG 11,234.0 0.24 -0.39 3.01 7.90 6.61 5.82 4.72 - - 5.57 3.89
iShares Brazil EWZ 11,093.8 0.65 13.58 121.18 -54.37 74.82 20.83 31.00 32,195 13.8 40.62 3.69
iShares FTSE/Xinhua China FXI 10,180.1 0.73 3.82 47.28 -47.73 54.81 6.02 19.84 72,013 18.6 39.99 1.28
DIAMONDS Trust DIA 9,045.5 0.17 8.04 22.72 -32.10 8.78 -3.22 1.83 98,013 16.4 18.29 2.70
iShares R1000 Value IWD 8,795.2 0.20 4.07 19.23 -36.45 -0.73 -9.06 -0.35 31,309 15.8 21.22 2.36
MidCap SPDR (S&P 400) MDY 8,485.0 0.25 5.57 37.52 -36.40 7.20 -2.12 3.01 2,566 18.4 23.52 1.22
iShares BarCap 1-3 Yr Treasury SHY 7,667.1 0.15 -0.11 0.36 6.61 7.35 4.73 3.91 - - 2.10 2.41
Financial SPDR XLF 6,848.4 0.21 -3.26 17.50 -54.90 -19.19 -24.62 -11.58 37,728 21.6 36.33 1.71
iShares S&P 400 MidCap IJH 6,519.3 0.21 5.51 37.81 -36.18 7.30 -1.91 3.21 2,566 18.4 23.46 1.28
Vanguard Total Bond Market BND 6,241.5 0.14 0.11 3.67 6.88 - - - - - - 4.04
iShares S&P 500 Growth IVW 5,796.3 0.18 7.83 31.13 -34.78 8.84 -2.36 1.43 54,406 18.6 18.69 1.38
Energy SPDR XLE 5,616.0 0.21 6.30 21.81 -38.97 36.86 0.58 10.97 48,610 14.8 26.42 1.82

Source: Morningstar. Data as of December 31, 2009. Exp Ratio is expense ratio. 3-Mo is 3-month. 3-Yr and 5-Yr are 3-year and 5-year annualized returns, respectively.
Mkt Cap is geometric average market capitalization. P/E is price-to-earnings ratio. Std Dev is 3-year standard deviation. Yield is 12-month.

66 March/April 2010
Blanchett continued from page 37
Appendix II: Benchmark Indices continued
Russell
Large Growth Russell 1000 Growth
Large Blend Russell 1000
Large Value Russell 1000 Value
Mid-Cap Growth Russell Mid Cap Growth
Mid-Cap Blend Russell Mid Cap
Mid-Cap Value Russell Mid Cap Value
Small Growth Russell 2000 Growth
Small Blend Russell 2000
Small Value Russell 2000 Value

Works Cited
“2009 Investment Company Fact Book.” Investment Company Institute. http://www.icifactbook.org/.
Carhart, Mark M. 1997. “On Persistence in Mutual Fund Performance,” Journal of Finance, vol. 52: No. 1, 57-82.
Cremers, Martijn, Antti Petajisto, and Eric Zitzewitz. 2008. “Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation.” Working paper version July 31, 2008.
Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Bonds and Stocks,” Journal of Financial Economics, vol. 33: 3-53.
French, Kenneth R., http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Israelsen, Craig. 2007. “Variance Among Indexes.” Journal of Indexes, May/June: 26-29

Gardner continued from page 45


true of any returns-based performance metric. This fact must primary goal of target date funds is creating wealth at a
be kept in mind in interpreting the Russell TDM: It is a mea- certain fixed “cash-out” point in the future. Performance en
sure of performance over a given time period, not a predictor route to that final number is important because of how it
of future performance. influences that end result.
• Takes into account the timing of cash flows as a typical
Conclusion investor saves for retirement.
During June and July 2009, Congress held hearings and • Determines the value over a given performance period
heard testimony regarding the performance of target date by differences in the returns of the funds in the family
funds. This reflects how important these investment vehicles and the benchmark returns. A returns-based measure
have become and how great the need is for credible perfor- will capture the performance differentials that are due
mance measures. The industry needs a measure that: to glide path structure, asset mix and active/passive
• Provides a valid estimate of the true value for a given implementation, the three key components of target
family of funds, using fund returns over a limited evalu- date fund performance differences.
ation period. • Measures performance relative to a passive investable
• Reflects the relative importance of each fund’s posi- alternative.
tion on its glide path: Returns of funds near their • Can be used to meaningfully compare the performance
target dates have more influence on retirement wealth of any two families of funds over a common perfor-
than returns of more distant funds. This is because the mance period.

References
Christopherson, J.A., D.R. Cariño and W.E. Ferson (2009). “Portfolio Performance Measurement and Benchmarking,” McGraw-Hill.
Gardner, G. and A. Sirohi (2009). “The Russell Target Date Performance Metric: Description of Methodology,” Russell Research, August.
Goodwin, T. (1998). “The Information Ratio,” Financial Analysts Journal. July/August, pp. 34-43.
Maxie, D. (2009). “Getting Personal: Target date funds find ways to cut costs.” Wall Street Journal, August 3.
Spaulding, D. and J.A. Tzitzouris, ed. (2009). “Classics in Investment Performance Measurement,” The Spaulding Group.

Endnotes
1Maxie (2009).
2For calculation specifications, see Gardner and Sirohi (2009).
3The total return of global equity as measured by the 67 percent/33 percent mix of the Russell 3000 and Russell Global ex-U.S. Indexes minus the return of the Barclays Capital U.S Aggregate
Bond Index.

Disclosures
Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a subsidiary
of The Northwestern Mutual Life Insurance Company.

www.journalofindexes.com March/April 2010 67


The Future Of ETFs
HUMOR

The ETFs Of 2010


By Dave Nadig

One of the things we pride ourselves solely in companies whose stocks have
on at Index Publications is our crystal been unnecessarily punished. Key hold-
ball. By poring over obscure SEC filings, ings include Crocs, Vonage, Transmeta,
combing through patent and trademark and the recovered assets of Internet
cases and good old-fashioned shoe-leath- retailer Webvan.
er reporting, we think we’ve got a pretty SCAM: This actively managed stock-
good handle on where the indexing and picking fund from a major active mutual
ETF industry is headed. Here for the first fund manager will be the first to take
time is a selection of ETFs we’re particu- advantage of a special SEC “blinding”
larly looking forward to seeing. exemption. While the NAV of the fund
Fabulous investment As always, market conditions and SEC will be published, creation baskets will
opportunities await approval can delay the launches. be made entirely of precious metals.
ETF investors WEED: With medical marijuana now Redemptions will be made in cheese.
this year. legal in 14 states, it was only a matter of FAT: Cashing in on the continued high
time before the ETF industry cashed in levels of unemployment, demographic
on the trend. Based on the “High Times trends and the American obsession with
Righteous Buzz Index,” WEED will invest fast food, this ETF will invest solely in
in agribusiness companies, the hemp fast-food companies and manufacturers
futures market and fungible stockpiles. of insulin pumps.
CHTO: WEED’s physically backed sister SPAM: Following up on the success of
fund will consist entirely of high-calorie OOK, this ETF invests solely in compa-
snack foods. The fund’s assets, which will nies based in the Hawaiian Islands, and
be placed in a vault in Amsterdam, will be Hormel Foods Corp (with some inexpli-
audited biannually, or whenever WEED’s cable crossover into Russian Internet
custodians get the munchies. start-up firms)
SCUM: This “special situations” fund LOL: A new active fund managed by an
focuses on the assets of some of the expert group of Blackberry-armed 14-year-old
country’s most creative investors and girls, who seek to replicate trends hidden in
accountants, old and new. Not just focus- the catalog of Lady Gaga.
ing on cleanup operations in the after- BOO: Tracks the Scooby Doo Phantom
math of Madoff or the credit crisis, SCUM Index of amusement parks owners and
will track down the current “hot picks” hotel operators.
from such luminaries as Bernie Ebbers LENO: Invests solely in seven-month
and Charles Keating. call options on companies with second-
FLOP: A true value play, FLOP will invest place positions in their markets.

68 March/April 2010
Ever wonder exactly what you’re investing in? Every day, we provide
a complete list of holdings for each of our tax-efficient ETFs -
including the PowerShares QQQ. Visit www.InvescoPowerShares.com
to see what you may be missing.

There are risks involved with investing in ETFs including possible loss of money. The funds are not actively managed and are subject to risks
similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. Shares are not
FDIC insured, may lose value and have no bank guarantee. Invesco PowerShares does not offer tax advice. Investors should consult their
own tax advisor for information regarding their own tax situations. PowerShares is a registered trademark of Invesco PowerShares Capital
Management LLC. ALPS Distributors, Inc. is the distributor for QQQ. Invesco PowerShares Capital Management LLC is not affiliated with ALPS
Distributors, Inc.

An investor should consider the Fund’s investment objective, risks, charges and expenses carefully before investing. To obtain a
prospectus, which contains this and other information about the QQQ, a unit investment trust, please contact your broker, call
800.983.0903 or visit www.invescopowershares.com. Please read the prospectus carefully before investing.

Shares are not individually redeemable and owners of the shares may acquire those shares from the Funds and tender those shares for
redemption to the funds in Creation Unit aggregations only, typically consisting of 50,000 shares.
www.invescopowershares.com | 800.983.0903
VGSH VGIT

VANGUARD SHORT-TERM VANGUARD INTERMEDIATE-TERM


GOVERNMENT BOND ETF GOVERNMENT BOND ETF

VGLT

VANGUARD LONG-TERM
GOVERNMENT BOND ETF

New Bond ETFs from Vanguard I Offering targeted exposure to the government
sector of the domestic fixed income market, these ETFs provide options for
tailoring your portfolio within the government sector. Choose short-, intermediate-,
or long-term coverage. Lower costs,* tight tracking, and diversification may reduce
manager risk and provide returns more in line with the index. Expertise, lower
costs, and trusted name. Just what you’d expect from Vanguard.™ Connect
with Vanguard® at 800-523-1178 or visit our dedicated advisors’ website at
advisors.vanguard.com/etf.

To buy or sell Vanguard ETFs,™ contact your financial advisor. Usual commissions apply. Not redeemable. Market price
may be more or less than NAV. Visit advisors.vanguard.com/etf to obtain a Vanguard prospectus which contains
investment objectives, risks, expenses, and other information; read and consider carefully before investing. All ETFs are subject to
risk, including possible loss of principal. Investments in bond funds are subject to interest rate, credit, and inflation risk. *Source: Lipper
Inc. as of December 31, 2008. Based on 2008 industry average expense ratio of 1.19% and Vanguard average expense ratio of 0.20%.
©2010 The Vanguard Group, Inc. All rights reserved. U.S. Pat. No. 6,879,964 B2; 7,337,138. Vanguard Marketing Corporation, Distributor.
Sourcing Liquidity...At The Right Price SM

Institutional Order Execution


ETF’s. Options. Equities.
WallachBeth Capital LLC is an ‘inter-market-broker’ specializing in exchange-listed equity
options, index products, ETF’s, and equities.

Operating on a full-disclosed agency basis, our role is to demystify the challenges of executing
trades within highly fragmented markets. By doing so, we are able to provide a vital link for
those seeking liquidity and best price execution with complete transparency.

Our team is comprised of product experts that understand market dynamics and the nuances of
transacting in all trading environments. We are relied upon for leveraging trading system
technologies and industry-wide relationships to efficiently and cost-effectively execute complex and
potentially market-impacting orders.

www.wallachbeth.com

WallachBeth Capital, LLC


100 Wall Street Suite 6600 New York N.Y. 10005
Tel. 646.237.8585 Fax 212.495.0270

Member FINRA • SIPC • CBSX • ISE • ARCA • NYSE Amex Options