EXCHANGE TRADED FUNDS
STRATEGIES FOR INVESTING
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Exchange Traded Funds, also know as ETF's, have experienced tremendous growth in assets and popularity over the past few years. The proliferation of new ETF's, representing virtually every asset class or sector, has attracted significant cash flows. For example, according to the Investment Company Institute (ICI) in 1999 only $12.1 billion were invested in these vehicles. By 2000, that number swelled to over $65 billion. Since the 1993 introduction of the SPDR, which tracks the S&P 500, the field has now grown to 115 funds in total with assets of $120 billion. These do not include Trust-issued receipts, such as Holding Company Depository Receipts (HOLDRS), as they are not issued by registered investment companies. As shown in the table below, there are currently 69 ETF’s that track domestic indices, 41 that track foreign indices and 5 bond ETF’s.
ASSETS OF EXCHANGE-TRADED FUNDS BY TYPE (millions of dollars)
September 2003 August 2003 December 2002
Total Domestic Equity Index 106,180 104,453 R 92,904
Domestic (Broad-based) 91,034 89,271 R 82,365
Domestic (Sector/Industry) 15,145 15,182 10,539
Global/International Equity Index 9,367 8,506 5,324
Bond Index 4,206 4,320 3,915
All 119,753 117,279 R 102,143
NUMBER OF EXCHANGE-TRADED FUNDS BY TYPE
September 2003 August 2003 December 2002
Total Domestic Equity Index 69 69 66
Domestic (Broad-Based) 38 38 35
Domestic (Sector/Industry) 31 31 31
Global/International Equity Index 41 41 39
Bond Index 5 4 8
All 115 114 113
Source: ICI
THE MECHANICS
ETF's can be used to accomplish several strategies. However, let’s first address what they are and how they work. The figure on the next page illustrates how ETF's differ from traditional mutual funds. The primary feature is that an ETF investor purchases shares that represent a basket of securities in the underlying index. The investor sends cash to the market maker who uses those funds to purchase securities in the index. The market maker then delivers a basket of securities to the fund manager in exchange for ETF shares that are then delivered to the investor. This differs from a traditional mutual fund in that the assets are not commingled but remain separate. An ETF investor therefore, is not impacted by the actions of other shareholders. This gives the investor control over purchases and sales and thus can make ETF's relatively tax efficient.
This structure also provides most of the flexibility offered by individual securities, but allows an investor to target certain style or market cap allocations. While there are several other uses for ETF's, one of the primary applications cited is to improve an investor's control over taxes. According to a survey by Financial Research Corporation, the top two reasons for owning ETF's involve tax efficiency as well trading and tax flexibility.
David T. Reilly, Director
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Having said that, any dividends, or capital gains realized due to changes in the index members must be distributed to shareholders. For most indices constituents are generally changed when corporate actions such as mergers and acquisitions occur. The Russell indices however, are re-constituted annually on July 1st. Despite the distribution require-ment for income and gains, ETF's tend to be more tax efficient than mutual funds. In addition, with ETF's the investor is only responsible for their portion of that gain. This is unlike the commingled assets of a mutual fund where capital gains are evenly distributed to shareholders regardless of how long they've been in the fund. Whether ETF's are part of a passive or an active investment approach, they can be used to improve both the tax efficiency and flexibility of a portfolio.
Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to mar-ket volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. There is no assurance that the price and yield performance of the index can be fully matched.
FAQ: Exchange Traded Funds (ETF's)
Q:What are Exchange Traded Funds and how do they work?
A:Most ETF's are structured as open-ended mutual funds while some of the original ETF's such as the SPDR's were structured as Unit Investment Trusts. In either case both are registered under the Investment Company Act of 1940. These shares are listed on the American Stock Exchange, are priced every 15 seconds and trade just like a stock. ETF's trade through a Market Maker who can create shares as needed. For example, when you invest $10,000, you receive your own basket of securities representing that particular underlying index.
Q:How do ETF's differ from Closed End funds?
A:Shares of exchange traded funds are created and redeemed as needed. This is in contrast to closed end funds that are made available to the public through an offering of a fixed number of shares. These shares are then traded among investors usually on the American Stock Exchange. Since there are a fixed number of shares, the market value of a closed end fund can trade at a premium or discount to the underlying NAV due to supply and demand.
Q:What are the underlying indices that ETF's track?
A: There are four primary index providers, Standard & Poor's, Dow Jones, Frank Russell and Morgan Stanley Capital Intl (MSCI). Merrill Lynch has also created some industry indices known as Holding Company Depository Receipts or HOLDRS. These are generally very concentrated portfolios and are not registered under the Investment Company Act of 1940.
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EXCHANGE TRADED FUNDS
Figure 1 ETF’s In-Kind Transfer Enables Tax Efficiency vs. Traditional Funds Traditional US mutual funds
Investor (buyer) Capital Markets Fund Customer Service Cash Shares of Fund Cash Securities
Exchange Traded Funds
Investor (buyer) Capital Markets ETF Market Makers Exchange
ETF Fund Advisor
Brokerage Acct.
Cash
ETF Shares
Basket of securities
ETF Creation Units Cash
Securities
Index Funds and ETF's are obliged to distribute portfolio gains to shareholders by year end. These gains may be generated due to index rebalancing and the need to meet diversification requirements. Certain traditional mutual funds may be tax-efficient as well.
Reasons for Potential Interest in ETF’s
% of Respondents Indicating Primary
Rank Reason Reason for Owning
1 Tax Efficiency 55%
2 Trading & Tax Flexibility 48% 3 Lower Expense Ratios 46% 4 Diversification 39% 5 Invest in Entire Market Segment 37% 6 Access to Sectors/Indices 35% 7 Continuous Pricing 26%
Q:Who are the main ETF providers?
A:Exchange Traded Funds are primarily offered through Barclay's Global Investors under the iShares brand and StateStreet Global Advisors under the SPDR's and Streettracks brands.
Q:What are the considerations in choosing an ETF?
A:There are generally two main considerations when selecting which index to track. Some indices are broadly based with several constituents, while others are very concentrated with only a handful of holdings. For example, the Russell 3000 is currently made up of close to 2770 securities while the Diamonds Trust simply holds the 30 Dow stocks. The other consideration is the tax efficiency. Since the Russell indices undergo a re-constituted once a year, this may cause higher turnover compared to other indices where index members are generally changed only due to corporate actions such as a mergers or acquisitions. However, turnover does not necessarily translate into less tax efficiency as gains and losses are offset within each index.
Q:Do all ETF's exactly replicate their benchmark index?
A:While all ETF's aim to track a particular index, there are two approaches employed. Some use an exact replication strategy by owning all of the underlying securities in that Index and some use a representative sampling strategy which uses quantitative models to capture similar performance with less holdings than the underlying index. The replication strategy generally produces less tracking error than does the representative sampling approach.
Q:Can ETF’s be used dollar cost average similar to mutual funds?
A:ETF’s can be used to dollar cost average, but they can be more complicated and costly than using mutual funds. This is because ETF’s trade like a stock, where purchases and sales are subject to commissions.
Q:How are the dividends treated?
A:With SPDR's, dividends are accumulated by the trust from the underlying securities and held as cash until distribution date. This causes a slight "cash drag" on performance during a rising market. Alternatively, iShares offer a bit more flexibility in that, dividends can either be held in an interest bearing account or reinvested right away.
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TICKER ETF PRODUCT NAME Large Cap
DIA DIAMONDS TRUST 1
FFF FORTUNE 500TM INDEX TRACKING STOC IVV ISHARES S&P 500 INDEX FUND IWB ISHARES RUSSELL 1000 INDEX FUND IWV ISHARES RUSSELL 3000 INDEX FUND
IYY ISHARES DOW JONES U.S. TOTAL MARKET INDEX FUND OEF ISHARES S&P 100 INDEX
RSP RYDEX ETF S&P 500 TRUST SPY SPDR 500
VTI VANGUARD TOTAL STOCK MKT INDEX VXF VANGUARD INDEX TRUST
Large Cap Growth
ELG STREETTRACKS DOW JONES U.S. LARGE CAP GROWTH INDEX FUND IVW ISHARES S&P 500/BARRA GROWTH INDEX FUND
IWF ISHARES RUSSELL 1000 GROWTH INDEX FUND IWZ ISHARES RUSSELL 3000 GROWTH INDEX FUND QQQ NASDAQ 100 TRUST
Large Cap Value
ELV STREETTRACKS DOW JONES U.S. LARGE CAP VALUE INDEX FUND IVE ISHARES S&P 500/BARRA VALUE INDEX FUND
IWD ISHARES RUSSELL 1000 VALUE INDEX FUND IWW ISHARES RUSSELL 3000 VALUE INDEX FUND Mid Cap
MDY MIDCAP SPDRS
IJH ISHARES S&P MIDCAP 400 INDEX FUND IWR ISHARES RUSSELL MIDCAP INDEX FUND Mid Cap Growth
IWP ISHARES RUSSELL MID CAP GROWTH INDEX FUND IJK ISHARES S&P MIDCAP 400/BARRA GROWTH INDEX FUND Mid Cap Value
IWS ISHARES RUSSELL MIDCAP VALUE INDEX FUND IJJ ISHARES S&P MIDCAP 400/BARRA VALUE INDEX FUND Small Cap
IJR ISHARES S&P SMALLCAP 600 INDEX FUND IWM ISHARES RUSSELL 2000 INDEX FUND
TICKER ETF PRODUCT NAME Small Cap Growth
DSG STREETTRACKS DOW JONES U.S. SMALL CAP GROWTH INDEX FUND IJT ISHARES S&P SMALLCAP 600/BARRA GROWTH INDEX FUND IWO ISHARES RUSSELL 2000 GROWTH INDEX FUND
Small Cap Value
DSV STREETTRACKS DOW JONES U.S. SMALL CAP VALUE INDEX FUND IJS ISHARES S&P SMALLCAP 600/BARRA VALUE INDEX FUND IWN ISHARES RUSSELL 2000 VALUE INDEX FUND
Large Cap Foreign
DGT STREETTRACKS DOW JONES GLOBAL TITANS INDEX FUND EFA ISHARES MSCI EAFE
EZU ISHARES MSCI EMU
IEV ISHARES S&P EUROPE 350 INDEX FUND ILF ISHARES S&P LATIN AMERICAN 40 ITF ISHARES S&P TOPIX 150 IOO ISHARES S&P GLOBAL 100 Country Index
EPP ISHARES MSCI PACIFIC EX-JAPAN INDEX FUND EWA ISHARES MSCI AUSTRALIA INDEX FUND EWC ISHARES MSCI CANADA INDEX FUND EWD ISHARES MSCI SWEDEN INDEX FUND EWG ISHARES MSCI GERMANY INDEX FUND EWH ISHARES MSCI HONG KONG INDEX FUND EWI ISHARES MSCI ITALY INDEX FUND EWJ ISHARES MSCI JAPAN INDEX FUND EWK ISHARES MSCI BELGIUM INDEX FUND EWL ISHARES MSCI SWITZERLAND INDEX FUND EWM ISHARES MSCI MALAYSIA INDEX FUND EWN ISHARES MSCI NETHERLANDS INDEX FUND EWO ISHARES MSCI AUSTRIA INDEX FUND EWP ISHARES MSCI SPAIN INDEX FUND EWQ ISHARES MSCI FRANCE INDEX FUND EWS ISHARES MSCI SINGAPORE INDEX FUND EWT ISHARES MSCI TAIWAN
EWU ISHARES MSCI UNITED KINGDOM INDEX FUND EWW ISHARES MSCI MEXICO INDEX FUND EWY ISHARES MSCI SOUTH KOREA EWZ ISHARES MSCI BRAZIL
EXCHANGE TRADED FUNDS
Investing in Small and Mid-Cap funds may involve increased volatility and potentially less liquidity.
Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability.
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TICKER ETF PRODUCT NAME Sector Index
BBH BIOTECH HOLDRS BDH BROADBAND HOLDRS BHH B2B INTERNET HOLDRS EKH EUROPE 2001 HOLDRS
FEF FORTUNE E-50TM INDEX TRACKING STOCK HHH INTERNET HOLDRS
IAH INTERNET ARCHITECTURE HOLDRS IBB NASDAQ BIOTECHNOLOGY
IDU ISHARES DOW JONES U.S. UTILITIES INDEX FUND IGE ISHARES GOLDMAN SACHS NATURAL RESOURCES IGM ISHARES GOLDMAN SACHS TECHNOLOGY IGN ISHARES GOLDMAN SACHS NETWORKING IGV ISHARES GOLDMAN SACHS SOFTWARE IGW ISHARES GOLDMAN SACHS SEMICONDUCTOR IIH INTERNET INFRASTRUCTURE HOLDRS IXC ISHARES S&P GLOBAL ENERGEY IXG ISHARES S&P GLOBAL FINANCIAL IXJ ISHARES S&P GLOBAL HEALTHCARE IXN ISHARES S&P GLOBAL INFOTEC IXP ISHARES S&P GLOBAL TELECOM
IYC ISHARES DOW JONES U.S. CONSUMER CYCLICAL INDEX FUND IYE ISHARES DOW JONES U.S. ENERGY INDEX FUND
IYF ISHARES DOW JONES U.S. FINANCIAL INDEX FUND IYG ISHARES DOW JONES U.S. FINANCIAL SERVICES INDEX FUND IYH ISHARES DOW JONES U.S. HEALTHCARE INDEX FUND IYJ ISHARES DOW JONES U.S. INDUSTRIAL INDEX FUND
IYK ISHARES DOW JONES U.S. CONSUMER NON-CYCLICAL INDEX FUND IYM ISHARES DOW JONES U.S. BASIC MATERIALS INDEX FUND IYR ISHARES DOW JONES U.S. REAL ESTATE INDEX FUND IYW ISHARES DOW JONES U.S. TECHNOLOGY INDEX FUND IYZ ISHARES DOW JONES U.S. TELECOMMUNICATIONS INDEX FUND
TICKER ETF PRODUCT NAME Sector Index (continued)
MII STREETTRACKS MORGAN STANLEY INTERNET INDEX FUND MKH MARKET 2000+ HOLDRS
MTK STREETTRACKS MORGAN STANLEY HIGH TECH 35 INDEX FUND OIH OIL SERVICE HOLDRS
PPH PHARMACEUTICAL HOLDRS RKH REGIONAL BANK HOLDRS RTH RETAIL HOLDRS
RWR STREETTRACKS WILSHIRE REIT SMH SEMICONDUCTOR HOLDRS SWH SOFTWARE HOLDRS TTH TELECOM HOLDRS UTH UTILITIES HOLDRS WMH WIRELESS HOLDRS XLB SPDR BASIC INDUSTRIES XLE SPDR ENERGY XLF SPDR FINANCIAL XLI SPDR INDUSTRIAL XLK SPDR TECHNOLOGY XLP SPDR CONSUMER STAPLES XLU SPDR UTILITIES XLV SPDR CONSUMER SERVICES XLY SPDR CYCLICAL/TRANSPORTATION Short Term Bond
SHY ISHARES TR 1 3YR TREAS Intermediate/Long Term Bond
IEF ISHARES TR 7 10YR TREAS LQD ISHARES TR GOLDMAN TLT ISHARES TR 20+ TREAS
AGG ISHARES LEHMAN AGGREGATE BOND FUND
EXCHANGE TRADED FUNDS
LPL does not engage in investment banking services nor has LPL or the analyst(s) been compensated during the previous 12 months by any company mentioned in this Report for any non-investment banking securities-related services and non-securities services.
The opinions expressed herein are for general information only, are subject to change without notice, and are not intended to provide specific advice or recommendations for any individuals. Please contact your adviser with any questions regarding this report.
For more complete information regarding the risks, fees and expenses, contact your IAG Financial Adviser for a prospectus. Read carefully before investing.
Funds that invest exclusively in one sector or industry involve additional risks. Lack of industry diversification - subjects the investor to increased industry specific risks.
