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Understanding Exchange-Traded Funds: History, Mechanics, and Comparisons with Mutual Funds

This presentation explores the world of Exchange-Traded Funds (ETFs), highlighting their unique characteristics, historical development, and the mechanics that drive their functionality. From their inception in the 18th century in the Netherlands to the rise of modern ETFs, we delve into how they operate, the strategies behind arbitrage, and their advantages over traditional mutual funds. With an increasing number of ETFs available and significant net inflows, this guide aims to provide a comprehensive understanding of ETFs' role in the financial ecosystem.

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Understanding Exchange-Traded Funds: History, Mechanics, and Comparisons with Mutual Funds

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  1. Exchange-Traded Funds by Brady Finkenaur Powerpoint Templates

  2. Exchange-Traded Funds • Walks Like a Stock • Talks Like a Mutual Fund • Not Exactly Like Either • Gradually Taking the Place of the Mutual Fund in the Financial Ecosystem

  3. History of ETFs: The First Mutual Fund • Developed in the Netherlands-1774 • Liquidity Crisis in Amsterdam • Vehicle for Small Investors to Pool Funds • Broadly Diversified Across 100 assets on Three Different Continents • Lasted Over 120 Years

  4. History of ETFs: The Modern Day Mutual Fund • Early1970’s: Research Shows That Actively Managed Funds Underperform Benchmark Indicies • 1975: Jack Bogle Launches Vanguard 500, the First Index Mutual Fund • Originally Ridiculed, Bogle’s Passive Investing Strategy Soon Gains Popularity

  5. History of ETFs: Emergence of the ETF • 1987: Stock Market Crash Creates Another Liquidity Crisis • 1989: AMEX and Philadelphia Stock Exchange Trade “Index Participation Shares” (IPS) • Chicago Mercantile Exchange and CFTC file suit to stop IPS

  6. History of ETFs: The SPDR • 1993: Standard and Poor’s 500 Depositary Receipt • Unit Investment Trust Type Structure • State Street Bank as Trustee • Passive Index Fund That Tracks the Performance of the S&P 500

  7. ETF Mechanics: Warehouse Receipts Process Receipt Farmer Trader Cash Grain Cash Receipt Receipt Receipt Warehouse Kellog’s Grain

  8. ETF Mechanics: Process

  9. ETF Mechanics: Process

  10. ETF Mechanics: Basket Composition • Price-Weighted Index (Dow Jones Industrial Average) • Market Capitalization-Weighted Index (S&P 500, NASDAQ) • SPDR 500 (SPY) Scaled to 1/10th of the S&P 500 Portfolio and Contains Constituent Stocks in Proper Proportions

  11. ETF Mechanics: Basket Composition-SPY Top 10 Holdings

  12. ETF Mechanics: Net Asset Value • Value of Underlying Portfolio • Creation/Redemption Process Takes Place at the NAV • Calculated and Disseminated Once a Day • Intra-day Portfolio Value (IPV) Tracks Intrinsic Value During Trading

  13. ETF Mechanics: How Do I Know I’m Getting The Right Price? • Authorized Participants Engage in Arbitrage to Obtain Profit • If ETF Shares Trade at a Discount to IPV, Then AP Would Buy ETF Shares, Exchange for Basket and Sell Stocks • If ETF Shares Trade at a Premium to IPV, AP Would Buy Basket, Exchange for ETF Shares and Sell Shares

  14. ETF Mechanics: Arbitrage • Constant Arbitrage Throughout the Day Keeps the ETF Price in Line With the NAV • Fees and Trading Costs Create “Bubble” Around NAV Where Arbitrage is Not Profitable • Market Makers Also Profit From Bid/Ask Spread

  15. ETF Mechanics: Tracking Error • Divergence Between Price Behavior of ETF and Underlying Basket That Can’t Be Arbitraged • “Cash Drag”: Dividends, Distributions, etc. • Thinly Traded Index • Large Portfolio Turnover • Average Tracking Error 0.39-0.52%

  16. ETFs Versus Mutual Funds

  17. SPY Versus Vanguard 500 SPY • Expense Ratio: 0.11% • AUM (billions): $128 • Tax-Adjusted 10 year return: 7.98% Vanguard • Expense Ratio: 0.17% • AUM (billions): $129 • Tax-Adjusted 10 year return: 8.07%

  18. ETF and Mutual Fund AUM (in $ trillions)

  19. ETFs Catching Up • Net Inflows of $806 Billion vs. $804 Billion Mutual Fund Inflows Since 2006 • Over 1,400 Different ETFs Now Available • Can Invest by Sector, Commodity, Geography, Asset Class, etc. • Efficiency Increases With The Trading Volume

  20. References • Ackert L. F. and Y. S. Tian. “Arbitrage and Valuation in the Market for Standard and Poor’s Depositary Receipts”, Financial Management (2000) v29, 71-87. • Daley, Paul, P. Dorencz and D. Bargerstock. “ETF Liquidity Explained: A Framework for the ETF Trader,” Journal of Indexes, March/April 2010. • Davidson, Lee. “The History of Exchange Traded Funds,” Morningstar.com, http://www.morningstar.co.uk/uk/news/69300/the-history-of-exchange-traded-funds-etfs.aspx , (Last Accessed 4/19/2013) • Deville, Laurent. “Exchange Traded Funds: History, Trading, and Research,” Paris-Dauphine University, 2006. http://halshs.archives-ouvertes.fr/docs/00/16/22/23/PDF/ETF-survey.pdf (Last Accessed 4/18/2013) • “How Do ETFs Work?” Flexshares.com. http://www.flexshares.com/education-research/how-work (Last Accessed 4/19/2013) • Richards, Archie Jr., “All About Exchange-Traded Funds,” McGraw-Hill, New York, 2003.

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