Introduction

Pitfalls of Indexed Investing

- Understanding what you own

Synthetic vs. Physical Size Index Construction Style

Edward Allen, CFA

Derivatives

Tax

Introduction: How we use ETFs

Introduction: Largest Positions

2003

2005

2007

2009

2011

90 million 1.5 million

150 million

200 million

308 million

90 individuals and families

8% S&P 500

5% Topix

7% S&P 500

12% S&P 500

16% MSCI World

Introduction

Synthetic vs. Physical

Size Index Construction Style Derivatives Tax

Regulatory Attention
The exposures of these funds raises some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions The IMFs Global Financial Stability Report, April 2011 The expectation of ondemand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress The Financial Stability Board, 12 April 2011 We will look at the full range of possibilities; that could include concluding that some categories of synthetic risk ETFs are not appropriate for retail investors Hector Sants, FSA Chief Executive

Summary of different Exchange Traded structures

Physical-based ETFs ETC/ETN Exchange Traded Notes Fully replicated and optimised Unfunded Swap-based ETFs Swap-based ETFs Unfunded Swap-based ETFs with multiple counterparties Yes Not necessarily Yes Yes Fully funded Swap-based ETFs over collateralised Yes Not necessarily No - pledged only Yes Fully funded Swapbased ETFs over collateralised with multiple counterparties Yes Not necessarily No - pledged only Yes

Exchange listed Holds underlying index securities Holds assets Operational counterparty risk

Yes Depends

Yes Yes (unless lent out) n/a Yes - if securities lending practiced

Yes Not necessarily Yes Yes

Over collateralisation
Transparency

No

n/a
Yes (some securities lending not transparent) Yes Yes (depends if index is compliant)

No
Depends on provider Yes Yes

No
Depends on provider Yes Yes

Up to 20%
Depends on provider Limited Yes

Up to 20%
Depends on provider Yes Yes

Multiple Aps UCITS compliance

Yes No

Source: Lyxor

Physical vs. Synthetic

Physical
Tracking Error a result of the skill of the provider, and may be subject to index optimisation.

Synthetic
Minimises tracking error by using index performance swaps

Counterparty risk limited to any stock lent out

Fully funded or partially funded? Counterparty risk limited to swap exposure?

May lend stock

May lend stock

May take physical delivery of stock via an Authorised Participant (AP)

Allows to pass on other efficiencies such as tax optimization, lower holding costs (custody/foreign exchange transactions) and enhance corporate actions management source: Lyxor Differing levels of complexity; tendency to be tarred with the same brush.

Simplicity of structure

Introduction
Synthetic vs. Physical

Size
Index Construction Style Derivatives Tax

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Size: Big is beautiful

Assets SPDR S&P 500 SPDR Gold Trust Vanguard Emerging Markets iShares MSCI EAFE iShares Emerging Markets $89,000,000,000 $60,000,000,000 $48,000,000,000 $40,000,000,000 $40,000,000,000 Daily Volume 141,000,000 15,000,000 17,000,000 15,000,000 55,000,000 Spread (%) 0.008 0.007 0.02 0.01 0.02

Market Vectors Double Long Euro PowerShares Short Commodities Elements US Sector Momentum Elements Benjamin Graham Value Elements Benjamin Graham Large Cap Value

$1,200,000 $1,200,000 $1,100,000 $1,000,000 $600,000

2006 1384 220 2143 232

1.0 1.5 3.7 3.6 4.1

depending on who you ask

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Size: Premiums and discounts

SPY SPDR S&P 500 $89,000,000,000

BVL

Elements Benjamin Graham Large Cap Value

$600,000

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Volatility

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Introduction
Synthetic vs. Physical Size

Index Construction
Style Derivatives Tax

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Index Construction: Index choice

Lyxor Russia Lukoil Surgutneftegaz Oil & Gas Gazprom Norilsk Nickel Novatek OAO DJ RusIndex Titans 10 15% 15% 15% 13% 12%

DB X Tracker Russia: Gazprom Sberegat Bank Lukoil Norilsk Nickel Rosneft

MSCI Russia Capped Index 21% 13% 13% 7% 6%

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EM Local Bonds

iShares

SPDR

Index data as at 31 July 2011 Source: State Street Global Investors

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Index Construction: Bubbles

100% 90% 80% 70% 60% 50% 40% Consumer Staples 30% 20% 10% 0% 1990 1990 1991 1992 1993 1994 1995 1995 1996 1997 1998 1999 2000 Consumer Discretionary Industrials Materials Utilities Telecommunication Services Information Technology Financials Health Care

S&P 500 sector weights 1990 to 2000 (above) - source: State Street

S&P IT sector index performance (left) - source: Bloomberg

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Index Construction: Financials

30%

20%

30%

10%

20%

0% FTSE 100 MSCI World Emerging Markets 30%

10% 20% 0% FTSE 100 MSCI World Emerging Markets 10%

0% FTSE 100 MSCI World Emerging Markets

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Introduction
Synthetic vs. Physical Size Index Construction

Style
Derivatives Tax

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Style
The FTSE UK Dividend+ Index is a yield weighted index designed to select and measure the performance of higher yielding stocks within the universe of the FTSE 350 Index, excluding investment trusts. The FTSE UK Dividend+ Index selects the top 50 stocks by one-year forecast dividend yield, and the constituents weightings within the index are determined by their dividend yield as opposed to market capitalisation. source FTSE

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Introduction
Synthetic vs. Physical Size Index Construction Style

Derivatives
Tax

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Derivatives

AIG-backed ETF Securities products plummet

Among the worst-hit products are ETFS Livestock, which has plunged 81.06% since yesterday's close, while ETFS precious metals and ETFS petroleum have dropped 50.68% and 51.01% respectively.
ETFS says it is working on providing investors with liquidity after a number of firms stopped making markets in its AIG-backed Commodity Securities products as the US insurers credit rating slipped.

- Citywire, Daniel Grote on Sep 16, 2008

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Derivatives
ETFS Leveraged Crude Oil (LOIL) is designed to provide investors with a total return equivalent (before fees and expenses) to 200% of the daily percentage change in the DJUBS Crude Oil SubIndex SM (the Sub- Index), which is an index tracking the futures price of crude oil plus a collateral yield. source ETFS June 2011

Specific Risks of Leveraged ETCs Twice the daily movements of the index and therefore any falls in the index are magnified If the index falls by 50% or more in one day, an investment in a Leveraged ETC will lose all of its value ETCs are volatile and volatility is doubled for Leveraged ETCs Returns measured over periods longer than one day may differ from twice the indexs return over that period Leveraged ETCs are only suitable for professional investors who understand leverage and are willing to magnify potential losses Please see the Prospectus for a more detailed explanation and a more complete list of risk - source: ETFS Index factsheet June 2011

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Performance of Leveraged ETFs

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Introduction
Synthetic vs. Physical Size Index Construction Style Derivatives

Tax

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Tax

Domicile
Reporting and Distributor Status Stamp duty

This discussion does not constitute tax advice, is probably inaccurate, and should not be relied upon.

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Any Questions?

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