Exchange Traded Funds

S I M P L E P R O D U C T S . S O P H I S T I C AT E D S T R AT E G I E S .

Contents
3 4 6 8 10

Introduction ETFs capabilities and strengths ETFs the simple trade behind sophisticated strategies ETFs versus futures Conclusion

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ETFs Simple products. Sophisticated strategies.

Introduction
Exchange Traded Funds (ETFs) are essentially straightforward products _ index-tracking instruments _ but in the hands of a skilful professional investor they become the building blocks of sophisticated investment strategies.
Institutional use of ETFs has grown almost exponentially in the US over the past decade and European institutions are now driving similar growth across the EU. As the range of ETFs available on the London Stock Exchange has grown, so too has the potential for executing more interesting and intricate strategies. ETFs are now tracking global, country-specific and asset-specific indices, covering a variety of asset classes including commodities, high-yield equities and bonds bringing simplicity, flexibility and cost-effectiveness in their wake. Its no surprise that ETFs are being used more widely by creative investment professionals everywhere.

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ETFs bring a wide range of investments within reach that might otherwise be difficult to access efficiently .

ETFs capabilities and strengths

Flexibility ETFs can be used in a number of ways either on their own to gain exposure to an index, or in combination with other products as part of more complex strategies. One of their key strengths is that they free you up to focus on your area of core expertise by providing broad exposure to an index. ETFs can play a key part in core-satellite strategies and tactical asset allocation, as well as having many other uses, as outlined on pages 6 -7. Wide range of underlying ETFs are not restricted to European blue-chip indices they bring a wide range of investments within reach that might otherwise be difficult to access efficiently. This makes it cost-effective to trade emerging markets over a short time horizon, or to swap out of UK and into Eurobonds in just two trades, for example. A full list of current ETFs traded on the London Stock Exchange is included at the back of this brochure. Trades like a share, as liquid as the underlying ETFs offer full exposure to international and domestic indices with just one trade, and settle in Euroclear UK & Ireland Limited (formerly CREST Co) with on-book trades offering the protection of the central counterparty service. Furthermore, the liquidity of the ETF itself is immaterial ETFs are as liquid as the underlying index constituents because you can exchange the underlyings for ETFs on a daily basis (see diagram, opposite). This means that an ETF can provide easily accessible exposure to many indices where the future is illiquid. There is also usually full dividend participation, with income paid via Euroclear.

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Low tracking error ETFs combine the tradability of investment trusts with the tracking precision of unit trusts this minimal tracking error is achieved through the arbitrage opportunities which arise when the ETF trades away from Net Asset Value (NAV). This is a function of the creation/redemption process whereby the basket of securities that makes up the index can be exchanged for an ETF on a daily basis, and vice versa (see diagram, below)

ETFs are not derivatives Fund managers without a derivatives mandate may have difficulty finding a means of investing in an index whilst avoiding the cost and complex settlement often associated with program trades. ETFs are classified as a regular security and are Collective Investment Schemes. In addition, most ETFs are UCITS III compliant. Because ETFs are not derivatives, they do not require any daily margin calculation or mark-tomarket, and can be traded using existing systems without the need for further risk assessment tools. No Stamp Duty Trading is tax efficient as ETFs are free of UK stamp duty in the secondary market.

ETF Mechanics

Secondary market Cash Investor Broker ETF Exchange

Primary market Basket of securities ETF Market Makers Cash ETF Custodian ETF Creation Units

Securities Capital Markets

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More investment professionals are discovering new ways in which ETFs can form the building blocks of investment strategies. Some of the ways ETFs can be used to enhance returns are outlined below:
Core-satellite strategy This common asset allocation strategy involves investing a large portion of a portfolio (the core) in a passive product to achieve beta profiting from the systematic risk or volatility inherent in a particular index whilst actively investing the remaining assets (the satellite) to achieve abnormal returns attributable to manager skill. Owing to their low tracking error, ETFs have been popular as the core element for some time; but now, with ETFs based on narrower and more specific indices, managers can actively trade ETFs as elements of the satellite to gain alpha returns. In fact, some managers invest exclusively in ETFs. Cash equitisation Because they are so easily tradable, ETFs can be used to eliminate the cash drag which often results from unexpected or significant capital inflows. Additionally, ETFs can be an efficient way of achieving instant investment in an index whilst you seek out the specific opportunities within it.

ETFs the simple trade behind sophisticated strategies.

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Tactical asset allocation ETFs make tactical asset allocation easy. Its possible to gain instant access to a whole index with a single trade. This extends a fund managers investment capabilities to a wide variety of different markets such as Japan, emerging markets, highyield stocks or corporate bonds. Swapping between Europe and the emerging markets, for example, can be achieved in just two trades. Recover the management fee through lending Lending ETFs to institutions that have taken short positions mitigates the management fee, whilst still maintaining exposure to the index. The income generated from this can cover a very significant portion of the annual management fee. Shorting Because ETFs trade just like a share, its possible to short a whole index simply by shorting the ETF. The SB&L market for ETFs is constantly growing, ensuring ETFs are readily available to borrow in order to meet shorting obligations.

Pairs trading With such a wide range of ETFs now available, there are many ways they can be used in pairs trading strategies. Shorting the stock whilst going long the ETF, or vice versa, captures the relative outperformance of the long position over the short. You can even use ETFs for both legs: if it is predicted that Taiwan could outperform the emerging markets index for example, then its possible to go long the MSCI Taiwan ETF and short the MSCI Emerging Markets ETF (for illustrative purposes only). Hedging ETFs are perfect for hedging long or short exposure, by going short or long on the ETF respectively. Hedging using the wide variety of ETFs available on the London Stock Exchange can be both effective and efficient, particularly where the future is relatively illiquid. Additionally, ETFs do not require quarterly rolls or margin maintenance, reducing the administrative burden and cost of hedging.

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ETFs versus futures

There are many instruments which provide exposure to indices, but few provide the simplicity and flexibility of ETFs. As outlined in the table opposite, ETFs have a number of key advantages over futures: there is no need to roll the contract each quarter the associated savings often significantly outweigh an ETFs annual management fee; there is no need to calculate daily variation margin; and liquidity is limited only by the liquidity of the underlying index constituents.

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Financial instrument Pricing Market liquidity Maturity Reinvestment risk Short sales Costs for purchase/sale Minimum order size Dividend payment Margin management Management fee Potential for lending revenue

ETFs Stock indices Continuous Equal to liquidity of underlying stocks None None Yes Normal Exchange fees 1 ETF (ca 30) Generally quarterly payment via Euroclear No Yes Yes

Futures Derivatives Continuous Variable based on demand/supply Limited lifespan Yes Yes Initial and variation margin payments and rollover costs 10 x index (ca. 50,000) Cash settlement at maturity Required No No

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Conclusion
ETFs. Simple products. Sophisticated strategies This brochure presents just some of the opportunities ETFs offer the skilful investment professional. The flexibility of ETFs is shown in their many uses and is tempered only by your imagination.

Contact For further information on how ETFs can benefit the professional investor contact the product manager: etfs@londonstockexchange.com or visit: www.londonstockexchange.com/etfs

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London Stock Exchange plc 10 Paternoster Square London EC4M 7LS Telephone +44 (0)20 7797 1000 www.londonstockexchange.com
May 2009 London Stock Exchange plc. Registered in England and Wales No 2075721. The information contained in this publication is for guidance only and London Stock Exchange plc shall not be liable for decisions made in reliance on it. The price of ETFs may go down as well as up and you should seek the advice of professional advisers before investing in ETFs. The London Stock Exchange crest and logo, are trademarks of London Stock Exchange plc. 269/MAS/ETF