Modest-looking but crucial modifications to the fundamental design of Universal Investment Trusts and mutual funds are at the root of SPDRs, WEBS and Diamonds. They have given the American Stock Exchange a new lease on life. The reason is simple: The new structures allow professional investors and money managers to reap important benefits.
Recent active coverage in the financial press has caused the SPDR and similar financial instruments known as ETFs to attract a great deal of attention. ETF is an acronym for Exchange Traded Funds, a new type of stock exchange tradable security, that retains many of the attributes of a mutual fund even though the SEC does not permit ETFs to be referred to as such.
Despite this publicity, there has been little published on the details of the ETF operating systems and of how they differ from mutual funds.
The first ETF, the Standard & Poor's Depository Receipt, or SPDR, was introduced on the American Stock Exchange (AMEX) in January of 1996. There are now in excess of $10 billion of assets in the SPDR Fund and it and its increasingly numerous relatives regularly account for more than 50% of the Exchange's equity trading volume. These securities have accounted for virtually all of the Exchange's increase in equity trading volume since their introduction. It is an understatement to observe that this innovation has been a very good thing for the AMEX as well as the professional investing community.
In addition to SPDR, ETFs now include 11 other Standard and Poor's index funds, 17 World Equity Benchmark Shares (WEBS) based on the Morgan Stanley Capital International (MSCI) country indexes, and the Diamond based on the Dow Jones Industrial Average. More are coming.
ETFs are divided into two "subspecies". The original SPDR, the Mid Cap SPDR, the DIAMOND and the S&PNASDAQ-100 are all based on a modified unit investment trust structure. The seventeen WEBS and the nine S&PSector Funds are structurally management investment companies (mutual funds). To investors, all of the funds operations appear to be identical, although there are differences in management and operations. Each type has advantages and disadvantages.
ETFs are moving into the market place at a very rapid rate. Chart 1 shows the growth in trading volume of the 30 ETFs now listed on the AMEX and Chart 2 shows the growth of assets under management of these securities.
ETFS VERSUS MUTUAL FUNDS
A claimed disadvantage of ETFs, compared with mutual funds, is the brokerage fee associated with purchasing the former. On the other hand, there are no-load mutual funds, though they may also assess various types of fees other than those to cover operations. To make the comparison simple, we have compared a small-sized trade in a typical ETF with a mutual fund that assesses no charges other than for operations. The Vanguard S&P 500 index mutual fund would be a good example: Both it and the SPDR are based on the same index.
Purchases and redemptions of the Vanguard S&P500 Fund are priced at the net asset value (NAV) of the fund at the close of the trading day. In contrast, ETFs are purchased or sold on the Exchange during the trading day at the best available bid or offer price. Discount brokers such as Schwab and even very large brokerage houses such as Prudential Securities have sharply reduced their brokerage fees. Currently, even a relatively small purchase of 100 shares of SPDRS at $110.00 per share can be made at a brokerage fee of $30.00 or 0.27% of price. With intra day Index price changes commonly 1% or greater, even such a small trade could experience a greater adverse price change by being priced at end of day NAV than by having to pay such brokerage fees. In addition, the SPDR investor is able to use limit orders, stop orders and all the other tools available to stock traders, including margin financing in accordance with FRB Regulation T. None of these are available to Vanguard mutual fund buyers.
While the brokerage fee issue in isolation has often been cited as a disadvantage of all the most salient qualities and costs of ETFs, it is more informative to view a point by point comparison of ETFs and mutual funds. Table 1 makes this comparison.
|TABLE 1 COMPARISON OF PARAMETERS|
|AMEX SPDR VS. VANGUARD S&P 500 MUTUAL FUND|
|Comparison of Features||AMEX SPDR||VANGUARD S&P-500|
|Annual Fund Operating||0.18%||0.18%|
|Cost Broker's Commission||Yes||No|
|Buy/Sell at Intraday||Yes||No|
|Prices close to NAV|
|Purchase/Selling Price Set||At time of transaction||At close of market|
|Type of Orders||Same as stocks||Market at close|
|Portfolio Turnover Ratio||Low||Low|
|Taxable Capital Gains||Yes*||Yes|
|Tax Efficiency: Bull Market||High||High|
|Tax Efficiency Bear Market||High*||Potentially high|
|Three Year Average Return||27%||27%|
|Legal Structure||Open End UIT**||Mutual Fund|
|Minimum Investment||One Share||Minimum dollar value set by fund|
|Purchase||By Deposit of Designated||Cash|
|Large size of Stock Portfolio|
|Redemption||Receipt of Designated||Sized Cash|
|Large Stock Portfolio|
|* Redemption in shares of portfolio stocks does not incur capital gains to the Fund|
|** Current new ETFs are management investment company basic structures|
|*** SPDR dividends are reinvestable at the quarterly distribution.Vanguard dividends could technically be reinvested as received. The current dividend yield on the SPDR and the Vanguard S&P 500 Fund is 1.16%. Assuming that the dividends would be distributed on average at the mid point of the quar- terly distribution, the value of such earlier re-investment would be having 0.14% of the Fund invested two weeks earlier. Such difference could easily be lost by having to value the investment at end of day price.|
ETFs, either in UIT or Management Investment Company versions, are of the same basic legal structure as their standard UITand mutual fund counterparts. But there are very important differences from the standard types that result in very different performance.
The ETF is two-tiered. At the level of dealing directly with the fund in unit/share large block sized creations and redemptions, the transactions are priced at the NAV of the fund at the close of the trading day just as the SEC Regulations require for standard UITs and mutual funds. Trades in the units/shares are made at prices prevailing at the time of execution at any time during the trading day.
However, at the fund level payments are made by delivery of designated blocks of index portfolio shares rather than cash. Since the closing market prices of the component stocks will be the same as those used to calculate the end of day NAV of the fund, the NAVof the portfolio will be very close in value to the fund's NAV. Small differences, which might exist, are taken care of by payment of a small balancing amount in cash. The importance of this "in kind" payment is that it permits an investor purchasing a creation-sized block of shares directly from the fund to purchase the required portfolio of shares at any time during the trading day and establish his cost of ETF shares. This, even though the portfolio is valued at the fund's NAVat the close of trading.
It is this ability to establish the purchase price of the units/shares purchased at any time during the trading day, which permits execution of arbitrage transactions. In those cases where demand causes the units/share price to rise above its intrinsic value, the arbitrageur can purchase the required portfolio shares while simultaneously selling the unit/shares. This will cause the price of the unit/shares to be restored to their intrinsic value. If the unit/share prices fall below their intrinsic value, the reverse transaction can take place. This two-tiered system is at the very heart of the ETF design and is what allows the ETFs to trade as they do.
Because of the special structure of the ETFs, their traded prices track the underlying securities portfolio's NAVs very closely, allowing a range of strategies for hedging against or capitalizing on movements in the general market. Chart 3 shows the SPDR tracking error from December 1997 to March 1999.
NSCC SYSTEM CHANGES
The foregoing system, which causes the ETF to perform as it does, is easy to describe in principle but requires that the trading system permit very efficient executions on the stock exchange and transfer of share portfolios without corresponding transfer of cash. Fortunately, systems permitting the trading of large designated portfolios of stock with a single command already existed on the major stock exchanges.
What was not available at the time the SPDR was conceived was a system permitting transfer of securities for anything other than cash payment. The National Securities Clearing Corp. (NSCC) continuous net settlement system (CNS) could only transfer shares against cash payments. Fortunately Mr. Dave Kelly, CEO of NSCC, thought enough of the SPDR's potential to authorize construction of a new system permitting paymentless transfers, designed and supervised by Michael Kelleher, Henry Belusa, and Raymond Nolte, key personnel at NSCC. Without these changes, ETF arbitrage transactions would have been very difficult to execute.
To provide easy access to information for executions of creations and redemptions, each night, the ETF fund manager for each fund transmits the next day's exact creation redemption stock portfolio basket to NSCC. From there it is published in machine-readable form to all NSCC members who have signed up for this information. With this in their computers, trading organizations can continually compare ETF portfolio NAVvalues with trading prices of shares/units, to determine potential arbitrage opportunities.
Another outcome of the two-tiered ETF design is a very high tax efficiency. SPDR tax efficiency is different from that of mutual funds designed for this purpose. ETF accrued dividends are distributed in the same manner as for mutual funds. However, most unit/share transactions occur outside the fund and do not cause the fund to sell shares to pay redeemers. Those redemptions that do occur are in large sized blocks and are paid for by the fund with portfolios of shares. These payments do not generate capital gains or losses to the fund - which means none have to be passed along to the fundholders.
Capital gains or losses can be generated by changes in Index composition to track changes in the referenced index. Tax efficient techniques have been developed to minimize the tax impact of such changes.
One of the most important features of the ETF system design is its inherently low operating cost. Mutual funds maintain a transfer agent function to keep track of shareholders and to take care of purchases, redemptions, and distribution of dividends. ETF shares/units are held only in book entry form at the Depository Trust Company (DTC). This permits the ETF funds to make bulk distributions to DTC, which re-distributes to its members of record. The elimination of this fund transfer function is a substantial factor in maintaining the low cost of ETF operations.
The cost reductions arising from this structure include the ability to lump management of a group of funds into a single operation, thus gaining economy of scale. In addition, because the mutual fund has a board of directors, it is permitted to make certain changes in operating procedures without requiring a vote of shareholders. Amutual fund is also permitted to lend up to 1/3 of portfolio stocks, the income from which serves to further reduce operating expenses.
It is likely that ETFs, whether of the UIT or the mutual fund variety, will only increase in number, use and convenience.
One of the impediments to the more rapid introduction of ETFs is the lack of SEC Regulations specifically governing this type of product. Each new filing is required to cite all of the previous exemptions to the '40 Act the SEC has granted to existing ETFs. There is no basic reason why standards could not be established that would enable funds to begin operations with minimal filing. The SEC staff includes many very intelligent people who see this need. Unfortunately, the SEC is short-handed, and it becomes a matter of choice of whether to work on current filings (with every filer clamoring to get his approved first), or work on changes in regulations.
As an optimist, the writer believes that such a set of regulations will appear in due course. However, it is a bit unsettling to note that the Act, which governs ETF securities, is known as the '40 Act. One hopes the enabling regulations will not be known as the Regs of '40 - meaning 2040.