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8/9/2019 Sauter-Nuts Bolt ETFs
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For Internal use only
The Nuts and Bolts of ETFs
The Institute for Quantitative Research in Finance
April 5, 2005
Gus Sauter, CIO and Managing Director
The Vanguard Group
2005 the Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
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The Nuts and Bolts of ETFs
ETF StructureMechanics of the Creation Process
Advantages/Characteristics of ETFsUsers and Uses of ETFsMiscellany
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ETF Structure
[ETFs] Are Better Than Index Mutual
Funds
Forbes Magazine
August 21, 2000
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ETF Structure
Open-End
Mutual Funds
All Other ETFs
SPDRsMidCap SPDRs
QQQs
Diamonds
Closed-End
Unit
Investment Trusts
(UITs)
Management
Investment
Companies
Face Amount
Certificate
Company
Three Types Of Registered Investment Companies (RICs)
Investment Company Act of 1940
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ETF Structure
Index
Mutual
Fund
Conventional Shares
Investor
Conventional Fund Structure
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ETF Structure
Index
Mutual
Fund
Investor A
Investor B
Specialist/AP
ETF Structure
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ETF Structure
Exemptive Relief Needed To Create an ETF
2(a)(32) Mutual fund securities must be redeemable
22(d) and 22(c)-1
Every investment company security transaction must receive the
NAV next determined
24(d) Prospectus delivery requirement for every secondary market trade
17(a)(1) and 17(a)(2)
Investors who own more than 5% of a RIC are affiliates and can
not invest or redeem inkind
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ETF Structure
ETFs are a
Great New
Product
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ETF Structure
ETFs Are Another Way To Distribute An Old
Product
If an investor does not want to invest in the
underlying investment, then they do not want
an ETF.
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ETF Structure
To date ETFs have focused on index funds, but they
might develop into a distribution channel for other
investments
Commodities Gold (GLD)
Active Mutual Funds
CurrenciesDerivatives
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The Nuts and Bolts of ETFs
ETF StructureMechanics of the Creation Process
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Mechanics of the Creation Process
Hurdles To Creating An ETF
Can an investment pool be created?Does the investment allow for transparency of theholdings?
Is a creation/redemption unit feasible?
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Mechanics of the Creation Process
Information Needed To Create An ETF
Delivery Basket
Intraday Indicative Value (IIV)Hedging Basket
Also Need Real-Time Index Level
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Mechanics of the Creation Process
Creation Process
ETF sponsor transmits Portfolio Creation File (PCF) toCustodian on t-1
2,583 shares XOM
4,200 shares GE
4,299 shares MSFT
2,045 shares C
1,688 shares WMT
Residual Cash
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Mechanics of the Creation Process
Creation Process
ETF sponsor transmits Portfolio Creation File (PCF) to
Custodian on t-1Custodian processes PCF and sends it to NSCC on t-1NSCC sends file to SIAC (for pricing service) andApproved Participants (AP) on t-1
Approved participant purchases securities in PCF andNotifies sponsor of intention to create before 4 p.m.
eastern standard time on t
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Mechanics of the Creation Process
Source of Information Needed To Create An
ETF
Indexed Active
Delivery Basket PCF ETFIntraday Indicative Value (IIV) PCF PCFHedging Basket PCF PCF
Real-Time Index Level Index Provider N/A?
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The Nuts and Bolts of ETFs
ETF StructureMechanics of the Creation ProcessAdvantages/Characteristics of ETFs
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Characteristics of Indexed ETFs
Historical long-term outperformance Low cost
Broad diversification relative to investment styleRelative tax efficiencyFlexible trading
Real time Short sale Purchase on margin (if qualified)
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Characteristics of Indexed ETFs
Are ETFs Low Cost Index Funds?
Yes, But
There are 106 ETFs with conventional alternatives 64% compete against lower cost retail or high net worth
shares
100% compete against lower cost institutional shares
Source: Strategic Insight and The Vanguard Group as of 2/15/2005
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Characteristics of Indexed ETFs
Source Of Low Cost
Inherent to indexed approachShareholder recordkeeping cost borne by brokeragecommunity
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Characteristics of Indexed ETFs
Shareholder Recordkeeping by Fund Type
Conventional Millions of
Fund Shareholders
ETF DTC Street Millions of
Name Shareholders
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Characteristics of Indexed ETFs
If ETFs become dominant distribution channel
for long-term investments, can they maintain
low cost?
Will the brokerage community continue to eat
the cost of shareholder recordkeeping, or will
brokers charge asset based fees?
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Characteristics of Indexed ETFs
Source of Relative Tax Efficiency
Inherent to low turnover index strategyTax loophole for RICs for in-kind distributions
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Characteristics of Indexed ETFs
Arbitrage Ensures ETFs Trade Near Fair
Value
ETFs are open to creation/redemption dailyETF trading rich
AP sells ETF at premium and hedges position bypurchasing stocks in market
AP submits stocks for creation unit at fair value at end ofday
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Characteristics of Indexed ETFs
Comparison of ETFs And Conventional
Classes Of Index Funds
Expense Ratio X X
Transaction Costs X
Relative Tax Efficiency X X
Trading Flexibility X
Number of Products X
Buy with Leverage* X X
ETF Conventional
* If qualified.
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The Nuts and Bolts of ETFs
ETF StructureMechanics of the Creation Process
Advantages/Characteristics of ETFsUsers and Uses of ETFs
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Evolution of ETF Usage
Traders Hedgers SpeculatorsArbitrageurs
Institutions
Hedge FundsCorporationsPortfolio
Managers
Intermediaries
Broker DealersRIAs
Retail
Individuals
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Users and Uses of ETFs
Traders
Futures Substitute
Day TradingMarket TimingArbitrageHedging
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Users and Uses of ETFs
Institutions
Long-Term Investment
Futures SubstituteTactical Asset allocationCash equitizationTransition managementTax managementHedgingDuration/Credit Fine Tuning
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Users and Uses of ETFs
Intermediaries
Asset allocation
StrategicLong-Term InvestmentPortfolio Completion
Tactical
Sector RotationCash equitizationTax management
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Users and Uses of ETFs
Retail Uses
Long-Term InvestmentBroad Diversification
Portfolio Completion
Tactical Asset allocation
Tax management
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The Nuts and Bolts of ETFs
ETF StructureMechanics of the Creation ProcessAdvantages/Characteristics of ETFsUsers and Uses of ETFsMiscellany
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Miscellany
Hurdles For Active ETFs
Preserving the integrity of the fund
Must provide a certain degree of transparencyCapacity constraints (fund closure)Arbitrage process breaks downETFs cantrade at a premium (but not at a discount)
Clone versus exchange traded share
The SEC
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Miscellany
Out-Market Making A Market Maker
Sponsor generates incorrect PCF
Intraday indicative value is incorrectIf market maker doesnt recognize mistake, more astutetrader can arbitrage the quotes
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Miscellany
The Future For ETFs
Consolidation of look-alike funds?
More niche products?Active ETFs?A sea change in the way funds are distributed?Pricing?
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