A presentation on:

General Applications of Exchange Traded Funds

Justin PascoeDirector of Investments

20. 8. 2002

2

Table of Contents

1. What are ETFs

2. Why have ETFs become so popular

3. Users and Applications of ETF

4. Global Developments of ETF

5. Developmental Challenges

6. Conclusion

What are ETFs?

4

What are ETFs?

Characteristics

Commingled fund structure

Listed on the exchange

Trade like ordinary shares

Passively managed against an index

Usually priced at a fraction of the index e.g: TraHK is 1/1000th, SPDR is 1/10th,

QQQ is 1/40th

Contribute and redeem in-kind

5

In-kind Subscription/Redemption

Investor

ETFCreation

Redemption

Share basket

Units

Units

Share Basket

Investor

ETF

Not as simple as taking a mutual fund and listing it on the exchange

Special in-kind creation and redemption mechanism

6

Importance of in-kind Creation and Redemption

Reduces transaction costs borne by the fund that result from investors’ activities

The ordinary mutual fund has to acquire/sell stocks in its portfolio when investors buy into and/or redeem from the fund, thereby incurring transaction costs

In-kind mechanism contributes to the lowering of the expense ratio of the fund

Facilitates arbitrage activities

Specialists, market makers and arbitrageurs compete to capture pricing discrepancies, which results in the ETF trading at its fair value

Hence increases the liquidity of ETFs

7

Arbitrage Activities

Unit price >NAV

Unit price<NAV

ETF

Cash Futures

Investors will:

• accumulate the units

• redeem the units

• sell the underlying shares

Investors will:

• accumulate the share basket

• create the units

• sell the units

Unit price closely tracking the NAV

Additional dimension for arbitrage improves market efficiency

8

ETF Arbitrage Matrix

Futures

If Units Cheap vs.

Stocks+ Units

- Stocks

Redeem units for stocks which are used to

cover the borrowed stocks

+ Units

- Futures

- Units

+ Stocks

Use stocks to create new units to replace the borrowed units OR buy back

units and sell stocks when units are cheap

- Units

+ Futures

+ Long position (Buy) - Short position (Borrow and sell)

If Units Expensive vs.

Opening Trade

Sell units and covert futures before it expires; or sell units and

let futures expire on the expiration day

Buy units and sell futures before it expires; or buy units and

let futures expire on the expiration day

Closing Trade

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-2.00%

-1.50%

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1.50%

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Closing Premium/Discount

Average

TraHK Premium/Discount Analysis

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Two Levels of Tracking

Tracking of the ETF’s traded price against the NAV

depends on the efficiency of the arbitrage process

Tracking of the ETF’s NAV against the index (Tracking Error)

depends on the expertise of the fund manager – in the design of the basket and in the rebalancing techniques

need to subtract the accrued dividend from the ETF’s NAV before comparing with the index

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Hybrid ProductSubscription /Redemption as Open-ended Mutual Funds, Traded on stock exchange as Close-ended Mutual Funds

SubscriptionInstitutional

Investors/Intermediaries

RedemptionInstitutional

Investors/Intermediaries

Fund

Retail Investors

Intermediaries Institutional Investors

Stock

次級市場Secondary Market

Stock

Arbitrage provides critical link between ETF, Equity and Futures markets

UnitUnit

Primarily Market

Market Price

Subscription/Redemption at NAV

Why ETF is getting more and more popular?

13

Benefits to the Investors

Virtues of Indexation

Indexation enforces diversification

Obtains broad market exposure

Transparency – Investments & Performance

Advantages of Listing on Stock Exchange

Simple and flexible dealing

Small board lot size (10 shares)

Trading throughout the day

Can buy on margin or short-sell

Can place limit orders

Highly liquid

Special Features of ETF

Only one transaction to buy a diversified portfolio

Low expense ratio

Fair pricing

Adds to market depth, liquidity and efficiency

In Korea

Exemption from 0.3% transaction tax on the sale of ETF units

Short-selling of ETF exempted from the up tick rule

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Cost is a a Major Consideration Annual Cost Comparison

* Annual portfolio turnover =Annual Trading Volume / 2

Fund Size

Expenses ETF Actively Managed Mutual Funds in Korea

Portfolio Turnover(A)*

5.00 – 10.00% 100.00 – 200.00%

Manager Transaction Costs(B)

0.50 – 1.20% 0.50 – 1.20%

Yearly Expenses (A) X (B)

0.025 – 0.12% 0.50 – 2.40%

Management Fee 0.25% 0.50%

Other Expenses 0.42% 1.00%

Total 0.695 – 0.79% 2.00 – 3.90%

Comparison of ETFs with other Investment Products

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ETFs vs Active Mutual Funds

ETF Actively Managed Mutual Funds

Expense Structure <70 basis points >200 basis points

Performance In line with Index Possible outperformance or underperformance

Traded on Stock Exchange Yes No

Ability to Short/Borrow Yes No

Subscription/Redemption In-specie Cash

Add/Remove Exposure Any time market open Daily Price

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ETFs vs Closed-ended Mutual Funds

ETF Closed End Funds

Expense Structure <70 basis points >200 basis points

Market Price and NAV Tracking Closely Large discount or premium that can persist

Traded on Stock Exchange Yes Yes

Liquidity High Low

Subscription/Redemption In-specie No

Ability to Short/Borrow Yes Limited

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ETFs vs Open-ended Index Funds

ETF Open-ended Index Fund

Expense Structure Low Low

Tracking Error Minimal Higher than ETF

Traded on Stock Exchange Yes No

Add/Remove Exposure Any time market open Daily

Ability to Short/Borrow Yes No

Subscription/Redemption In-specie Cash

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ETFs vs Index Futures

ETF Index Futures

Expense Structure Low Commission cost in rolling position

Need to Roll Position No Yes – hence roll risk

Margin Calls from Mark-to-Market No Yes

Margin Accounting Complexities None High

Dividends Yes No

Ability to Short Yes Yes

Types and Volume Many Less

Leverage No – but can create leverage by borrowing to

buy ETF

Yes

ETFs Users and Applications

21

ETFs Users

Institutional Investors

Market Intermediaries

Hedge Funds

Financial Advisors

Retail Investors

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Applications of ETFs

Asset Allocation/Sector & Style

Use ETFs to gain country or sector exposure while limiting stock-specific risk – avoid frustration of the right country or sector choice, but the wrong stock pick

Rebalance allocation anytime during market hours and without the hassles of multi-stocks settlement

Efficient access to markets which have restrictions on foreign capital participation

Build core portfolio cheaply with broad-based & country ETFs and the “satellite” portfolio with industry sector ETFs

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Core/Satellite Asset Allocation Strategy

Core Investments

Individual Stocks

Sector Funds

Growth

Small-Cap

Large-Cap

Value

資料來源 Source: MSDW 股票研究 MSDW Equity Research

Higher Risk/Higher Reward

Lower Risk/Lower Reward

Equity Risk Pyramid

Individual Stocks

Sector Funds

Large, Mid, Small-Cap Funds

Growth & Value Funds

Broad-based Indices

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Applications of ETFs

Equitize Cash Inflows

Avoid drag of cash position on equity portfolio returns

achieve temporary equity exposure until portfolio manager decides which stocks to buy

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Applications of ETFs

Use ETFs to create equitized liquidity reserve

To satisfy redemptions or withdrawals, compared to selling individual stocks, the ETF liquidity reserve can be liquidated

– Quicker

– Easier

– Lower transactions costs

– No effect on individual stock price

Enhance Management of Cash Outflows

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Applications of ETFs

Hedge Equity Portfolio Exposure

Short ETF position can provide hedge against price declines

Alternative to futures and without the roll risk – especially attractive for institutions which are not permitted or prefer not to use derivatives

Allows the hedging of exposure to specific stock indexes or market segments not available with futures

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Applications of ETFs

Manager Transition Trades

Facilitate transition of assets from a terminated investment manager to a new investment manager

Liquidate terminated manager’s portfolio and invest in ETFs to maintain equity exposure

When new manager is selected, ETFs can be sold to deliver cash or redeemed to deliver component stocks of ETF to new manager

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Applications of ETFs

Relative Value, Long/Short Strategies

Strategies can include:

Go Long broad market Indexes, country or sector Indexes expected to outperform

Go Short the broad market Indexes, country or sector Indexes expected to underperform

Position can be leveraged by doubling the size of the long position versus the short

Anticipate sector rotations with long or short positions in industry sector ETFs

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Privatization of Shares Held by Government

Innovative use of ETFs designed by SSgA – First used by the Hong Kong Government and hence the creation of TraHK

Government repackaging their shareholdings into ETF units and placing the units to institutional and retail investors through an initial public offering

Key advantages are:

Minimal market impact

Stock neutral

Diversifies ownership amongst retail and institutional investors

Broadens the capital markets with the introduction of a new investment product

Recently adapted for the unwinding of cross-holdings of Japanese banks But a crucial difference – there is a lack of new investors and new sources of

liquidity into the Japanese product

Applications of ETFs

Trends and Development of ETFs

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Midcap SPDR

DIAMOND, Sector SPDRs

QQQs, iUnits 60, TraHK

SPDR

LDRs, iShares,streetTRACKSDJ CN 40, Xact OMX,SATRIX 40

WEBs

462

423

1,055

2,159

6,205

14,598

31,025

$103,242

$74,337

0 20,000 40,000 60,000 80,000 100,000

1993

1994

1995

1996

1997

1998

1999

2000

2001/12/31

DAX, TALI 25, M-S CAC 40, TSE300, XMTCH (SMI)

 Worldwide ETF Growth in Assets

Data as of Dec 31, 2001 (USD millions)Source: SSgA ETF group, AMEX

By 28 June 2002, assets under management reached US$120.6b in 238 ETFs

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Existing Products 

SSgA manages more than 33% of the ETF assets worldwide, including:

SPDR, Fortune, Select Sector SPDR, DJ Canada 40, StreetTRACKS, & TraHK

Source: BloombergData as of Jun 30, 2002 (USD Millions)

TraHK3,586

QQQ19,040

iShares MSCI EAFE3,999

OSE Nikkei 2252,687

TSE Topix8,024

iShares S&P 5003,629

MidCap SPDRs5,890

SPDRs26,896

iShares Russell 2000

2,742

DIAMONDS3,430

Others38,072

Select Sector SPDR2,805

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ETFs in the Global MarketTop 10 Global ETFs by Turnover

Source: SSgA ETF Group, Bloomberg

Rank Name Symbol Tracking Against Daily Turnover

(in USD mn)*

Manager/Trustee

1 NASDAQ-100 Index Tracking Stock

QQQ NASDAQ 100 2,871.6 Bank of New York

2 SPDRs (Standard & Poor’s Depository Receipts)

SPY S&P 500 2,103.5 State Street Global Advisors

3 DIAMONDS Trust DIA Dow Jones Industrial Average

444.5 State Street Global Advisors

4 MidCap SPDRs MDY S&P MidCap 400 Index

114.1 Bank of New York

5 iShare Russell 2000 IWM Russell 2000 71.5 Barclays Global Investors

6 DAXEX DAXEX GR

Germany DAX Index

53.0 IndexChange

7 Master Share CAC 40 CAC FP France CAC 40 Index

42.6 Lyxor Asset Management

8 Select Sector SPDR – Financial Fund

XLF S&P Financial Index

40.0 State Street Global Advisors

9 iShare MSCI EAFE EFA US MSCI EAFE Index 35.4 Barclays Global Investors

10 iUnits S&P/TSE 60 Index Fund

XIU CN Canada S&P / TSE 60 Index

35.2 Barclays Global Investors

* Average daily turnover for the year ended 28 June 2002

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ETFs in the Global MarketExisting Products AUM : US$120.6b in 238 funds*

N AmericaAUM : US$ 93.5 bn

No. Funds : 118

Europe & Middle EastAUM : US$ 8.9 bn

No. Funds : 93

Asia PacificAUM : US$ 17.6 bn

No. Funds : 24

Source: Morgan Stanley Research

* Data as of 28 June 2002, not including HOLDRS

STI

* Including

Singapore’s first local ETF listed on 17 Apr 2002

South AfricaAUM : US$ 0.6 bn

No. Funds : 3

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U.S. Lead in ETFs - Reasons for dominance of the US market

First mover advantage

Favorable end-user response

The number of institutional investors reporting holding one or more US listed ETFs or HOLDR has increased to 1,162 in June 2002 from 911 institutions in June 2001

(Source: Morgan Stanley Research and Thomson Financial)

Well developed market infrastructure

Key theme is asset growth

In the 1st half of 2002, assets have grown by US$5.5 billion to about US$93.5 billion and 1 new ETF was launched

36

ETFs in Europe

ETFs are winning investors Significant increase in usage of ETFs by European institutions, from 32 institutions in June 2000

to 246 in June 2002 (Source: Morgan Stanley Research)

Rapid product launches In the 1st half of 2002, there were 21 new ETF launches and assets increased by US$2.9 billion

to about US$8.5 billion

Cross-listing is common As of 28 June 2002, the number of primary listings was 92 but the number of total ETF listings

was 154.

Key theme is pan-Europe sector based ETFs Introduction of Euro

Institutional investors move from country based to sector based allocation

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ETFs in Asia Pacific

ETFs in Asia Pacific

Hong Kong

Japan

Australia

Singapore

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ETFs in Hong Kong

Tracker Fund of Hong Kong (TraHK) was the first ETF listed outside North America in 1999

US$4.3 billion IPO the first stage of Hong Kong Government’s disposal of shares purchased in events of August 1998

Tap Mechanism an on-going disposal mechanism for the Government’s remaining holdings

Incentive package with Loyalty Bonuses has resulted in TraHK being less liquid initially than typical ETF of this size

Current assets under management of about US$3.8 billion

Cross-trading iShares in Hong Kong from May 2001

Korea & Taiwan the first 2 of a planned 6

Launch of iShares MSCI China Free in Hong Kong in November 2001 Current assets under management of about US$38 millions for Hong Kong retail investors

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Observations from TraHK

Local investors prefer local indices

Low cost and transparency are the major appeal

Benefits to the capital market:

More investment choices – benefits investors

Development of long-term equity holding culture – 70% of investors from IPO still retaining their units even after the distribution of all loyalty bonuses

Increased efficiency of index futures pricing

Increased liquidity resulting from arbitrage activities

Active trading of derivatives positive for the development of the product

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Marketing important aspect especially in the initial stages To increase investor awareness and familiarity

Operationally demanding product Need to interact with numerous parties

Importance of fully integrated systems

Experience is key - steep learning curve and inexperience incurs the risk of developing a flawed product

Extremely profitable business for the stock exchange

Observations from TraHK (Con’td)

41

ETFs in Japan

Japan ‘mass launch’ of 5 ETFs in July 2001

Indices approved for ETF development increased from 4 to 8:

Nikkei 225, Nikkei 300, Topix, S&P Topix 150, MSCI Japan, FTSE Japan, DJ Industrial Average, Nasdaq-100

A total of 17 ETFs listed currently, with total assets of about US$14 bn

60% of the ETF assets came from the injection of crossholdings of Mitsubishi Tokyo Financial Group (MTFG) and Meiji Life.

No clear evidence of strong institutional use of ETFs except for the unwinding of cross-holdings in the above cases by MTFG and Meiji Life.

As these ETF units were created for share unwinding purpose, it has resulted in persistent short futures open interests in the market as well as these ETFs being less liquid than typical ETF of this size.

Product design far from satisfactory

Different creations and redemptions processes due to different interpretation of the trust law by the ETF issuers

Trade basket is typically published more than 1 day prior to the trade date – creates uncertainty in the fund management process especially when large corporate actions are pending.

42

<TRADING VALUE> Jul.01- Feb.2002 Jul.01- Dec.01 Jan.2002

Ratio Ratio Ratio

<Property> 688,727 73% 469,290 77% 59,283 65%

<Brokerage> 256,962 27% 140,366 23% 31,962 35%

<Financial Institutions> 25,632 10% 12,131 9% 5,964 19%

<Investment Trusts> 5 0% 5 0% 0 0%

<Business Companies> 23,392 9% 10,279 7% 3,006 9%

<Securities Companies> 14,438 6% 8,581 6% 1,605 5%

<Individuals- cash> 87,164 34% 51,695 37% 10,236 32%

<Individuals- margin> 60,482 24% 34,419 25% 7,269 23%

<Foreigners> 45,849 18% 23,255 17% 3,881 12%

Japan ETFs - Trading Dominated by Proprietary Trading

Source: Tokyo Stock Exchange

43

ETFs in Australia

ASX 200 & ASX 50 ETFs launched in August 2001 Rapid growth from US$ 40 mn at launch to US$ 114 mn at the end of June 2002

Importance of complementary futures contract

ETF tracking Listed Property Trust Index launched in Feb ’02, with AUM of about US $21mn as at end of June 2002

ETFs(Data as of 28 June 2002)

Source: Bloomberg

Assets under Management

(USD mn)

Average Daily Turnover

(USD)

StreetTRACKS S&P / ASX 200

73.7 4,169,660

StreetTRACKS S&P / ASX 50

14.0 40,000

44

ETFs in Singapore

Cross-listing 5 US ETFs in Singapore from May 2001

SPDR, iShares S&P500 and Diamonds

DJ US Technology

iShare Singapore

streetTRACKS Straits Times Index Fund launched on 17 April 2002

Replicating many key features of TraHK

based on well-known local index

drawing new investors into market (CPF approved)

low cost structure

but no Tap Mechanism or loyalty bonuses => ‘organic growth’

45

ETF Asia Overview

Asia clearly under-represented globally

Why?

Less sophisticated market infrastructures

– settlement, ability to short-sell, etc

Index construction issues - liquidity & concentration

Investor focus has been on active management / stock selection

Limited offering of cost-effective products

– institutions / arbitrageurs very cost sensitive

New funds coming as providers meet demand

Developmental Challenges

47

Developmental Challenges

Regulatory

Funding

Fiscal

Operational

• Hybrid Product• Shareholder Protection• Investment Concentration Restrictions

• Securities Marketplace Infrastructure• Disseminating Information• Settlement• Basket Creation

• Financial Status• Tax on Creations and Redemptions

• Distribution• Incentive Structure• Marketing

48

Service Provider Example: SPDR / TraHK Role

Stock Exchange AMEX/HKEX Conduit for trading Promotes the product

Regulator SEC / SFC Provides the legal infrastructure

Index Provider S&P / HSI Services Engineers the index to be tracked

Investment Manager SSgA Tracks the designated index

Clearing Depository DTC / HK Clearing Settles the transactions

Registrar DTC / Central Registration Registers the units of the trust

Trustee/Custodian State Street Bank & Trust Values the trust and holds trust assets

Market Maker Spear Leeds(for SPDR)

Ensures liquidity Promotes the product

Participating Dealers Securities Houses Ensure fluid trading

Distributor ALPS Mutual Fund Services (for SPDR)

Promote and sell the product

Interaction with Multiple Parties

49

Funding Challenge - Launching by IPO or Seed Capital

Advantages of IPO

Achieve investor awareness immediately

Enable the ETF to gather sufficient assets to attain a economically viable size

Assures liquidity

Equal chance of participation by all investors

50

Both the Tracker Fund of Hong Kong and Satrix40 are one of the most liquid counters traded on their respective exchanges.

Precedents of Launching ETF via IPO

Hong Kong South Africa Brazil

ETF Tracker Fund of Hong Kong

Satrix40To be announced

Promoter EFIL (Hong Kong Government)

CoreCapital Bank, Gensec bank, and

Johannesburg Stock Exchange

Development Bank of Brazil

Date of launch 12 November 1999 27 November 2000 Under preparation

Benchmark Index Hang Seng Index All Share Top 40 Companies

Bovespa Index

Assets under management at launch

HKD 33.3 billion Rand 2.6 billion N/A

Assets under management(as of 31July 2002)

HKD 27.3 billion Rand 3.6 billion N/A

Daily turnover(average for the year ended 31July 2002)

USD 7.5 million USD 1.1 million N/A

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Funding Challenge - Launching by IPO or Seed Capital (cont’d)

Launching by reliance on seed capital

The main advantage is minimal expense

Disadvantages are:

It will take a much longer time before the assets in the ETF build up – see the example of SPDRs and other ETFs

As a result, liquidity is usually constrained in the initial period

As the APs are not the end-user, there is no new capital inflow into the market

Conclusion

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Benefits that a Successful ETF can bring to the Capital Market

Increased investor choice

Low cost investment vehicle

Development of long-term equity culture

Benefits of indexation – e.g. enforcing diversification

Can be used as a risk management tool

Increase in market liquidity

ETFs rank among the most liquid counters in most markets

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So what is a successful ETF?

Asset under management – large

Liquidity – high

Bid/ask spread (re market price) – narrow

Total expense ratio – low

Tracking error against the index – minimal

Difference between traded price and NAV - small

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The State Street Advantage Product and Personnel Experience

State Street is the pioneer of exchange traded funds (ETFs) – began the design and development of SPDR in 1990 in conjunction with AMEX

Largest, sole service provider of ETFs worldwide with over 33% market share worldwide, including structuring, distribution and management

Manager of US$28 billion SPDR, largest ETF in the world and US$3.8 billion Tracker Fund of Hong Kong, largest ETF in Asia (ex-Japan)

Preferred partner of stock exchanges to development their system platform for ETFs

AMEX, Toronto Exchange, Hong Kong Exchange, Singapore Exchange, Australia Exchange

Invested and committed significant time and resources in the development of ETFs that vary by legal structure and trade under different market conditions

Specialists are involved in every step of the ETF process, from development, to conversion, and to successful implementation in North America, Europe and Asia - dedicated, experienced ETF Asian Team