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8/14/2019 Energy ETFs and ETCs Final
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8/14/2019 Energy ETFs and ETCs Final
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Energy ETFs and
ETCs
2009 Dimple Singh (20081014)Nidhi Chhajed (20081033)
Puneet Dutt (20081037)
Riddhi Kedia (20081043)
9/14/2009
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Contents
Table of Contents
1. What are ETFs 3
2. What are Energy ETFs?3
3. Green ETFs4
4. Advantages of ETF 9
5. Stapled Securities 20
6. Structured Products 28
What Are ETFs?
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track
indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy
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shares of an ETF, you are buying shares of a portfolio that tracks the yield
and return of its native index. The main difference between ETFs and other
types of index funds is that ETFs don't try to outperform their corresponding
index, but simply replicate its performance. They don't try to beat the
market; they try to be the market.
ETFs have been around since the early 1980s, but they've come into their
own within the past 10 years.
What are Energy ETFs?
A broad class of ETFs that includes funds focused on oil and gas exploration,
the generation, distribution and retail sale of gas and other refined products,electric utilities and alternative energy production. Energy ETFs may invest
in only US based companies, globally based energy companies, or a blend of
the two.
The offerings within the energy ETF class include replications of the energy-
sector stocks found in the S&P 500, U.S. energy producers, global energy
producers and funds of a particular sub-sector designation, such as nuclear,
coal, gas, etc.
The weighting of stocks within these ETFs can be market-cap based, equally-
weighted or fundamentally weighted, based on financial metrics like net
earnings and dividend yield.
Energy ETFs represent a sector that is widely held by both conservative and
risky investors, because energy represents a large portion of the broad
economy. This is evidenced by energys high percentage allocation within
broad market averages like the S&P 500.
There is also increasing interest in green energy and alternative energy
development, so a growing number of ETFs focus on companies engaged in
alternative and clean energy production.
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Energy ETFs have the advantage of intraday pricing and trading, which can
make them more attractive than similarly invested mutual funds. Investors
should read the fact sheets and prospectuses carefully to be sure of what
guidelines the ETF has with regards to similar focus areas, such as mining
and commodities.
Green ETFs
Green ETFs are ETFs that invest in companies which are looking to benefit
from investing in green technologies and make their money out of clean
energy and related areas.
Here is a list of green energy ETFs.
Power shares Green ETF
Power Shares Wilder Hill Clean Energy Portfolio (PBW): This green ETF tracks
the Wilder Hill Clean Energy Index and will normally invest 80% of its assets
in companies that are engaged in cleaner energy and conservation. The
underlying index has got 54 publicly traded companies with a market cap in
the range of $126 million and $26 billion.
Power Shares Water Resources Portfolio (PHO): This green ETF tracks the
Palisades Water Index and invests in a group of companies that focus on
potable water, water treatment, and the technology and services directly
related to water consumption. The underlying index contains 33 companies
that are publicly traded in US and have market cap in the range of $1.1
billion and $266 billion as on June 30, 2008.
Power Shares Wilder Hill Progressive Energy Portfolio (PUW): PUW green ETF
tracks the Wilder Hill Progressive Energy Index and is comprised of US listed
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companies that are significantly involved in transitional energy bridge
technologies, with an emphasis on improving the use of fossil fuels. This
means that this fund invests in companies that are working towards
improving energy efficiency from fossil fuels and nuclear power in the
medium term. The underlying index comprises of 45 companies with a
market cap between $304 million and $101 billion as on June 30 2008.
Global Nuclear Energy Portfolio (PKN): As the name suggests, PKN is a green
ETF that focuses on companies that are engaged in the nuclear energy
sector. The companies may be present in reactors, utilities, construction,
technology, equipment, service providers and fuels.
Power shares Global Clean Energy Portfolio (PBD): This is a global green ETF,
which means that it invests in companies that are engaged wind, solar,
biofuels, hydro, wave and tidal, geothermal and other relevant renewable
energy businesses around the world. The underlying index contains 86
companies between a market cap of $27.9 million and $18.8 billion as at
December 31st 2008. The companies are domiciled in Australia, Austria,
Belgium, Brazil, Canada, China, Denmark, France, Finland, Germany, Hong
Kong, India, Ireland, Italy, Japan, New Zealand, Norway, Philippines, Spain,
Switzerland, Taiwan, the United Kingdom and the United States.
Power Shares Global Water Portfolio (PIO): This green ETF invests in
companies around the world that focus on the provision of potable water,
the treatment of water and the technology and services that are directly
related to global water consumption.
Power Shares Clean Tech Portfolio (PZD): This is a slightly different type of
green ETF because it invests in Clean Tech companies. Clean Tech
companies are defined as those that provide knowledge-based products (or
services) that add economic value by reducing cost and raising productivity
and/or product performance, while reducing the consumption of resources
and the negative impact on the environment and public health. As of June
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30, 2008 the underlying index consisted of 76 companies with a market cap
between $395.4 million and $101.6 billion.
Power shares Global Wind Energy Portfolio (PWND): PWND is an ETF that
invests in companies that are engaged in the wind energy business globally.
The underlying Index is designed to measure the performance of global
companies engaged in the wind energy industry, which are primarily
manufacturers, developers, distributors, installers and users of energy
derived from wind sources.
Van Eck Green ETF
Global Alternative Energy ETF (GEX): This green ETF invests in global
companies engaged in the production of alternative fuels and / or related
technologies. The Index Country breakdown is quite interesting with US
accounting for 38.3%, followed by Denmark with 19.3%, Spain 15.0%,
Germany 7.2%, China 5.5%, Austria 5.4% and a few other countries with less
than 5%.
Environmental Services ETF (EVX): EVX invests in companies that engage in
business activities that may benefit from the global increase in demand for
consumer waste disposal, removal and storage of industrial by-products, and
the management of associated resources.
Nuclear Energy ETF (NLR): This green ETF focuses on companies that are
related to the nuclear energy business worldwide.
Solar Energy ETF (KWT): The KWT ETF invests in companies that derive at
least 66% of their revenues from solar power and related products and
services.
First Trust Green ETF
First Trust ISE Global Wind Energy Index Fund (FAN): The ETF invests in
companies related to wind energy globally. The maximum country exposure
on this ETF is Spain with 30.35%, followed by Germany with 15.36%,
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followed by US with 10.95%, Denmark 8.22%, Belgium 5.77% and a few
other countries with less than 5%.
First Trust ISE Water Index Fund (FIW): This ETF focuses on companies that
derive a substantial portion of their revenues from potable and wastewater
industries. There are 36 stocks in this index and it has maximum exposure
to the Industrials sector.
First Trust Nasdaq Clean Edge Green Energy Index Fund (QCLN): This
ETF invests in stocks that are publicly traded in the United States and that
are primarily manufacturers, developers, distributors and/or installers of
clean energy technologies.
Claymore Green ETF
Claymore S&P Global Water Index ETF (CGW): This green ETF invests in
water companies globally. It is a passive fund that invests in the stocks of
the underlying index that is composed with 25 securities of water utilities
and infrastructure companies and 25 securities of watery equipment and
material companies.
Claymore / MAC Global Solar Energy Index ETF (TAN): The TAN ETF tracks itsunderlying index which is designed track companies within the following
business segments of the solar energy industry: companies that produce
solar power equipment and products for end-users, companies that produce
fabrication products (such as the equipment used by solar cell and module
producers to manufacture solar power equipment) or services (such as
companies specializing in the solar cell manufacturing or the provision of
consulting services to solar cell and module producers) for solar power
equipment producers, companies that supply raw materials or components
to solar power equipment producers or integrators; companies that derive a
significant portion of their business from solar power system sales,
distribution, installation, integration or financing; and companies that
specialize in selling electricity derived from solar power.
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Benefits
ETFs combine the range of a diversified portfolio with the simplicity of
trading a single stock. Investors can purchase ETF shares on margin, short
sell shares, or hold for the long term.
Passive management Harness the market
The purpose of an ETF is to match a particular market index, leading to a
fund management style known as passive management. Passive
management is the chief distinguishing feature of ETFs, and it brings a
number of advantages for investors in index funds. Essentially, passive
management means the fund manager makes only minor, periodic
adjustments to keep the fund in line with its index. This is quite different
from an actively managed fund, like most mutual funds, where the manager
continually trades assets in an effort to outperform the market. Because
they are tied to a particular index, ETFs tend to cover a discrete number of
stocks, as opposed to a mutual fund whose scope of investment is subject to
continual change. For these reasons, ETFs mitigate the element of
"managerial risk" that can make choosing the right fund difficult. Rather
than investing in a fund manager, when you buy shares of an ETF you're
harnessing the power of the market itself.
Cost-efficient and tax-efficient
ETF tracks an index without trying to outperform it; it incurs fewer
administrative costs than actively managed portfolios. Typical ETF
administrative costs are lower than an actively managed fund, coming in
less than .20% per annum, as opposed to the over 1% yearly cost of some
mutual funds. Because they incur low management and sponsor fees, and
because they don't typically carry high sales loads, there are fewer recurring
costs to diminish your returns.
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Passive management is also an advantage in terms of tax efficiency. ETFs
are less likely than actively managed portfolios to experience the trading of
securities, which can create potentially high capital gains distributions.
Fewer trades into and out of the trust mean fewer taxable distributions, and
a more efficient overall return on investment.
Efficiency is one reason ETFs have become a favored vehicle for multiple
investment strategies - because lower administrative costs and lower capital
gains taxes put a greater share of your investment dollar to work for you in
the market.
Flexibility
ETF shares trade exactly like stocks. Unlike index mutual funds, which are
priced only after market closings, ETFs are priced and traded continuously
throughout the trading day. They can be bought on margin, sold short, or
held for the long-term, exactly like common stock. Yet because their value is
based on an underlying index, ETFs enjoy the additional benefits of broader
diversification than shares in single companies, as well as what many
investors perceive as the greater flexibility that goes with investing in entire
markets, sectors, regions, or asset types. Because they represent baskets of
stocks, ETFs, or at least the ones based on major indexes, typically trade at
much higher volumes than individual stocks. High trading volumes mean
high liquidity, enabling investors to get into and out of investment positions
with minimum risk and expense.
Long-term Growth
It was in the late 1970s that investors and market watchers noticed a trend
involving market indexes - the major indexes were consistently
outperforming actively managed portfolio funds. In essence, according to
these figures, market indexes make better investments than managed
funds, and a buy-and-hold strategy is the best strategy to reap the
advantages of investing in index growth.
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How do indexes work?
A stock market index is a list of related stocks, together with statistics
representing their aggregate value. It is used chiefly as a benchmark for
indicating the value of its component stocks, as well as investment vehicles
such as mutual funds that hold positions in those stocks. Indexes can be
based on various categories of stocks. There are the widely known market
indexes, such as the Dow Jones Industrial Average, the NASDAQ Composite,
or the S&P 500. There are indexes based on market sectors, such as tech,
healthcare, financial; foreign markets; market cap (micro-, small-, mid-,
large-, and mega-cap); asset type (small growth, large growth, etc.); even
commodities.
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Advantages of Exchange-Traded Funds (ETFs)
It was State Street Global Advisors that launched the first exchange-tradedfund (ETF) in 1993 with the introduction of the SPDR. Since then, ETFs have
continued to grow in popularity and gather assets at a rapid pace. The
easiest way to understand ETFs is to think of them as mutual funds that
trade like stocks. Of course, trading like a stock is just one of the many
features that make ETFs so popular, particularly with professional investors
and individual investors who are active traders. Let's go over these
attractive features.
The benefits of trading like a stock
The easiest way to highlight the advantage of the ETF trading like a stock is
to compare it to the trading of a mutual fund. Mutual funds are priced once
per day, at the close of business. Everyone purchasing the fund that day
gets the same price, regardless of the time of day their purchase was made.
Because, like traditional stocks and bonds, ETFs can be traded intraday, they
provide an opportunity for speculative investors to bet on the direction ofshorter-term market movements through the trading of a single security. For
example, if the S&P 500 is experiencing a steep rise in price through the
day, investors can try to take advantage of this rise by purchasing an ETF
that mirrors the index (such as a SPDR), hold it for a few hours while the
price continues to rise and then sell it at a profit before the close of
business. Investors in a mutual fund that mirrors the S&P 500 do not have
this capability - by nature of the way it is traded, a mutual fund does not
allow speculative investors to take advantage of the daily fluctuations of its
basket of securities.
The ETFs stock-like quality allows the active investor to do more than simply
trade intraday. Unlike mutual funds, ETFs can also be used for speculative
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trading strategies, such as short selling and trading on margin. In short, the
ETF allows investors to trade the entire market as though it were one single
stock.
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Low Expense Ratios
Everybody loves to save money, particularly investors who take their
savings and put them to work in their portfolios. In helping investors save
money, ETFs really shine. They offer all of the benefits associated with index
funds - such as low turnover and broad diversification (not to mention the
often-cited statistic that 80% of the more expensive actively managed
mutual funds fail to beat their benchmarks) - plus ETFs cost a lot less.
Compare the Vanguard 500 Index Fund, often cited as one of the lowest of
the low-cost index funds, and the SPDR 500 ETF. The Vanguard fund's
expense ratio of 18 basis points is significantly lower than the 100+ basis
points often charged by actively managed mutual funds. But when
compared to the SPDR's 11-basis-point expense ratio, the Vanguard fund's
expense ratio looks quite high. In fact the SPDR is 40% lower, which is tough
to argue with.
Do keep in mind, however, that because ETFs trade through a brokerage
firm, each trade incurs a commission charge. To avoid letting commission
costs negate the value of the low expense ratio, shop for a low-cost
brokerage (trades under $10 are not uncommon) and invest in increments of
$1,000 or more. ETFs also make sense for a buy-and-hold investor who is in
a position to execute a large, one-time investment and then sit on it.
Diversification
ETFs come in handy when investors want to create a diversified portfolio.
There are hundreds of ETFs available, and they cover every major index
(those issued by Dow Jones, S&P, and NASDAQ) and sector of the equities
market (large caps, small caps, growth, and value). There are international
ETFs, regional ETFs (Europe, Pacific Rim, emerging markets) and country-
specific (Japan, Australia, U.K.) ETFs. Specialized ETFs cover specific
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industries (technology, biotech, and energy) and market niches (REITs,
gold).
And ETFs cover also other asset classes, such as fixed income. While ETFs
offer fewer choices in the fixed-income arena, there are still plenty of
options, including ETFs composed of long-term bonds, mid-term bonds and
short-term bonds. While fixed-income ETFs are often selected for the income
produced by their dividends, some equity ETFs also pay dividends. These
payments can be deposited into a brokerage account or reinvested. If you
invest in a dividend-paying ETF, be sure to check the fees prior to
reinvesting the dividends, as some firms offer free dividend reinvestment,
while others do not.
Studies have shown that asset allocation is a primary factor responsible for
investment returns, and ETFs are a convenient way for investors to build a
portfolio that meets specific asset allocation needs. For example, an investor
seeking an allocation of 80% stocks and 20% bonds can easily create that
portfolio with ETFs. That investor can even further diversify by dividing the
stock portion into large-cap growth and small-cap value stocks, and the
bond portion into mid-term and short-term bonds. Or, it would be just as
easy to create an 80/20 bond-to-stock portfolio that includes ETFs tracking
long-term bonds and those tracking REITs. The large number of available
ETFs enables investors to quickly and easily build a diversified portfolio that
meets any asset allocation model.
Tax Efficiency
ETFs are a favorite among tax-aware investors because the portfolios that
ETFs represent are even more tax efficient than index funds. In addition to
offering low turnover - a benefit associated with indexing - the unique
structure of ETFs enables investors trading large volumes (generally
institutional investors) to receive in-kind redemptions. This means that an
investor trading large volumes of ETFs can redeem them for the shares of
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stocks that the ETFs track. This arrangement minimizes tax implications for
the investor exchanging the ETFs since the investor can defer most taxes
until the investment is sold. Furthermore, you can choose ETFs that don't
have large capital gains distributions or pay dividends (because of the
particular kinds of stocks they track).
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Conclusion
The reasons for the popularity of ETFs are easy to understand. The
associated costs are low, and the portfolios are flexible and tax efficient. The
push for expanding the universe of exchange-traded funds comes, for the
most part, from professional investors and active traders. Nevertheless,
long-term investors will find that the broad-market based ETFs can find a
place in their portfolios when they have an opportunity for occasional large-
size purchases of securities. Investors interested in passive fund
management, and who are making relatively small investments on a regular
basis, are best advised to stick with the conventional index mutual fund. The
brokerage commissions associated with ETF transactions will make it too
expensive for those people in the accumulation phase of the investment
process.
ETF Product Structures
Exchange-traded funds (ETFs) and related exchange-traded products (ETPs)
can use various types of product structures. Each structure has its own
unique advantages and disadvantages. Knowing the subtle differences can
help you to make informed investment decisions.
Lets examine five key product architectures.
Open end funds
The vast majority of traditional ETFs follow an open-end structure. This
product design is quite flexible and allows the usage of derivatives, portfolio
sampling and securities lending. Dividends in open-end funds are
immediately reinvested and usually distributed to shareholders either
monthly or quarterly. The open-end structure is used by major ETF families
like the iShares, State Street Global Advisors and Vanguard. Almost all open-
end ETFs will follow either stock or bond indexes. While the open-fund
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structure is generally tax-efficient, its still a good idea to position tax
inefficient asset classes like bonds or REITs into tax-deferred accounts.
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Unit Investment Trusts (UIT)
The UIT structure is considerably more restrictive compared to the open end
fund. For example, it does not reinvest dividends, but instead holds them
until they're paid out to shareholders. This creates a phenomenon known as
"dividend drag." UITs are not allowed to loan securities in their portfolios and
they must fully replicate their underlying indexes. Also, unlike open-end
funds, UITs have expiration periods which typically last anywhere from a few
years to decades. The Dow DIAMONDS (DIA), Power Shares QQQ Trust
(QQQQ), and the SPDRs S&P500 (SPY) each use the UIT structure. UITs are
generally very tax efficient.
Grantor Trust
This type of product structure is used by popular single commodity ETPs like
the SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV). Since these
products own the physical metal and not the futures contracts on the metal,
gains are taxed at ordinary income rates, which are currently 28%. The
grantor structure is also used by other commodity focused products like the
Power Shares DB Commodity Index Tracking Fund (DBC). Like many other
commodity ETPs, DBC uses futures contracts to obtain its commodities
exposure. ETPs that use futures contracts are taxed each year even if you
don't sell them. Capital gains are currently taxed at a hybrid rate of 60%
long-term and 40% short-term gains. While its rare, some ETPs that invest
in stocks like the HOLDRS use the grantor trust format. All of the HOLDRS
are concentrated baskets of stocks that follow no index. The original stocks
installed inside the trust remain fixed and aren't rebalanced.
Limited Partnerships
The LP structure is used by the United States Oil Fund (USO). Just like the
previously mentioned DBC, this particular LP uses futures contracts to obtain
its oil commodities exposure. LPs that use futures contracts are taxed each
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year even if you don't sell them. Capital gains are taxed at a hybrid rate of
60% long-term and 40% short-term gains. At the end of each tax year,
investors are sent a Schedule K-1.
Exchange Traded Notes
ETNs are debt instruments linked to the performance of a single commodity,
currency or index. They have a set maturity date and they do not usually
pay an annual coupon or specified dividend rate. ETNs can be traded or
redeemed before the maturity date. If the note is held to maturity, the
investor is paid the return of the notes underlying index, minus the annual
expense ratio. ETNs carry issuer risk which is tied to the credit worthiness of
the financial institution backing the ETN. If the issuers financial condition
deteriorates, it could negatively impact the value of the ETN, regardless of
how its underlying index performs.
Gains on stock, bond and commodity ETNs are taxed at either long-term or
short-term capital gains rates depending on how long you've held them.
Typically these types of ETNs don't distribute dividends or interest income,
so they are very tax-efficient. In 2007, the IRS ruled that currency ETNs
should be taxed as bonds, regardless of whether the interest inside the note
is automatically reinvested and not paid out until the note holder sells their
ETN.
ETFs Provide Easy Access to Energy Commodities
If you fill up a car with gasoline or heat a home with oil or natural gas, you
know that rising energy costs have put a dent in your budget. But do you
also know how easy it is to buy shares in a brokerage account or IRA that
can help you hedge energy commodity price increases?
This article will help investors understand the benefits of investing in energy
commodity ETFs and detail choices available to interested investors. It
specifically covers investments that seek to track commodities prices - not
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ETFs that invest in energy sector stocks, in which investment returns are
influenced by the overall direction of the stock market and do not always
mirror energy commodities prices.
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World of ETFs
In recent years, thanks to the growth of exchange-traded funds (ETFs),
ownership of energy-sector commodities has become more accessible for
individuals. For example, buying one share of the U.S. Oil Fund ETF
(AMEX:USO) gives you exposure roughly equal to one barrel of oil. If oil
prices rise by 10% in a given period, your investment should theoretically
appreciate by about the same percentage. You can own oil through this ETF
without incurring the cost normally associated with storage or transport. The
only costs that you will pay include brokerage fees to buy and sell shares
plus a modest ongoing management fee.
USO is not mentioned as a specific investment recommendation. It is
significant because it was the first energy commodity ETF introduced, in
February of 2006, and remains one of the most popular by asset size and
trading volume. Since USO's introduction, ETF energy commodity choices
have greatly expanded.
Why invest in energy commodity ETFs?
ETFs are traded on exchanges (like stocks), and shares may be bought or
sold throughout the trading day in large or small amounts.
At the heart of the "energy complex" is crude oil and products refined from
it, such as gasoline and home heating oil. Natural gas is a by-product of oil
exploration and a valuable product in its own right, used throughout the
world for heat and power generation. Lesser products in the energy complex
include coal, kerosene, diesel fuel, and propane and emission credits.
Energy commodity ETFs can be useful tools for constructing diversified
investment portfolios for the following reasons:
1. Inflation hedge and currency hedge potential - Energy has
recognized value all over the world, and this value does not depend on any
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nation's economy or currency. Over time, most energy commodities have
held their values against inflation very well. For example, the spot price of a
barrel of crude oil increased at an average annual rate of 6.5% per year from
1950 through 2007. Over the same span, the annualized increase in the U.S.
Consumer Price Index was 3.9%. Energy prices tend to move in the opposite
direction of the U.S. dollar - prices increase when the dollar is weak. This
makes energy ETFs a sound strategy for hedging against any dollar declines.
2. Participation in global growth - Demand for energy commodities keep
growing in industrializing emerging markets such as China and India. In
2007, as in most years, the U.S. consumed about 25% of the world's 85
million barrels of total daily oil production, and U.S. consumption has been
increasing by about 3% per year, according to the International Energy
Agency. Some experts believe that it will be difficult for global oil production
to grow in the future due to dwindling reserves, especially in Saudi Arabia. In
addition, several of the world's leading oil export nations (ex. Russia, Iran,
Iraq, Venezuela and Nigeria) are politically volatile and could be unreliable
as future sources of supply.
3. Portfolio diversification - According to modern portfolio theory,
investors can increase portfolio risk-adjusted returns by combining low-
correlating assets in which returns do not tend to move in the same
direction at the same time. However, few asset classes accessible to
individual investors have consistently produced low correlations with U.S.
stocks. Correlations are measured on a scale of 1 (perfect correlation) to -1
(perfectly negative correlation). Oil is among the few asset classes that have
consistently produced very low (or negative) correlations with U.S. stocks.According to Fact Set, the correlation between oil futures and the S&P 500
Index was -0.31 for the five-year period 2002-2007. For this reason,
investors can expect oil commodity holdings to help diversify and balance
stock-heavy portfolios.
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4. Backwardation - Backwardation is the most complex (and least
understood) benefit of some energy commodity ETFs. These ETFs place most
of their assets in interest-bearing debt instruments (such as short-term U.S.
Treasuries), which are used as collateral for buying futures contracts. In
most cases, the ETFs hold futures contracts with the least time left to
delivery - so-called "short-dated" contracts. As these contracts approach the
delivery date, the ETFs "roll" into the next shortest-dated contracts.
Most futures contracts typically trade in contango, which means that prices
on long-delivery contracts exceed short-term delivery or spot prices.
However, oil and gasoline historically have often done the opposite, which is
called backwardation. When an ETF systematically rolls backwardated
contracts, it can add small increments of return called "roll yield", because it
is rolling into less expensive contracts. Over time, these small increments
add up significantly, especially if backwardation continues.
Although this explanation may sounds highly technical, roll yield historically
has been the dominant source of investment return in oil, heating oil and
gasoline futures contracts. According to an analysis by author and analyst
Hilary Till, long-term annualized returns of these futures contracts exceeded
spot prices significantly, as shown in Figure 1, below, and the major reason
for this differential was backwardation roll yield.
Annualized Returns from 1983 to 2004
-Futures
Contract
Spot
Price
Crude Oil 15.8% 1.1%
Heating Oil 11.1% 1.1%
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Gasoline (since Jan.
1985)18.6% 3.3%
Source: "Structural Sources of Return and
Risk in Commodity Futures Investments"
by Hilary Till(Commodities Now, June 2006)
Figure 1
It should be noted that these energy contracts occasionally move from
backwardation to contango for intervals of time. During such times, roll yield
may be lower than shown in the table; they may even be negative.
Historically, natural gas has not shown the same tendency toward
backwardation and roll yield benefit as the three contracts listed in the
table.
Types of Energy ETFs
Energy ETFs can be divided into three main groups:
1. Single contract - These ETFs participate principally in single futures
contracts. For example, the iPATH S&P GSCI Crude Oil Total Return Index
(NYSE:OIL) exchange-traded note (ETN) participates in the West Texas
intermediate (WTI) light sweet crude oil futures traded on the New York
Mercantile Exchange. Note: An ETN is an exchange-traded note, a structure
that works much the same way as an ETF. Power Shares DB Oil Fund
(AMEX:DBO) participates in the same WTI contract.
USO, the pioneering energy commodity ETF, is a subject of some
controversy because it nominally participates in a single contract (WTI),
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while also dabbling in several other energy complex contracts. Therefore,
most investors do not consider it be a pure single-contract ETF.
2. Multi-Contract - These ETFs offer diversified exposure to the energy
sector by participating in several futures contracts. The iShares S&P GSCI
Commodity-Indexed Trust (NYSE:GSG) has about two-thirds of its total
weight in the energy sector and the remaining one-third in other types of
commodities. It tracks one of the oldest diversified commodities indexes, the
S&P GSCI Total Return Index.
Power Shares DB Energy Fund (AMEX:DBE) is a pure energy sector fund
diversified across commodity types. It participates in futures contracts for
light sweet crude oil, heating oil, Brent crude, gasoline and natural gas. The
ETF seeks to track an index that optimizes roll yield by selecting futures
contracts according to a proprietary formula.
3. Bearish - Energy sector commodities can be volatile, and some investors
may want to bet against them at times. The first "bearish" energy
commodity ETF is Claymore MACRO shares Oil down Trade able Trust
(AMEX:DCR). It is designed to produce the inverse of the performance of WTI
oil. This ETF is one-half of a pair of MACRO shares, a concept through which
two ETFs are issued together but traded separately to track, respectively,
the up and down movements in a commodity. (The other half of this pair is
Claymore MACRO shares Up Trade able Trust (AMEX: UCR).
Final Points
While ETFs have made energy sector commodities more accessible to
investors, it's important for investors to understand the mechanics of how
individual ETFs work. Specifically, investors should realize that virtually all of
these ETFs participate in futures contracts, and the "roll yield" of these
contracts can be a major source of positive or negative return, depending on
patterns of backwardation or contango. Multi-contract ETFs such as GSG and
DBE can be a good way to add broad energy exposure across multiple
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contracts. But at times, some of these contracts may be in backwardation
(producing positive roll yield) while others are in contango (producing
negative roll yield).
For investors who own stock-heavy portfolios denominated in U.S. dollars
and wish to increase diversification and inflation-hedge potential, some
energy sector exposure may be advisable. However, it's a good idea to have
a long-term horizon for such investments because they can be volatile over
brief periods. Crude oil can be an especially valuable commodity for adding
diversification because it has consistently produced negative correlations
with U.S. stocks.
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What are stapled securities?
Stapled securities are created when two or more different things are
contractually bound together so that they cannot be sold separately. Many
different types of securities can be stapled together. For example, many
property trusts have their units stapled to the shares of companies with
which they are closely associated. The effect of stapling will depend upon
the specific terms of the stapling arrangement. The issuer of the stapled
security will be able to provide you with detailed information on their
particular stapling arrangement. However, in general the effect of stapling is
that each individual security retains its legal character and there is no
variation to the rights or obligations attaching to the individual securities.
Although the stapled security must be dealt with as a whole, the individual
securities that are stapled are treated separately for tax purposes. For
example, if a share in a company and a unit in a unit trust are stapled: the
owner continues to include dividends from the company and trust
distributions from the trust separately in their income tax return, and the
share is a separate capital gains tax (CGT) asset from the unit so capital
gains and losses are determined separately for each asset. Because each
asset that makes up your stapled security is a separate CGT asset, you must
work out a cost base and reduced cost base for each of them. If you
acquired the assets after they were stapled you do this by apportioning, on a
reasonable basis, the amount you paid to acquire the stapled security (and
other costs) between the various assets.
In real estate a common model internalizes management - where an ASX
listed trust and its own management company trade together. It may link a
passive (rental) income with a more active (non-rental) one. Income in the
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active business may be fee-based (relatively stable) or profit based (e.g. a
development company).
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Gives a company greater earnings stability
Provides a greater scale
Provides diversification or vertical integration
Provides product flexibility
Management interests aligned and fees retained in group
...And the securities all have quite different characteristics!
Basis of apportionment
One reasonable basis of apportionment is to have regard to the portion of
the value of the stapled security that each asset represented. The issuer of
the stapled security may provide assistance in determining these amounts.
Example
On 1 September 2002 Cathy acquired 100 ABC stapled securities which
comprised a share in ABC Ltd and a unit in the ABC Unit Trust. She paid
$4.00 for each stapled security and, on the basis of the information provided
to her by the issuer of the stapled securities, she determined that 60% of
the amount paid was attributable to the value of the share and 40% to the
value of the unit. On this basis, the first element of the cost base and
reduced cost base of each of Cathy's shares in ABC Ltd will be $2.40
($4.00 x 60%). The first element of the cost base and reduced cost base of
each of Cathy's units in ABC Unit Trust will be $1.60 ($4.00 x 40%)
If you acquired your stapled securities as part of a corporate reorganization,
such as the 2004 arrangement undertaken by the Westfield Group, you will,
during the restructure, have owned individual assets that were not stapled.
The cost base and reduced cost base of each of these assets will be
calculated in accordance with the specific terms of the stapling
arrangement. The stapling does not result in any CGT consequences for you,
because the individual assets are always treated as separate assets.
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However, as the example below demonstrates, there may be other aspects
of the whole restructure arrangement that will result in CGT consequences
for you.
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Example
Jamie acquired 100 units in the Westfield America Trust (WFA) in January
2003. Immediately prior to the merger of WFA with Westfield Holdings Ltd
(WSF) and Westfield Trust (WFT) in July 2004, the cost base of each of his
units was $2.12 (total cost base = $212 ($2.12 x 100)).
Under the arrangement Jamie's original units in WFA were firstly
consolidated in the ratio of 0.15 consolidated WFA units for each original
WFA unit. After the consolidation, Jamie held 15 consolidated WFA units with
a cost base of $14.13 ($212/15) each. There are no CGT consequences for
Jamie as a result of the consolidation of his units in WFA. Jamie then
received a capital distribution of $1.01 for each consolidated unit he held.
CGT event E4 happens as a result of the capital distribution. Consequently,
Jamie must reduce the cost base of each of his consolidated WFA units by
$1.01 to $13.12.
The capital distribution was compulsorily applied to acquire a share in WSFand a unit in WFT. The cost base and reduced cost base of Jamie's new units
in WFT will be $1.00 and $0.01 for each new WSF share.
The securities were then stapled to form a Westfield Group security. There
are no CGT consequences for Jamie as a result of the stapling of each
consolidated WFA unit to each new WFT unit and WSF share.
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Following the arrangement, Jamie holds 15 Westfield Group Securities each
with a total cost base of $14.13. Each security is made up as follows:
Element Cost base (initial)
WFA unit $13.12
WFT unit $1.00
WSF share $0.01
Total $14.13
You must apportion the capital proceeds you received for the stapled
security between the various assets in the stapled security and then work
out whether you have made a capital gain or loss from each asset. If you
acquired a particular asset on or after 20 September 1985, you will make a
capital gain on the disposal of that asset if the capital proceeds received
from the disposal exceed your cost base. You will make a capital loss if your
reduced cost base is greater than your capital proceeds.
Note: Some securities may have additional taxation provisions that applyupon disposal for example, traditional securities also attract the traditional
security provisions.
Any capital gain or capital loss made on the disposal of a security in a
stapled security acquired before 20 September 1985 will be disregarded.
Example
On 1 August 1983 Kelley purchased 100 shares in XYZ Ltd for $4.00 per
share. In August 2002, Kelley was allocated 100 units in XYZ Unit Trust
under a corporate reorganization of the XYZ Group. The units were acquired
for $1.00 each, with the funds to acquire the units coming from a capital
reduction made to her shares. At that same time, Kelley's shares in XYZ Ltd
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and units in XYZ Unit Trust were stapled and became known as XYZ stapled
securities.
Kelley disposed of all of her XYZ stapled securities on 1 March 2004 for
$8.00 per security. On the basis of the information provided by the issuer of
the stapled securities, Kelley determined that of this amount 70% or $5.60
per share ($8.00 x 70%) was attributable to the value of her XYZ Ltd shares
and 30% or $2.40 per unit ($8.00 x 30%) to the value of her units in the XYZ
Unit Trust.
Kelley must account for the sale of each of the elements (shares and units)
of the stapled securities separately. As Kelley acquired her XYZ Ltd shares
before 20 September 1985, any capital gain or capital loss she makes on
the disposal of these shares will be disregarded.
Kelley will make a capital gain of $1.40 per unit ($2.40 $1.00) on the
disposal of her units in the XYZ Unit Trust. As Kelley owned those units for
more than 12 months, she may choose to apply the CGT discount to further
You must apportion the capital proceeds you received for the stapled
security between the various assets in the stapled security and then work
out whether you have made a capital gain or loss from each asset. If you
acquired a particular asset on or after 20 September 1985, you will make a
capital gain on the disposal of that asset if the capital proceeds received
from the disposal exceed your cost base. You will make a capital loss if your
reduced cost base is greater than your capital proceeds.
Note: Some securities may have additional taxation provisions that apply
upon disposal for example, traditional securities also attract the traditional
security provisions.
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Any capital gain or capital loss made on the disposal of a security in a
stapled security acquired before 20 September 1985 will be disregarded.
Example
On 1 August 1983 Kelley purchased 100 shares in XYZ Ltd for $4.00 per
share. In August 2002, Kelley was allocated 100 units in XYZ Unit Trust
under a corporate reorganization of the XYZ Group. The units were acquired
for $1.00 each, with the funds to acquire the units coming from a capital
reduction made to her shares. At that same time, Kelley's shares in XYZ Ltd
and units in XYZ Unit Trust were stapled and became known as XYZ stapled
securities.
Kelley disposed of all of her XYZ stapled securities on 1 March 2004 for
$8.00 per security. On the basis of the information provided by the issuer of
the stapled securities, Kelley determined that of this amount 70% or $5.60
per share ($8.00 x 70%) was attributable to the value of her XYZ Ltd shares
and 30% or $2.40 per unit ($8.00 x 30%) to the value of her units in the XYZ
Unit Trust.
Kelley must account for the sale of each of the elements (shares
and units) of the stapled securities separately.
As Kelley acquired her XYZ Ltd shares before 20 September 1985, any
capital gain or capital loss she makes on the disposal of these shares will be
disregarded.
Kelley will make a capital gain of $1.40 per unit ($2.40 $1.00) on the
disposal of her units in the XYZ Unit Trust. As Kelley owned those units formore than 12 months, she may choose to apply the CGT discount to further
reduce her capital gain.
Scrip for scrip roll-over relief enables a shareholder to disregard a capital
gain they make from a share that is disposed of as part of a corporate
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Expiry date: Undated
Underlying assets: FTSE 100 (current index level 5000)
Conversion ratio: 1000:1 (1000 trackers per index unit)
Strike: 0
Exercise style: European
Tracker priced at: 500p
Figure 1: (Source: London exchange.com)
As can be seen from Fig 1, the tracker replicates the index without
leverage. In this case, should the FTSE 100 fall 500 points, the tracker will
lose 50p in value and should the FTSE 100 rise 500 points, the tracker will
gain 50p in value.
Although no dividend is paid out, any income streams are built into the
capital value of the tracker over its lifetime. However, as always, the precise
terms should be checked with the Issuer.
Below is a further example this time the underlying is the S&P 500 index.
Trackers are not limited to equity indices, and in fact can be issued on any
underlying asset; however this is a useful example because of the currency
risk.
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Bonus Tracker:
These instruments have slightly more complex structures comparable to
fixed-term life products or insurance bonds.
However, they are continuously priced throughout their lifetime and
investors do not face early redemption penalties. In addition, bonus trackers
can be issued as much shorter-dated instruments where required.
A bonus tracker is a combination product incorporating:
a zero strike Call (or standard tracker)
a barrier option (down-and-out Put)
The tracker simply replicates the performance of an underlying with no
leverage and will expire at the value of the instrument or index it is tracking.
A down-and-out Put is a type of option called a barrier option which ceases
to exist when the underlying asset reaches a predetermined level (in our
next example, 3000) and is therefore cheaper than a standard option.
Figure 2:
Bonus tracker
Issuer: ABC Bank
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Issue date: January 2005
Expiry date: January 2010
Bonus Level: 6000
Barrier level: 3000
Underlying asset: FTSE 100
Conversion ratio: 1000:1
Issue price: 450p
Above is an example of a FTSE 100 bonus tracker with a bonus level of 6000
(which translates to 600p due to the conversion ratio of 1000:1) and a
barrier level of 3000. This product is the combination of a zero strike Call (or
tracker) and a Put option with a strike of 6000 and a knock out level of 3000.
This means that should the FTSE 100 fall below 3000 at any point during the
five year life of this product, the Put component will knock-out leaving the
product as a simple tracker which will track the FTSE 100 index until expiry.
However, if the FTSE 100 doesnt fall below the barrier level of 3000, the Putoption will remain guaranteeing a minimum payout level of 6000 (i.e. 600p)
at expiry regardless of where the FTSE 100 index is at expiry (above the
barrier level of 3000).
At maturity
On expiry the FTSE 100 index closes at 4000 having never fallen below 3000
during the five year lifespan of the product. The zero strike Call (or tracker)
has a value of 400p while the Put has a value of 200p (strike price final
index level) giving a total return of 600p.
If, on the other hand, the FTSE 100 had fallen below 3000 at any point
during its lifetime, then the Put option would have knocked out and the
total return would simply be that of the zero strike Call (or plain tracker) of
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400p. Should the closing level of the FTSE 100 be above 6000 at expiry (e.g.
7050), the total return would be that of the zero strike Call (or tracker) of
705p. This is the case even if the barrier level has previously been hit.
Accelerated trackers
Accelerated trackers are growth orientated structured products.
These instruments give additional upside performance whilst maintaining a
1:1 relationship on the downside in return for surrendering income streams
related to the underlying asset.
Figure 3:
In the example above, the two dotted lines represent the pay-out profiles of
the plain tracker and at-the-money Call option which form the components.
The solid line represents the profit and loss profile of the accelerated
tracker.
At maturity
On expiry, the holder of the accelerated tracker has the right to:
1. If the final underlying asset price is greater than or equal to the
initial underlying asset price: Initial price + (initial price x [participation level
x change in underlying])
2. Otherwise: Initial price + (initial price x change in underlying)
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This means that should the index have risen 10% in value at maturity, then
the investor will receive a 21% profit. In this case, 121 in cash (100 + (100
x [210% x 10%])).
The investor does not have to worry about the currency risk associated with
the underlying asset being priced in Yen as this product is Quanto and
currency risk is hedged out on the investors behalf by the issuing bank.
Despite the accelerated upside, the investor faces no additional downside
risk (excluding foregoing any income). Should the index have fallen 10% at
maturity, the investor will realize a loss of -10%, in this case 9.
Reverse trackers
Reverse trackers are very similar to standard trackers but have an
inverse relationship with the underlying asset should the price of
the underlying asset fall, the price of the reverse tracker will rise.
These products can also be referred to as bear certificates.
Figure 4:
Figure 4 shows the inverse relationship the reverse tracker has with the
price of Lloyds TSB plc if the share price falls 10p, then the reverse tracker
price would rise 10p and vice versa.
Reverse tracker
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Issuer: ABC Bank
Issue date: February 2005
Expiry date: February 2010
Underlying Asset: Lloyds TSB plc (current Lloyds price 475p)
Conversion ratio: 1:1
Strike: 800p
Exercise style: European
Issue price: 325p
In effect, this is a Put option, but so deeply in-the-money as to have a linear
price relationship with the underlying. However, should the underlying asset
price increase dramatically towards the strike, the linear relationship will
break down and the instrument will increasingly take on the characteristics
of a standard Put option.
As with all trackers, no dividends are paid, but any income streams are built
into the capital value of the tracker over its lifetime check the pricing
supplement for details specific to each product.
Discount trackers
Discount trackers allow investors to buy into the performance of an
asset at a discount to the actual underlying price.
However, the potential gain is limited to a pre-defined level (the
cap level).
A discount tracker is a combination product incorporating:
a zero strike Call (or tracker)
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writing a Call option
The tracker simply replicates the performance of an index as described
above, with no leverage, and will simply expire at the value of the index or
underlying it is tracking.
This is akin to covered call writing where the options writing income
translates to a discount on the underlying asset. Selling the Call option
means that the investor benefits from the premium, hence the discount.
Upside is capped however, as any rise in value of the underlying asset above
the strike price is cancelled out by the liability created in selling the Call
option (Call option strike price = cap level).
Discount tracker
Issuer: ABC Bank
Issue date: February 2005
Expiry date: February 2006
Cap: 430p
Underlying asset: Marks & Spenser (M&S)
Conversion ratio: 1
Underlying price: 400p
Product price: 360p (10% discount)
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Figure 5:
In the example above, the two dotted lines represent the profit and loss
expiry profiles of the tracker and the short Call option. The solid line
represents the profit and loss profile of the discount tracker.
At maturity
Should the value of M&S increase by 25% to 500p, the discount tracker
would reach the cap limit of 430p (a 19.4% rise in value).
Should the value of M&S increase by 7% to 428p, the value of the discount
tracker will be 428p (an 18.9% rise in value).
Should the value of M&S fall by 20% to 320p, the value of the discount
tracker would also fall to 320p (but because of the discount purchase price,
this would represent only an 11.1% fall in value).
It can be seen from the above that additional downside protection is
purchased at the expense of limiting upside exposure above a certain level.
As with all trackers, no income is paid out but, according to the terms of
each product, is built into the capital value.
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Figure 6:
As can be seen from the above chart, the investor faces no downside risk
over the three year lifetime of the product but takes part in 100% of any
upside performance.
This achieved by purchasing a zero coupon bond and using the discount
from nominal value to invest in a call option. The zero coupon bond matures
at par, thereby guaranteeing the investors capital, whilst the call option
maintains the upside exposure required
At maturity
On expiry, the holder of the capital protected instrument has the right to:
1. If the final underlying asset price is greater than or equal to the initial
underlying asset price:
Initial price + (change in underlying / conversion ratio x participation)
2. Otherwise:
The higher of
a) Initial price / conversion ratio x protection level
b) Final price / conversion ratio
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In this case, regardless of whether the index falls to zero by the time the
product expires, the investor is guaranteed to receive the initial price of the
product when launched. So a fall of -100% equates to a 0% movement in
the product.
Should the index rise over four years, then the investor fully partakes in any
capital appreciation. A 15% rise in the FTSE100 will result in a 15%rise in
the value of the product. However, it should be remembered that the income
attributable to the underlying asset has been given up in order to achieve
this payout profile.