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An Investor’s Guide to Indices

Chapter 3

Index Access Via Products

INDEX-LINKED INVESTMENT PRODUCTS MAKE PASSIVE INVESTING POSSIBLE.

INDEX-LINKED INVESTMENT PRODUCTS COME IN MANY SHAPES AND FORMS, INCLUDING:

  • ETFs and Index Mutual Funds
  • ETNs
  • Index-Linked Options and Futures
  • Structured Products
  • Insurance Products

THE BIRTH OF INDEX-LINKED PRODUCTS

THE INVESTMENT WORLD CHANGED FOREVER ON AUGUST 31, 1976.

Chances are this date doesn’t ring a bell. But if you own an index mutual fund, an exchange traded fund (ETF), or any other index-linked investment, you’ve certainly felt the impact. August 31, 1976, was the day the first index mutual fund—the Vanguard S&P 500®—came to market and changed the future of investing.

Before the Vanguard S&P 500 index fund launched, major indices like the S&P 500 or the Dow Jones Industrial Average® were market benchmarks that could be used as tools for measuring the performance of active portfolio managers, but not as the basis for actionable investment decisions.

Today, retail banks, insurance companies, ETF providers, and options and futures exchanges develop and market tens of thousands of index-linked products to satisfy an ever-growing demand for access to the returns of equity, fixed income, commodity, and other types of indices. The products that are available differ not only by issuer, but also in their investment objectives, structure, and the access they provide to index returns.

ETFS AND INDEX MUTUAL FUNDS

ETFS AND INDEX MUTUAL FUNDS ARE PRACTICALLY SYNONYMOUS WITH INDEX INVESTING.

These products are widely available, easy to buy and sell (liquid), and designed to meet a variety of investment goals. The funds’ issuers, sometimes referred to as sponsors, are financial services companies. Some of these firms concentrate on either ETFs or mutual funds, while others offer both types of products.

While index mutual funds have been on the market almost twice as long as ETFs, there are now almost twice as many ETFs as index funds—with more than half linked to an index from S&P Dow Jones Indices. The rapid expansion of ETFs that began in the U.S. now extends around the world.

Growth of ETFs Globally

Source: ETFGI

Going beyond broad market exposures, ETFs are now used to access markets and strategies that might otherwise be available only through active management. For example, it’s possible to invest in ETFs on indices that seek to limit risk, track high-dividend-paying stocks, or even measure market volatility.

HOW ETFS AND INDEX MUTUAL FUNDS WORK

Each ETF and index mutual fund has a specific investment objective. To achieve that objective, the fund typically builds its index-based portfolio in one of three ways:

Most ETFs and index mutual funds use this approach. Typically these investment products are also weighted in a manner that is consistent with the index weighting.

This might be for strategic reasons or because it’s not feasible to purchase all of the components in the index. For example, indices that track thousands of securities, or those that hold some less liquid components may be difficult to replicate. Whatever the reason, the performance of a fund that uses the sampling method may differ from the index performance more than it would with full replication.

While this approach provides the same return as the index, it exposes fund holders to the risk that the counterparty may default on its obligation. Clearing the SWAP through a clearing house tends to mitigate the counterparty risk.

ETFs and index mutual funds resemble each other in some basic ways:

  • Investors in both ETFs and index mutual funds own shares in a fund, not the individual securities in the fund’s portfolio.
  • ETFs and index mutual funds typically pass through income from their underlying investments, after expenses and any capital gains from updating their portfolios, to fund shareholders on a proportional basis.
  • The intent of each ETF or index mutual fund is typically to replicate the performance of the index it tracks. For example, if the annual return on an underlying index is 10%, the objective of an ETF or mutual fund following the index is, with a few exceptions, to match that 10% return as closely as possible. Of course, if the index loses value, the ETF or index fund’s return reflects that loss directly as well.

Actual results vary among equity products linked to the same index. In the case of index mutual funds, the primary reason for the variation is the fee structure, with higher costs translating directly into a lower return. Returns may also diverge if a fund uses a sampling of index components rather than full replication to create its portfolio, or if the fund’s cash reserve, which it maintains to cover share redemptions, acts as a drag on results.

With an ETF, differences in return, or what is known as tracking error, can result from its fees and from the way the product is structured. Among the most important structural factors that may affect return are:

  • Whether dividends are reinvested
  • Whether there’s a brokerage commission for reinvesting dividends
  • Whether the ETF uses derivatives, leverage, or other strategies to enhance return or hedge against losses

HOW ETFS AND INDEX MUTUAL FUNDS DIFFER

The most significant differences between ETFs and index mutual funds—in addition to the greater variety and larger market share of ETFs—are the ways they can be traded and their tax efficiency.

Because ETFs trade like stocks, they can be bought on margin or sold short, even on a downtick. Short selling is widely used in hedging and other risk management strategies. For example, if an investor thinks a particular stock is promising but is part of a lagging sector, he might buy the stock but short an ETF tracking an index of the sector. Since index mutual funds do not trade like stocks, this kind of strategy would be more difficult to execute if they were used.

Tax efficiency is another differentiator. ETFs do not redeem shares that investors wish to sell as mutual funds typically do. This means that an ETF does not generally liquidate holdings to cover redemptions, as index mutual funds may have to do. Forced liquidations have the potential to create capital gains, some of which may be short-term gains that could increase the tax liability of the mutual fund shareholders.

ETFs vs. Mutual Funds

ETFs INDEX MUTUAL FUNDS VS Replicate performance of an index OBJECTIVE Replicate performance of an index Typically highly diversified DIVERSIFICATION Typcially highly diversified Throughout trading day, at current market prices TRADING FREQUENCY Once per day, at the closing net asset value Can be bought on margin or sold short TRADING FEATURES Cannot be bought on margin or sold short Low EXPENSE RATIOS Low Purchase through brokerage account AVAILABILITY Purchase from a fund company or through a retirement plan

Further, although both ETFs and index mutual funds tend to have low turnover rates, typically updating their portfolios when the components of their underlying indices change, an ETF may deliver greater tax efficiency. This is because of the unique process by which ETF shares are typically created and redeemed in regularly recurring tax-free exchanges between the ETF sponsor and a number of authorized participants, generally major financial institutions.

Specifically, an authorized participant delivers a basket of the ETF’s underlying securities to the sponsor in exchange for a number of shares, typically 50,000, and can redeem that number of shares to receive the basket of securities in return. For every instance of redemption, the ETF sponsor chooses to return, from among the securities it holds, those with the lowest cost basis. This means that when the ETF’s portfolio is updated, the securities that are sold have a higher average cost basis than they otherwise might have. As a result, the ETF may be able to pass on lower capital gains to its shareholders than the index mutual fund can.

A key difference between mutual funds and ETFs is that mutual fund shares are traded just once a day, at the closing net asset value (NAV), which is determined by the total market capitalization of its index-derived portfolio, minus fees and expenses, divided by the number of outstanding shares. ETF shares, on the other hand, trade throughout the day at current market prices. This may make them more versatile for meeting a variety of investment objectives, but it does mean that the market price can be at a premium or discount to NAV. In reality, though, the market prices of many ETFs, especially those that are most widely traded, tend to be extremely close to their NAVs.

PUTTING ETFS TO WORK

Who uses ETFs? Retail and institutional investors, including asset managers, pension funds, endowments, and fiduciaries, among others, either include ETFs in their holdings or construct entire portfolios with these products. One reason is that ETFs—or, more precisely, specific products within the ETF universe—represent various investment strategies from conservative to aggressively contrarian.

Some ETFs may be purchased for their diversification. Even less-diversified ETFs, such as a narrowly focused sector fund, may provide exposure to the performance of multiple companies, which theoretically carries less risk than owning just one or two of the companies in the index. Typically low expense ratios also make ETFs attractive.

In addition, both retail and institutional investors who adopt a core-satellite strategy may supplement a portfolio with tactical allocations to sector or strategy ETFs based on what’s happening in the marketplace or the economy as a whole. The core portfolio may itself be built entirely of ETFs or with a combination of individual securities and ETFs.

At the opposite end of the spectrum, active traders use ETFs for the arbitrage opportunities they may provide when NAVs and market prices diverge. So do hedge funds and other firms, which may have no interest in holding the underlying assets but have serious interest in realizing profits.

TOTAL ETF AUM (USD MILLION)
$2,794,703
ETF/ETP AUM as of September 2015. Source: ETFGI.

ETFs may be used as tools in other ways as well. For example, they may be useful for investors wishing to comply with the wash-sale rule when taking capital losses on an individual stock, since an ETF that holds the stock is not considered a “substantially identical” investment. Further, ETFs can be used in a number of hedging strategies, either to protect unrealized portfolio gains or to limit further losses.

Despite these advantages, many more retail investors own mutual funds than own ETFs. One reason has been that most ETFs must be traded through a brokerage window, something that only a limited number of employer-sponsored retirement plans offer. Since ETF prices change throughout the day rather than being set once a day, the difficulty of determining valuation is also cited as a factor. Another reason often cited is the fact that you can’t buy fractional shares in an ETF, which complicates allocation of employee deferrals to a plan. At least some of these issues may be resolved though, as some plan sponsors have introduced suites of commission-free ETFs.

* For more information on ETFs and risks associated with ETFs, please see http://www.investopedia.com/articles/investing/050316/what-all-investors-should-know-about-etfs.asp

ETNS

EXCHANGE TRADED NOTES (ETNs), WHICH ARE ISSUED BY INVESTMENT AND COMMERCIAL BANKS, RESEMBLE ETFS IN A NUMBER OF WAYS.

Both are index-linked products, and both trade on an exchange at their current market prices. Like ETFs, ETNs offer access to a variety of markets that might otherwise be accessible only through active management. Like ETFs, ETNs are often linked to broad and narrow stock market indices, strategy indices, and commodity indices, including the S&P VIX Futures Indices.

However, ETNs and ETFs do differ in significant ways. Unlike ETFs, which are equity products, ETNs are unsecured debt securities. As a result, ETNs may expose investors to credit risk, market risk, and sometimes call or early redemption risk. Some ETNs are collateralized, which means that note holders may recover a percentage of their principal in case of default, though the terms of the arrangement may also limit return potential. Many ETNs, however, do not offer principal protection.

Further, ETNs don’t own the investments included in the underlying indices as ETFs do. Instead of seeking to replicate index return, most ETN issuers offer a payment at maturity that’s linked to the performance of the underlying index during the term, minus fees and other expenses. The precise method for calculating the return is detailed in the offering document. Maturity may be 10 to 40 years from the date of issue. As with zero-coupon bonds, the issuers don’t typically pay interest during the note’s term.

Since an ETN has no assets, it has no net asset value (NAV). Instead, the issuer calculates and publishes an indicative value throughout the trading day. Like an ETF’s NAV, the indicative value may or may not be close to the current market price.

ETNs tend to be easier to bring to market than ETFs for regulatory reasons, so in some cases an ETN tracking a particular index may be available before an ETF tracking that index. And ETNs tend to be popular with investors who seek a potentially higher return than may be available with conventional debt securities, as well as with investors who want to add some equity exposure to a debt portfolio.

INDEX-LINKED OPTIONS AND FUTURES

OPTIONS EXCHANGES AND FUTURES EXCHANGES OFFER CONTRACTS ON MARKET INDICES, SUCH AS S&P 500 INDEX OPTIONS AND S&P 500 FUTURES.

Options exchanges and futures exchanges offer contracts on market indices, such as S&P 500 Index Options and S&P 500 Futures. While these derivative products differ in some important ways, they are similar in allowing investors—both retail and institutional—to hedge or to speculate on the level of the underlying index on the date when the contract expires, which is specified in the contract.

Options investors may buy or sell a contract at a specific price, called the strike or exercise price, which is above or below the current index level. Buyers, called holders, choose between a call option and a put option, based on the direction they expect the index to move.

Buying a contract gives the investor the right to exercise at expiration, if the index has moved to the expected level, and collect a cash settlement. A buyer also has the right to sell a contract before expiration if that move would provide a profit. However, a buyer is under no obligation to act.

Options sellers, called writers, also choose between a call and a put, and they collect a premium for selling. Sellers can offset the contract at any point before expiration by purchasing the same contract they sold. However, if the contract isn’t offset and the option holder decides to exercise, the seller is required to make the cash settlement that is due the holder.

Futures investors also buy or sell a contract on a particular index by opening a position. However, both parties are required to follow through on the terms of the contract at expiration unless it has been closed, or offset, with an opposing position, as most are.

Futures also differ from options in their potential cost. Instead of paying or receiving a one-time premium, futures investors make an initial margin payment, and the value of their accounts is updated daily either with a credit or a loss, based on the changing level of the index. If the account value falls below the maintenance margin, the investor must add to the account to bring it back to the required level.

Investors may buy or sell options or futures contracts based on how they expect the market to behave. For example, if options investors think the index will fall, they might hedge to protect unrealized gains by purchasing put options. If the market does fall, they can exercise the option and collect the settlement price.

Likewise, futures investors might hedge to protect an existing position or to help manage the price of a future stock purchase. In the latter case, the investor would buy a contract on the relevant index. If the index goes up, the cost of the stock purchase will be offset by the gain on the contract. Conversely, if the index goes down, the contract loss will be offset by the lower cost of buying the stocks.

As is the case with other index-linked products, options and futures contracts are seen as a means to make a portfolio more diversified.

STRUCTURED PRODUCTS

A STRUCTURED PRODUCT COMBINES TWO ASSET CLASSES, SUCH AS A SHORT-TERM NOTE AND AN INDEX, TO CREATE A HYBRID THAT LINKS THE INTEREST THE NOTE EARNS TO THE RETURN OF THE INDEX.

Interest is paid only at maturity, subject to the terms of the specific product—and the terms typically vary substantially from product to product. Commercial and investment banks issue a variety of index-linked structured products.

Despite their link to an equity index, structured products are typically unsecured debt obligations of the issuer, and therefore subject to credit risk. One exception is an index-linked CD, which, as a bank deposit, can be FDIC-insured. Structured products are not always listed on an exchange, and if they are, they may be thinly traded, so typically there’s no readily available secondary market or an accurate way to determine their value.

Structured products may be fairly conservative as well as highly speculative and extremely complex. At one end of the scale, there are structured products that offer principal protection and income generation, though limited return. At the other end, some of the products offer the potential for greater return but at the risk of being exposed to significant leverage.

This variety makes structured products potential diversification tools for high-net-worth investors and asset managers. Structured products are also seen as tools for enhancing returns.

INSURANCE PRODUCTS

INSURANCE COMPANIES OFFER TWO TYPES OF INDEX-LINKED PRODUCTS: FIXED INDEX ANNUITIES AND INDEX-LINKED UNIVERSAL LIFE INSURANCE POLICIES.

These products are intended for people interested in earning a potentially higher rate of return than the current market interest rate, often as a way to enhance retirement savings. The return for which the policyholders are eligible, the way the return is calculated, and how it will be credited are specified in the insurance contract.

The insurance issuer typically promises that if the underlying index’s value rises, it will credit a portion of the index return as an interest payment to the policyholder’s account. However, the interest that’s credited may not be the actual index return. Each policy typically has both a participation rate and a maximum crediting rate, described as a cap. A participation rate is the percentage of index gain that will be counted toward calculating the interest payment. Each insurer sets its own rate, which may range upward from 60% of the index return. The insurer also sets the maximum percentage that will be credited in any one year, often 10% to 14%. Both of these rates can be modified over the life of the policy.

To illustrate how an index-linked product works, assume that a hypothetical policy has a participation rate of 80% and cap of 12%. A year in which the underlying index gained 20%, the participation rate of 80% would result in a return of 16%. However, because of the cap, it would actually be 12%. Some insurers also subtract a margin or asset-based fee, called a spread, from the return before applying the participation rate and cap.

Some index-linked products may offer downside protection by guaranteeing that the least interest a policy or annuity will earn in any year is 0%. This means the principal would not be eroded in years when the index loses value. Some issuers may guarantee a minimum return—say 2%—to be paid from earnings on its fixed income investments if the return on the index would provide less.

To meet its commitment to pay index-linked interest, the insurer typically purchases rolling call options on the underlying index, which it can exercise or sell at a profit if the index exceeds the strike price before expiration.

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    • It enters into a SWAP agreement with one or more counterparties
    • It buys all of the securities in an index
    • It purchases a representative sampling of the components of an index
    • It buys securities it believes will outperform the index
    • They trade throughout the trading day
    • They can be shorted
    • They can be purchased through a broker or from a fund company
    • They can track portfolios of stocks but not bonds
    • Futures
    • ETFs
    • Structured products
    • Annuities
    • The product’s issuer
    • The product’s investment objective
    • The product’s structure
    • All of the above
    • The difference between the performance of an index-based portfolio and the index
    • Differences in the performance of index funds due to portfolio manager error
    • The sum of accumulated rounding errors in index performance calculations
    • None of the above
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