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Implementing Investment Decisions with Exchange Traded Products

Netherlands CFA conference

21st November 2012

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Introduction Why is exchange traded product implementation important? Main methods of implementation Case Studies Optimisation Techniques

Table of Contents

Introduction

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Kris Walesby, Head of Capital Markets for ETF Securities□ Responsible for Sell-Side relationships

Implementation, why it’s important and why it will grow in importance□ Why implementation is important

□ Main methods for implementation

□ Case Studies

□ Optimisation Techniques

□ Questions and Answers

Introduction and overview

Why is ETP implementation so important?

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Grumeti river Not possible to avoid

□ To get to the fertile plains

□ And to get back

The Great African Migration

Annual Event – Tanzania to Kenya 1,800 miles 1.5 m Wildebeest, 300k Zebra

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Asset allocation decision

Investment Decision Lifecycle

Product selection

Implementation

Initial Rebalance Exit

Total Cost Of Ownership

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Investors naturally focus on headline fees - TERs However there are other considerations, including

Rebalancing costs

Swap fee

Licensing fee

Implementation costs

Implementation costs are becoming increasingly recognised by European ETP investors as one of the most important aspects to focus on

Don’t Just Look At The Headline Fee

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Implementation is always important

However time horizons dictate the relative importance of implementation to the portfolio manager

The Importance of Time Horizons

Time Horizon Strategy Relative importance of implementation

Long Term Buy and Hold Low

Medium Term Regular rebalancing Medium

Short Term Tactical/Opportunistic High

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Example European ETPs – One Year Time Horizon

Provider 1

Provider 2

Provider 3

Provider 4

0 10 20 30 40 50

23

7

18

12

29

39

25

29

Total Cost (Bid-Offer Spred + 1 Year Total Expense Ratio)

Bid-Offer Spread 1 Yr TER

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Example European ETPs – One Month Time Horizon

Provider 1

Provider 2

Provider 3

Provider 4

0 5 10 15 20 25

23

18

12

7

2

2

2

3

Total Cost (Bid-Offer Spred + 1 Month Total Expense Ratio)

Bid-Offer Spread 1mth TER

Main Implementation Methods

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Main Methods for Implementation

On Exchange OTCRisk Risk @NAV

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ETPs are priced with reference to their underlyingHowever there are other elements to consider too

What does this mean in practice? Four main elements to an ETP price: Underlying spread Level of risk Creation/Redemption costs Existing Inventory – This acts as a price reducer

Mid Price: - $25.00

Bid Price : - $24.50

Offer Price: - $25.50

Underlying spread

Risk spread

Creation spread

Existinginventory

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Main Methods for Implementation: On Exchange

Advantages

Anonymous

Centrally cleared

Usually cheap

Usually multiple counterparties

Disadvantages

Orderbooks can be shallow

No direct recourse to market maker

On Exchange OTC

Risk Risk @NAV

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Main Methods for Implementation: OTC @ Risk

On Exchange OTCRisk Risk @NAV

Advantages

Large blocks at one price

Direct recourse to market maker

Disadvantages

Counterparty risk

Credit Lines need to be in place

Not anonymous

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Advantages

No market risk

Paid commissions for little work

Achieve NAV

Lower cost than a risk trade (usually)

Disadvantages

No opportunity to price at risk

Negative intraday price move

No possibility to “get inside spread of underlying”

Market Maker

Client

On Exchange OTC

Risk Risk @NAV

Main Methods for Implementation: OTC @ NAV

Optimising Portfolio Implemetation

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Use limit orders where possible Don’t judge the potential liquidity by looking at historical volumes Check the trading times of the underlying Don’t compare closing price to NAV iNAVs are often useful but not always

Capital Markets teams:- a critical aid to optimising implementation

Suggestions for Optimising Portfolio Implementation

Case Studies: Trading On Exchange

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Market makers compete with each other to provide the lowest price for an investor to buy at (Ask) and the highest price to sell at (Bid)

Within these prices the market makers have already included: The spread of the underlying Risk that they may be wrong Existing inventory Implied cost of creating and redeeming In this case the “top of the order book” is a spread of 15 basis points or 0.15% = (53.67 –

53.59)/53.59 * 10,000

Trading ETPs on ExchangeExample: State Street Euro Corporate Bond (SYBC GY Equity)

Case Studies: Trading @ NAV

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Client Disadvantages – Further explanationNegative intraday price move

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Appendix

How does one assess the liquidity of an ETP?

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ETPs. They trade like stocks.....

On exchange Europe:- approximately 7:50 am- 4:45 pm

(UK Time:- includes auctions)

Intraday pricing via bid and offer prices

Order book size illustrates market makers buy/sell interest

OTC Market Makers will offer two way prices

Normally (but not necessarily) larger size order

Normally (but not necessarily) higher commissions

ETF Securities Physical Gold (PHAU LN) and Barclays (BARC LN) have the same trading mechanics

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…but their liquidity has different drivers

Traditional Securities Have a limited amount of free float shares available

Liquidity is driven by demand/supply

Historical volumes and trading patterns are used to predict future trading patterns

Exchange Traded Products Price and liquidity are dictated by the underlying securities not the ETP

Extremely limited “supply/demand” effect as the funds are open ended

Historical volume is only useful to show popularity not tradability

Techniques like VWAP are irrelevant

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Primary & Secondary Market - Interconnected

Investors trade via the exchanges (Secondary) or OTC directly with a market maker.

The market maker will execute the order using existing inventory, via the exchanges or by creating/ redeeming units on the primary market.

The decision on this will be based on the balance between what is cheapest and what bears least risk for the market maker.

Primary Market Secondary MarketMarket Makers

ExistingInventory

Investors

ETP

1

2

3

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Underlying Liquidity

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ETP LiquidityLook at the underlying

ETFS WheatTicker:- WEAT LNAverage Daily Volume:- $1.54m

CBOT FutureTicker:- W A ComdtyAverage Daily Volume:- $1,126m

Explanation ETFS Wheat trades $1.54m per day on average However, the relevant measure of how much trading can

be done is the underlying contract This trades over $2b per day on average - Ratio:-

ETC/Future = 0.14% Many times over $1.7m ADV could be traded through the

ETC with minimal impact Taking a conservative estimate of 10% of the average

underlying trading, this means that $113m can be traded on the ETC without any significant price impact

UBS and BAML have committed to $250m each of liquidity per day for the products they back

ADV ($mn) Code ExchangeADV Month

Max DV Month

Min DV Prev Month

Wheat W CBOT 1,125.7 3,911.7 4.2

1st Month Futures**

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Arbitrageurs keep the price close to fair value

Trader sees the ETP trading at $25.70 vs the underlying at $25.50. She: Buys underlying units at $25.50 Sells ETP units at $25.70 Creates ETP units in exchange for the underlyings i.e. at $25.50 Risk free profit $0.20 per unit

Fund: ETF Securities Example ETP

Mid Price: $25.00 Underlying Offer: $25.50 ETP Bid: $25.70

Underlying

ETP

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Important Information

Important Information

General

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