Exchange Traded Fund (ETF)- A new opening for investment

Presenter:M. Hasan Mahmud, Executive Director, Bangladesh Securities and

Exchange CommissionFor:

Chittagong Stock Exchange Ltd.Date: October, 08, 2015

A few words

• Within twenty-two years Exchange Traded Funds (ETFs) have emerged as one of the most popular investment vehicles for both institutional and individual investors throughout the world.

• In line with the global market practice, Bangladesh Securities and Exchange Commission (BSEC) has also come forward to introduce this new product in the Capital Market of Bangladesh.

• After demutualization of Stock Exchanges both the Stock exchanges also showed their keen interest to launch ETF as their first new product in the market.

Introduction to ETF

Part 1

Introduction to ETF

Contents of Part I

What is an ETFWho owns the assets of the ETFReturns from ETF and its investorsFormation of ETFEvolution of ETF Reasons behind ETF growthTypes of ETF

What is an ETF?

• An ETF can be described as a pooled investment vehicle with units that can be bought or sold throughout the trading day on a stock exchange at a market-determined price that is usually close to its net asset value.

• It offers the advantages of both mutual fund and stock.

A combination of Mutual fund and Stock

Mutual Fund Stock

On exchange intraday trading

Transparency (Trading flexibility)

Risk Control + Different Trading strategies = ETFDiversification ( Hedging,

Buying and holding, selling, etc.)No tenure or size limitation (open-ended fund)

Who owns the assets of the ETF?

• Similar to mutual funds, ETF owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and offers investors a proportionate share in a pool of stocks, bonds, and other assets.

• Shareholders do not directly own or have any direct claim to the underlying investments of the fund; rather they indirectly own these assets i.e., they have beneficial interest in the assets of ETF.

Returns from ETF and its investors

• What returns investors may expect from ETF?ETF unit holders are entitled to a proportion of the profit of the ETF and they may get a residual value in case the fund is liquidated. Of course they can make capital gain by selling the unit.

• Who invests in ETF?All types of investors, from individuals with relatively small accounts and simple strategies to sophisticated hedge funds managing billions.

Formation of ETF

• Structure of ETF: The ETF structure can be corporate type or investment trust type. The actual investment vehicle structure will vary by country, and within one country there can be multiple structures that co-exist. Since in Bangladesh we are already following the trust type structure for mutual fund therefore, trust structure for ETF may be suitable in Bangladesh.

Evolution of ETF • History of ETF:

- The innovations of both closed and open ended mutual fund structures were rooted in financial crisis. Similarly, the exchange-traded fund structure has its roots in the stock market crash of 1987. So, the ETF is not a very old concept of investment.

- The first real attempt at something like an ETF was the launch of Index Participation Shares for the S&P 500 in 1989. But the attempt was not successful since it required high level of minimum investment and it was sued by Chicago Mercantile Exchange.

- However, the idea of placing a fund on an exchange wasn't dead. In Canada, the Toronto Index Participation Shares tracking the Toronto Stock Exchange 35 (TSE 35) began trading on the Toronto Stock Exchange in 1990 and became very popular.

Evolution of ETF - On the heels of this product's success, the concept of an exchange-traded fund was re-energized in the US.- Over the next few years, the concept make its way through the regulatory channels and ended in 1993 with what many consider to be the first, modern representation of the exchange-traded fund in the US: Standard & Poor's Depositary Receipts (SPDRs) tracking the S&P 500 index. - In 1996, the first iShares ETFs to debut included a suite of international equity ETFs targeting Australia (EWA A-), Canada (EWC B-) etc.- In 1998 sector SPDRs were introduced, A lineup of products targeting the major sectors of the U.S. economy. The Sector SPDRs were pretty straightforward, splitting up the S&P 500 by sector.

Evolution of ETF - In 2002, bond ETF was introduced. Bond ETFs are tremendously popular exchange-traded products that track various bonds. - In 2004 Gold SPDR (GLD) was launched, the first commodity ETF to debut was (GLD A-), which offers exposure to physical gold bullion .- In 2006, Barclays launched the first two exchange-traded notes: two products offering exposure to commodity futures contracts.

- In 2009, Schwab, a brokerage firm debut Commission Free ETFs: four funds that could be traded commission free within Schwab accounts.

- In 2010 ETFs Assets hit US$1 trillion mark . As of June 30, 2015, the total net assets of ETFs were near to US$2.9 trillion with 5,466 numbers of total ETFs in comparison to approximately US$29 trillions net total assets of mutual funds.

Evolution of ETF• Global ETF scenario:

- The U.S. ETF market—with 1,411 funds and nearly $2.0 trillion in assets under management at year-end 2014—remained the largest in the world ( almost 73 percent of the ETF assets worldwide).- In comparison to the US; ETFs in many developing markets are still in the early years.- Growth rates in Asia Pacific are among the highest in the world (assets expected to continue expanding at 20-30% per annum).- Though the growth rate is high but the region is fragmented and there are significant local variations.- Japan is the largest and best established market, while Hong Kong continuous to be the region’s largest hub for offshore investment and Korea has an increasing innovative domestic ETF market where leveraged products are very popular.

Yearly growth of global ETF

Global ETF Market:

Global ETF size by region

Reasons behind ETF growth• Factors driving ETF growth:

The following factors are behind the accelerated world-wide growth of ETFs -

a. Large verity of indices of Equity, Fixed Income, Commodity and others are covered by ETFs.

b. Facilitation of investors’ education and training by large broking houses.

c. Special market campaigns by many on-line brokers in an effort to win new accounts.

d. Major fund platforms embracing ETFs.e. Regulatory changes in the US, Europe and many emerging markets

that allow funds to make larger allocations to ETFs.f. Development and growth of investment styles that employ products

like ETFs that delivers low cost investment opportunity.

Types of ETF

• Types of ETF: ETF can be of many types based on objectives of investment or operational procedures followed. Some major types are as follow:

1. Index Fund: Most ETFs are index funds that attempt to replicate the performance of a specific index. Indexes may be based on stocks, bonds, commodities, or currencies.

2. Stock ETF: A security that tracks a particular set of equities, similar to an index, such as large- cap, small-cap, growth,

value, etc. 3. Bond ETF: Exchange-traded funds that invest in bonds are

known as bond ETFs. 4. Commodity ETF: Invest in commodities, such as precious

metals, agricultural products, or hydrocarbons.

Types of ETF5. Currency ETF: Invests in a single currency or basket of

currencies. Currency ETFs aim to replicate movements in currency in the foreign exchange market by holding currencies either directly or through currency-denominated short-term debt instruments.

6. Actively Managed ETF: An exchange-traded fund that has a manager or team making decisions on the underlying portfolio allocation or otherwise not following a passive investment strategy.

7. Leveraged ETF: Leveraged exchange-traded funds (LETFs), are a special type of ETF that attempt to achieve returns that are more

sensitive to market movements than non-leveraged ETFs.8. Inverse ETF: Inverse ETFs are designed to seek daily

investment results that correspond to the inverse daily performance of their underlying index or benchmark.

Operational aspect of ETF

Part II

Operational aspect of ETF

Contents of Part IIParties of ETFMechanics of ETFBenefits of ETF for the InvestorsRisks of ETFWhat ahead

Parties of ETFThe following parties will be required for ETF:-

1. Stock Exchanges: To provide trading platform and act as index provider. 2. Asset Management Company (AMC): To manage the ETF in accordance with investment objectives and Trust Deed, track the designated benchmark index, initiate ETF through initial issuance of units, create and redeem units of the ETF. 3. Sponsor: To initiate the fund through contributing the initial subscription requirement (i.e. minimum 10% of the target size of the fund). Sponsor enters contract with trustee (trust deed) and also appoints custodian and AMC of the Fund. 4. Trustee: To look after the funds property and ensure that AMC acts in accordance with the investment objectives, Trust deed, prospectus and securities laws.

Parties of ETF

5. Custodian: To be appointed by Sponsors to hold underlying securities and provide Depository Participant services for creation and redemption. 6. CDBL: To provide platform for settlement, delivery and transfer of securities through computerized book entry system. 7. Stock Broker: Stock broker(s) designated by AMC will facilitate off-loading of ETF units in the secondary market. All stock brokers will participate in buying and selling of ETF units on behalf of investors. 8. Authorized Participants (AP): Also known as Market Makers, any Stock Broker appointed by the Asset Manager shall work as like selling agent and also play the role of Market Makers.

Mechanics of ETF

• How ETF works:- An ETF originates with a sponsor that chooses the investment objective of the ETF.- In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index.

- Then sponsors appoints the Trustee, AMC, and Custodian of the ETF. The AMC perform the formalities to lunch the ETF.

Mechanics of ETF• Retail investors are not allowed to buy/redeem units directly

with the fund rather at Exchange.

• Authorized participants are only permitted to purchase and redeem units directly with fund.

• Creation and redemption process directly with the fund at Net Asset Value (NAV) is called “Primary Market Operation”

• Trading at the Exchange for buy and sell of units both for retail investors and Authorized Participants is called ‘Secondary Market Operation”

Mechanics of ETF• Each ETF must calculate daily NAV and Intraday Indicative

Value (IIV).• Trading Prices at Premiums and Discounts of NAV creates

“arbitrage opportunities” for Market Makers.• For different reason(s) a gap between ETF performance and

concerned index performance may exist which is known as tracking error.

• Trading Prices at Premiums and Discounts of NAV creates “arbitrage opportunities” for Market Makers.

• “Arbitrage Opportunities” in ETF keeps the trading prices of ETF close to NAV.

Benefits of ETF for the Investors

• Benefits ETF offer to investors:It appears that there are many benefits that an ETF can offer to its investors. Some of them are as follows-a. Buying and selling flexibility-- ETFs are priced and can be purchased and sold throughout the trading day just like ordinary shares with real time trading i.e., investment value can be realized in real time which is not possible for open ended mutual fund because it is traded only at the end of the day at the NAV disclosed by the Asset Management Company. It is better than close end mutual fund because close end mutual fund’s NAV may not reflect actual underlying assets whereas ETF’s NAV reflects actual underlying assets because of arbitrage possibility.

Benefits of ETF for the Investors

b. Portfolio diversification-- ETPs can track a wide variety of sector-specific, country-specific, and broad-market indexes. They may provide diversification to an investor’s overall portfolio with lowest cost, because one unit may represent multiple underlying stocks, bonds, and/or other asset classes.

c. Minimum trading unit--Minimum trading lot is just one unit. Can be bought with margin and one can place limit order.d. Expense ratios -- In general, underlying fees and expenses are less than mutual funds. It has been observed that when the average management fees for mutual funds are within the range of 3-4% of annual average weekly NAV of the funds, the same is within the range of 0.25 to 0.35% for index based ETFs.

Benefits of ETF for the Investors

e. Tax efficiency-–Investors have been attracted to ETFs because they have lower portfolio turnover than actively managed funds and fewer realizations of capital gains. Because these transactions are in-kind, the ETF does not incur any tax regarding there transactions. As a result, many ETF investors do not incur capital gains taxes until they sell their ETF Units. f. Transparency -- The holdings of securities in most ETF portfolios are made public every day. Investors may be able to determine the positions within the portfolio at any time. Moreover, the price at which an ETF trades in the secondary market is a close approximation to the market value of the underlying securities held in its portfolio.

Benefits of ETF for the Investors

g. Ease in transfer to BO account -- Can be easily delivered to one’s demat account.

h. Rising popularity of passive investments -- Investor demand for index-oriented products, has been strong for the past several years. From a survey it has been found that during January 2007 to June 2014, index domestic equity mutual funds and ETFs received $855 billion in cumulative net new cash and reinvested dividends, while actively managed domestic equity mutual funds experienced an outflow of $595 billion over the same period.

Risk factors of ETF

• Major risks associated with ETFs: a. Market risk: ETFs are typically designed to track the performance of certain indices, market sectors, or groups of assets such as stocks, bonds, or commodities. ETF managers may use different strategies to achieve this goal, but in general they do not have the discretion to take defensive positions in declining markets. b. Tracking errors: Tracking errors refer to the disparity in performance between an ETF and its underlying index/assets. Tracking errors can arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index/assets, and the ETF manager’s replication strategy. Tracking error upto certain level is permissible; if it surpasses the level then it is a matter of concern for the fund because in that case it cannot ideally replicate the relevant index. c. Liquidity risk: Market makers provide liquidity to facilitate trading in ETFs. Although most ETFs are supported by one or more market makers, there is no assurance that active trading will be maintained. In the event that the market makers default or cease to fulfill their role, investors may not be able to buy or sell the product.

What ahead?

• The inherent features and structure of ETF may simply attract every level of investors to invest in ETF. BSEC is planning to introduce at least one ETF in each of the exchanges by June 2016.

• Asian Development Bank (ADB) is also suggesting the Commission under the Capital Market Development Programme -III to introduce at least one ETF by 2016.

What ahead ?

• In this regard Commission formed a three member Core Committee. Two separate sub-committees are also formed with the representation of the different stakeholders like exchange, depository, asset manager, custodian, Trustee, Stock Broker, merchant banks and other intermediaries to assist the Core Committee.

• Already the Core Committee has prepared the Interim report on ETF with a good support of all the stakeholders. Presently, the Core Committee is also working to formulate the necessary rules and guidelines for introducing ETF in Bangladesh.

Thank you