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Chapter 15

Chapter 15. HW 5 will be posted this thursday. ETFs vs. Index funds Index tracking Model Hedging strategy for a portfolio using a put option. Index Investing Index Funds Vs ETFs. Index Funds : Open-End Mutual Funds that track an index (Vanguard S&P500 Index Funds, 1976)

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Chapter 15

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  1. Chapter 15 • HW 5 will be posted this thursday. • ETFs vs. Index funds • Index tracking Model • Hedging strategy for a portfolio using a put option

  2. Index InvestingIndex Funds Vs ETFs • Index Funds : Open-End Mutual Funds that track an index (Vanguard S&P500 Index Funds, 1976) • ETFs (exchange traded funds): Closed end Funds whose traded shares track an index. SPDR – SP500 (SPY 93); VIPER; iSHARES; QQQQ

  3. The ABCs of ETFs • "E" is for exchange. ETFs are listed like any stock, with a ticker symbol. Also, options are available on about half of listed ETFs. • "T" is for traded. ETFs are bought and sold throughout a trading day, whereas mutual funds are priced once daily at the market close. • "F" is for fund -- in this case an index fund. ETFs track segments of the U.S. and global securities markets by following benchmarks like the S&P 500 (SPX: news, chart, profile), the Dow Jones Industrial Average (DJI: news, chart, profile), and the Lehman Aggregate Bond Index. If you want exposure to health-care, mid-cap value, or Brazilian stocks, there is an ETF to accommodate your needs.

  4. Rapid Growth • Back in 1993, there was just one -- SPDRs(AMEX: SPY). By 2001, there were roughly 90 ETFs available, with approximately $83 billion in assets. • In September 2006, there were 290 ETFs with $350 billion in combined assets. And things are not slowing down. Since March 2009, WSJ reports that investors pumped $57 billion into EFT holding US stocks, while withdrew $66 billion from the mutual funds. • Now $1 trillion invested in 700 – 1000 ETFs.

  5. New Trends • Originally modeled after index funds, ETFs have gradually narrowed to target specialized slices of the market. • It also concentrates the risks of specialization, tilting a portfolio away from the diversification that makes index investing attractive.

  6. A basket of opinions • Although ETFs have been around since the 1990s, investors should exercise caution with any ETF lacking a long track record. • A few of these don't have a one-year performance record, let alone a three-year record -- arguably an important milestone -- so only time will tell whether they can build solid track record over longer time periods

  7. Merits of ETFs I • ETFs are continuously priced throughout the trading day, whereas mutual fund sales take place at the end of the day price. • In theory, ETFs should be able to more closely track an index than a mutual fund. Index fund managers are confronted with the need to provide liquidity to buyers and sellers of their fund's shares, which requires them to hold a percentage of their assets in cash.

  8. Merits of ETFs II • Because ETFs trade like a stock, an investor can employ a wider range of trading techniques with them, such as stop loss and limit orders, and short sales. • Increasingly, futures and options are becoming available on the more liquid ETFs, which creates more potential trading strategies.

  9. Merits of ETFs III • The operating expenses on many ETFs tend to be lower than on index mutual funds which track the same index, because ETFs don't provide the same level of service to their owners that mutual fund owners receive (e.g., telephone service centers, free fund transfers, check writing privileges, etc.).

  10. Merits of Index Funds I • Operating expenses are only part of the story. When you buy an ETF, you also pay a brokerage commission, which you usually avoid when you buy an index mutual fund (which rarely carry front end sales loads). • For people who dollar cost average -- investing an amount of money each month into the index fund or funds they own, the ability to avoid trading commissions makes mutual funds a much better deal over time.

  11. Merits of Index funds II • If you are a long term, buy and hold investor, the ability to trade ETFs throughout the day, and to employ a wide range of trading strategies really isn't very useful. • Mutual fund companies provide a range of services that many discount brokerages do not (this assumes that, in order to minimize sales commissions, people buy ETFs through discount rather than full service stockbrokers). • In practice, many ETFs have had larger tracking errors than comparable mutual funds.

  12. Index Tracking Model • To construct an index fund with a subset of the index assets. For example, can we construct a SP500 index fund with 100 stocks? • Benefits: less transaction costs; more focus on smaller numbers of stocks. • Goal: construct a fund behaving similar to an index with better performance (See an example on the Web)

  13. Index tracking Model • RI = b1*S1 + b2*S2 + . . . + Bn*Sn + E Where RI is an Index return; Bn is investment weight Sn is a stock E is error or residual.

  14. Solution (Solver) • Min Var (E) • Choosing (changing) b1 ….. bn • Constraints • Sum of b1 thru bn is one. • and others

  15. Compared to Sharpe’s Style Model • Ri = bi1F1 + bi2F2 + ….+ binFn+ ei, • Ri ? F = ? b ? ei? • Target Cell? • Constraints?

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