An Introduction to

Exchange Traded Funds

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 Contents

I. An Overview of ETFs
§ What are ETFs
§ How do ETFs work
§ How are ETFs traded (Creation/Redemption)
§ How are ETFs used
§ ETFs, ETPs, ETNs, ETCs
II.ETFs in the GCC
§ Recent developments
§ Practical considerations in developing and offering an
ETF
§ Case Study of Dubai Gold Securities
 What is an Exchange Traded Fund
(ETF)?
§ Often used to describe a variety of exchange traded products that are not
strictly ETFs
§ Investment vehicle – generally structured like a mutual fund (i.e., open-
ended) - that offers public investors an undivided interest in a pool of
securities or other assets
§ Generally has investment objective of seeking to replicate the returns of a
specific securities index, and therefore operates much like traditional
index fund
§ Similar in many ways to traditional mutual funds except that shares in an
ETF, like a stock, are:
– Listed and traded on an exchange
– Priced throughout the trading day
– Can be bought on margin, sold short, or traded using limit orders
– Incur commissions
– Settles in the same manner as a stock
 ETF = Hybrid Security

§ ETFs therefore possess characteristics of both:

– traditional mutual funds, which issue redeemable
shares; and
– closed-end investment companies, which generally
issue shares that trade at negotiated market prices on
a securities exchange and are not redeemable
§ Flexibility of a stock with the diversification offered
by an index fund
§ E.g., SPDR S&P 500 ETF
– first ETF to be launched on 22 January 1993
– designed to offers investors price and yield
performance of the S&P 500 Index before expenses
 How do ETFs Work?
§ Although ETFs are generally structured like mutual
funds, unlike traditional mutual funds, ETFs fund
companies do not sell or redeem their individual
shares at net asset value (NAV)
§ Instead, investors can only buy or redeem shares
directly from the sponsoring fund company in
50,000 share blocks called ‘‘Creation Units’’,
making financial institutions typical purchasers
§ Retail investors generally can only buy or sell in the
secondary market
 ETF Trading Process – Who’s involved?
Stock Exchange Platform for listing & trading

Market Maker Provides continuous bid/ask quotes to ensure

availability of prices and liquidity

Fund Manager Responsible for the tracking of the ETF’s benchmark

index

Approved Participant Has ability to create and redeem ETF shares with the
(Broker/Dealer) Fund Manager

Investor/ Trader Buys or sells ETF shares on Stock Exchange or

through Approved Participant
 ETF Trading
Primary Market Secondary Market

Purchase
Cash (OTC)
Basket Approved
ETF Investor/
Fund Manager Participa Trader
nt
Creation Unit ETF Shares

ETF Shares¹
Cash

Exchange

¹ ETF or Creation Unit

 ETF Creation
§ Approved Applicant that purchases a creation unit of ETF
shares:
 1. deposits with the ETF a ‘‘purchase basket’’ of certain
securities and other assets identified by the ETF that day; and
 2. then receives the Creation Unit in return for those
assets
§ The basket generally reflects the contents of the ETF’s
portfolio and is equal in value to the aggregate NAV of the
ETF shares in the creation unit
§ After purchasing a Creation Unit, the Approved Applicant
may hold the ETF shares, or sell some or all in secondary
market transactions
 ETF Redemption and Sale
§ The redemption process is the reverse of the purchase process
§ The Approved Applicant acquires (through purchases on securities
exchanges, principal transactions, or private transactions) the number of
ETF shares that comprise a creation unit, and redeems the creation unit
from the ETF in exchange for a ‘‘redemption basket’’ of securities and
other assets
§ As with any listed security, investors may trade ETF shares at market
prices. ETF shares purchased in secondary market transactions are not
redeemable from the ETF except in creation units
§ An investor holding fewer ETF shares than the amount needed to
constitute a creation unit (most retail investors) may dispose of those
ETF shares by selling them on the secondary market. The investor
receives market price for the ETF shares, which may be higher or lower
than the NAV of the shares, and pays customary brokerage
commissions on the sale
 Arbitrage and Tracking Error
§ ETFs tend to trade at, or close to, the NAV of the underlying
shares as arbitrageurs usually take advantage of any
significant premium or discount relative to the underlying
index.
§ An arbitrageur will buy/sell the ETF and place an offsetting
sell/buy order in the underlying basket of component
securities.
§ Divergence is possible in an ETF’s performance relative to the
index it tracks owing to differences caused by:
– Fund fees and expenses
– Tracking error when optimization strategies are used to track the
index
– Rebalancing due to corporate actions and index changes
– Dividend reinvestment policy of the fund
§ It’s the transparency of the ETF’s portfolio that facilitates this
arbitrage opportunity
 ETFs and ETPs

§ ETF often used as a catchall term but:

– ETFs
▪ structured as an investment company (See section 3(a)(1)
of the Investment Company Act)
– open-end investment companies or
– Unit investment trusts
– Exchange Traded Products (ETPs)
▪ structured as:
– Grantor trust (many commodity-based products, e.g.,
Exchange Traded Commodities (ETCs))
– Partnerships
– Notes (Exchange Traded Note (ETNs))
 Commonalities of ETFs and ETNs

§ Exchange Traded
§ Easily accessible investment vehicle providing
exposure to wide range of asset classes
§ Low Tracking Error
§ Exposure to market risk of asset class/index
 Specific Features of Securities-based ETF

§ Fund holds underlying securities in a ring-fenced separate

account exposing the investor to no counterparty risk of the
issuer. In the case of failure of the fund issuer, the investor
has recourse directly to the pool of underlying shares or
bonds.
§ High transparency with regards to the holdings of the fund.
§ Opportunity for additional income to further reduce costs (i.e.
through securities lending inside the ETF) is better than for
other ETPs as in-specie ETFs hold index securities
§ Multiple market makers (Approved Participants) can create
and redeem new shares with the fund company promoting a
highly competitive pricing, both on and off exchange
("multi dealer model")
 Specific Features of SWAP-based ETF
§ Fund holds a basket of securities (which can be different from the
underlying index securities) and an index swap. The swap
counterparty risk is limited to a maximum of 10% of the value of
the fund under UCITS rules. The investor has recourse to the basket
of securities in the case of failure of the fund issuer.
§ Structure allows compliance with UCITS rules on more indices than
cash-based ETFs (i.e. commodity ETFs)
§ Sometimes tax advantages possible (i.e. avoidance of stamp tax)
§ While multiple market makers can price swap-based ETFs on and off
exchange, every creation and redemption with the fund company
generally involves a single swap counterparty
§ But see Source ETF Platform with multiple swap providers
§ Also see migration of swaps into ETN/ETCs
 Specific Features of ETN

§ Investor owns a note, exposing the investor to

the counterparty risk of the note issuer
which is sometimes mitigated through
collateral or guarantees
§ More flexibility to issue products, i.e., on
single commodities and currencies
§ Possible access to structured product type
solutions
 ETFs v. ETNs

Source: BGI ETF Landscape (September 2009)

 Exchange Traded Commodities (ETCs)

§ Broad-based Indices - e.g., S&P GSCI, DJAIG

§ Sub-Indices - e.g., energy, livestock, precious metals,
agriculture)
§ Individual Commodities
§ Based on physically held assets – e.g., gold, silver,
platinum, palladium, basket of all four
§ Based on futures
§ Based on forwards
§ Inverse/leveraged
 ETF Toolbox

Source: BGI ETF Landscape (September 2009)

 Benefits of using ETF
Transparency Investors know the ETF composition at any given time
Liquidity Offer two sources of liquidity:


- That measured by secondary market trading volume (traditional liquidity); and

- Liquidity of the underlying via the creation and redemption process

Diversification ETFs provide immediate exposure to a basket or group of securities for instant
diversification
Broad range of asset classes including equities, bonds, commodities, Investment themes

etc
Flexibility ETFs are listed on exchanges and can be traded at any time the market is open
Pricing is continuous throughout the day

Cost Effectiveness ETFs offer a cost-effective route to diversified market exposure



The average total expense ratio (TER) for equity ETFs in Europe is 37 bps versus 87


bps (per annum) for the average equity index tracking fund and 175 bps (per annum) for
average active equity fund
Securities lending ETF units and underlying assets can be lent out to potentially offset holding costs

Source: BGI ETF Landscape (September 2009)

 How ETFs are Used
Strategic Market Exposure: Implement broad variety of investment strategies
Directional Plays: establish directional market position using
long/short strategies
Core-Satellite Strategies: Strategic focus
Rebalancing: correct drift in portfolio’s asset allocation or style
Completion: Add uncorrelated instruments/asset classes

Tactical Interim Beta: Maintain exposure to a given market while searching

for specific investment
Cash Equitisation: invest cash rapidly and cost effectively
Derivatives Alternative: broad range of Delta 1 exposures through
single line cash-based settlement
Exposure Management: readily shift portfolio emphasis by adjusting
exposures
Thematic: implement thematic exposure

Source: BGI ETF Landscape (September 2009)

 Institutional Usage of ETFs

Source: BGI ETF Landscape (September 2009)

 Size of ETF Market
§ GLOBAL ETF ASSETS HIT AN ALL TIME HIGH OF Us$933 BN AT THE END OF Q3 2009 - 4.8%
ABOVE THE PREVIOUS ALL TIME HIGH OF Us$891 BN SET IN AUGUST 2009.


§ AT THE END OF Q3 2009 THE GLOBAL ETF INDUSTRY HAD 1,819 ETFS WITH 3,247 LISTINGS,
ASSETS OF $933.49 BILLION, FROM 96 PROVIDERS ON 40 EXCHANGES AROUND THE
WORLD.


§ YTD ASSETS HAVE RISEN BY 31.3% WHICH IS MORE THAN THE 22.5$% RISE IN THE MSCI
WORLD INDEX IN USD TERMS.


§ YTD THE NUMBER OF ETFS INCREASED BY 14.3% WITH 295 NEW ETFS LAUNCHED, WHILE
72 ETFS WERE CLOSED.


§ IN Q2 THE NUMBER OF ETFS LISTED IN EUROPE SURPASSED THE US WITH 751 ETFS LISTED
IN EUROPE, COMPARED WITH 710 IN THE US


§ THERE ARE CURRENTLY PLANS TO LAUNCH 811 NEW ETFS.



§ YTD THE AVERAGE DAILY TRADING VOLUME IN USD DECREASED BY 21.8$ TO US$63.0 BN.


§ AUM
– 1st STANDARD & POORS (S&P) AUM OF US$220.83 BN AND 227 ETFs
– 2nd MSCI AUM of US$214.80 BN AND 262 ETFs
– 3rd BARCLAYS CAPITAL AUM US$77.64 BN AND 62 ETFs
 ETFs in the GCC

§ December 2008 – ADX publishes Listing

Rules for Foreign ETFs
§ 2 March 2009 – Dubai Gold Securities (ETC)
lists on NASDAQ Dubai
§ August 2009 – Capital Markets Authority in
KSA announces that it will promulgate ETF
Rules in 4Q’09
§ 4Q’09(E) – NBAD launch of ETF on ADX
 Case Study - Dubai Gold Securities

§ An initiative of the World Gold Council and

the Dubai Multi Commodities Centre
§ Shariah-compliant ETC backed 100% by
physical allocated gold bullion held by a
custodian
§ Listed and traded on NASDAQ Dubai
§ Designed to track the price of spot gold bullion
§
 Practical Considerations
§ Legal and Regulatory
– Legal Form of Product
– Structure of and jurisdiction of incorporation of Issuing Vehicle
– Jurisdiction(s) of Listing
– Regulatory Regime
– Choice of law governing all contracts
§ Market Infrastructure
– Market Makers/Approved Applicants
– Short Selling
– Clearing & Settlement
§ Nature of the product
– Shariah-compliant
– Physically-based
– Currency denomination
 Dubai Gold Securities – Who’s involved?
Issuer Dubai Gold Securities LLP
DIFC Limited Liability Partnership

May issue up to 1 billion Dubai Gold Securities subject to deposit

of gold with Custodian

Management Dubai Gold Investment dmcc
Company Administers requests by Approved Applicants to create and

redeem Dubai Gold Securities

Exchange NASDAQ Dubai

Listing Authority

Platform on which the securities are traded

Registrar NASDAQ Dubai CSD

Maintains the register of holders of Dubai Gold Securities
 Dubai Gold Securities – Who’s involved?
Market Maker HSBC bank PLC
Obliged pursuant to a market making agreement with the

Exchange to make continuous two-way prices in a minimum order

size in the security during market hours
Approved HSBC Bank PLC and Morgan Stanley
Applicants Pursuant to an agreement with the Issuers, each has the ability to

create Dubai Gold Securities subject to the deposit of gold with the
Custodian. Similarly can redeem securities for gold subject to the
Custodian cancellation
HSBC BankofUSA, the relevant
NA securities
Maintains the gold backing each security in an Allocated Account

(i.e., one that is excluded from the Custodian’s assets). The gold is
stored in its vault in London
 Creation of Dubai Gold Securities
NASDAQ Dubai London Bullion Market

AA’s Day T +1
NASDAQ Approved Instructions to transfer gold
DUBAI CSD Applicant (AA)
Account

NASDAQ Day T
HSBC
Dubai Transmission of
Creation Order (Custodian)
CSD

Day T+2
Transferred to
Allocated Account
Day T+2
Notification that a valid Creation
Order has been received and to DGS LLP’s
create new securities Allocated
DGS LLP Account
 Uses of Dubai Gold Securities
§ Momentum trade – short term play, swing or position trade
§ Mitigating sector risk - portfolio or currency exposure
§ Hedging - US dollar and inflationary hedge
§ Tactical exposure – easily allocate gold to discretionary
portfolio or target asset allocation
§ Diversification benefit
§ Long term fundamental and strategic play
§ Short or margin eligible
§ Cash equitisation
 ETFs – A Final Glance
§ OPEN-ENDED INDEX TRACKING FUNDS
§ MANAGED BY ASSET MANAGERS
§ BOUGHT AND SOLD THROUGH BROKERS
§ TRADE ON THE EXCHANGE LIKE ANY OTHER STOCK
§ SETTLE LIKE ANY OTHER SHARE ON THE EXCHANGE
§ CAN BE PURCHASED, CLEARED AND HELD IN BROKERAGE OR CUSTODIAL ACCOUNT
§ CAN GO LONG OR SHORT
§ LENDABLE AND MARGINABLE
§ TANSPARENT UNDERLYING PORTFOLIOS AVAILABLE DAILY
§ REAL TIME INDICATIVE NAV
§ WILL PRICE AROUND THEIR NAV DUE TO THE CREATION⁄REDEMPTION PROCESS
§ ARE LIQUID
§ LIQUIDITY REFLECTS LIQUIDITY OF UNDERLYING BASKET OF SHARES NOT THE
TRADING VOLUME OF THE ETF – AS LONG AS TRADING WITH A BROKER
WHICH IS AN AUTHORISED PARTICIPANT
§ CREATION⁄REDEMPTION PROCESS MAKES ETFs AS LIQUID AS UNDERLYING
SHARES
§ UNIQUE STRUCTURE FOR BROKERS WHO ENTER INTO LEGAL AGREEMENTS
WITH THE ETF ASSET MANAGERS TO BE AUTHORIZED PARTICIPANTS,
CREATION - REDEMPTION AGENTS OR LIQUIDITY PROVIDERS
§ PORTFOLIO OF SECURITIES CAN BE EXCHANGED FOR “CREATION
UNITS”
§ “CREATION UNITS” CAN BE REDEEMED FOR UNDERLYING PORTFOLIO
§ CREATION⁄REDEMPTION (“IN KIND”) FEATURE ALLOWS FOR
ARBITRAGE AND RESULTS IN THE FUND TRADING NEAR NAV