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This chapter is from the book

Notes

1 There are hundreds of other indices, too.

2 Funds that do not hold securities are not legally known as ETFs in the United States. However, there does not seem to be common agreement on what to call these funds. Some call them exchange traded portfolios (ETPs) or exchange traded vehicles (ETVs).

3 This is a hypothetical index, and investors will not find an ETF in the United States that has only three stocks in it because it is insufficiently diversified.

4 This creation and redemption mechanism allows ETFs to be more tax efficient relative to mutual funds, as highlighted in the "Tax Efficiency" section of this chapter.

5 This example has been simplified for ease of explanation. It assumes that the value of the fund will be equal to the net asset value (NAV) of the component shares. The NAV of a fund is calculated by this formula:

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In reality, an ETF's price is determined in the open market. However, due to the ability of the ETF to be redeemed for its underlying basket of stocks, and for the ability to use the underlying basket of stocks to create an ETF, there is usually very little difference between the NAV of the ETF and the market price, especially for the highly liquid ETFs. For some of the more thinly traded ETFs, or those with foreign securities, there may be more of a divergence. An ETF's prospectus usually contains material describing the magnitude and frequency of these divergences between the NAV and the ETF's price in the market.

6 The weights here are given for ease of example. The values of the weights in the index can be set in any number of ways. The weights could be assigned by price, assigned by the market capitalization of the stocks in the index, equally weighted, or based on any of a number of methodologies. An ETF's documentation explains the methodology.

7 This process, known as benchmarking, shows how an investment manager performs relative to a particular market. If a manager did better than the market, then the manager was considered to have outperformed the market. If the manager did worse than the market, then the manager was considered to have underperformed the market.

The comparison is somewhat oversimplified. First, a benchmark needs to be relevant to measure a manager's performance. That raises the question of what is the market to be benchmarked. Indices reflect the biases of their makers. For example, the constituents of both the Dow Jones and the S&P 500 are selected by committees with great discretion to decide what to include. These indices are not really passive investment instruments but actually the results of active decisions of what to add, or subtract, based on a committee's decision of what represents the stock market or the economy. Isn't that active management?

Even so-called rules-based indices derive from rules based on someone's conception of what belongs in an index. Those rules could be based on market capitalization, or volume of trading, or some other criteria that may appear scientific because it is quantitative but in reality is the result of a human decision of where to set a cutoff for inclusion in an index. Is it always easy to classify a company? What is GE, for example? Is it a financial company, a manufacturing company, a media company? The answer is it is all of those. Placing a company into a sector, or industry, is not always so simple.

Also, what is the appropriate benchmark? It is not appropriate to benchmark a biotech fund manager who manages a fund with small capitalization companies that are not profitable against the S&P 500, a broad market index that contains established companies with large capitalizations across many industries. The S&P tends to be less risky than a biotech fund, because it is more diversified, and the companies are larger and tend to be profitable, whereas many biotech companies may never turn a profit.

Another difficulty using benchmarks is that a simple comparison of a fund with a benchmark does not account for risk. If a fund underperforms a benchmark, but the fund is much less risky, then did the fund really underperform? If the funds are compared based upon returns that account for the risk of the investment, then it is easier to compare.

Here is a way that investors can think about risk. This reasoning is the same that Harry Markowitz used to develop Modern Portfolio Theory.

  • If two portfolios have the same return, the one with less risk is superior.
  • If two portfolios have equal risk, then the one with the better returns is superior.

Looking at risk-adjusted returns may be a better way to compare a fund with a benchmark. A number of measures can be used to do this, including the Sharpe ratio, Treynor ratio, or Jensen's measure. Each of these measures compares the return of the portfolio in question with that of a risk free instrument—usually the return on treasury bills over a three year period.

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The Sharpe ratio measures the amount of return per unit of risk. A higher Sharpe ratio means a higher risk adjusted return.

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The Treynor ratio measures the amount of return per unit of risk, with the unit in this case being beta, which compares how much the portfolio in question moves relative to the market as a whole. A higher Treynor ratio implies a more efficient use of risk.

Jensen's Measure = Portfolio return - Risk-free return - Portfolio beta x (Benchmark return - Risk-free return)

Jensen's measure is used to compare a money manager with a market index and determine whether the risk is balanced by the reward. Although it requires more calculation than the other measures, it does provide more information about the performance of a fund relative to a benchmark. If the investor then factors in costs, it provides more information about the cost effectiveness of investing with a particular fund.

Using risk adjusted returns helps hold fund managers to account, as they may take risky bets in order to match a benchmark—with potentially harmful consequences for the investors. A fund that underperforms a benchmark, with greater risk, could reveal a predilection toward risky bets by the fund manager. Managers who attempt to beat the benchmark may take excessive risks, but these do not show up in the simplistic benchmark comparisons that are widely used in advertisements for funds or in press coverage.

8 For a discussion of the whole move toward indexing and its academic basis, readers will benefit from reading Burton Malkiel's A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (New York: W.W. Norton & Company, 2007). Malkiel holds the Chemical Bank Chairman's Professorship in Economics at Princeton University and is a former member of the President's Council of Economic Advisors.

9 Originally the portfolio of an index fund was designed to replicate, or copy, the index it tracked. A fund that replicates an index has all the stocks that are in the index in the same weights as the index. Today, funds may either replicate the index or use a representative sample of stocks in the index to track the index. A fund that samples an index has most of the stocks in weights that approximate those in the index, but not the complete match of a fund that replicates an index. Funds that use a representative sample of the index have the potential for larger tracking error than funds that replicate an index, as discussed in footnote 10.

10 This difference in performance between the index and the fund is known as tracking error and is discussed in this chapter in the section "Tracking Error."

11 Buying on margin creates a double-edged sword—it can magnify gains and losses. If the market drops quickly and a speculator fails to meet his margin requirement, the broker can liquidate his position to meet the requirements.

12 Theoretically an investor could invest in an industry by buying a number of companies in that industry, but that could get expensive due to commissions and may prove complicated when it comes to managing an industry portfolio. ETFs allow you to get in and out of an industry by buying or selling in one shot. Also, for certain industries that have a strong overseas component—such as green technology—it may be difficult for U.S. investors to buy the overseas securities directly, whereas they can access those securities easily through an ETF, which does trade on a U.S. exchange. The ETF operator handles the foreign transactions for the investor.

13 Also known as passive investment risk and replication management risk.

14 There are a few actively managed ETFs, but their numbers are miniscule and the assets under management even more inconsequential. According to the Investment Company Institute, at the end of 2008, there were 12 actively managed ETFs, with less than $250 million in assets in the United States out of a total of 728 ETFs with total assets of $531 billion.

15 This risk can be considered a subset of market risk, which is the risk that the shares a fund owns can fall in value for any number of reasons. That risk can't be escaped.

16 Also known as noncorrelation risk, index tracking risk, and management risk.

17 First Trust Exchange-Traded Fund, Prospectus, May 1, 2009, 4.

18 U.S. Securities and Exchange Commission, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors, http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm, last modified 8/18/09.

19 Ibid.

20 Ibid.

21 Ibid.

22 ETNs are not investment funds and are not registered under the Investment Company Act of 1940.

23 Unless a payer notifies you otherwise, dividends should be assumed to be ordinary dividends. Ordinary dividends are found in box 1a of any Form 1099-DIV that an investor receives. Source: IRS Publication 550.

24 The IRS defines Qualified Foreign Corporation as follows in Publication 550:"Qualified foreign corporation. A foreign corporation is a qualified foreign corporation if it meets any of the following conditions.

  1. The corporation is incorporated in a U.S. possession.
  2. The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Treasury Department determines is satisfactory for this purpose and that includes an exchange of information program. For a list of those treaties, see Table 1-3.

    Table 1-3. Income Tax Treaties

    Income tax treaties that the United States has with the following countries satisfy requirement (2) under Qualified foreign corporation.

    Australia

    Austria

    Bangladesh1

    Barbados2

    Belgium

    Canada

    China

    Cyprus

    Czech Republic

    Denmark

    Egypt

    Estonia

    Finland

    France

    Germany

    Greece

    Hungary

    Iceland

    India

    Indonesia

    Ireland

    Israel

    Italy

    Jamaica

    Japan

    Kazakhstan

    Korea

    Latvia

    Lithuania

    Luxembourg

    Mexico

    Morocco

    Netherlands

    New Zealand

    Norway

    Pakistan

    Philippines

    Poland

    Portugal

    Romania

    Russian Federation

    Slovak Republic

    Slovenia

    South Africa

    Spain

    Sri Lanka3

    Sweden

    Switzerland

    Thailand

    Trinidad and Tobago

    Tunisia

    Turkey

    Ukraine

    United Kingdom

    Venezuela

  3. The corporation does not meet (1) or (2) above, but the stock for which the dividend is paid is readily tradable on an established securities market in the United States. See Readily tradable stock, later.

Exception. A corporation is not a qualified foreign corporation if it is a passive foreign investment company during its tax year in which the dividends are paid or during its previous tax year.

Controlled foreign corporation (CFC). Dividends paid out of a CFC's earnings and profits that were not previously taxed are qualified dividends if the CFC is otherwise a qualified foreign corporation and the other requirements in this discussion are met. Certain dividends paid by a CFC that would be treated as a passive foreign investment company but for section 1297(d) of the Internal Revenue Code may be treated as qualified dividends. For more information, see Notice 2004-70, which can be found at www.irs.gov/irb/2004-44_IRB/ar09.html.

Readily tradable stock. Any stock (such as common, ordinary, or preferred stock), or an American depositary receipt in respect of that stock, is considered to satisfy requirement (3) if it is listed on one of the following securities markets: the New York Stock Exchange, the NASDAQ Stock Market, the American Stock Exchange, the Boston Stock Exchange, the Cincinnati Stock Exchange, the Chicago Stock Exchange, the Philadelphia Stock Exchange, or the Pacific Exchange, Inc.

25 This is the list of nonqualified dividends from IRS Publication 550:

"The following dividends are not qualified dividends. They are not qualified dividends even if they are shown in box 1b of Form 1099-DIV.

  • Capital gain distributions.
  • Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations, and similar financial institutions. (Report these amounts as interest income.)
  • Dividends from a corporation that is a tax-exempt organization or farmer's cooperative during the corporation's tax year in which the dividends were paid or during the corporation's previous tax year.
  • Dividends paid by a corporation on employer securities which are held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation.
  • Dividends on any share of stock to the extent that you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property.
  • Payments in lieu of dividends, but only if you know or have reason to know that the payments are not qualified dividends.
  • Payments shown in Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends."

26 According to IRS Publication 550, the minimum holding period is as follows:

"You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment. When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it....

Exception for preferred stock. In the case of preferred stock, you must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days. If the preferred dividends are due to periods totaling less than 367 days, the holding period in the preceding paragraph applies....

Holding period reduced where risk of loss is diminished. When determining whether you met the minimum holding period discussed earlier, you cannot count any day during which you meet any of the following conditions.

  1. You had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities.
  2. You were grantor (writer) of an option to buy substantially identical stock or securities.
  3. Your risk of loss is diminished by holding one or more other positions in substantially similar or related property."

27 Wisdom Tree, International Sector Funds, Prospectus, 4.

28 Many of the funds of Wisdom Tree are built around dividend paying companies, so investors in their funds may want to pay attention to the status of taxes on dividends.

29 Also known as sector risk or nondiversification risk.

30 Interest rates in the Eurozone are set by the European central bank. Individual members of the Eurozone cannot arbitrarily adjust their rates or alter the value of their currencies to adjust to changing economic conditions. Those decisions are made centrally.

31 Also known, for U.S. investors, as non U.S. security risk.

32 U.S. investors may qualify for a foreign tax credit when investing in global funds, provided that more than 50% of the index is made up of non-U.S. companies. Otherwise, investors only qualify for a tax deduction, which in all likelihood means they pay more taxes on their overseas investments.

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