Answer number 3

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Answer number 3

  1. 1. 3. Who are the major users of ETFs (institutional vs. retail)? How does this impact how afund manager would market its product?In order to understand whether the institutional investor or retail investors are the major users ofETFs, we must understand the differences between these two investors and the notion of theinstitutional investors and retail investors. Retail investors incorporate individual investors, retailplatforms, banks and SMSFs, whereas institutional investor incorporates wholesale fundmanagers, hedge funds, sovereign wealth funds, endowment funds and many more. Often theinstitutional investors use ETFs to make tactical asset allocations, the rationale being they canreact quickly and gain exposure when they see an opportunity or trend in the market. Since the1993 launch of the first U.S. ETF, the S&P 500 SPDR, assets in U.S. ETFs have grown in analmost-perfect upward curve – as the graph below shows – through the end of the first quarter of2011, when ETF assets reached a record $1.07 trillion. When the ETF was first formed, it was acomplete new financial product and it difficult for the retail investors to understand ETFproducts. As the result most of the ETFs shares were purchased by the institutional investor. Itwas only after 1999-2000, the audience for retail investor started to grow. At present, it has beenestimated that roughly half of the $1 trillion in U.S. ETF assets are owned by institutionalinvestors (ETF share of US retail fund market has been shown in exhibit 3) includingendowments, pensions, hedge funds, trading desks and others, and the remaining half owned byretail investors including investors acting on their own behalf or through financial intermediaries.Even today, when the new ETFs shares are issued, the retail investors start buying them onlywhen they become familiar with the product. This is again because of the fact that ETF conceptis not that simple. It is true that in the beginning when ETS was first launched ETFs held abasket of securities that replicated the component securities of broad-based stock market indexes,such as the S&P 500. One of the major reasons why retail investors are being attracted is that itprovides access to more exotic asset classes, such as emerging-markets stocks, master limitedpartnerships, the Chinese Yuan, platinum, Brazilian infrastructure-related stocks, and manyothers. Along with this, there is also a large and growing number of ETFs that provide exposureto strategies, such as shorting crude oil prices, investing in short-term futures on the CBOEImplied Volatility Index (or VIX), or hedging the S&P 500 Index with gold. (In addition, thereare nearly 1,500 ETFs outside the U.S.) However, the recent years, ETFs has been developedbased on the more specialized indexes, that includes the indexes which are designed for bond
  2. 2. indexes and international indexes. For example- Leveraged and inverse which were launched in2006 uses derivates and such newly introduced concepts are not simple and it takes time for theretail investors to understand and this is a very strong reason why the retail investors are hesitantto by new ETF products.Also, we know that the newly issued ETFs do not come to the retail investors or institutionalinvestors directly but it passes from to the issuer of the ETF to the large institutional trader andthen these large institutional passes ETF shares to the retail investor or other institutionalinvestor. Thus, the large institutional always has the option either to sell these ETFs shares orhold these ETFs shares to make profit through arbitrage. The profit could be made througharbitrage when ETF’s unit values differ from the underlining NAV of the portfolio. Hence, thelarge institutional may hold the large amount of ETF shares to make arbitrage profit( thoughunlikely) and this might make the ETF shares out of the reach of retail or other institutionalinvestors. Large deviations from NAV have been observed in the case of the FXI – 1.34% inApril 2005 – and for the PGJ, a much more significant 3.11% in February 2005 (shown inExhibit 4). In January 2005, the price of the latter fund was $13.27; its NAV was $13.1, so theshares sold for a 1.3% premium. Within one month, the price of the PGJ rose to $13.9 and soldfor a 3.1% premium over its NAV of $13.5. The range of this discount also has been much widerfor PGJ (at 3.3%) than for FXI (1.7%). It is obvious that the large intuitional investor made hugemoney through arbitration. This deviation signals the retail investors that they should enter themarket of ETF with the incomplete information. And such incident also makes the retail investorto stay from ETFs shares. To prevent the retail investor, the ETF provider must educate themabout the basics and working mechanism of ETF.A leveraged ETF tracks the value of an index, a basket of stocks, or another ETF, with theadditional feature that it uses leverage. The performance of leveraged ETF can differ verysignificantly over the time and it may deviate from the daily stated objectives due to thecompounding. Hence holding these leveraged ETF shares for longer term can be damagingparticularly for the retail investors. In fact in 2011, the UK Financial Service authority (FSA)showed concerns regarding the suitability of leveraged Fund to the retail investor. The UKfinancial Service Authority did not impose ban on the leveraged ETF but then it showed itsconcern. This implies that retail investors will keep themselves away from leveraged ETF. Also,
  3. 3. the leveraged ETF were introduced in 2006 and eventually it was not able to attract the retailinvestors because it was very complex method (as it was constructed using the derivatives) tounderstand and it was also very risky for the retail investors.The largest US and Europeans are respectively the vanguard Total stock market ETF (USD 131billion) and the Lyxor ETF DJ Euro Stoxx 50 (5.9 billion). These ETF providers provide theretail investors to obtain reasonably ―mainstream‖ core investment exposure and thus it has beenable to attract the retail investors to a great extent. In addition to this, these ETFs have enable theretail investors to access difficult or costly asset class and markets, strategies that werepreviously restricted to large institutional investors only. These types of ETFs could attract theretail investors and hence slowly and gradually the retail investors also started investing in ETF.The fund manager must market its product analyzing the various parameters. Some of theparameters that fund manager must consider are as follows:-Dedicated institutional channelThe fund manager must focus the institutional channel to attract the institutionalinvestors. One way of implementing the dedicated institutional channel is the launchingof the ―institutional web portal‖. The web portal must include the investment objectiveand it also must highlight on various risk( trading risk, sector risk, trading discount toNAV risk, market risk etc.) associated with the ETF Such web portal would provide theinstitutional investors with the information specific to its need.Strategic marketingThe growth of the exchange-traded fund industry form the year 2000 has seentremendous as it has been able to attract both the retail and institutional investors. Manyexperts believe that ETF has high potential for a future increase in assets and trading.Things are going to well up to this time; and now the time has come to improve strategicmarketing. Strategic marketing includes strategies to efficiently reach clearly definedtarget groups (institutional or retailers) with an optimized mix of products, price,message, brand, and products.Marketing ETF as a low cost and high liquidity productThere are number of advantages that ETF provides including low fees and high liquidity.As we know that the retail investors are more price sensitive as compared to institutional
  4. 4. investors as institutional investor focus on return where as retail investor focus both onthe return and cost associated with the financial product. Thus, the ETF provider needs tomarket its ETF products as low cost and highly liquid products, targeting particularly tothe retail investors. This marketing strategy can have huge influence in the South Asianregions as 80% of the investors in ETF are institutional whereas only 20 % of the retailinvestors. It has become necessary to market these ETFs for retail investors in the SouthAsian regions. Thus, ETF providers can position their ETF product as low cost and liquidproducts in the South Asian regions.Substitutability effect of the products offered by the firmThe fund manager must be aware of the fact that new product of ETF might havenegative as well as positive effect on the firm. Overall, the net effect depends upon thepresence of cannibalization effect and the intensity of competition in the industry. Forexample: If we consider vanguard ETF and conventional mutual fund then the degree ofsubstitution effect can be determined by the cost differences that is associated with theshare class. If the lower operating cost, lower initial investment requirements, andadditional trading options of the ETFs outweigh the additional trading costs, such asbrokerage fees and bid-ask spreads, then Vanguard’s ETFs should cannibalize theircorresponding conventional index funds. However, if the additional costs associated withtrading Vanguard’s ETFs outweigh the benefits from their lower fees and additionaltrading options, then Vanguard’s strategy of offering both ETF and conventional fundshare classes of the same index can be an effective way of attracting heterogeneousinvestors through different distribution channels.Trends in AsiaIn Asia, the ETF market is still in primitive stage. Though the first ETF was launched in HongKong way back in 1999 but the investor started favoring ETF financial product only after theglobal financial crisis of 2008. The market participants also say that that asset under managementin Asian ETFs accounts only for 6% of the global total.
  5. 5. On an average in USA and UK, we can say that the average market occupied by retail andinstitutional market is same, meaning that retail investors comprises of 50% of the market andthe institutional investors comprises the remaining 50% of the market. In Asia, however manypeople have estimated that 80% of the ETF shares are bought by institutional investor whereas20 % are bought the retail investor. This can understood because the Asian ETFs are still youngand it is not fully understood by the investor. Even in US, when ETF was first launched, themajor users of ETF were only institutional investors but with the flow of time the retail investorsalso became familiar with ETFs. Hence, at present in Asia, it is the duty of fund manager and thefirm to educate the investors (both retailer and institutional investor) about the advantage of ETFas well as teach them the working mechanism of ETFs. This has to be done very soon in the nearfuture because globally the debates about the leveraged and inverse ETF, tracking error and theuses of derivatives. In other words, we can that the ETF product is not the same which waslaunched in 1993 but with the flow of time it has become more and more complex. And againit’s the duty of ETF providers of Asia to educate the investors about the complexities of ETF, asthe Asian investors have many things to learn today.
  6. 6. 4. Should Vanguard launch is EFTs as share classes of existing funds or as entirely newproducts? Discuss.The rapid growth of ETF business in US has kept Vanguard in dilemma that if it should launchits ETS as a share class of existing funds or as entirely new products. When contemplating thelaunch of EFTs as share classes of existing funds or as entirely new products, Vanguard mustfirst identify if they are a logical fit with or a natural extension of the asset manager’s corecompetencies. As Vanguard is already established player in the indexed mutual funds andbecause of its unique corporate structure it would be better if Vanguard launches EFTs as shareclasses of existing funds or as entirely new products.Following are the advantages if Vanguard launches the in EFTs as share classes of existing fundsor as entirely new products:-Proven track recordVanguard was in launch in 1975 and because of its unique ownership structure, it wasable to reduce the cost for the investors who bought the mutual funds of Vanguard. Withthe proven track record, if ETF is added in its service line investors as well as fundmanager can see the performance of the share class and take necessary action whenrequired.Cost advantageSince Vanguard is already established player, the initial cost would be substantially verylow if Vanguard adds the ETF as a share class of existing funds rather than creating anentirely new product.Compare the performancesIf the ETF is launched as share class of existing funds then the investor can compare theperformances of the indexed mutual funds with the new ETF. This will provide directglimpse of the advantages of the ETF as well.Quickly reach the profitable scaleVanguard can quickly reach the profitable scale as it can achieve the economies of scaleof large pool of assets which will ultimately reduce the operating and trading costs. Alsothe cash flows into conventional shares can minimize transaction costs tied torebalancing.Reducing tracking errorVanguard could reduce the tracking error because their ETF would immediately reach asize that would not require the fund manager to use a small sample of an index.Tax benefitsThe unique corporate structure also provides tax benefits to the non- ETF shareholders.To meet cash redemption requests from non- ETF shareholders, Vanguard can sell highcost basis securities to generate a capital loss. These losses offset any current taxable
  7. 7. gains and, if not exhausted, can be carried forward to offset future capital gains—arecycling that is not likely within stand-alone ETFs.Indexing expertiseVanguard has expertise in indexed funds and ETF shares many characteristics of indexedfunds. This will help Vanguard to use the same expertise while launching ETF as existingshare class.Along with these advantages, with this practice Vanguard would also be expose ETF shareholders to a risk they would not have, if ETF were launched as entirely new products. This mighthappen when large number of mutual fund class holders would demand the redemption and thesecurities sales could trigger the capital gain and this would be distributed to all the fundinvestors, whether they belong to mutual fund class or the ETF share class.Regardless of the approach taken to launch the ETF, Vanguard will have to focus on thefollowing areas before launching ETFsDistribution considerationsThe company must first identify its target audience. There are many firms which avoidretail investors and they consciously aim for hedge funds and wealth managers with theirsophisticated products while there are also funds who aim for the retail audience.Operational considerationsThe managers must also consider what structure Vanguard Company must follow inorder to deliver the investment strategy. Capabilities in collateral management, trustedrelationship with the service providers, strong authorized participants, links to the marketmaker/specialist community are some of the areas which Vanguard must follow.4. Should Vanguard launch is EFTs as share classes of existing funds or as entirely newproducts? Discuss.The rapid growth of ETF business in US has kept Vanguard in dilemma that if it should launchits ETS as a share class of existing funds or as entirely new products. When contemplating thelaunch of EFTs as share classes of existing funds or as entirely new products, Vanguard mustfirst identify if they are a logical fit with or a natural extension of the asset manager’s corecompetencies. As Vanguard is already established player in the indexed mutual funds andbecause of its unique corporate structure it would be better if Vanguard launches EFTs as shareclasses of existing funds or as entirely new products.Following are the advantages if Vanguard launches the in EFTs as share classes of existing fundsor as entirely new products:-
  8. 8. Proven track recordVanguard was in launch in 1975 and because of its unique ownership structure, it wasable to reduce the cost for the investors who bought the mutual funds of Vanguard. Withthe proven track record, if ETF is added in its service line investors as well as fundmanager can see the performance of the share class and take necessary action whenrequired.Cost advantageSince Vanguard is already established player, the initial cost would be substantially verylow if Vanguard adds the ETF as a share class of existing funds rather than creating anentirely new product.Compare the performancesIf the ETF is launched as share class of existing funds then the investor can compare theperformances of the indexed mutual funds with the new ETF. This will provide directglimpse of the advantages of the ETF as well.Quickly reach the profitable scaleVanguard can quickly reach the profitable scale as it can achieve the economies of scaleof large pool of assets which will ultimately reduce the operating and trading costs. Alsothe cash flows into conventional shares can minimize transaction costs tied torebalancing.Reducing tracking errorVanguard could reduce the tracking error because their ETF would immediately reach asize that would not require the fund manager to use a small sample of an index.Tax benefitsThe unique corporate structure also provides tax benefits to the non- ETF shareholders.To meet cash redemption requests from non- ETF shareholders, Vanguard can sell highcost basis securities to generate a capital loss. These losses offset any current taxablegains and, if not exhausted, can be carried forward to offset future capital gains—arecycling that is not likely within stand-alone ETFs.Indexing expertiseVanguard has expertise in indexed funds and ETF shares many characteristics of indexedfunds. This will help Vanguard to use the same expertise while launching ETF as existingshare class.Along with these advantages, with this practice Vanguard would also be expose ETF shareholders to a risk they would not have, if ETF were launched as entirely new products. This mighthappen when large number of mutual fund class holders would demand the redemption and thesecurities sales could trigger the capital gain and this would be distributed to all the fundinvestors, whether they belong to mutual fund class or the ETF share class.
  9. 9. Regardless of the approach taken to launch the ETF, Vanguard will have to focus on thefollowing areas before launching ETFsDistribution considerationsThe company must first identify its target audience. There are many firms which avoidretail investors and they consciously aim for hedge funds and wealth managers with theirsophisticated products while there are also funds who aim for the retail audience.Operational considerationsThe managers must also consider what structure Vanguard Company must follow inorder to deliver the investment strategy. Capabilities in collateral management, trustedrelationship with the service providers, strong authorized participants, and links to themarket maker/specialist community, are some of the areas which Vanguard must follow.
  10. 10. ReferencesKleim, Donald B., “Size Related Anomalies and Stock Returns Seasonality: Further EmpiricalEvidence,” Journal of Financial Economics, 12, June 1983, pp. 13–33.Reinganum, Marc R., The Anomalous Stock Market Behavior of Small Firms in January:Empirical Tests for Tax-Loss Effects,” Journal of Financial Economics, 12, June 1983Monthly discount/premium summary( Exhibit 4)

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