ETF Landscape: Celebrating 10 Years of ETFs in Europe - BlackRock

ETF Landscape April 2010Celebrating 10 Years of ETFs in Europe from BlackRockInvestment concernsETFs possess risks related to the securities in their underlyingindices. ETFs are subject to risks applicable to any investment inportfolios of common stocks or bonds, including that of generallylower prices and the chance that they may underperform moreconcentrated or actively managed portfolios. By targetingperformance in line with indices, investors are also foregoingopportunities to outperform.ETFs are subject to ‘tracking error’ risks. Factors such asexpenses, imperfect correlation between an ETF’s stocks andthose in its underlying index and regulatory policies may causean ETF’s return to deviate from its underlying index. Six majorsources of tracking error are summarised below: Fees and expenses: expenses of all fund products reducetotal return. Although ETFs have the low expense ratios, feeswill cause an ETF to underperform its index over time. Premiums/discounts: on any date, the closing price of anETF may be at a premium or discount to its Net Asset Value(NAV) due to supply and demand factors. This will affectreported performance of the ETF versus its index. Dividend reinvestment: some ETFs hold dividends in cashand only pay them out to investors on a periodic basis. Incontrast, some ETFs can reinvest dividends daily. A lag individend reinvestment can cause small underperformance inrising markets. Optimised replication: many ETFs use computeroptimisation techniques to design portfolios to closely trackthe index while minimising transaction costs. Under thistechnique, the ETF omits or underweights some stocks (usuallythe less liquid or smaller-cap stocks). This technique, ifproperly used, should have only a minor effect on tracking. Rebalancing: ETFs are required to make changes in thecomposition of their portfolios when stocks are added to ordropped from the index. The timing, market impact, andtransaction costs of the changes can affect performance. Nonconcurrent trading hours: some ETFs trade in theUnited States when their underlying markets are closed. Forexample, the Japanese market is closed while an ETF trackingthe Japanese market is trading on NYSE Arca. Given increasedcorrelation between markets, ETFs based on the Japanesemarket may appear to be at a premium prior to the start of thetrading day in Japan when the United States’ market is up inanticipation that the Japanese market will rally. Similarly, on adown day in the United States, the ETFs on the Japanesemarket may appear to trade at a discount.Many European investors prefer ETFs that are UCITS funds froma regulatory and dividend withholding point of view. SomeEuropean investors are only allowed to invest in UCITS funds. ForEuropean and Asian investors, dividend withholding may behigher when investing in US listed ETFs as they may sufferdividend withholding within the ETFs as well as on dividends paidout of the ETF.Basic ETF structuresETFs have distinctive features. Each ETF is designed to track aspecific index. They provide access to investment styles, assetclasses, markets, and different sectors. They are structured asopen-end funds which are domiciled and registered in manycountries around the world. The assets of ETFs are held bycustodians in a ring fenced structure.Most ETFs purchase the underlying securities in the index withthe majority fully replicating their underlying index, many havethe capacity to employ optimisation and sampling techniques.These ETFs may exclude certain securities and deviate from theirbenchmark constituent weights, which could lead totracking error.The open-end structure typically allows funds to lend stock,which may generate extra income. In addition, these funds canhold other securities and financial instruments, including cashand equivalents and futures. Dividends are typically paid outquarterly, semi-annually or annually, although some ETFs doreinvest dividends in the fund.In Europe, a new approach is being used to create funds andETFs which utilise a total return swap plus a basket of securitiesto comply with the diversification rules under Undertakings forCollective Investments in Transferable Securities (UCITS III) todeliver index performance rather than purchasing the underlyingsecurities in the index.Investors who are expressing concerns over counterparty risk,transparency and liquidity when using structured products,swaps, certificates, and notes are showing a preference for ETFswhere the structure is a fund, and often, more specifically forETFs which purchase the underlying securities in the index.ETFs tend to trade at or close to the NAV of the underlyingbasket of shares. Arbitrageurs would take advantage ofsignificant premium or discount relative to the underlying index.An arbitrageur would typically buy or sell the ETF and place anoffsetting buy or sell transaction in the underlying basket ofcomponent stocks or futures.ETF providers have continued to expand their product ranges inmore specialised areas to cater for the growing number ofprofessional and retail investors using ETFs as advanced portfolioconstruction tools.The increasing availability of these highly-specialised ETFs acrossthe full spectrum of equities, fixed-income and alternativeinvestments now ensures that investors can use ETFs to instantlyreallocate capital to take advantage of new investmentopportunities as market conditions stabilise.44 This document is not an offer to buy or sell any security or to participate in any trading strategy. Please refer to important information and qualifications at the end of this material.