This week and the next

1
This week and the next

• Test 3 Next Tuesday 1030 AM
• Covers Chapters 13, 14 15 on the Web.
• Review for the whole semester this Thursday

2
Index InvestingIndex Funds Vs ETFs

• Index Funds Open-End Mutual Funds that track an
  index (Vanguard SP500 Index Funds, 1976)
• ETFs (exchange traded funds) Closed end Funds
  whose traded shares track an index.
• SPDR (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 SP 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. As BusinessWeek reported "Upwards
  of 5 billion in new assets flowed into ETFs in
  the second week of October alone."

5
Recent Updates

• According to the Investment Company Institute,
  ETF assets totaled more than 568.7 billion of
  the more than 1 trillion in stock index funds as
  of Jan. 31, 2008 -- a 32 increase over last
  year, but down 39.7 billion from December.

6
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.

7
Best Performers in 2008

• UltraShort Semiconductor ProShares 
• (SSG) YTD 40.33
• UltraShort QQQ ProShares  (AMEX QID) 39.95
• UltraShort Technology ProShares  (AMEX REW)
  38.29
• iShares Silver Trust  (AMEX SLV) 32.83

8
Risk - Down Market

• Most of the betrs-performers rely on the bear
  market. UltraShort QQQ from ProShares As the
  market declines, this ETF seeks to double the
  fall as a gain.
• For example, if the "Cubes" -- a.k.a. PowerShares
  QQQ (Nasdaq QQQQ) -- falls 10, the UltraShort
  QQQ would like to make a 20 gain on that
  decline.
• That's similar to the performance the ProShares
  counterpart UltraShort SP 500 (AMEX SDS) seeks
  out.

9
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

10
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.

11
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.

12
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.).

13
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.

14
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 versus the index than comparable mutual
  funds.

15
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 a fund behaving similar to an index with
  better performance (See an example on the Web)

16
Index tracking Model

• RI b1S1 b2S2 . . . BnSn E
• Where
• RI is an Index return
• Bn is investment weight
• Sn is a stock
• E is error or residual.

17
Solution (Solver)

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