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EXPANDING THE INDIAN EQUITIES MARKET THROUGH ETFS

Prepared for the National Stock Exchange by students of Georgetown University’s International Executive MBA Program

Jen McDonald Mavis Motherway Pablo Pezzimenti Dan Polk Amish Sheth Glenn Zirbser

International Executive MBA Program Jen McDonald Mavis Motherway Pablo Pezzimenti Dan Polk Amish Sheth Glenn Zirbser

Prologue

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I. Introduction and Objectives

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II. Background on ETFs

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Introduction to ETFs

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Brief History of ETFs in the

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III.

ETF Statistics and Global Trends

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Worldwide ETF Growth

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Worldwide ETF Trends

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U.S. ETF Trends

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Uses of ETFs in the U.S

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IV.

Anatomy of an ETF

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Creating an ETF

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Key Roles in a Working ETF

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The Flow of Funds in a Working ETF – Dissecting the Cube

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V.

Indian ETF Market

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Suboptimal Liquidity

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Root Causes of Low and Inconsistent Volume

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The Indian Market Potential

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Opportunities

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Pension Reform

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VI. Recommendations

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VII. Appendix

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Appendix 1: Worldwide ETF Success Factors

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Appendix 2: Detailed Analysis of the Nasdaq-1000 Index Tracking Stock

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Appendix 3: Gold ETFs

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Appendix 4: Pension Reform in India

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Appendix 5: India – U.S. Comparison.…………………………………………………………………46 Appendix 6: Catalysts for ETF Growth Worldwide……………………………………………………56

Appendix 7: Letter from Bob Tull to the Turkish government regarding shorting…………………….57

VIII. Sources…………………………………………………………………………………………….60

Prologue

The year is 2005. The Indian Subcontinent is a booming megalopolis of economic growth and youthful ambition. Economic liberalization in India has created a 6-7% real GDP growth and optimists are predicting a growth pattern that could reach the 7-8%. By 2020, India, the world’s largest democracy, will become the fastest growing economy out of 34 developed and emerging markets. Moreover, its GDP per capita will double, from roughly USD$2,500 to almost USD$5,000. 1 The effects of such rapid growth can be felt from the fields of Kolkata to the venture capital offices on Sand Hill Road. The opportunities for domestic and foreign direct investment in India will create a return like no other, where vested capital will see an immediate and generous return.

The financial markets are not exempt from this tremendous prospect for growth. The over-subscription of IPOs, the potential for long-term returns on equity owned by India's citizens and the influx of foreign capital all represent a significant opportunities in this new market. The ability to harness the investments that are contributing to this growth is crucial to the success of the financial markets. As the reins are loosened on privatization, the monies coming into India will need a stable, regulated and liquid environment in which investments can reside.

First, these investments should measure appropriately against other holdings. Second, the investments should be actively traded, as evidenced by the liquidity in other global financial capitals. Third, the investment should be subject to a market velocity and flexibility that creates the freedom to buy freely and divest at a moment’s notice.

We are convinced that the avenues of a fortuitous investment in India are about to expand. These investments will be comprised of India's domestic community as well as foreigners seeking to increase their exposure to India’s prospect of long-term growth. We believe that the optimal place for these monetary interests is in equity positions of the private companies that are leading the way for India. Stock exchanges around the world have been in search of a financial instrument that invites massive quantities of investment; yet is self-sufficient in its ability to index and regulate its pricing. They have found those characteristics in Exchange Traded Funds. ETFs are rapidly becoming a staple investment tool for a wide spectrum of investors, both individual and institutional alike. 2 Therefore, as India opens its arms to a more abundant investment in its equities, the following dissertation proclaims that the procurement, utilization and efficient use of ETFs on India's National Stock Exchange represent the ideal financial vehicle to harbor the inevitable influx of capital and help speed India’s transition into an economic superpower.

Jennifer McDonald Mavis Motherway Pablo Pezzimenti Daniel Polk Amish Sheth Glenn Zirbser

I.

Introduction and Objectives

The National Stock Exchange (NSE) commissioned a consulting project by Georgetown University’s International Executive MBA program to gain a deeper understanding of the success factors that led to the worldwide popularity of Exchange Traded Funds (ETFs). The NSE intends to apply this knowledge to its own ETF marketplace in order to achieve the following objectives:

Drive more investors into the Indian equity marketplace by providing an efficient and cost- effective way to invest Build liquidity on the exchange Grow transaction revenue Achieve stabilization through market downturns Increase visibility of equity investments to foreign institutions

The paper itself is written to accomplish the following:

Understand why ETFs are successful in the West Our findings are the result of exhaustive research on the history of ETFs. We personally visited and interviewed early pioneers and experts within the ETF industry to gain an understanding of the forces that led to the inception and ultimate success of this innovative financial product. These advisors lend their advice daily to global companies, regulators and investors. We review the state of today’s ETF market and worldwide trends in an effort determine the actions the NSE can undertake to achieve success in this market.

Understand the structure and dynamics of an ETF and its exchange sponsorship Here we dissect the world’s most traded security, NASDAQ's Cube (“QQQ”) to understand the fund’s business model and operations. It highlights the benefits of owning an index and sponsoring an ETF based on the index.

Identify the forces that promote or discourage ETF trading in India Next, we review the state of the ETF market in India today and try to identify why it has fallen short of expectations. We identify the forces that promote or discourage trading volumes on the underlying ordinaries and identify the root causes of low and inconsistent volumes that impact the overall efficient use of ETFs.

Assess the Indian market potential and highlight the opportunity in India We explore the nuances of the Indian equities market. While this information cannot be universally applied to the Indian ETF market, we believe it provides valuable insight into how ETFs should be structured and marketed for maximum participation given the current equity environment. We also explore other factors that could catalyze the growth of ETFs such as pension and retirement reform and the recent introduction of commodities as the underlying ordinaries of ETFs.

Recommend measures that can be taken by the NSE and the government of India to promote the efficient and extensive use of ETFs Finally, we put forth a set of recommendations to improve the regulatory, structural and product environment for the NSE and its portfolio of listed ETFs. Without some regulatory changes, ETFs will

remain less popular than other investment vehicles. Therefore, it is imperative that the NSE partner with Indian regulatory bodies to lobby for changes to policies that are holding ETFs back. Ultimately, doing so will add to the equity markets in India.

II. Background on ETFs

Introduction to ETFs

Exchange Traded Funds are financial products comprised of a specified basket of securities designed to mirror a specific market index. ETFs combine the benefits of a single stock with the instant diversification and investment principals of a conventional mutual fund. Like mutual funds, ETFs represent a fractional ownership in a portfolio of securities. Yet, unlike mutual funds, ETF investors do not purchase or redeem shares from the fund. Instead, like stocks, investors buy and sell shares of ETFs on an exchange or market, like the American Stock Exchange, the Nasdaq Stock Market, or New York Stock Exchange. 3

ETFs are established in the United States as either Unit Investment Trusts (UIT), such as the Nasdaq 100 trust known as the Cube, or as open-end funds, such as the numerous iShares ETFs. Both structures enable ETFs to continuously offer shares through a unique creation and redemption process, resulting in demand- based levels of share supply. The differences in structure are described in more detail later in this report. This fact, combined with the opportunities for market makers to arbitrage based on any

slight differences in premiums or discounts on the net asset value (NAV) through creation and redemption, serves to keep ETF share pricing closely aligned with that of the underlying securities. Indeed, the closing price in 2004 of the Nasdaq 100 Index Tracking Stock (NASDAQ: QQQQ), known as the Cube, tracked within 0.25% of its NAV on 85% of trading days – the remainder of trading days showed a 0.251 – 0.5% deviation. This is shown in Figure 1. 4

Nasdaq-100 Index Tracking Stock Proximity to Net Asset Value (NAV)

120 100 80 60 40 20 0 0-.25% .251-.50% .501-1.00% 1.01-1.50% 1.51-2.00% > 2.00% Frequency
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.251-.50% .501-1.00% 1.01-1.50% 1.51-2.00%
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Closing Price Proximity to NAV

Closing Price Above Trust NAV Closing Price Below Trust NAV

Closing Price Above Trust NAV

Closing Price Above Trust NAV Closing Price Below Trust NAV

Closing Price Below Trust NAV

Figure 1: Proximity to NAV

Both retail and institutional investors have found ETFs to be excellent investment vehicles. Across all types of investors, there are a number of key characteristics that make ETFs attractive, most notably:

Continuous, Intraday Pricing: In sharp contrast to traditional mutual funds, ETFs trade on exchanges throughout the day. As a result, pricing is continuously updated. On many exchanges, pricing is available in seconds.

Access to Sectors and Indexes: Since each ETF share represents a fraction of a basket of securities, ETFs provide simple, low-cost access to numerous sectors and industries (e.g., Telecommunications),

as well as popular indexes (e.g., S&P 500). ETFs also provide many opportunities for style investing – growth, value, core, etc.

Ability to Track an Entire Market Segment: The core guiding principle of an ETF fund manager is to track the underlying index as closely as possible. As a result, ETFs provide investors with a simple, transparent and accurate means of tracking a complete market segment.

Diversity in Investment Opportunities: Managing around the fate of single stocks is an important part of many individual and institutional investment strategies. ETFs, through their expansive underlying basket of securities, allow instant portfolio diversification.

Low Expense Ratios: Unlike actively managed mutual funds that charge high fees for fund manager expertise, marketing, and high levels of fund retooling, ETFs inherently have low expense ratios because of limited fund manager decision-making.

Tax Efficiency: In the U.S., the most successful ETFs provide excellent tax efficiency through low turnover rates, as well as the unique in-kind creation and redemption process that shields investors from capital gains associated with cash-outs.

Transparency: ETFs demonstrate a high level of transparency because they are based on well- published fund holdings – these are most commonly a basket of equities that track an index.

Equitize Cash: Both institutional and retail investors find ETFs to be a low-cost option for parking excess cash in the broad stock market.

Portfolio Risk Management: Unlike traditional mutual funds, ETFs support market, limit, and short trading, as well as derivative products such as options and futures. 5,6,7

Brief History of ETFs in the U.S.

1987 Stock Market Crash The 1987 stock market crash in the U.S. crystallized a growing concern among investors – mutual funds, which publish pricing and allow trading only once a day at 4:00pm, do not give investors any flexibility in the face of major market changes. Indeed, mutual investors who saw the market plummeting on the day of the crash frantically contacted their brokers with sell orders. However, mutual fund buy and sell orders cannot be executed until market close. Furthermore, they cannot be reversed once they are sent in. Many investors who had sold hoping to preserve their gains ended up with large losses.

To add insult to injury, the day following the crash showed a remarkable recovery across the market, with overall price improvement that was among the highest single day gain in recent years. To many mutual fund investors, this made matters even worse, since buy orders could not be executed until market close that next day (after the completion of the market rally). In response to this obvious shortcoming, an investor-led groundswell began for a product that enabled investors to track a basket of securities that had the advantages of a mutual fund and a stock.

The Launch of the Spider: Slow Growth at First In its quest to increase trading volume, the American Stock Exchange (AMEX) pioneered the ETF by working for years with the Securities and Exchange Commission (SEC) to create SPDR, which tracks the Standard & Poor's 500 stock index. 8 Mutual fund companies and brokerage houses were against the idea because it could eat into their large profit margins. However, the AMEX was persistent in its quest to gain an exception to the rules that governed mutual funds and the Spider finally launched in 1993.

Since the launch of the SPDR in 1993, ETFs popularity steadily grew as investors all over the world began to discover their advantages. Growth started slowly at first – only one new ETF was introduced

between 1993 and 1995. 9 Although assets under management (AUM) were growing rapidly, it was unclear what the long-term success of the ETF would be.

The Introduction of the Diamonds and the Cube (QQQQ) Since 1993, when only the Spider existed, the growth in the ETF industry has been remarkable. The spark that ignited the growth explosion for ETFs was in 1995 when the American Stock Exchange eliminated the fee it had imposed on redemptions. 10 Originally, the AMEX wanted to encourage the creation of shares and discourage redemption. There was a fee to create units and a multiple of this fee to redeem them. Effectively this meant that investors could efficiently get into the ETF, but it was difficult for them to get out. Once the AMEX eliminated the fees, investor interest exploded. 11 The number of ETFs jumped by 425% in 1996 from 4 to 21 and assets under management grew 128% in that year alone. 12

The American Stock Exchange launched the “Diamonds,” which tracks the Dow Jones Industrial index, in 1998. Nasdaq Global Funds followed suit shortly thereafter, in 1999, with the launch of the “Cube,” which tracks the Nasdaq 100 index.

The Cube was an instant hit on the American Stock Exchange. In the middle of the tech bubble, millions of people wanted to get access to high-flying technology stocks. The Cube represented an easy way to get a piece of the action without getting too much exposure to one company. According to John Jacobs, CEO of Nasdaq Global Funds, the Nasdaq knew it was going to have a hit when Jacobs realized that it would take a broker 20 minutes to put together the basket of Nasdaq 100 securities. The Cube could achieve the same result almost instantaneously. With price changes happening minute by minute, the Cube provided a level of efficiency that had not been matched up to that point. The Cube had instant liquidity because of the tremendous interest in the product – first by institutions and then almost immediately by retail investors. 13

Technology Bubble Burst

The growth in ETF investments took another big step forward with the burst of the technology bubble in 2000. Investors found tech- centric ETFs, such as the Cube, to be excellent shorting instruments. Indeed, over 50% of the positions held in the Cube in 2000 were short. The mutual

fund scandals in 2003 also heightened investor interest in ETFs. With high-levels of transparency and unlimited trading flexibility, retail

Growth in U.S. ETF Assets

250 228 200 155 150 105 85 100 70 50 0 2000 2001 2002 2003
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228
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155
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Figure 2: Year 2000 – 2004, Growth in U.S. ETF Assets

investors in particular piled-in to ETFs. Barclays, the sponsor of the gigantic iShares family of ETFs, estimates that retail investors now account for half its ETF assets, up from 30% two years ago.

By the end of 2004, over 150 ETFs were available – Figure 2 shows the growth in U.S. ETF assets over the past 5 years. Total assets in ETFs jumped by more than 50% last year, to $227 billion. 14,15,16

III. ETF Statistics and Global Trends

Worldwide ETF Growth

As of March 31, 2005, there were 362 different ETFs with 461 listings on 32 exchanges around the world. 17 With nearly USD$315 billion dollars in assets under management, ETFs are a force to be reckoned with. 18 The SPDR alone has $55.8 billion in AUM. 19 The QQQQ represents the most heavily traded equity in the world with an average daily share volume of nearly 86.5 million every day 20 (note that the QQQQ also represents the world’s most traded option and future 21 ). On April 28, 2005, 40% of all stock market activity was driven by ETFs. 22

Today, the U.S., Europe and Japan have the most ETFs when measured by AUM and number of instruments. 23 73% of ETF assets under management remain in the U.S. with the least amount of ETF assets under management in India. 24

Europe alone has 214 listings, in part because of the numerous exchanges and differing tax laws in the

ETF Listings by Country - March 2005

U.S.ETF Listings by Country - March 2005 Hong Kong Australia Singapore Europe Japan Israel Taiwan China

Hong KongETF Listings by Country - March 2005 U.S. Australia Singapore Europe Japan Israel Taiwan China South

AustraliaETF Listings by Country - March 2005 U.S. Hong Kong Singapore Europe Japan Israel Taiwan China

SingaporeETF Listings by Country - March 2005 U.S. Hong Kong Australia Europe Japan Israel Taiwan China

Europe Japan Israel Taiwan China South Korea
Europe
Japan
Israel
Taiwan
China
South Korea

IndiaU.S. Hong Kong Australia Singapore Europe Japan Israel Taiwan China South Korea Canada South Africa New

Canada

South Africa2005 U.S. Hong Kong Australia Singapore Europe Japan Israel Taiwan China South Korea India Canada New

New Zealand

continent. 2 5 25

We expect this number to grow as new ETFs hit the market. Between January 2004 and March 2005, 85 new market. Between January 2004 and March 2005, 85 new

ETFs were launched. As of Q1 2005, 53 new ETFs are planned – including the first ETF in China, 20 in Europe and 32 in the U.S. 26 Several ETFs have also

closed, including 9 in 2004. 27 Experts indicate that the reasons for ETF closure include: 28

Irrelevance of the benchmark

o Generally, an ETF follows an index that is already actively used, particularly by institutions. ETFs that track indices with no relevance to the financial sector will generally not be successful. The most successful indices are ones that investors can use to more efficiently to gain access to an index/sector or ones that allow investors to easily hedge their risks.

Market timing and impatience of fund sponsors

o The Cube was successful because it was launched at the height of the technology bubble, creating instant interest and liquidity. However, if an ETF is launched that represents a sector that is not in favor, it may not be successful. If the sponsor is not willing to wait it out, it could fail.

Underperforming the market

o Investors will ultimately use the most efficient investing vehicle to gain access to a sector or index.

Decline of the sector the ETF mirrors.

Although the AMEX led the way in creating the first ETF, Barclays Global Investors (BGI) and State Street Global Investors have been the primary beneficiaries. The two companies account for 69% of ETF assets under management worldwide. BGI has over 41% market share; State Street has a little over 26%. 29 Both firms are aggressively launching new products in countries around the world. For example, State Street is sponsoring China’s new ETF tracking that country’s Shanghai 50 Index. 30

Worldwide ETF Trends

As more institutional and retail investors have discovered the advantages of ETFs, AUM have grown. In fact, assets under management grew by 47% in 2004 alone. 31 ETF trading volumes are also increasing. In 2004, trading volume increased 4.9% to $9.55 billion 32 as more institutions and retail investors discovered the many benefits of ETFs. In the past four years alone, the number of institutions holding ETFs grew from 448 to 1413. 33

of institutions holding ETFs grew from 448 to 1413. 3 3 This growth is a result

This growth is a result of two phenomena:

1. Portfolio managers are increasingly using ETFs to gain exposure to international benchmarks. 34

2. Institutions are using ETFs as a cash management tool. Mutual funds can easily equitize cash that they would otherwise have to have on-hand. Pension funds may just park their money in the SPDR when they are between managers. 35

U.S. ETF Trends

In the U.S., ETF popularity also is continuing to grow, even though ETFs have yet to become a household name. In fact, John Jacobs, CEO of Nasdaq Global Funds, said that up until a few years ago it was not uncommon to find CEOs of public companies that did not know what ETFs were.

ETFs are still primarily an index-investing tool, and their percentage of the country’s total index investments has grown to over one-third because of their tax efficiency and low impact costs. 36

Other trends in the U.S. include: Actively managed ETFs Activity managed ETFs are the newest

Other trends in the U.S. include:

Actively managed ETFs Activity managed ETFs are the newest product on the horizon. Pending full approval from the Securities and Exchange Commission, actively managed ETFs would operate very similar to a mutual fund – there would be an active manager who tries to pick stocks that will beat a market index.

Experts disagree about whether this product will be viable. Those who believe that ETFs are only good for index investing believe that actively managed ETFs will be a failure. One of the biggest obstacles is the transparency of the underlying portfolio. The appeal of the traditional ETF is that there is complete transparency into the underlying portfolio, allowing for arbitrage opportunities and risk management applications.

Portfolio managers of actively managed ETFs would not want or allow this level of exposure because other investors would be able to mimic their investment decisions without the added costs. The American Stock Exchange is testing a number of technologies to get around this issue, including a database that mimics the risk portfolio of the underlying securities without revealing the specific stocks. 37 Some argue that this lack of complete transparency will make actively managed ETFs less attractive than traditional ETFs. Others argue that the time has come for another low-cost alternative to traditional mutual funds. Either way, mutual fund managers are very wary of actively managed ETFs because they believe that they will further cut into their traditional business and therefore reduce their profits.

The increasing popularity of ETF derivatives As ETFs gain popularity, so does the popularity of derivative products based on them. In fact, QQQQ has the number one option and future on the market today. 38 51% of U.S. ETFs have options today. Although ETFs could be viewed as competing with futures, Gary Gastineau, Principal of ETF Consultants LLC, says that “Even collectively… [ETFs have] posed only a limited challenge to stock index futures volume, particularly in the S&P 500 space.” 39

Unlisted trading privileges mean that ETFs can be traded on any exchange When the SPDR launched in 1993, the AMEX was the only place that it could traded. Today, the popularity of electronic trading and unlisted trading privilege allows ETFs to be traded on any exchange. Therefore, the exchange that offers the best efficiency will generally get the trade.

ETFs have benefited from unlisted trading privilege, but the AMEX has suffered tremendously because of this phenomenon. Despite the fact that the AMEX is paying the extremely high licensing fee to Standard and Poors, other exchanges are benefiting from increased trading volume of the Spider. Although profit on transaction fees have been virtually eliminated in the U.S., more trading volume is important to the extent it generates more information vending revenue for the stock markets. Amex is responding by making a large infrastructure investment, but it may be too little too late.

Programs underway to try to attract mainstream retail investor 40 The Nasdaq recently announced that they are working with a partner on a pilot program to allow investors without a brokerage account to cost-effectively purchase shares of the Cubes on a regular basis. John Jacobs said that the service is designed for everyday investors who want to dollar-cost average in ETFs. The plan is to expand to other products if the pilot is successful.

Experts believe that the Nasdaq’s partner is a brokerage firm that will allow consumers to make trades for $1 to $2. Given that high brokerage commissions are one of deterrents of ETFs over mutual funds, this development could have a significant negative long-term effect on the popularity and uses of mutual funds.

Uses of ETFs in the U.S.

The Institutional Investor and ETFs The U.S. market is comprised of approximately 50% institutional and 50% retail investors – institutional is defined as a non-bank entity that trades securities in large enough share quantities or dollar amounts to qualify for preferential treatment and lower commissions, usually upwards of $100 million. Although institutional investors divide their investments among equities, bonds, cash, and alternative instruments, which include private equity, venture capital, hedge funds and real estate, the overall ratio in the U.S. tends to be 60% equities to 40% fixed income.

For the most popular ETF, the Cube, institutional investors hold 42% of the shares. This proportion is considered higher than for most ETF’s. The Cube’s top institutional shareholders are Goldman Sachs, Morgan Stanley, Credit Suisse and Bear Stearns, functioning primarily as brokers, not as final investors.

The number of institutional investors in ETFs has risen dramatically. Research conducted by Deborah Fuhr, executive director for Investment Strategies at Morgan Stanley, shows that U.S.-based institutions that held one or more ETFs grew to 1413 by March 2005.

The Hedge Fund Investor and ETFs In the U.S., hedge funds have the same privileges as and are considered institutions. Hedge funds represent investments by fewer than 100 individuals, all financially qualified participants measured by net worth or liquidity. Vega Asset Management is reputed to be the largest hedge fund with just under $11 billion in assets.

In a recent Deutsche Bank 2005 Alternative Investment Survey, the hedge fund industry's estimated total assets, which are believed to be around $1 trillion, are represented as follows: 43% funds-of-funds, 15% family offices and high-net-worth individuals, 11% pension funds, and 7% endowments and foundations. Banks, corporations, consultants, insurance companies, and "other" comprise the remaining 24%. On a global basis, the most common hedge fund strategies are equities (36%), arbitrage (20%), event driven (13%), macro (12%), distressed securities (5%) and sectors (4%). 41

Institutions are regulated as to how they can use leverage. The defining difference between a hedge fund and an institutional investor in the Securities Act of 1940 is that hedge funds are not regulated as to how much leverage it can use. The protective measures put in place in response to the crash of 1929 and subsequent market difficulties in the 1930s still apply to the institutional investor. Closed end funds must abide by the ranges of the 1940 Act as well. If the leverage is debt, the limit is $1 of debt for every $3 of equity. If the method is issuing preferred stock rather than taking on debt, half of it may be used for leverage. In a $300 million fund, for example, 150 million could be used for preferred issues. Hedge funds may use unlimited leverage, creating it through options, futures, and margins.

Greenwich Research reports that hedge funds are the biggest users of ETFs. Hedge funds account for 70% of ETF volume, and the “traditional long-only” investment community (mutual funds) accounts for 25% of ETF volume. With an average holding period of 12 days in the most popular exchange traded funds, it is believed that they are being used for speculation or cash equitization. The more sophisticated the trading desk, the more likely they are to be used and the more trading they encourage. Hedge funds were clearly a catalyst for growth in the U.S. In the appendix, we have included information about the incidents that catalyzed ETF growth in other countries across the globe.

A debate is raging about whether hedge funds are beneficial or detrimental to capital markets. Much discussion has been devoted to the role hedge funds may have played in the Asian crisis of 1997-1999. As a result, many countries are reluctant to permit hedge funds to trade on their exchanges. That notwithstanding, according to EurekaHedge Advisors, proprietary traders and hedge funds now make close to 60% of the trades in most Asian markets. Hong Kong, Singapore, and Australia have attempted to regulate hedge funds. 42

Reporting and codes of conduct are governments’ primary concerns with hedge funds. They want to see where hedge funds’ short positions might post threats to market stability. The April 1999 report, Hedge Funds, Leverage and the Lessons of Long Term Capital Management, provides an extensive analysis of the Asian crisis and how oversight may be built in so that capital markets might avail themselves of the additional liquidity hedge funds bring. Additionally, the September 1999 paper Hedge Funds: What do we really know? published by the IMF addresses the question of hedge fund market impact.

The Retail Investor and ETFs The retail investor is an individual who buys and sells securities for a personal account, and not for another company or organization. The retail investor must purchase shares through a broker dealer, often online.

U.S. retail investors, in aggregate, represent $18 trillion in assets. Equities make-up the largest portion of these assets, comprising 46% of U.S. retail investment. Market linked products (e.g., index funds, leveraged and inverse index funds, and exchange traded funds) are growing in popularity. Currency, bank

savings accounts, money market funds, and CDs, which totaled 19% of the invested dollars, have been steadily declining. 43

With the introduction of ETFs, the retail investor has gained access to investment strategies once only available to professional investors. Through one share of an ETF, which can be traded throughout the day through any broker, the individual investor has access to buy a long or short position on a broad market, an industry, or a country, in a very cost efficient way. Previously, this opportunity was only available to institutions, which used specialty brokerage firms that packaged units of broad segments (e.g., the S&P 500). These firms acted as specialists – to buy $20 million of the S&P 500, one would buy a pre- packaged unit from them.

ETFs are also beginning to benefit the retail investor through reduced expense ratios on other products. Though still very small when compared to mutual funds, ETFs are having some effect on them. Both Fidelity and Vanguard, two of the largest mutual fund providers, are reducing expense ratios on their mutual fund products due to ETF pressures. At the same time, Vanguard has also notified its customers that it will enforce a rule that had been in effect, but not widely used. They will no longer permit an investor to “round trip” in a mutual fund. A sale from one fund cannot be followed by a purchase in that fund unless the purchase meets certain conditions, like dividend reinvestment. 44 As both Vanguard and Fidelity offer ETFs and mutual funds, it appears that this is an attempt to clearly differentiate products for their retail investors, as the investors look to ETFs to gain the “institutional advantage.”

IV. Anatomy of an ETF

Creating an ETF

The formation of an ETF begins with the Sponsor. Much like a general contractor in a building project, the Sponsor initiates the fund and brings together the needed role players. In the United States, this process begins with filing with the Securities and Exchange Commission (SEC) for approval. After gaining approval, the Sponsor and its Distributor, who manages the marketing, sales, and administrative aspects of the ETF, bring-in the first Authorized Participant (AP). The role of the AP is to do initial and ongoing creation and redemptions of creation-unit sized blocks of ETF shares. In order to start this process, the AP may borrow a large block of securities, such as from an institutional investor, or may buy securities on the open market. Once the necessary securities are obtained, the AP works with the designated Trustee to create initial the ETF. The AP, who is typically a market maker, then begins the process of making a market for the ETF shares on an exchange. This generalized ETF formation process is shown in Figure 3. The red font in the figure denotes the parties involved in the creation of the Nasdaq 100 Tracking Stock (Nasdaq: QQQQ), known as the “Cube.” 45,46 A more detailed description of each player’s role is shown in Appendix 2.

Figure 3: Formation of an ETF

Figure 3: Formation of an ETF

Key Roles in a Working ETF

While ETF shares trade on the exchange like any other traditional security, the similarities end there. Figure 4 shows a generalized model of the key players, relationships, and inputs/outputs for an ETF in the United States. The red font in the figure denotes players that are part of the Cube. The upper left portion of the figure shows the daily trading activity of the ETF shares, both by retail and institutional investors, through a Market Maker (in this case, Susquehanna Specialists). Based on demand for ETF shares, as well as arbitrage opportunities associated with differences in the ETF price and the net asset value (NAV) of the underlying ordinaries, APs will work directly with the Trustee to create and redeem ETF units.

This creation/redemption process, shown in the middle section of the figure, occurs “in-kind,” offering a number of tax advantages to the U.S. investor (as discussed in this report). The Sponsor and Distributor continue to provide oversight, sales, and marketing support as the working ETF evolves – this involvement is illustrated in the lower portion of the figure. Also critical to note is the role the capital markets play in the ETF. Shown in the upper right portion of the figure, the capital markets serve to provide the underlying securities that constitute the ETF, as well as the primary source of income for the key players (i.e., dividends). 47,48,49

Figure 4: The ETF Workflow

Figure 4: The ETF Workflow

The Flow of Funds in a Working ETF – Dissecting the Cube

An important aspect of a working ETF is the flow of funds – i.e., the inputs and outputs – associated with each player and transaction. The generalized U.S. ETF has the following key funds flows:

Daily trading fees.

Creation/redemption fees.

Dividend income to the Trust.

Dividend and capital gains distributions to unit holders.

Expenses associated with the Sponsor, Distributor, and Index.

All of these fund flows, combined with the constant vacillations in the number of ordinary shares in the Trust, serve to impact the ETF’s most critical metric – its total net assets. Figure 5 illustrates this generalized model of funds flow. The red font in the figure shows flows from the Cube (Nasdaq: QQQQ)

for fiscal year 2004. As shown in the figure, the Trust sits at the center of the wheel of the flow of funds

and non-trading activity.

the critical role of managing the major financial inflows (i.e., dividends) and numerous outflows (i.e., distributions, expenses, fees). In the case of the Cube, the Trustee (i.e., The Bank of New York) managed the following:

In addition to the mechanical duties of creation and redemption, the Trustee has

Inflow of $59,439,915

Outflow of $8,613,794 for dividend distribution.

Outflow of $30,295,705 for expense accrued through the sponsor.

For these services, the Trustee levied a fee of $13,841,499 for FY2004. As discussed above, a critical metric for the ETF is its total net assets, as expenses and fees are determined as a percentage of fund assets.

Figure 5: The Flow of Funds in an ETF

Figure 5: The Flow of Funds in an ETF

Another point highlighted in Figure 5 is that the Cube’s Sponsor, unlike the other key parties, does not take a fee for its role in the ETF operation. This is the case because the Cube was established as a Unit Investment Trust (UIT). Some of the first and largest ETFs were structured as UITs, including the Cube, the SPDR (AMEX:SPY), and the Dow Jones Diamonds (AMEX:DIA). The UIT structure was originally selected for ETFs because it was cheap and easy to manage. A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust. Thus, while UIT's can levy reimbursement for key expenses, such as marketing and index licensing, they cannot charge and retain a fee.

Table 1: Cube Highlights, FY2004:

Total Trust Net Assets: $20,380,384, 827

Number of Nasdaq-100 Shares: 580,150,000

NAV per share (based on securities and other assets):

$35.13

Shares Traded: 25 Billion

Dividend Income: $59,439,915

Dividends Distributed to Unitholders: $8,613,794

In contrast to this structure, many U.S. ETFs are now established as open-end mutual funds (e.g., iShares family of ETFs). Open-end mutual fund ETFs charge management fees for fund operation. iShares, for example, charges 9 bps for management of their S&P500 ETF. In addition to retaining a management fee,

the open-end mutual fund structure allows the fund to immediately reinvest dividends, lend securities, and use derivatives in managing the portfolio – things that UITs cannot do. 50,51 Table 1 shows several key Cube metrics, such as total trust assets, for FY2004. In addition, more detailed analysis of Cube vital statistics was prepared for this report, as shown in Appendix 2. 52,53,54,55

V.

Indian ETF Market

Suboptimal Liquidity

The NSE currently trades five ETFs. The success of these financial products has been varied and sporadic. While some ETFs have exhibited periods of promising volume and growing investor confidence, sustainable liquidity has been lacking. Volatility and relatively large volume variability, as exhibited by the following table, are the norm.

Average Price (Rs) Volatility (i.e. σ) Average Volume Vol. Variability (i.e. σ) Volume σ/µ

UTISUNDER

171.3

28.1

113,808

171,573

151%

JUNIORBEES

114.0

104.4

3,674

10,967

299%

NIFTYBEES

144.1

39.5

10,970

25,055

228%

BANKBEES

311.6

54.5

1,596

4,787

300%

LIQUIDBEES

1000.0

0.02

4,025

4,640

115%

Source: NSE databases (data gathered from launch of each ETF through June 2005)

By comparison the table below exhibits the same variables for a sample of U.S. ETFs; volume is noticeably more stable. The coefficient of variation [(σ/µ) x 100] is considerably lower than is the case in Indian ETFs. It’s worth noting that this is not the case with all U.S. ETFs; however, it is a trend in the more successful ETF products.

 

Average

Volatility

Average

Volume σ/µ

Price (USD$)

(i.e. σ)

Volume

Vol. Variability (i.e. σ)

Nasdaq Cubes (QQQQ)

58.0

42.0

67,541,444

36,217,874

54%

ISHARE NQ BIOTCH (IBB)

70.0

14.0

558,303

500,640

90%

VANGUARD VIPERS (VNQ)

55.0

33.0

34,274

27,417

80%

Source: Yahoo Finance (data gathered from launch of each ETF through June 2005)

The following graphs 56 depict price and volume data for each of the five Indian ETFs as of their respective initial postings on the NSE. Corroborating the volume numbers depicted in tables above, the graphs illustrate a recurring pattern of unsustainable liquidity.

------------ price ------------ volume 250 1,200,000 1,000,000 200 800,000 150 600,000 100 400,000 UTISUNDER: a
------------ price
------------ volume
250
1,200,000
1,000,000
200
800,000
150
600,000
100
400,000
UTISUNDER: a passively managed open-ended
exchange traded fund that tracks the S&P CNX
NSE Nifty 50 Index.
50
200,000
0
0
17-Jul-03 06-Oct-03
19-Dec-03
22-Mar-04
07-Sep-04
Price
14-Dec-04
23-May-05
Volume
400 140,000 350 120,000 300 100,000 250 80,000 200 60,000 150 40,000 100 20,000 50
400
140,000
350
120,000
300
100,000
250
80,000
200
60,000
150
40,000
100
20,000
50
0
0
06-Mar-03
07-Jul-03
03-Oct-03
05-Jan-04
22-Apr-04
19-Jul-04
09-Oct-04
11-Jan-05
29-Apr-05
Price
Volume
250 700,000 600,000 200 500,000 150 400,000 300,000 100 200,000 50 100,000 0 0 450
250
700,000
600,000
200
500,000
150
400,000
300,000
100
200,000
50
100,000
0
0
450
35,000
400
30,000
350
25,000
300
20,000
250
200
15,000
150
10,000
100
5,000
50
0
0
1010
45,000
08-Jan-02
40,000
17-May-02
35,000
1005
30,000
24-Sep-02
25,000
04-Feb-03
1000
20,000
17-Jun-03
15,000
995
10,000
23-Oct-03
5,000
01-Mar-04
990
0
04-Jun-04
08-Jul-04
08-Jul-04
12-Nov-04
28-Mar-05
24-Sep-04
29-Nov-04
05-Jan-05
21-Feb-05
22-Mar-05
16-Jul-03
28-Apr-05
10-Oct-03
05-Jan-04
05-Apr-04
02-Jul-04
27-Sep-04
27-Dec-04
Price
Price
Price
23-Mar-05
Volume
Volume
Volume

JUNIORBEES: The next rung of liquid securities after S&P CNX Nifty is the CNX Nifty Junior index. Along with the S&P CNX Nifty, the CNX Nifty Junior make-up the 100 most liquid stocks.

NIFTYBEES: the first ETF introduced in India:

Benchmark Funds introduced the product on January 8, 2002. Each Nifty BeES unit is 1/10th of the S&P CNX Nifty Index value.

BANKBEES: Banking Index Benchmark Exchange Traded Scheme (Bank BeES) is an Open Ended Index Fund tracking the CNX Bank Index.

LIQUIDBEES: Liquid Benchmark Exchange Traded Scheme is the first money market ETF in the world. Liquid BeES invests in a basket of call money, short-term government securities and money market instruments of short and medium maturities.

Root Causes of Low and Inconsistent Volume

There are two potential explanations for this suboptimal performance. The low liquidity of Indian ETF products may be the result of (i) the inability of Authorized Participants (AP) to generate the demanded ETFs or (ii) inadequate interest on the part of Indian retail and institutional investors. The model below traces the root causes of these two possibilities.

liquidity of

underlying

shares

operational

friction

AP unable to create/redeem shares insufficient interest
AP unable to
create/redeem
shares
insufficient
interest
AP unable to create/redeem shares insufficient interest demand for ETFS exists low liquidity for ETF product

demand

for ETFS

exists

low liquidity

for ETF

product

negative tax

implications

inability to

short

large bid/ask

spreads

(i.e. high liquidity impact costs)

lack of

awareness

high liquidity impact costs) lack of awareness no demand f or ETFs lack of market makers

no demand

for ETFs

lack of

market

makers

Obstacles for Authorized Participants: There are two possible impediments that may limit the AP’s ability to generate shares of the ETF. The first is illiquidity in the underlying shares of the index; the second is the lack of a fluid operational mechanism to allow for rapid transactions. Both of these components are critical in facilitating the creation and redemption of shares that allows APs to (a) absorb demand fluctuations in the market and (b) allow arbitragers to step in when the price of the ETF wanders too far from the NAV of the underlying stocks.

Liquidity of Underlying Shares 57 : Some investors mistakenly believe that the liquidity of an ETF is dependent on average trading volume, or the number of shares traded per day. However, this is not the case. The most accurate measure of ETF liquidity is the liquidity of the underlying stocks in the index. It is the trading volume of these underlying shares that determines the ability of the AP to create or redeem ETF units. Based on their ability to purchase the underlying stocks, APs can create ETF shares instantly as long as the underlying shares are liquid. In essence, there is unlimited liquidity in ETFs based on indexes with liquid underlying shares.

In

analyzing India’s current situation, the underlying liquidity issue is not a major obstacle to the liquidity

of

the ETFs themselves. In fact, as a general rule Indian underlying stocks exhibit a higher volume of

trading than their respective ETFs. In the U.S., by comparison, the more popular ETFs tend to be more liquid than their underlying stocks. Secondly, the number of units required to redeem or create shares is

relatively lower in the Indian market. While most APs require a minimum of 50,000 units in the U.S., that

number is only 10,000 in India. As a result, the underlying shares need only be one-fifth as liquid in order

to allow for the same creation/redemption capability.

This chart 58 indicates the number of securities in both the S&P 500 and the NIFTY 50 whose share trading volume is either greater than or less than the specified number of shares in the first column. As a more “comparable” measure, the equivalent percentage relative to the total basket is also given.

As a result of substantial trading volume and relatively lower redemption unit requirements, India’s underlying shares exhibit enough liquidity to facilitate the creation and redemption of ETF units by Authorized Participants.

In other words, the liquidity of underlying shares is

not a root cause of the low and erratic ETF trading volume.

 

S&P

% of

NIFTY

% of

500

Basket

50

Basket

> 25,000,000

 

shares

6

1.2%

1

2.0%

> 10,000,000

 

shares

29

5.8%

3

6.0%

> 5,000,000

 

shares

79

15.8%

4

8.0%

< 1,000,000

 

shares

167

33.4%

35

70.0%

< 500,000 shares

58

11.6%

24

48.0%

< 250,000 shares

7

1.4%

10

20.0%

< 100,000 shares

0

0.0%

4

8.0%

AP Redemption

50,000

 

10,000

 

Unit Requirements

Note: data taken from trading on 6/27/05

Operational Friction: Having confirmed the liquidity of the Indian ETF underlying shares, we dismiss this as a potential hindrance to the creation/redemption process. Yet, obstacles in this in-kind redemption process do exist. This is evident in the instances where prices of certain ETFs have deviated from the NAV of their respective shares. It would seem that, even though the underlying shares are abundantly liquid, the necessary infrastructure is not in place to ensure the ability to process fluid arbitrage transactions.

A practical example of how operational friction might wreak havoc on an ETF can be seen in the case of

the Prudential ICICI Mutual Fund’s SPIcE index. As the price of the ETF rose above the NAV price, the lack of a fluid transaction mechanism may have hindered the ability of arbitragers to redeem shares quickly enough to equilibrate price through the in-kind trade redemption process. As a result, the ETF price continued to rise deviating substantially above the NAV. Consequently, in June of 2005, the Bombay Stock Exchange was forced to revoke SPIcE’s trading privileges 59 .

Insufficient Interest: The previous section explored obstacles to liquidity while assuming the existence

of investor demand for ETF products. This section analyzes the various causes that obstruct ETF trading

volume by limiting the very attractiveness of ETFs to Indian investors.

Negative Tax Implications 60 : India’s current tax regulations are directly hindering capital investment in its ETF markets. Indian investors interested in ETFs must endure heavy tax burdens highlighting one of the most significant differences between Indian and U.S. markets. While U.S. ETFs enjoy heavily

publicized tax advantages over mutual funds 61 , their Indian counterparts suffer from greater taxation than alternative financial vehicles such as mutual funds and futures-options contracts.

Impact Cost of Taxes on Bid/Ask Spread

TAX

Basis Points

Selling of Units by AP on market Buying underlying by AP on market Buying units by AP on market Selling underlying by AP on market MF redemption tax

10

10

10

10

20

Total impact cost on Bid/Ask spread

60

Additionally, the investor pays 10 basis points for each buy/sell transaction.

Specifically, Indian ETFs are hampered by the following four tax regulations:

1)

2)

When a fund buys/sells the underlying ordinaries, it pays a tax of 10 bps. When ETF units are redeemed, the "investor" pays 20 bps. As discussed above, the Spider originally imposed a fee on redemption that was not imposed on creation units. Experts believe that this fee inhibited the trading of the Spider

the first few years since its inception. When the ETF share is actually sold on the market/exchange, the seller and the buyer each pay 10 bps. As per the Finance Act 2004, the STT states that upon the sale of shares (including ETFs), where the transaction of such sale is entered into in a recognized stock exchange, the seller and buyer shall split a tax payment equivalent to 0.0020 of the sale. By comparison transactions on derivatives are taxed 0.000133 of the sale (Circular No.: NSE/F&O/0062/2004) Long-term capital gains tax in India is nil. However, short-term capital gains on ETFs are taxed 10 bps. In the U.S., ETFs benefit from an in-kind trade capital gains tax-advantage; according to the IRS, “the exchange of essentially identical items does not trigger capital gains.” However, this in-kind trade capital gains “loophole” does not apply in India. The significance of these tax disadvantages is augmented when applied to an ETF where low cost and low fees are supposed to be a major draw.

3)

4)

While some of these taxes don’t apply directly to investors looking to buy or sell ETF shares on the market, these shareholders will inevitably bear the brunt of the costs of these four taxes being passed on to them through the bid/ask spread.

In summary, success with these financial products is dependent upon ETFs displaying (at best) a tax advantage and (at worst) tax neutrality. 62 If not addressed, India’s current ETF tax disadvantages will continue to hinder ETF market growth.

Inability to Short: While Indian regulations theoretically permit shorting, the lack of stable regulatory mechanisms to protect prospective players in the shorting market is drastically limiting the efficacy (hence the demand) of ETFs. 63 Specifically, there is currently a lack of regulation and/or enforcement related to:

Protecting the entities that lend shares from being burned by short-sellers that fail to return shares at the appointed time; and

Protecting buyers from individuals engaging in naked shorting (the illegal practice of short selling shares that haven't been borrowed or do not exist at all).

As a result, these players are unwilling to facilitate shorting, severely limiting the effectiveness of ETFs as financial hedging mechanisms.

Margin requirements on short sales are a prime example of how the Indian regulatory structure fails to protect the stakeholders in shorting markets. In India, the general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction. Thus, a margin account of Rs. 100,000 worth of stock/cash can be leveraged to borrow Rs. 200,000 of stock to sell short. 64 By comparison, the U.S. margin requirement on a short sale calls for 150% of the short sale proceeds. In other words, the entire amount received from the proceeds of the sale plus an additional 50% of the proceeds is the initial margin requirement on a short position. 65 While U.S. regulations ensure sufficient collateral, Indian regulations are too liberal regarding margin requirements - thus leaving the lending entities unprotected and without much recourse should a margin call be necessary.

By comparison, the U.S. government has gone out of its way to facilitate the shorting of ETFs. The SEC has streamlined this process through strict enforcement of proactive regulatory schemes. An example of this is the recent “Regulation SHO,” 66 which provides a new framework for the regulation of short sale securities; including (i) new locate and delivery requirements, (ii) stricter definitions of ownership for short sale purposes and (iii) new ticket-marking requirements.

Furthermore, in order to further facilitate shorting, the SEC couples its strict regulatory enforcements with loose down-tick requirements. In the U.S. shorting is permitted whether the price of the ETF is moving up or down (down-tick rule). By comparison, U.S. securities can only be shorted if the price is moving up (up-tick rule). In effect, the index based ETFs (due to their implicit diversification) are not perceived as susceptible to the downward pressure sometimes experienced by heavily shorted individual shares.

Through the creation of an environment that fosters shorting, ETF markets benefit in the following ways:

Increased exchange transactions and arbitrage opportunities without putting significant downward pressure on the shares of the index.

Tighter spreads due to increased liquidity.

Increased market maker participation as a result of sustained liquidity.

Due to ETF variety (i.e. ETF tracking different market capitalization segments, sectors, countries, regions and styles), ETF shorting is ideal for hedging long and short strategies in just about any conceivable portfolio; thus, complementing other trades and increasing overall volume. To put this phenomenon into perspective, consider that the average NYSE stock has a short interest of about 2%. In contrast, the average short position for all U.S. ETFs has varied between 16.2% and 33.7% in the last 2 years. In April 2004, the short interest on the Russell 2000 was nearly 70%! 67 .

Security lending revenue earned on ETFs shares can (at times) more than cover the annual total expense ratio. This is particularly the case for the heavily shorted ETFs (i.e. QQQQ, SPDR).

Permitting shorting on ETFs is not only a U.S. phenomenon. A number of governments have recognized the critical link between shorting and the success of ETFs. These governments are aware that these index products are not susceptible to the downward pressure individual securities sometimes experience as a result of shorting. Consequently they are permitting shorting while tightening regulations to protect all players in the shorting market. As a result, investors in countries such as Singapore, Turkey, and Hong Kong are currently allowed to short ETFs.

Large Bid/Ask Spreads: While the QQQQ is within 0.05 USD$ 100% of the time, 68 its Indian

counterparts suffer from relatively large ask/bid spreads. This leads to excessive liquidity impact costs, resulting in diminishing demand for these index-based products. The impact cost is especially detrimental

to ETFs since these financial products aim to give you the same returns as the index against which they

are benchmarked. In effect, these high impact costs may pull an ETF’s returns substantially below its benchmark index. 69

Nifty 50 - Monthly Impact Costs

1.25 1.00 0.75 0.50 0.25 0.00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05
1.25
1.00
0.75
0.50
0.25
0.00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05

Monthly Average Impact Cost for a portfolio size of Rs.5 million

A major cause for the inability to close the gap in

the ask/bid spread is the lack of market makers in the ETF space. Market makers are not interested

in an illiquid market and markets are normally

unable to reach a mature liquid state without the assistance of market makers.

As is evident in this graph 70 , over the last 4.5 years the Nifty 50 index has made strides in lowering its impact costs. Nevertheless, ETF impact costs continue to be too high.

Nevertheless, ETF impact costs continue to be too high. M ARKET M AKERS L IQUID M

MARKET

MAKERS

LIQUID

MARKETS

continue to be too high. M ARKET M AKERS L IQUID M ARKETS This brings us

This brings us to the crux of the problem, a chicken and egg scenario where liquidity and market makers are both critical in propelling the market forward. Yet, the absence of both leaves the Indian ETF market

in dire need of a jump-start.

Lack of Awareness: Low customer awareness plays a prominent role in the lack of liquidity exhibited by the ETF market. In the U.S. market where ETFs have experienced relative success and where products such as the QQQQ and SPDR boast substantial marketing budgets, average investors (and even many financial professionals) have not fully familiarized themselves with ETF products. This problem is amplified in India were ETF visibility is considerably less pronounced. The NSE and Benchmark Funds are well aware of ETF’s limited exposure; yet they are prudently reluctant to sink resources into a marketing budget until the above-mentioned operational and regulatory hurdles have been satisfactorily addressed.

The Indian Market Potential

As major indices reach new peaks in the domestic capital markets, the Indian retail investors appear to be shying away from the incredibly bullish equity markets. In what can only be surmised as a lack of confidence in the market, the Indian retail investors are turning their backs on nominal returns of 44.9 percent per annum over the past three years in the equity markets. Instead, they seem to be favoring the debt market despite being out performed by 38 percent per annum over the same time period. The percentage of household savings in 2003-2004 making its way into the equity markets is a paltry 1.4%,

down from 7.6% in 2001. During this same period, the total percentage of allocation in fixed-income (currency, bank deposits, and bonds) has increased from just over 50% to close to 70%.

Household Savings Allocation

100% 80% 60% 40% 20% 0% 1999-00 2000-01 2001-02 2002-03 2003-04 Percentage
100%
80%
60%
40%
20%
0%
1999-00
2000-01
2001-02
2002-03
2003-04
Percentage

Ye ar

Shares and debenturesProvident and Pension Funds Insurance Funds Claims on Government Deposits Currency

Provident and Pension FundsShares and debentures Insurance Funds Claims on Government Deposits Currency

Insurance FundsShares and debentures Provident and Pension Funds Claims on Government Deposits Currency

Claims on GovernmentShares and debentures Provident and Pension Funds Insurance Funds Deposits Currency

DepositsShares and debentures Provident and Pension Funds Insurance Funds Claims on Government Currency

CurrencyShares and debentures Provident and Pension Funds Insurance Funds Claims on Government Deposits

The share of the equity market belonging to retail investors has steadily declined from 16.9% to 10.8% between March 2001 and March 2005. During this same time period, the holdings in equity shares owned by foreign institutional investors climbed from 10.9% to 23.4%. 71 With continual loosening of rules, limits, and restrictions impeding overseas capital inflow, this trend should continue. It’s fairly evident that the growth in the Indian equity market is largely being fueled by the increasing FII inflows.

FII Inflow

200,000.00 150,000.00 100,000.00 50,000.00 0.00 -50,000.00 1993 1995 1997 1999 2001 2003 2005 Ye ar
200,000.00
150,000.00
100,000.00
50,000.00
0.00
-50,000.00
1993
1995
1997
1999
2001
2003
2005
Ye ar
Yearly Inflow
Cumulativ e Inf low
Rs Crore

With growing foreign investments and low domestic investments, the Indian equity markets are currently dependent on the foreign flows and a decline or reversal of these flows could be disastrous. Therefore, it is critical that the retail market increase it’s participation in the equity market. Finance Minister Chidambarm has been encouraging the retail investors to participate in the equity market. India is transitioning from a high interest rate to a lower interest rate country but its fixed-income oriented mindset is limiting its transition to the equities market. Below is a breakdown of ownership of the Indian equity market. 72

Indian Equity Ow nership Life Insurace Corp (LIC) 4% UTI Other 1% Promoters 13% 26%
Indian Equity Ow nership
Life Insurace Corp
(LIC)
4%
UTI
Other
1%
Promoters
13%
26%
Mutual Funds
3%
FII
16%
Government
Indian Public
Promoters
11%
26%

Recent Developments

The advances in the regulatory environment, the bullish market, and low interest rates haven’t been enough to reverse the declining participation (as percentage of savings) of domestic retail investors in the equity market. However, two recent developments have the potential for finally reversing this trend and both of them involve the use of ETFs. The first development is the pension reform taking place in India and the second development is the imminent launch of a Gold ETF.

The pension reform may act as a catalyst for domestic equity investments as the establishment of the New Pension System (NPS) and its use of private fund managers (PFMs) brings a chunk of Indian retirement savings into the equity market. Through partnerships, marketing, and education, we believe ETF products can become one of the primary avenue for these funds. We discuss Indian pension reforms in more detail below.

The imminent introduction of a Gold ETF will provide retail investors a more efficient alternative for owning gold. India’s obsession with gold is well known. It holds approximately 13,000 tons of the precious metal, accounting for roughly 9% of the global cumulative mine production. The availability of Gold via the equity market has implicit advantages that protect the investor from the fraudulent claims of street-corner jewelers, elimination of insurance costs, elimination of safekeeping headaches, and gradual accumulation in small lots.

These two developments should go a long way in infusing retail investors in the Indian equity market. As household saving rates climb and as retail investors become more comfortable in investing in the equity market, the domestic funds represent a major source of future growth opportunity for the capital markets.

Foreign Institutional Investment Foreign institutional investors collectively own major stakes in many of India’s leading firms, resulting in

one-third of India’s blue-chip companies being owned by non-Indians.

Indian equity market represents a substantial growth opportunity for ETF products. According to James McGowan, Managing Director, Exchange Traded Funds, New York Stock Exchange, institutional investors represent approximately 30% of the holders of ETFs in the United States. Furthermore, the institutional investors account for most of the trading volume, as they tend to be more active than the

retail investors who typically buy and hold.

This FII investment into the

The volume of ETF trading vis-à-vis trading of the underlying ordinaries is low and infusion of institutional investors as core holders of ETF products would not only increase the AUM but also increase the trading volume. As institutional investors increase the breadth of their coverage which often spans across various emerging markets, their ability to research individual equities in specific countries may become limited. This is particularly true of mid-sized institutions with limited resources. In such cases, ETFs represent an exceptional vehicle to gain exposure to a broad index while avoiding high management costs. In addition, ETFs are an excellent way for FIIs to equitize cash waiting to be invested in the Indian market.

According to John Jacobs, Executive Vice President and Chief Marketing Officer, The Nasdaq Stock Market, institutional investors are the leaders and retail investors follow their lead. If this is true, engaging FIIs (comprising a vast majority of all institutional holdings in India) will eventually lead to increase retail investor confidence and use of ETFs. The foreign institution investors should continue to grow if the political and economic climate in India continues on its current path.

Opportunities

Due to the policy and operational issues analyzed in the previous section, Indian ETFs have not performed to their full potential. Nevertheless, as these issues commence to be addressed, the Indian ETF market finds itself particularly well-positioned to take advantage of two plausible opportunities. First, as India undergoes pension fund reform, the funds that will accumulate in the New Pension System represents a unique opportunity for ETFs to garner a substantial portion of the enormous amount of assets that will accumulate in this system (see Appendix 4). Second, capitalizing on an environment receptive to commodities as investment vehicles, India is poised to take advantage of ETFs tracking specific commodities or baskets of commodities.

Pension Reform The U.S. Example Twenty-four years ago in the U.S., under the presidency of Ronald Reagan, the first 401(k) plan was created .The 401(k) is a self funded retirement plan utilized heavily by millions of workers in the U.S. to build a retirement nest-egg that was previously provided by fully funded company pensions. The popularity and utilization of the 401(k) plan can be attributed primarily to its deferred tax benefit and the decline of company pension plans.

As of the end of 2003, the 401(k) plan assets grew to $1.9 trillion and consisted of 42 million workers. Also as of the end of 2003, 45% of 401(k) plan assets were invested in equity funds. If we include the equity portion of balanced funds and company stock, the percentage of plan assets invested in equity fund increases to 67%. 73 The 401(k) in the U.S. is likely to become one of the largest asset owned by individuals aside from their home.

The dollar-power helped fuel the bull market in the 1990s and revolutionized the mutual fund industry, which was quick to market the plans in their early days and now manages more than half of 401(k) assets. 74

Emerging Market Example Various emerging markets have introduced pension reforms and are experiencing an increase in assets under management by private fund managers (PFM). As an example of how large the assets under

management (AUM) can grow, Chile’s AUM has reached 54% of GDP, 20 years after pension reform. Other countries experiencing rapid AUM are Mexico, Peru, Uruguay, Hungary, and Kazakhstan. 75

A study by Walker and LeFort (2000) found a statistically significant impact of pension fund’s AUM on

various aspects of the capital market including equity pricing, lower volatility, less sensitivity to external shock, accumulation of institutional capital, better legal and regulatory framework, higher transparency,

and higher integrity. There does remain a big variance from market to market in the percentage of assets that go into the equity market as opposed to the debt market.

Pension reform is also taking place within South East Asian countries including Taiwan, China, and Singapore. In Singapore, for example, the folks at State Street Global Advisors that manage the STI (Straits Times Index) ETF hope that pension reforms in the country will serve as a catalyst for broader retail acceptance of their ETF product. 76

The Opportunity in India With the recent pension reforms and the formation of the NPS, an increasing portion of the growing AUM

of

the pension system will make its way into the domestic capital market. The assets under management

of

the pension system should grow dramatically and represent a significant opportunity for ETF products

to

become a primary vehicle to park some of the pension assets. A primary concern of pension systems

and its participants is managed growth. ETFs are an ideal product for such investment goals as they provide a way to invest in a broad index with transparency and low annual costs. As an example of how the low management costs can add up to real savings, take for example an investment of $5,000 sitting in an ETF versus a mutual fund for a period of 30 years. If we take the average management cost of ETFs (80 basis points) and the average management cost of mutual funds (200 basis points), ignoring dividends and tax implications, we can compute that the ETF account would grow to $36,906 while the mutual fund account would grow to only $25,930.

Commodity ETFs

India finds itself in a particularly good position to take advantage of the emerging ETF commodity markets. The country’s economic culture is a good fit with these new financial products. In fact, the concept of a gold bouillon based ETF (the engine that is currently driving the commodity ETF phenomenon) was the brainchild of Benchmark Mutual Funds. As the first to propose gold tracking ETFs in 2002, India was the innovator in this space. Despite the halt to its progress due to regulatory friction, other countries have capitalized on this financial innovation (see attached Gold ETF Chronicle).

Exchange traded funds, based on commodity derivatives provide another opportunity, uniquely suited to the NSE’s capabilities and its desire to reach the retail investor.

Applications for ETFs indexed to commodities and commodity derivatives are seeing a surge in the US. There have been a number of recent applications for ETFs indexed to commodities, including silver, oil and bundles of commodities, as well as to currency, and dividends.

In May, Deutsche Bank AG’s DB Commodity Services LLC applied for a commodity basket ETF that would track the Deutsche Bank liquid commodity index-excess return (crude and heating oil, aluminum, gold, corn and wheat)

GOLD ETF CHRONICLE

India, May 2002: Benchmark Mutual Fund proposed a Gold ETF, Gold BeES, which would have been the world's first Gold ETF, and an instance of financial innovation from India. However, regulatory friction slowed down the process allowing other major markets to preemptively develop their own Gold ETFs.

Timeline 2002 India (May): Benchmark Mutual Fund proposes worlds first Gold ETF; however, regulatory friction
Timeline
2002
India (May): Benchmark Mutual Fund proposes
worlds first Gold ETF; however, regulatory friction
prevented rapid implementation of the new product.
2003
Australia, (March): Gold Bullion Co. launches
first gold ETF on ASE.
India (Oct.): gold futures trading resumes in India.
UK (Dec.) : LSE posts gold bullion ETFs “GBS”
2004
Johannesburg (Dec.): JSE posts gold bullion ETF
U.S. (Nov.): Street Tracks launches “GLD” ETF on AMEX
2005
U.S. (Jan.): IShares Gold ETF “IAU” launches on
India (July): UTI Mutual fund announces plan to launch
Gold-ETF (GETF)

Lessons Learned:

1) While the World Gold Council originally perceived their ETF product would be most attractive to retail investors this did not turn out to be the case. In fact, 85% of the original Australian Gold ETFs were held by institutional investors. Thus, the WGC realized at this early stage that this ETF idea appeals more to institutional investors than retail buyers. Therefore, when the WGC got around to launching gold ETFs in other countries (UK, U.S., etc.) it was more sensitive to the needs of institutional investors. 2) Transparency is key, existing ETFs have run into some transparency “problems” because of the following issues:

- The key custodian, HSBC, can use sub-custodians and even sub-

subcustodians

- HSBC is not liable for the acts or omissions of its sub-custodians

- The locations of the vaults of the sub-custodians are not disclosed

- Neither the Trustee or HSBC monitors the activities of any sub-custodians

India should look to eliminate these loose regulatory issues before they become a problem. 3) First mover advantage has proven critical in the ETF gold market. Street tracks’ (GLD) 3-month head start over IShares (IAU) has allowed it to capture the vast majority of the market (see graph below). On average GLD captures 95.7% of the daily U.S. Gold ETF trading volume.

and would invest in futures contracts and forward contracts, as well as in cash and U.S. Treasury securities. 77

In an effort to build funds around the movement of oil prices, two applications have recently been filed:

(1) one by Macro Securities Depositor LLC, of Morristown, N.J., which registered for an exchange-traded vehicle pegged to the price of oil (2) the second by Standard Asset Management, which filed a registration statement for a limited partnership called New York Oil ETF LP, which would track the price of a barrel of light, sweet crude oil, minus the fund's expenses. The fund would invest in oil futures contracts on the New York Mercantile Exchange, as well as options on oil futures contracts, forward contracts for oil and over-the-counter transactions based on the price of oil. 78

The difference between these and equity based ETFs is that there are no underlying securities - they are all based on derivatives or a type of derivative product. In the U.S., they are registered as investment trusts.

Recognizing that there may be yet undetermined risks associated with these newer ETFs, and that there is some complexity to developing them, we believe that a number of factors suggest the NSE is in a strong position to sponsor and support this type of ETF:

The NSE has a very strong equity derivatives market

93% of derivatives trading is conducted by small brokerage retail participants; an ETF based on derivatives would flow naturally into the hands of the retail investor. 79

With the easing of government restrictions on commodity futures and the 2002 creation of electronic exchanges, commodities derivatives have grown substantially. Overall, monthly trading volumes in commodities derivatives, at 1 trillion rupees ($22 billion) are almost 40% of the NSE’s equity derivatives market. Even with this level of growth and interest, there are still limitations as the Forward Markets Commission prohibits use of options and cash settlement.

Drawing the retail investor into the ETF product market with a product indexed to commodities derivatives (or other derivatives) should aid in acceptance, in much the same way familiarity with badla aided acceptance of single stock futures.

There has been reported success with the commodity ETF launched in Europe. The EasyETF GSCI, indexed to the Goldman Sachs Commodity Index, tracks 24 commodities across the energy, metal, agricultural and livestock sectors, by investing in futures contracts. 80

The retail investor has proven difficult to reach with equity products, partly due to risk averse behavior and partly due to their ability to earn reasonable returns in the debt market, averaging 9.7% over the last five years. 81 Commodity derivatives have proven to be successful products with the retail investor. An ETF based on commodity derivatives, but with more trading power, may provide an entrée product exciting enough, yet safe enough to draw the retail investor into the equity market.

VI.

Recommendations

The following recommendations seek to improve the regulatory, structural, and new product environment for the NSE and its ETFs. They are not, however a prescribed solution for the NSE in its endeavor to maximize the ETF potential on its exchange. Further, our recommendations are not intended to reflect that of a "western" or American style of investing. However, we could not ignore both the success and the various business dynamics represented by the ETFs in the United States and other markets. Ultimately, with the right product, marketing and regulatory environment, the NSE has the opportunity to take a leadership role in the development and deployment of innovative ETF products.

1. Begin an extensive lobbying initiative to persuade the Indian government to reduce or eliminate India’s current tax regulations that are directly hindering capital investment in the ETF marketplace. The government should adopt some measure of tax reform that considers revoking the Securities Transaction Tax ("STT") effective immediately (at the very least, the STT should be modified so ETFs benefit from the same tax advantages as other financial products; i.e. futures and options). The government should also consider eliminating short-term capital gains taxes associated with in-kind trade transactions.

The growing global ETF phenomenon has been the direct result of joint efforts between stock exchanges and governments. Without substantial governmental backing in the form of favorable tax regulations it is doubtful these products could have reached their current growth rates. Government support has been essential in ETF success in Singapore and Turkey.

The NSE would benefit greatly if such tax avoidance measure are introduced. The ultimate success of ETFs will be dependent on their tax advantages and (at the very least) tax neutrality.

2. Cooperate with the Indian government to build controls and ramp-up the enforcement of its shorting regulations. While Indian regulations theoretically permit shorting, the lack of stable regulatory mechanisms to protect prospective players in the shorting market is drastically limiting the efficacy (hence the demand) of ETFs.

In particular, the government needs to discourage naked shorting through strict enforcement of existing penalties (and, if need be, reinforce these guidelines through the development of new stricter regulations). The government, in cooperation with the investment community should discourage short return defaults through strict enforcement of existing penalties (and, if need be, reinforce these guidelines through the development of new stricter regulations). One remedy for the limited controls around the shorting of securities is to increase the required percentage of borrower’s portfolio to 100% of the short sale transaction. Currently the value of the borrower portfolio must be equal to 50% of the short sale transaction thereby guaranteeing the borrowers ability to return the borrowed shares. Clearly the NSE would benefit from this recommendation from the increase in trading volume.

In the appendix, we have included a letter written by Bob Tull of the American Stock Exchange to the Turkish government encouraging it to allow shorting for ETFs.

3.

Partner with Indian Pension Funds to begin a gradual and steady increase in the long-term

investment of ETFs. With the recent pension reforms and the formation of the New Pension System ("NPS”) an increasing portion of the growing AUM of the pension system will make its way into the domestic equity market. Pension fund managers need to be educated on the advantages of ETFs and their ability to index at the lowest possible cost. The NSE and the Sponsors of ETFs should also begin a campaign that educates investors on the benefits of ETFs as part of their retirement plans and why they

offer advantages to traditional mutual funds or individual securities.

4. The NSE should sponsor ETFs indexed to commodity derivatives, aimed at the retail investor.

The retail investor has proven to be difficult to reach with equity products in India, however, commodities

derivatives, on the other hand, have been highly successful in the retail marketplace. Drawing the retail investor in to the ETF market with a product indexed to commodities derivatives should aid in the gradual acceptance of equities.

5. Introduce market makers specifically for ETFs. In order to encourage fluid trading of ETFs,

investors need to easily buy and sell ETF shares. We recommend following the Swiss Exchange model. Switzerland has an electronic exchange and ETFs are the only financial vehicle that uses market makers. The Swiss model requires market makers to make trades when a bid or ask is within a certain spread of the NAV. There are nuances based on when and where the trading occurs and the amount of the trade, but experts believe that these rules have helped enhance liquidity on the market. 82

Once the NSE implements this rule, it should market “guaranteed trading” to retail and institutional investors alike.

6. NSE should strategically expand its current listings by creating and sponsoring new ETFs on

new indices that provide greater investor exposure to India's select industries. As evidenced by the Nasdaq in the United States, sponsorship of an ETF provides core benefits as well as direct promotional value to the securities listed. By creating new indices with correlating ETFs, the NSE will be promoting the overall velocity of trading and hence the liquidity of the listed underlying ordinaries as more investors seek alternative indexing and other methods to diversify at the lowest possible cost.

iShares, the often mentioned brand name family of ETFs managed by Barclays Global Investors, offers funds that track nearly 100 different indexes. Each of iShares ETFs tracks a specific asset class, style, sector region or country. BGI has become one of the world's largest asset managers by creating products and building market share in areas that are not covered by other ETF sponsors and they have reinforced their progressive growth by providing virtually every element of the equity markets.

The NSE will be better positioned to popularize ETFs by offering equities that implement a targeted asset strategy and enable investors to leapfrog traditional indexing and sector investing that is provided by the mutual fund industry. The NSE can differentiate its ETF offerings by providing investment avenues on diversified industry indices (e.g. the Indian biopharmaceutical industry) and capture the wave of new equity investments in these sectors through ETFs.

7. Market ETFs to the FIIs so that ETF products may be utilized for a portion of their holdings in India The growing number of registered FIIs that are investing an increasing amount of money into the Indian equity market represents a significant growth opportunity for both the AUM and trading volume of ETF products. A marketing campaign should be targeted towards these FIIs to utilize ETFs as an alternative to hand picking individual stocks or mutual funds. Currently there are roughly 600 FIIs registered within India and a marketing campaign targeting this group would appear to be much more feasible and cost effective next step than targeting the most difficult and expensive to reach retail investors. In addition, the amount of assets infused into the Indian equities market by these FIIs is large and growing, and any portion of these assets that find their way into ETF products would be significant.

VII. Appendix

Appendix 1: Worldwide ETF Success Factors

With the meteoric growth the past decade in the size and number of ETFs worldwide, a number of subject matter experts have risen to the forefront of the industry. ETFs were both founded and have experienced the largest growth in the United States. As such, the three most knowledgeable experts in ETF success factors are in the U.S.’s three large exchange 83 : Nasdaq Stock Market, New York Stock Exchange, and American Stock Exchange. The experts at these exchanges spearheaded the launch of the world’s first ETFs, have served as advisors for numerous ETF formations throughout the world, and continue to lead the way in ETF-related advancements. Table 2 shows the five most critical factors that each of these three experts believe contribute to the success of an ETF. 84,85,86

John Jacobs

 

James McGowan

Bob Tull

Executive Vice President and Chief Marketing Officer, The Nasdaq Stock Market, Inc.; CEO of NASDAQ Global Funds

Managing Director, Exchange Traded Funds, New York Stock Exchange

Vice President, ETF Marketplace, American Stock Exchange

High level of transparency in processes (including settlement, etc.) and information.

The level of assets - money is made on the assets, not the trades.

Understand what the Customers of NSE want.

Investing in the stock market must be part of the population’s culture -- this has been a huge hurdle in the U.K.

The Index it tracks must be well known and well marketed.

Create the information flow that incites the call of action to BUY.

Must be the most efficient way to gain exposure to a particular set of stocks.

The amount of institutional money benchmarked to the index.

Create something special, something different in a stand- alone ETF product.

Benchmarked against a meaningful index, as the ETFs primary role is as an index- investing vehicle.

It

helps to fill a niche role (e.g.

Ensure the supply side of the NSE; public companies that can recapitalize, float additional ordinaries.

gold, silver or oil or the Selective Dividend Index

Fund)

Must be either tax neutral or tax favorable.

A

deep understanding of

Use an ETF efficiently.

which products compete with

 

it

and could attract away

money.

Appendix 2: Detailed Analysis of the Nasdaq-1000 Index Tracking

Stock 87888990

Nasdaq-100 Index Tracking Stock (QQQQ)

Highlights – End of Year, 2004:

 

o

Total Trust Net Assets: $20,380,384, 827

o

Number of Nasdaq-100 Shares: 580,150,000

o

NAV per share (based on securities and other assets): $35.13

o

Shares Traded: 25 Billion

o

Dividend Income: $59,439,915

o

Dividends Distributed to Unitholders: $8,613,794

Roles:

 

o

o

Sponsor: Nasdaq Global Funds, Inc.

Begins the process of establishment of the ETF, and overseas the operation.

Reimbursed by the Trustee for expenses (e.g., federal and state annual registration

fees; marketing expenses). The UIT structure prevents the Sponsor from making a profit. However, there are

other benefits for being the Sponsor: marketing money allotted for the Qube serves to build the Nasdaq brand and its constituent listed companies; trading volume due to Qubes is beneficial to exchange b/c makes its listed companies happy.

Trustee (a.k.a. “Custodial Bank”): The Bank of New York Manages the Trust: holds underlying ordinaries, redeems and creates, manages

portfolio. The Trust’s objective is to provide results that generally match the price and yield

performance of the Index. However, it will at times fail to own securities that are part of the index. Thus, the portfolio held by the Trust is not managed, and the only purchases and sales made will be to meet the goal of matching the Index as close as is practicable. The Trust makes changes to the portfolio at least monthly, and more frequently in

the case that notable changes are made to the Index. Changes to the Index are evaluated to determine if and when a corresponding change needs to be made by the Trustee to the portfolio. Note: the Trustee considers transaction costs when evaluating whether or not to make a portfolio change in response to an Index change. Trustee takes a transaction fee for each creation and redemption (Ranges from $0 -

$1000, not to exceed 10 bps). Trustee takes a fee for maintaining the Trust’s accounting records, providing administrative services, and determining/adjusting the portfolio of underlying securities.

For the Qubes, the fee ranges between 4 – 10 bps of net asset value, depending on the size of the net asset value. This fee is a minimum of $180,000. If the Trustee’s compensation is less than the minimum, based on the NAV, then the Sponsor will pay the amount of the shortfall.

Trustee selection: Most important criterion is to determine how closely they can track the index. Second, determine their cost. At the time of the formation of the Qube, Trustees were easier to measure in terms of performance than other roles, since UIT’s had been around for a long time.

o

Distributor: ALPS Distributors

Distributors are involved in marketing, sales, and administrative aspects (e.g.,

manage broker-deal selling agreements, coordinate mass mailings and database management and reporting). Paid an annual flat fee by the Sponsor for distribution services.

Distributor selection: At the time of the formation of the Qube, there were only a few distributors in existence. Nasdaq first picked a law firm (Jones Day). When they looked for the distributor, they looked for one with some experience in this area, and one that is easy to work with.

o

Authorized Participants (AP): several large firms: Susquehanna Specialists, Merrill Lynch Professional Clearing Corporation, Spear Leeds & Kellogg, etc.

Process the redemption and creation of ETF shares to the Trust. For the Qube, Creation and Redemption must be in multiples of 50,000 ETF shares. At the time of the formation of the Qube, Susquehanna Specialists bought enough

ordinary shares to create 150,000 ETF shares. The AP’s job is to arbitrage and keep the tracking in check. They also lend shares out, for a fee, to allow shorting.

Expenses:

o

At the time of the formation of the Qube, the initial selection of the expense ratio was with the following three goals in mind: 1) extend the Nasdaq and Nasdaq Index brands; 2) provide additional volume and trading tools for the Nasdaq stocks; 3) break even (revenues cover expenses).

o

Annual Ordinary Operating Expenses: 0.20% of net assets 91

Trustee’s Fee: 0.06%, as a % of net Trust assets: $13,841,499 for 2004.

Nasdaq license fee: 0.04%: $8,804,330 for 2004. Paid by the Sponsor, and

reimbursed by the Trust. Marketing expenses: 0.10%: $21,154,762 for 2004. Paid by the Sponsor, and

reimbursed by the Trust. Other expenses: <0.01%: $336,613 for 2004. Paid by the Sponsor, and reimbursed by the Trust.

Trust Net Assets Growth:

o

The Trust grew by $319,112,781in total net assets in 2004. Increases:

$1,758,076,814 in realized and unrealized gains. Essentially, the base of underlying ordinaries appreciated, and the sale of ordinaries to rebalance resulted in gains. Decreases:

$8,613,794 in dividend distributions to unitholders.

$1,430,350,239 in unitholder transactions. Essentially, redemptions outpaced creations.

Distributions:

Dividends: Quarterly (last business day of April, July, Oct, Jan). Dividends distributions are accumulated from the underlying securities, net of Trust fees and expenses. Distribution of dividends is not made unless dividends exceed Trust fees. If dividends are not sufficient to cover Trust expenses, then at the time of the next portfolio rebalance the Trustee will sell securities to obtain sufficient cash proceeds.

Today, dividends cover all Qube expenses. Initially, The Bank of New York had to sell-off small amounts of shares to cover expenses.

o

Net Capital Gains distributions are made at least annually.

o

Cash Balance:

o

The Trust carries a small balance of cash: $11,003,938 in 2004.

o

The cash is there for slight rounding and tracking errors, and is often used during creations and redemptions. That is, the cash in the creation process is to account for slight variances in the weights of the stock in the basket versus those that are traded-in.

Ownership Summary:

o

Institutional:

390 Holders

~ 40% of total shares

Total Shares held: 222,609,859

Value of holdings: $8.5 billion

Top 5 Holders: Goldman Sachs, Morgan Stanley, CSFB, Bear Stearns

o

Retail:

~ 1 million retail investors.

Qubes tend to be more retail-oriented than other ETF’s, because they launched in a strong bull market.

o

Short Interest: ~ 200 million shares; Average 1.9 – 2.2 Days to Cover.

Key Statistics:

Assets and Shares The three major U.S. ETFs (i.e., Cubes, Spiders, Diamonds) have all lost assets the past few years due to redemptions outpacing creations. The U.S. market has shown low volatility over this time period. In prior years, there was a large amount of shorting, and thus a lot of institutional lenders were involved. Due to the decrease in volatility, there has been less shorting and thus less lending. As a result, these institutions have cashed-out (i.e., redeemed) their ETF shares. It is expected that when the market starts to pick-up again in volatility, that the creations will pick-up again. However, with the increase in overall value of the underlying stocks in the underlying portfolio, due to market gains, the net assets still have continued to increase over the past few years. The data table and figure, below, show this in more detail for the Cube.

 

Trust Net Assets

 

Change in QQQQ Shares

Year

Net Assets

Year

Change in Shares

Number of Shares

2002

$15,108,062,763

2002

107,800,000

729,800,000

2003

$20,061,272,046

2003

(110,800,000)

619,000,000

2004

$20,380,384,827

2004

(38,850,000)

580,150,000

Source: Prospectus: NASDAQ-100 Trust, Series

 

1

Net Assets

Nasdaq-100 Index Tracking Stock:

Share and Net Asset Growth

800,000,000 600,000,000 400,000,000 200,000,000 0 2002 2003 2004 QQQQ Shares
800,000,000
600,000,000
400,000,000
200,000,000
0
2002
2003
2004
QQQQ
Shares

Fiscal Year

$25,000,000,000

$20,000,000,000

$15,000,000,000

$10,000,000,000

$5,000,000,000

$0

Number of Shares Net Assets

Number of Shares

Number of Shares Net Assets

Net Assets

Price Stability In FY2004, the Nasdaq-100 Tracking Stock showed strong price stability. Indeed, 90.88% of trading days showed a change of less than 2.50%. The Nasdaq-100 Index showed similar properties. Price stability data is detailed in the following table and figure.

Daily Percentage Price Ranges, 1/1/04 - 12/31/04

 
 

Nasdaq-100 Index

 

Nasdaq-100 Trust

 

Range

Frequency

% of Total

Frequency

% of Total

0-1.00%

49

19.44%

33

13.10%

1.01-1.50%

96

38.10%

88

34.92%

1.51-2.00%

67

26.59%

73

28.97%

2.01-2.50%

27

10.71%

35

13.89%

2.51-3.00%

10

3.97%

10

3.97%

3.01-3.50%

3

1.19%

9

3.57%

3.51-4.00%

0

0.00%

2

0.79%

4.00-5.00%

0

0.00%

1

0.40%

> 5.00%

0

0.00%

1

0.40%

Total

252

100.00%

252

100.01%

Source: Prospectus: NASDAQ-100 Trust, Series 1

 

Nasdaq-100 Index Tracking Stock Price Stability:

Daily Percentage Price Ranges, 2004

Stock Price Stability: Daily Percentage Price Ranges, 2004 0-1.00% > 5.00% 1.01-1.50% 3.51-4.00%

0-1.00%> 5.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50%

> 5.00%0-1.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50% 0-1.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50% 0-1.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50% 0-1.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50%

1.01-1.50%0-1.00% > 5.00% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50%

3.51-4.00%

1.51-2.00%0-1.00% > 5.00% 1.01-1.50% 3.51-4.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50%

4.00-5.00%

2.51-3.00%0-1.00% > 5.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.01-2.50% 3.01-3.50%

2.01-2.50%

0-1.00% > 5.00% 1.01-1.50% 3.51-4.00% 1.51-2.00% 4.00-5.00% 2.51-3.00% 2.01-2.50% 3.01-3.50%

3.01-3.50%

Proximity to Net Asset Value (NAV) The Nasdaq-100 Tracking Stock shows a continued remarkable close tracking to its NAV. Indeed, on 85% of trading days, the Cube tracked within 0.25% of its NAV. In addition, frequency above and below the NAV was quite similar. Detailed data and trending are shown below in the table and figure.

Closing Prices v. Net Asset Value, 1/1/04 - 12/31/04

 

Closing

 

Closing

 

Price

Price

Above

Below

Trust NAV

Trust NAV

Range

Frequency

% of Total

Frequency

% of Total

0-.25%

107

86.99%

108

83.72%

.251-.50%

16

13.01%

19

14.73%

.501-1.00%

0

0.00%

2

1.55%

1.01-1.50%

0

0.00%

0

0.00%

1.51-2.00%

0

0.00%

0

0.00%

> 2.00%

0

0.00%

0

0.00%

Total

123

100.00%

129

100.00%

Source: Prospectus: NASDAQ-100 Trust, Series 1

 

Nasdaq-100 Index Tracking Stock Proximity to NAV:

Closing Prices v. Net Asset Value

120 100 80 60 40 20 0 0-.25% .251-.50% .501- 1.01- 1.51- > 2.00% 1.00%
120
100
80
60
40
20
0
0-.25%
.251-.50%
.501-
1.01-
1.51-
> 2.00%
1.00%
1.50%
2.00%
Frequency

Range

Closing Price Above Trust NAV Closing Price Below Trust NAV

Closing Price Above Trust NAV

Closing Price Above Trust NAV Closing Price Below Trust NAV

Closing Price Below Trust NAV

Proximity to Index The Nasdaq-100 Tracking Stock showed very close tracking to its target index, the Nasdaq-100. For the year 2004, the Cube had an average deviation of 0.625% from the index. Detailed monthly data and trending is shown below in the table and figure.

Net Asset Value v. Nasdaq-100 Index, 1/1/04 - 12/31/04

 

Trust NAV

Nasdaq-100

Percentage

Month

Equivalent

Index Value

Difference

Jan-04

1484.67

1493.08

-0.5633%

Feb-04

1462.32

1470.38

-0.5482%

Mar-04

1430.28

1438.41

-0.5652%

Apr-04

1393.4

1401.36

-0.5680%

May-04

1458.14

1466.22

-0.5511%

Jun-04

1508.07

1516.64

-0.5651%

Jul-04

1392.49

1400.39

-0.5641%

Aug-04

1361.58

1368.68

-0.5187%

Sep-04

1405.18

1412.74

-0.5351%

Oct-04

1478.66

1486.72

-0.5421%

Nov-04

1563.37

1571.5

-0.5173%

Dec-04

1597.52

1621.12

-1.4558%

Source: Prospectus: NASDAQ-100 Trust, Series 1

Nasdaq-100 Index Tracking Stock Proximity to Index

1700

1600

1500

1400

1300

1200

Jan- Feb- Mar- Apr- M Jun- Jul- Aug- Sep- Oct- Nov- Dec- 04 04 04
Jan-
Feb-
Mar-
Apr-
M
Jun-
Jul-
Aug-
Sep-
Oct-
Nov-
Dec-
04
04
04
04
ay-
04
04
04
04
04
04
04
04
Trust NAV Equivalent
Nasdaq-100 Index Value

Distribution of Bid-Ask Spread The Nasdaq-100 Tracking Stock proved to be the world’s most traded stock in 2004. As empirical research has shown, high trading volumes lead to tighter bid-ask spreads. The Cube showed a very tight spread in 2004, with 99.85% of trades executed with a spread of less than $0.05. In addition, 23.88% of trades occurred with locked or crossed trades. A market is considered to be locked (crossed) when the inside ask is equal to (is less than) the inside bid, which makes the National Best Bid and Offer ("NBBO") spread equal to (less than) zero.

NASDAQ uses the SuperMontage system for order placement. Prior to SuperMontage launching in October 2002, the major ECNs were all participating in NASDAQ. As such, these ECN's were subject to the same rule that required the market makers to execute against all posted orders before they lock or cross a market. Now that ECNs are operating independently, locks and crosses are happening in the largest, most widely traded stocks, like Cisco and IBM, where ECNs are major players. Indeed, NASDAQ executes only 51.59% of all trades in affiliated securities; while the three major ECNs: Island, Instinet, and ArcaEx – capture as much as 47.73% of trade flow. Thus, the primary reason for locks and crosses is access fees. Customer orders in major ECNs are not always executed on the NASDAQ due to the access fee associated with each system, such as SuperMontage. This can lead to a locked, or ultimately crossed, market. In 2003, 14.67% of NASDAQ’s NBBO spreads were non-positive. 9293

Bid/Ask Spread Distribution 1/1/04 - 12/31/04

Range

% of Total

Locked/Crossed

23.88%

$0.01 - 0.05

75.97%

$0.06 - 0.10

0.14%

$0.10 - 0.15

0.01%

$0.15 - 0.20

0.00%

$0.20 - 0.25

0.00%

$0.25 - 0.30

0.00%

> $0.50

0.00%

Total

100.00%

Source: Prospectus: NASDAQ-100 Trust, Series 1

Nasdaq-100 Index Tracking Stock:

Bid/Ask Spread Distribution

0%0%0%0%0% 24% 0% 76%
0%0%0%0%0%
24%
0%
76%

Locked/Crossed$0.10 - 0.15 $0.25 - 0.30 $0.01 - 0.05 $0.15 - 0.20 > $0.50 $0.06

$0.10 - 0.15Locked/Crossed $0.25 - 0.30 $0.01 - 0.05 $0.15 - 0.20 > $0.50 $0.06 - 0.10 $0.20

$0.25 - 0.30Locked/Crossed $0.10 - 0.15 $0.01 - 0.05 $0.15 - 0.20 > $0.50 $0.06 - 0.10 $0.20

$0.01 - 0.05Locked/Crossed $0.10 - 0.15 $0.25 - 0.30 $0.15 - 0.20 > $0.50 $0.06 - 0.10 $0.20

$0.15 - 0.20Locked/Crossed $0.10 - 0.15 $0.25 - 0.30 $0.01 - 0.05 > $0.50 $0.06 - 0.10 $0.20

> $0.50Locked/Crossed $0.10 - 0.15 $0.25 - 0.30 $0.01 - 0.05 $0.15 - 0.20 $0.06 - 0.10

$0.06 - 0.10Locked/Crossed $0.10 - 0.15 $0.25 - 0.30 $0.01 - 0.05 $0.15 - 0.20 > $0.50 $0.20

$0.20 - 0.25Locked/Crossed $0.10 - 0.15 $0.25 - 0.30 $0.01 - 0.05 $0.15 - 0.20 > $0.50 $0.06

Appendix 3: Gold ETFs

Background:

Gold is the underlying asset for the units of these ETFs. Every Gold ETF Unit represents a definite quantum of pure gold and the traded price of that Gold Unit moves in tandem with the price of the actual gold metal as is traded in any big gold merchant or in any metal exchange (at 1/10 the price of an ounce of gold).

For Example: streetTRACKS Gold Trust is an investment trust whose shares strive to reflect the performance of the price of gold bullion, less the Trust’s expenses. The Trust holds gold, and is expected to issue baskets in exchange for deposits of gold, and to distribute gold in connection with redemptions of baskets. The gold held by the trust will only be sold on an as-needed basis to pay trust expenses. The Trust is not managed like an active investment vehicle, and it's not registered as an investment company under the Investment Company Act of 1940.

Gold ETF Timeline:

- India, May 2002: Benchmark Mutual Fund proposed a Gold ETF, Gold BeES, which would have been the world's first Gold ETF, and an instance of financial innovation from India. However, regulatory friction slowed down the process allowing other major markets to preemptively develop their own Gold ETFs

- Australia, March 2003: Gold Bullion Company (Sponsored by World Gold Council) posts first gold ETF “ZAUWBA” on the Australian Stock Exchange

- India, October 2003: A major “first step” took place when futures trading on gold restarted in India (after gap of roughly 40 years).

- UK, December 2003 : London Stock Exchange posts gold bullion ETFs “GBS” (Sponsored by World Gold Council)

- Johannesburg, December 2003: Johannesburg Stock Exchange posts gold bullion ETFs “GBS” (Sponsored by World Gold Council)

- U.S., November 2004: Street Tracks launches “GLD” ETF on AMEX (Sponsored by World Gold Council)

- U.S., January 2005: Ishares Gold ETF “IAU” launches on NYSE (Sponsored by Barclays Global Investors)

- India, July 2005: UTI Mutual fund announces plan to launch Gold-ETF (GETF).

- Future: Potential future Gold ETFs are in the works in Hong Kong, Tokyo, Singapore and Zurich.

Opportunities for India:

- Environment receptive to gold as an investment vehicle because of existing ready and wide acceptability:

o

India is the world's largest consumer of gold. It accounts for 20 per cent of annual global gold “consumption”

o

An estimated 13,000 tons of gold rests in India, which is about 9 per cent of the global cumulative mine production

o

Gold is a prominent part of the rural economy, with a significant part of the rural credit market using it as collateral

- Gold ETF will provide an additional transparent platform for traders, fabricators and jewelry manufacturers to take long or short positions on the metal and also facilitate hedging and arbitrage opportunities.

- Gold has proven to be a good hedging vehicle since it is not highly correlated with other financial assets such as stocks, currency and bonds, which are directly affected by inflation and other macroeconomic forces

- Potential to bring many retail investors into the fold of capital markets; for these retail investors, it will facilitate easy buying of standard quality gold in small units without the hassle of safekeeping of the precious metal and cost of insurance

- this alternative form of investing in gold would also reduce the need for further imports of physical gold (i.e. positive effect on current account)

- Although Indians save nearly 25% of the GDP, a substantial portion gets locked into physical savings like gold. Gold BeES would help bring these savings from the physical domain into the financial sector.

Challenges for India:

Ensure involvement of “trade association”; a reputable institution needs to assume an active role to ensure fair market practices with respect to purity and other standard specifications (World Gold Council does this for most of the existing ETFs)

Keep costs of operations low in order to maximize profit for consumer. Must balance establishing transparent reputable system while minimizing expenses of valuations, benchmarking fees, capital adequacy norms, import, transportation and insurance costs.

Capital gains tax disadvantage. In the U.S., the IRS categorizes gold investments held for more than one year as "collectible," and taxes it at a higher long-term capital-gains rate of 28%, instead of the 15% rate applied on other investments.

Lessons Learned:

1)

While the World Gold Council originally perceived their ETF product would be most attractive to retail investors this did not turn out to be the case. In fact, 85% of the original Australian Gold ETFs were held by institutional investors. Thus, the WGC realized at this early stage that this ETF idea appeals more to

2)

institutional investors than retail buyers. Therefore, when the WGC got around to launching gold ETFs in other countries (UK, U.S., etc.) it was more sensitive to the needs of institutional investors. Transparency is key, existing ETFs have run into some transparency “problems” because of the following issues:

- The key custodian, HSBC, can use sub-custodians and even sub-subcustodians

- HSBC is not liable for the acts or omissions of its sub-custodians

- The locations of the vaults of the sub-custodians are not disclosed

- Neither the Trustee or HSBC monitors the activities of any sub-custodians

India should look to eliminate these loose regulatory issues before they become a problem.

3)

First mover advantage has proven critical in the ETF gold market. Street tracks’ (GLD) 3-month head start over IShares (IAU) has allowed it to capture the vast majority of the market (see graph below). On average GLD captures 95.7% of the daily U.S. Gold ETF trading volume.

Trading Volume 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 IA U GLD 11/18/2004
Trading Volume
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
IA U
GLD
11/18/2004
12/02/2004
12/16/2004
12/30/2004
01/13/2005
01/27/2005
02/10/2005
02/24/2005
03/10/2005
03/24/2005
04/07/2005
04/21/2005
05/05/2005
05/19/2005
06/02/2005
06/16/2005
06/30/2005

Gold Sources: