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Exchange-Traded Funds: Barclay's Brad Zigler
by Carl Sibilski | 06-23-2000 | E-mail Article to a Friend

Brad Zigler is a principal in charge of exchange-traded funds (ETFs) marketing and education at Barclays Global Investors (BGI)--which manages more than $780 billion in 1,500 different funds. BGI's fund advisory arm manages iShares, the world's largest family of exchange-traded funds.

Here is the complete session from the Ask the Expert Conversations forum. Zigler talks about:

What exchange-traded funds are.
The differences between Barclays' and Vanguard's index funds.
Taxes and expenses.

What are exchange-traded funds?
A question from chrisbaskett:

I would like to know in what way(s) are index mutual funds equal to or superior to exchange-traded funds.

Traditional mutual funds and exchange-traded funds (ETFs) share the biggest of all downsides: the possibility of capital losses. Comparing traditional mutual funds to ETFs is really a matter of considering trade-offs. A feature that may be attractive to one investor may be singularly unappealing to another. For long term investors, ETFs’ lower operating expenses, compared to traditional mutual funds, may more than compensate for round-turn brokerage fees. Those with shorter investment horizons, however, may think expense ratios are only second-level considerations.

If there’s one issue that stands out, it’s dollar cost averaging (DCA).

Most traditional mutual funds offer automatic investment plans. Since individuals buy ETF shares in the secondary market, they’re not establishing a direct relationship with the issuer. That’s what makes DCA so easy with traditional mutual funds: investors go straight to the shares’ issuer. There are, however, broker/dealers (e.g. and through which investors can set up DCA accounts for ETFs and individual stocks. For example, Sharebuilder allows DCA investments on a weekly or monthly basis, with no minimum, for $2 per transaction ($1 for custodial accounts). Hopefully, we’ll see discount brokers and wirehouses incorporating free DCA accounts into their service repertoire in much the same way they made free dividend reinvestment available for stock and ETF holders.

International ETFs
A question from oxysol:

How do you come up with indexes for the various international regions? What effect does currency flucuations have on the value of these indexes?

Indexes serving as iShares bases are created by firms independent of BGI. Domestic index providers include Standard & Poor’s, Dow Jones & Co., and Frank Russell Company. BGI presently manages 20 international iShares funds, too. Morgan Stanley Capital International’s country indexes are the bases for 19 funds in the iShares MSCI series (formerly known as World Equity Benchmark Shares, or WEBS). S&P provides international indexes for two iShares funds (one extant, one soon to be launched). Two more iShares MSCI funds, as well, are slotted for introduction shortly.

The primary force driving international ETF issuance is demand. If a significant investor segment wants a particular country or regional fund, that fund’s much more likely to be offered. But the decision to offer a particular fund has to be tempered with operational considerations.

Of primary concern is the liquidity and transparency of the targeted equity market. Markets in which price discovery is impeded or where settlement procedures are lengthy or costly present complications for portfolio managers. That’s why the first generation of BGI’s ETFs focused on well-established European and Asian markets. Presently, BGI is considering the addition of several more international funds, including those covering developing markets.

BGI international ETFs are not hedged against currency fluctuations. Investors in international ETFs not only take on the country’s or region’s equity market risk, they assume foreign exchange risk, too. If US investors used ETFs to counterbalance portfolios denominated in local currencies, the foreign exchange exposure actually makes the hedge more efficient. For speculative investments, however, it’s a mixed bag. Foreign exchange fluctuations can either magnify or mitigate portfolio performance.

Indexers as Commodity Management
A question from Scott Cooley, Morningstar fund analyst:

As a very large institutional index manager, what does Barclays bring to the table that some of its competitors don't have?

There’s a common misperception that anyone can run an index fund. It’s harder than most people can ever imagine. If you manage a full replication fund, everyone’s got a peek inside your knickers. It’s definitely a scale business as well. BGI is the world's largest manager of index funds, with over $600 billion in indexed assets under management (the balance of BGI’s nearly $800 billion asset base is split among actively managed, enhanced index, and money market funds). BGI’s been an expert in running index portfolios for nearly 30 years. BGI, in fact, developed the first index strategy in 1971. iShares are low cost category leaders because BGI has the scale of business to drive costs down. With exchange-traded funds, BGI doesn't have to build an enormous infrastructure to serve investors. iShares can be bought through any brokerage or advisory firm, keeping the cost to investors low.

Another question from Scott Cooley:

Also, in looking at daily performance numbers when a stock enters the S&P 500, it is clear that some managers are buying a stock before it formally enters the index. (We saw variations of as much as 10 basis points in various S&P 500 index funds' returns when Yahoo was added to the index.) What's Barclays' position on this?

Some S&P 500 indexers seemingly put on a rather loose interpretation of the term ‘full replication.’ Some own different share classes of the index components and are, as you noted, quite aggressive on the add/delete front.

Russell 3000 versus Dow Total Market iShares
A question from jop53:

Is there any significant difference between the iShares Russell 3000 index fund and the iShares Dow Jones U.S. Total Market index fund?

Yes, there IS a difference. But, performance-wise, the difference isn’t very big, at least for now.

The Dow Jones US Total Market Index is market cap-weighted, covering 95% of all US stocks (approximately 2,000 names). DJTM can be reconstituted quarterly.

The Russell 3000 Index, also market cap-weighted, covers 98% of what Russell describes as ‘US investable equity’ (about 2,800 names). Russell indexes are reconstituted annually.

The Dow Jones index’s price appreciated 4.81% since its February 14 debut, compared to the 5.76% earned by the Russell index. 30-day historic volatility for the Dow Jones index, as of today, has been 25.6%; Russell’s is 24.5%.

The truly essential difference between the two is trading flexibility and application.

The Dow Jones Total Market Index is comprised of ten market sectors including Basic Materials, Consumer Cyclicals, Consumer Non-Cyclicals, Energy, Financials, Healthcare, Industrials, Technology, Telecommunications, and Utilities. Each of these sectors is tracked by a unique iShares fund. Many portfolio management strategies are possible by combining or playing against members of the iShares Dow Jones family, such as sector overweights/underweights or short-long plays. In addition, there are four finer ‘slices’ of some of the Dow Jones market sectors for even more pinpoint segmentation.

iShares Russell 3000 Growth and Russell 3000 Value funds are expected to be launched in July, 2000. These funds will permit investors to emphasize/de-emphasize growth and value segments of the broad market within their portfolios as overlays in conjunction with the Russell 3000, or as stand-alones.

Figure the possible permutations of 15 Dow Jones market slices versus 3 Russell 3000 cuts.

Dividends Reinvestment
A question from Wickenden:

Why are dividends held in a non-interest bearing account for up to a year before being reinvested in the fund?

You might have us confused with someone else? Dividends on iShares portfolio securities are reinvested immediately.

Institutional Use
A question from smashing6:

Relative to closed-end funds, WEBS have high levels of institutional ownership. Why are institutional investors attracted to this type of investment? Are institutional investors using the share creation/redemption process to acquire/liquidate positions in foreign securities?

Again, WEBS (the former World Equity Benchmark Shares) have been folded into the iShares family as the MSCI fund series. The institutional interest in iShares MSCI funds isn’t surprising. Institutional accounts are just more likely to have international exposure that needs adjustment or hedging. The flexibility, liquidity, and country specificity of these funds make them extremely versatile portfolio management tools.

While acquisition and liquidation of foreign equity positions is a consequence of the creation/redemption process, it isn’t users’ primary objective. Liquidation of foreign securities positions involves the creation of iShares MSCI shares that have to be inventoried or sold off. Since these iShares portfolios are optimized, investors would have to assume the risk that their own securities holdings may not be ‘good delivery’ for the creation of iShares, too. Likewise, there’d be some uncertainty as to the names received when iShares are redeemed.

Gold Index
A question from edwashere:

Are there any EFT's based on Gold yet?

No, not yet. But we’re all ears. Do you have a particular gold index in mind?

Bond ETFs
A question from Bylo Selhi:

Barclays Global Investors Canada recently filed a prospectus for bond ETFs based on Canadian bonds. But the prospectus says only "The iG5 Fund seeks to replicate, to the extent possible, the return of a bond issued by the Government of Canada with a five year term to maturity. In order to achieve this objective, the iG5 Fund will invest in the Government of Canada bond selected by Barclays from time to time that has a time to maturity that closely matches the benchmark bond maturity."

Does this mean that the fund owns a single bond issue at any given time?

Yes, the ETFs (there’s both a 5-year and a 10-year bond fund planned in Canada) could own single issues at any given time. The funds are expected to roll into the next "on the run" bond approximately once per year. Not too many trades are needed to simulate a five- or ten-year maturity.

Another question from Bylo Selhi:

Must BGI constantly trade bonds in order to keep the maturity at the target maturity? If so doesn't this increase costs? Wouldn't a traditional bond ladder be more efficient?

Yes, there may have to be some trading to keep duration constant, but not much. And the fund gets the benefit of trading wholesale -- a key part of the value proposition for a fund of this type.

Trading increases costs anywhere, even in a ladder. If one year paper is held in a ladder, principal will have to be rolled annually into another maturity bucket. There’ll be transaction costs associated with the roll.

A ladder serves two purposes: it provides diversification across the yield curve and it creates an average maturity. ETFs do the same thing, but make the trades ‘automatically’ for investors.

Another question from Bylo Selhi:

Could you please explain a bond ETF’s objective?

The ETFs’ objectives will be the maintenance, to the greatest extent possible, of an average five- or ten-year maturity (with some maturity slippage over time between the rolls). If investors like five- or ten-year average maturities, they can hold just the five- or ten-year funds. To get a different average maturity exposure, investors at some time in the future may be able to ladder with other ETFs (additional ETFs with different average maturities are anticipated).

The economic value of the ETF is the ‘equitization’ of bonds - so that they trade like stocks with transparent, intraday prices, together with the ability to use limit and stop orders.

Determining Asset Allocation
A question from wendelldahl:

Do you offer modeling software for defining the investment policy? If not, how can a person define how their funds should be distributed among the iShares funds?

There are plenty of asset allocation models available from financial advisors and online sources. A query through some financial search engines (e.g. Yahoo! Finance) can point you in the right direction. Each investor’s situation is unique, so a solution derived from a software package should be viewed as suggestive rather than definitive.

BGI’s concentration is, instead, on the creation and management of a wide range of cost-effective and flexible asset allocation vehicles.

VIPER Legal Problem
A question from WScottM:

The suit of Vanguard by McGraw-Hill has been big news during recent weeks. At issue is Vanguard's contention that VIPERs require no new license for use of S&P intellectual property. Several questions about BGI come to mind:

Has BGI issued any public statement about the dispute?

It's not appropriate for BGI to comment further on a legal action in which it has no standing.

Another question from WScottM

How much, if anything extra, does BGI pay McGraw-Hill for the right to use S&P indexes as part of BGI iShares?

We’ve certainly read about S&P's suit against Vanguard. It's clear that brand and licensing are at issue. Common industry practice dictates that an investment company seek a license with an index provider before a portfolio is run off a proprietary index. BGI has license agreements with all index providers associated with iShares funds. Our fees to the index providers are not a matter of public disclosure.

Another question from WScottM:

Did BGI consider VIPER-like use of existing mutual funds, rather than the introduction of all new ETFs (BGI iShares)?

80% of BGI’s assets are managed in indexed collective accounts, not in mutual funds. To take the VIPER route (the creation of depository receipts on mutual fund shares) seemed counterintuitive. That would mean building mutual funds, then creating ETF versions. BGI just cut to the chase and created the ETFs directly.

Meaningful Data Comparisons
A question from deblaf:

But what about other indices? Given Barclays's experience an indexing approach, how long (from initial product start-up) might it take to get meaningful performance, cost, and tax efficiency data that one could use in a fair comparison of other investment products?

Well, first of all there needs to be a basis for comparison. If there are direct index product analogues (e.g., SPDRs vs. iShares S&P 500 Index Fund, MidCap SPDRs vs. iShares S&P 400 Index Fund) the job’s made easier, at least from a quantitative basis.

Seems to me that you need at least a full tax year to gauge tax efficiency and perhaps costs, since a lot of pooled investment products’ operating expenses are subsidized (BGI’s aren’t).

You can gauge some liquidity characteristics fairly quickly, say in the first 3-6 months. Average spreads are one liquidity metric. Tight spreads bespeak more liquid markets. Another liquidity yardstick’s the comparison of each product’s average volume divided by its outstanding shares. The higher the ratio, the more liquid the market.

From a medium-term performance standpoint, I think meaningful statistics like regressions and volatilities need to be built on at least two years of weekly data points. Morningstar, however, taking the longer view, needs 36 monthly data points of trailing data to generate publishable portfolio statistics like r2, alpha and beta.

Some comparisons, of necessity, involve qualitative assessments. Comparing sector index funds, for example, puts you in a position to decide between the Select Sector SPDRs and the iShares Dow Jones US Sector Funds. In S&P land, the large-cap 500 stock index is carved up into 9 sectors. Dow Jones, meanwhile, slices its 2,000 stock US Total Market Index into 10 sectors, covering all capitalization levels. You have to decide, for example, whether the Dow Jones Technology Sector Fund (IYW), covering 314 stocks across small-, medium-, and large-capitalization levels, is more useful for you versus the 94-stock wide large-cap Select Sector SPDR Technology Fund (XLK).

Discounts, Premiums & Arbitrage
A question from dickydo:

Is there potential for any discounts or premiums with ETF's? Is there any empirical evidence that arbitrage brings the pricing in close alignment with the NAV? Do you have any material we can access and review in this regard?

Yes. An excellent white paper on ETFs, penned by James L. Novakoff can be found
Here. Novakoff’s paper shows a year’s history in DIAMONDS’ (the ETF tracking the Dow Jones Industrial Average) premium/discount:

 DJIA Close versus DIAMONDS Closing Net Assets

Range ( % )


% of Total



















As you can see, premiums/discounts were limited to 25 basis points or less 78% of the time.

Difference Performance than Vanguard
A question from Bylo Selhi:

I'm disturbed by Dr. Bill Bernstein's recent article in Efficient Frontier, Tangled WEBS, which concludes, "if the WEBS experience is any guide, Barclays ... is the Gang That Couldn’t Shoot Straight. They can't even seem to get the S&P 500 right; the Barclays 500 Index Fund lags Vanguard's by 32 basis points per year since its 1993 inception despite a nearly identical expense ratio. For this reason alone I’d be exceptionally cautious about using any of the Barclays’ new products. A prudent policy would be to keep an eye on their TEs (tracking errors) over the next few years before jumping in."

How will BGI's new S&P, DJ and Russell iShares ETFs will address this issue?

Perhaps the good doctor should take note that BGI and Vanguard are shooting at different targets. The BGI product (WSPFX) is an institutional fund (with a $1 million minimum buy-in). Vanguard’s 500 Index VFINX is geared for retail.

Keep in mind that most of BGI’s indexed assets ($623 billion as of 12/31/99) are not in mutual funds, but in non-SEC regulated collective accounts. WSPFX is really a small accommodation for those clients preferring a mutual fund environment. BGI is restricted from discussing performance characteristics of its collective accounts in a venue where mutual funds are analyzed.

Partly, the performance differential is a function of the disparity in the funds’ sizes (Vanguard 500 Index is over 50 times larger than WFSPX), and the impact of larger-sized transactions that hit the BGI portfolio. Yes, size DOES matter! Vanguard 500 Index, too, is much more restrictive with respect to shareholder redemptions than WFSPX.

Perhaps more important is that Vanguard 500 Index takes on active risk with the explicit goal of recouping expenses. Vanguard 500 Index is not a pure replication fund. The BGI product is. BGI’s S&P 500 Index portfolio managers are not paid to assume active risk and BGI’s clients dictate that they don’t. Between WFSPX and Vanguard 500 Index, there are simply different mandates driven by different constituencies.

From this straw man, Bernstein seemingly wants to deduce a rationale for BGI’s ETF performance characteristics. He sets up another apple-to-oranges comparison when he pits iShares MSCI series funds (then known as WEBS) against Vanguard’s two regional funds. Each of the 17 iShares MSCI funds covered in Bernstein’s analysis is a single country fund. The Vanguard European fund covers fifteen countries; the Vanguard Pacific fund covers five countries. There’s simply more room to diversify, and to reduce costs and turnover, in funds based on 400 or 500 stocks versus those that are modeled on indexes with a median 30 or 40 issues.

To extend Bernstein’s metaphor, a straight shooter would normally compare single country funds against par - other single country funds. The response to the next question addresses that issue.

Futures Contracts
A question from brisni:

Do your index ETF's take advantage of futures contracts which may be trading at a discount?
If not, isn't this a disadvantage against Vanguard funds?

Most all iShares ETFs currently are full replication funds. BGI ETFs must maintain a continuous facility for ‘in-kind’ creation and redemption. Futures are not deliverable to Depository Trust Corp. and thus, aren’t included in the portfolios.

Discounts from futures’ ‘fair value’ may not be as prevalent as you think. Market efficiency has increased dramatically in the past few years and closed off much of this arbitrage opportunity. Nowadays the assumption of active risk in index fund management is more likely based upon the use of different share classes and aggressiveness on the add/delete front.

Tax-Efficient Indexing of Small Caps
A question from Ifindoubt1:

What do you think is the best way to index small caps such as the Russell 2000? When some stocks move from small cap to large cap, such as moving from the Russell 2000 to the Russell 1000, funds are forced to pay capital gains tax.

The only index fund that tracks the Russell 2000 presently is the iShares Russell 2000 (IWM). Keep in mind that there are also growth and value splits of the Russell 2000, tracked by the iShares IWO and IWN funds, respectively. But I surmise your question centers on the total index.

The problem may not be as big as it seems.

Russell indexes are reconstituted annually on July 1. It seems that the balloon of market capitalization in the Russell 2000 burst last year. According to Russell, the median capitalization of Russell 2000 Index companies actually fell 14% in 1999, while Russell 1000 member companies’ capitalization rose only 2%.

Russell 2000’s average annual turnover is 507 stocks. Last year seemed exceptionally busy for the index as 375 companies were deleted and 513 were added. Russell’s Steve Claiborne says only about a third of the Russell 2000 stocks deleted in 1999 actually ‘graduated’ to the larger cap Russell 1000. Realized losses from some of the other 250 deletes, a form of forced tax-loss harvesting, could be used to offset capital gains.

Tax-Efficiency and Structure Comparison
A question from skiff:

Are iShares mutual funds and do they accumulate undistributed gains as do other mutual funds? How are iShares different from WEBS and SPDRs?

iShares are open-end investment companies as defined under the 1940 Investment Company Act. As such, they share the same legal construction as traditional mutual funds. Spiders (SPY) are interests in a unit investment trust (UIT). Unlike ’40 Act open-end funds, UITs cannot immediately reinvest dividends received on portfolio securities. This produces the effect known as ‘cash drag.’ Over time, the performance of an index portfolio without cash drag will more closely approximate that of its underlying benchmark. Additionally, UITs have finite lives. Open-end funds are perpetual creatures.

WEBS (World Equity Benchmark Shares) was the former moniker of iShares MSCI series international funds. They, too, are organized as ’40 Act open-end funds.

Like traditional mutual funds, iShares are obliged to distribute accumulated capital gains to shareholders. But the structure of iShares minimizes capital gains exposure. Individual shareholder transactions don’t directly impact the iShares portfolio. Individuals buy and sell iShares in secondary market transactions through the facility of a stock exchange. But creation and redemption of iShares are done in large block sizes by institutions whereby iShares ‘creation units’ are swapped for the actual securities in the portfolio. These ‘in-kind’ transactions are not subject to capital gain tax.

Another question from skiff:

Why would an investor choose iShares over an index fund?

Tax efficiency may be one reason an investor might opt for iShares over a traditional index mutual fund. Another reason? Since iShares trade in the secondary market, most mutual fund transfer functions have been eliminated, lowering iShares’ operating costs.

Most all iShares domestic funds are replicants of their underlying indexes (currently, some of the Dow Jones sector funds are optimized). Provider-mandated index reconstitutions drive portfolio transactions for replication funds. iShares portfolio managers face the same tax-management challenges as their brethren in traditional, fully replicated index mutual funds.

International ETF Expenses
Another question from Bylo Selhi:

How can BGI justify the high (1 to 1.5 percent) expense ratios, plus brokerage fees and spreads, of owning WEBS? Doesn't this defeat the primary advantage (low costs) of indexing?

Why doesn't BGI also offer a single international WEBS/ETF that tracks the MSCI EAFE index? (Several Canadian banks offer EAFE open-ended index funds with expense ratios as low as 30 basis points.)

First of all, take a closer look at iShares MSCI (the former WEBS) funds. You’ll see the expense ratios across the board for these single country funds have been shaved to 84 basis points (.84%). Compare that to the average expense ratio reported for single country funds in the Morningstar Fund Selector database. Japan-only funds come in at an average 1.93% expense ratio; the average expense ratio for single country European funds is 1.97%. Single country funds will naturally have higher turnover rates, and resultant costs, than regional portfolios. Settlement costs alone in some of these funds can be horrendous. Did you know that settlement in France is T+30? Imagine the financing headaches you’d endure if your entire portfolio were nothing but French equities.

New international funds are being rolled out by BGI. An iShares fund based upon the Canadian S&P/TSE 60 Index (IKC) has been launched with a .50% expense ratio. An iShares S&P 350 Europe Index (IEV) is set to begin trading with a .60% expense ratio. And additional funds in the MSCI series are also planned.

Inheritance Tax?
A question from Jim Grover:

Are EFTs eligible for a step-up in basis, upon inheritance, as are stocks? My understanding is that open-ended funds are not eligible for this preferential tax treatment.

Caveat: never accept tax advice from a faceless entity on the Internet. Definitive advice should always come from your tax advisor, but I know of no reason why you shouldn’t assume stepped-up basis in ETF shares at inheritance.

Brad Zigler (a.k.a ‘Dr. Index’) can be reached through Barclays Global Investors iShares. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs, which may significantly affect the economic consequences of a given strategy. The risks associated with margin investing should be carefully considered. If margin account equity declines, an investor may be required to deposit more money or securities.

This concludes's Ask the Expert session with Barclay's Global Investment Principle, Brad Zigler. Please visit the Ask the Expert forum in Conversations if you would like to participate in future sessions.

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