Exchange Traded Funds Structures and Strategies Mary Kathryn

Exchange Traded Funds Structures and Strategies Mary Kathryn Campion, Ph. D. , CFA, AIFA Champion Capital Research, Inc. March 2007 Champion Capital Research, Inc. 1

Overview What are ETF’s? r Benefits and Applications r Practical Portfolio Strategies r Questions and Answers r Champion Capital Research, Inc. 2

What are ETF’s? Champion Capital Research, Inc. 3

What are ETF’s? : The Basics r r r r Exchange Traded Funds (ETFs) are open ended mutual funds. * ETFs represent a fractional ownership in the underlying securities in a particular index. ETFs can be traded like stock on the major stock exchanges. Unlike closed-end funds, the number of ETF shares can change daily. Intraday portfolio values are calculated every fifteen seconds. ETFs range in style, sector, country ranging from value, growth, international equity, commodity, and domestic to equity and fixed income. More and more specialty index funds created annually. v Other structures include exchange traded unit investment trusts and exchange traded grantor trusts. Champion Capital Research, Inc. 4

What are ETFs? : The Primary Providers Provider Name Barclays i. Shares State Street. Tracks Bank of NY BNY Vanguard VIPER’s Power. Shares Rydex Assets Managed $248. 5 billion $100. 3 billion $26. 8 billion $24. 2 billion $9. 3 billion $3. 8 billion • Data as of 2007 Champion Capital Research, Inc. 5

What are ETFs? : Explosive AUM Growth CAGR= 38. 5% • Source: Investment Company Institute 2006 Champion Capital Research, Inc. 6

What Are ETF’s: ETF Options Data as of Jan 2007 Champion Capital Research, Inc. 7

What Are ETFs? : Creation/Redemption Process r r r Index provider (S&P, Dow Jones, etc. ) announces changes in index. Fund manager (Barclays, State Street, etc. ) announces the contents – holdings and wtds - of the new creation units. A Market Maker (authorized participant (AP)) buys basket of securities in market then delivers the basket to the fund (trustee), which creates and delivers to AP the appropriate ETF units. The AP receives newly created fund shares and makes available to investors. The ETF will be custodied wherever investor clears trade. Champion Capital Research, Inc. 8

What Are ETFs? : Creation Process Cash Brokerage account Investor Cash ETF Authorized Participants ETF Shares Creation Units Capital Markets Securities Basket of Securities ETF Fund Advisor Champion Capital Research, Inc. 9

Benefits and Applications Champion Capital Research, Inc. 10

Benefits: The Good r r r Transparency Full market participation Style Consistency Trading flexibility Low costs Champion Capital Research, Inc. 11

Benefits? : The Bad and Ugly r r r Dollar cost averaging hurdle Float adjustment Tax consequences Dividend “Drag” Market Volatility Interest Rate and Credit Risks Champion Capital Research, Inc. 12

Applications: Diversification r r r Investment minimums Correlation and factors analyses Cost effective dynamic diversification Minimize concentrated portfolios Exploit global growth and currency opportunities Champion Capital Research, Inc. 13

Applications: Risk Management r r r r Real time risk management Dynamic beta adjustments Active indexing or “tilting” Duration management “Equitize” cash Limit and stop orders Hedging options Champion Capital Research, Inc. 14

Applications: Tax Management r r Low turnover through relatively passive management The creation/redemption process involves in-kind transfers, a non-taxable event Tax loss harvesting After tax alpha through cross sectional rotations Champion Capital Research, Inc. 15

Portfolio Strategies Champion Capital Research, Inc. 16

Portfolio Strategies: Strategic & Dynamic Strategies r r r Strategic long term diversified portfolios – including strategic MVO with simple re-balancing Enhanced indexed portfolios Easily achieve broadly diversified portfolio from concentrated portfolio Combine ETFs with active managers – including Core Satellite Develop Risk budgeting techniques Champion Capital Research, Inc. 17

Portfolio Strategies: Implementation Science (Modern Portfolio Theory) + Art (The Mix Between Index and Active) + Client Expectations Champion Capital Research, Inc. 18 2002 -i. S-0705 (Understanding Tolerance to Risk)

Potential Return % Portfolio Strategies: Traditional MVO Large-cap domestic stocks Small-cap domestic stocks International stocks TSY Bonds Bills Risk % (Std) Champion Capital Research, Inc. 19

Portfolio Strategies: Dynamic & Tactical Opportunities r Sector, style, country allocations r r Express business cycle views Greater international diversification beyond EAFE Wider re-allocation bands allow for consistent alpha Yield curve and credit quality management possible at all portfolio account sizes Champion Capital Research, Inc. 20

Portfolio Strategies: Dynamic Top Down Management Utilities Financial 2019 -i. S-0705 Consumer goods Fed Funds rate Source: BGI, Dow Jones, Bloomberg Champion Capital Research, Inc. 21

Portfolio Strategies: Enhanced MVO Portfolios Traditional MVO Portfolios Tactical Sector / Country Allocations Champion Capital Research, Inc. 22

• Source: BGI Champion Capital Research, Inc. 23 2019 -i. S-0705 Portfolio Strategies: Broad Diversification

Portfolio Strategies: These Strategies Work! • As of 12/31/06 Champion Capital Research, Inc. 24

Portfolio Strategies: Because of Low Fees Lowest fees in each strategy Strategy / Fees (in bps) CCR Strategic MF Industry Average CCR Strategic Tactical ETF Low Risk 67 117 20 22 Conservative 82 130 25 26 Moderate 89 136 27 29 Growth 101 147 31 34 Growth Plus 110 152 33 37 CCR International Emerging Satellite N/A N/A 59 * Morningstar and Champion 2_07 Champion Capital Research, Inc. 25

Portfolio Strategies: Fees Matter Growth Model Fees 34 bps 101 bps 147 bps $2, 593, 742. 46 Fees $59, 605. 97 $177, 064. 79 $257, 708. 16 Earnings Not Received $23, 077. 71 $62, 939. 74 $98, 605. 40 $2, 511, 058. 78 $2, 353, 737, 93 $2, 237, 428. 90 Gross Value Net Value Champion Capital Research, Inc. 26

Portfolio Strategies: Core / Satellite Traditional indexed “core” and satellite managers r New “satellite” structures r Plug ETFs with existing managers r Manage market risk (b), tracking error (s) and active risk (a) r a strategies can be governed by unique guidelines r Rebalancing efficiencies r Champion Capital Research, Inc. 27

Portfolio Strategies: Rebalance Opportunities 50% Growth 30% Growth 50% Value 70% Value 50% Value • Source: BGI Champion Capital Research, Inc. 28 2019 -i. S-0705 In order to reset portfolio to original strategic weights, sell 20% value manager/fund and buy 20% growth manager/fund.

Portfolio Strategies: Rebalance Opportunities $200, 000 taxable portfolio 2. Strategic asset allocation – 50% value / 50% growth 3. Active/index blend – 50% active / 50% index Source: BGI analysis. Champion Capital Research, Inc. 29 2019 -i. S-0705 1.

Portfolio Strategies: Rebalance Opportunities Portfolio grew to $210, 000 2. Value outperformed growth 3. Index growth outperformed manager growth manager Source: BGI analysis. Champion Capital Research, Inc. 30 2019 -i. S-0705 1.

Portfolio Strategies: Rebalance Opportunities New portfolio = 210, 000 2. Strategic weights = 50/50. 3. Allocate 105, 000 to each asset class. 4. Sell 15, 000 V; Buy 15, 000 G 5. Decision is to sell/buy active/index. Source: BGI analysis. Champion Capital Research, Inc. 31 2019 -i. S-0705 1.

Portfolio Strategies: Rebalance Opportunities Source: BGI analysis. Champion Capital Research, Inc. 32

Portfolio Strategies: International Satellites Champion Capital Research, Inc. 33

Portfolio Strategies: Budget Risk Like traditional risk / return analysis, identify clients risk tolerance. In Core Satellite construction, identify client’s propensity to endure both active and passive volatility. Active return (%) Moderate 5. 5 Higher Risk Index fund Index 65% Index fund 20% Moderate Risk Active mgr 35% 65% Benchmark (Russell 1000) Active mgr 80% Active mgr 35% 2 4 6 8 Tracking error (%) How much active manager risk? Source: BGI analysis. Champion Capital Research, Inc. 34

Portfolio Strategies: Refining within classes Higher Active Risk 0 Index fund 20% Index fund 65% Active mgr 80% Active mgr 35% Russell 1000 MSCI EAFE 6% Active Risk Budget 2002 -i. S-0705 Potential returns (%) Lower Active Risk (%) Source: BGI analysis. Champion Capital Research, Inc. 35

Summary r What are ETF’s? r r r Construction Methodology, Growth, Providers www. Active. Indexing. com, www. Index. Universe. com Benefits and Applications r r Costs, Liquidity, Diversification, Risk management, Tax management, Concentration, Rebalancing Practical Portfolio Strategies r Traditional MVO, Enhanced Indexing, Core Satellite, Risk Budgeting Champion Capital Research, Inc. 36

Discussion Mary Kathryn Campion, Ph. D. , CFA, AIF Champion Capital Research, Inc. Campion@championcapitalresearch. com 713. 435. 4374 December 2005 Champion Capital Research, Inc. 37

Portfolio Strategies: Tracking error Champion Capital Research, Inc. 38

Portfolio Strategies: Top Down Management Source: BGI and Dow Jones. Champion Capital Research, Inc. Fed begins easing policy 39 2019 -i. S-0705 Fed tightens policy

Portfolio Strategies: Managing a and s a Active manager return r r The over- or under-return earned by an active manager relative to a benchmark Active manager risk r The annualized standard deviation of a manager’s active return (usually calculated as tracking error) Champion Capital Research, Inc. 40 2002 -i. S-0705 r