SSgA: XRT Delivering On Its Promise

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Recently, several articles have been published questioning the structure of exchange-traded funds (ETFs), their role in the "flash crash" of May 6, as well as what some perceive as systemic risks they pose to the U.S. capital markets. Unfortunately, these articles have often reflected a lack of understanding of ETFs, which remain structurally sound, and of capital markets. This paper examines what remains the central premise of index-based ETFs-seeking to deliver index-tracking performance, despite a variety of factors-including sometimes-volatile asset levels, cash flows and short-interest levels. This paper specifically discusses the SPDR S&P Retail ETF (NYSEArca:XRT).

What Makes A Successful Exchange-Traded Fund?

There are many measures-most critically asset growth, trading volume, tight bid-ask spreads as well as the ability to track its index. In its purest sense, an ETF is a passive investment vehicle that seeks to closely track an index. Thus, the truest measure of a successful ETF should be how well it provides performance that matches the index.

The SPDR S&P Retail ETF ( XRT ) was launched on June 19, 2006. It is one of 24 SPDR ETFs that tracks a US sector or industry. As of December 31, 2010, XRT had $977 million in assets. XRT is one of only two ETFs that tracks retail stocks.

In its investment objective, the SPDR S&P Retail ETF seeks to replicate as closely as possible, before expenses, the total return performance of the S&P Retail Select Industry Index. The S&P Retail Select Industry Index is an equal weighted market cap index that held 64 stocks as of December 31, 2010. The index (and the ETF) consists of stocks in the apparel, automotive, specialty, food, computer and electronics, and internet retailers (Figure 1). The stocks in the index had a total market capitalization of $763 billion on December 31, 2010, and individual stock's market capitalization ranged from a high of $193 billion to a low of less than $1 billion. The index is rebalanced on a quarterly basis, meaning that after the rebalancings, each stock's weights will equal approximately 1.5%. Each stock's weighting will then float based on its market performance until the next rebalancing.

FIGURE 1:TOP 10 HOLDINGS FOR THE SPDR S&P RETAIL ETF ( XRT )
(AS OF DECEMBER 31, 2010)

ETFs_SS_fig1

Source:SSgA Global ETF Strategy & Research, as of 12/31/2010

Asset Growth And Trading Volume

Since its inception, XRT has steadily gained assets. As of December 31, 2010, the fund held $977 million in assets which placed it among the top 20% of U.S.-listed ETFs by AUM. As you can see above in Figure 2, however, even as the asset levels have increased, they have been volatile-which indicates that XRT is heavily used by institutional investors to express a view on the retail industry. Figure 2 also shows a correlation between higher trading volume-the bars in the chart-and asset levels.


FIGURE 2:SPDR S&P RETAIL ETF ( XRT ) ASSETS AND MONTHLY SHARE VOLUME

(For a larger view, please click on the image above )

Sources:Bloomberg, SSgA Global ETF Strategy & Research, as of 12/31/2010

Fund Inflows And Outflows

As you might expect, given the changes in asset levels of the fund, XRT has been subject to volatile inflows and outflows on a monthly basis. As Figure 3 shows, the largest monthly inflow was $628 million in June 2009, which increased the fund's assets from approximately $350 million to nearly $1 billion in assets at month end. The largest outflow was -$448 million in June 2010, which caused assets to drop from $1.2 billion to $675 million at that month end. As a result of these flows, it has not been uncommon to see the fund's assets double or drop by one-half from month to month.

FIGURE 3:MONTHLY XRT NET FLOWS

(For a larger view, please click on the image above )

Sources:Bloomberg, SSgA Global ETF Strategy & Research, as of 12/31/2010

Short Selling

Short selling involves someone selling a security that they do not own with a view to repurchase it later at a lower price. Covered short sales occur when the seller relies on a securities lending arrangement and is able (at the time of the sale) to deliver the securities that have been sold to the buyer. (For more information on short selling, please visithttp://www.sec.gov/spotlight/keyregshoissues.htm . The use of short selling entails a high degree of risk, may increase potential losses and is not suitable for all investors. Please assess your financial circumstances and risk tolerance prior to short selling).

ETFs are commonly used by investors to express both a long (bullish) and short (bearish) view on an index, asset class, sector or country. Short interest is measured in terms of the number of shares held short, which can also be expressed as a dollar amount (shares times share price) or percentage of total outstanding shares. Typically, sector and industry ETFs are among the ETF categories most often used for short selling. The retail stocks in XRT's index are part of the consumer staples and consumer discretionary sectors. While neither sector is among the largest in terms of ETF assets, both are among the largest in terms of short interest as a percentage of assets. (See Figure 4.)

FIGURE 4:SHORT INTEREST AS A PERCENTAGE OF ASSETS

ETFs_SS_fig4 *Short interest represents the number of shares reported as held short as a percentage of total shares outstanding.

Source:SSgA Global ETF Strategy & Research

The 20 largest ETFs by short interest ($) represent a wide range of ETF categories (see Figure 5). Many represent popular, broad-based indexes such as the S&P 500 or MSCI Emerging Markets. Others represent narrow slices of the market, whether countries such as China or Brazil, or sectors such as retail, real estate or banking.

In Figure 5, there are several ETFs indicating more than 100% in short interest. Some might interpret that to mean that the number of shares owned by investors exceeds the shares issued and that some shares are therefore unsupported by underlying assets. This is definitely NOT the case-all ETF shares are fully backed by underlying assets.

FIGURE 5:20 LARGEST US ETFS BY SHORT INTEREST ($)

(For a larger view, please click on the image above )

Source:SSgA Global ETF Strategy & Research, as of 12/31/2010

*Short interest represents the number of shares reported as held short as a percentage of total shares outstanding.

The following diagram provides a simplified view of the ownership chain for stock lending and shorting.

THE OWNERSHIP CHAIN FOR STOCK LENDING AND SHORTING

(For a larger view, please click on the image above )

When it comes to the reporting of short interest, however, even though only one investor has actual ownership of the 100 shares, in the example above two parties could report that they hold these shares short. As a result, these shares could be reported as 200% short. In addition, short interest data is gathered by the stock exchanges only twice per month (on the 14th and 30th), so this snapshot is often dated and the accuracy can be uncertain.

Even though ETF shares may be lent or borrowed in the secondary market and, as a result, appear on the ledger of multiple parties (both the borrower and the lender), there is only one owner of each ETF share. For an ETF that shows more than 100% in reported short interest, there is still only one owner per share and each share is fully backed by the ETF's underlying assets. There is also no risk that APs could attempt to redeem more than 100% of an ETF's outstanding shares. Across the entire SPDR ETF family, APs are required to represent that any shares tendered for redemption are first owned by the AP or the AP's client and provide proof of such ownership at the request of the ETF. In addition, the policies and procedures for the SPDR ETFs permit the ETFs to identify and reject any redemption request made by an AP for an amount in excess of the shares outstanding.

The SPDR S&P Retail ETF's Performance

Our original premise was that the truest measure of an ETF should be how well it does at matching the performance of the index. Since its inception on June 19, 2006, XRT has provided performance that closely tracks the S&P Retail Select Industry Index. Typically, an ETF that lags its index by the amount of its expense ratio. Notwithstanding the issue discussed above (i.e., volatile asset flows and high short interest) is considered to be tracking its index very well. XRT has actually done better than that-trailing the index by only 0.33%, less than its 0.35% expense ratio. (See Figure 6.)

FIGURE 6:SPDR S&P RETAIL ETF ( XRT ) PERFORMANCE

(For a larger view, please click on the image above )

Source:SSgA Global ETF Strategy & Research, as of 12/31/2010. Gross expense ratio:0.35%

Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.


Traditional mutual funds can see their performance affected by cash flows into or out of the fund. The reason for this is basic-cash inflows must be invested into securities and the time it takes to do this can lead to lagging performance due to cash drag. Cash outflows can be even more problematic because in the absence of maintaining a cash position (itself a drag on upside performance); they require the portfolio manager to sell securities, sometimes into a declining market. These security sales can also trigger capital gain implications for the fund's investors.

The SPDR S&P Retail ETF, like most ETFs, is designed to avoid the negative impact of cash flows through in-kind creations and redemptions. Instead of receiving cash inflows, an authorized participant ( AP ) delivers the full portfolio of securities in-kind, which means the portfolio manager does not need to invest in securities and incur cash drag. The in-kind process is even more beneficial for redemptions-because no securities need to be sold, the fund is not required to generate capital gains. Despite the frequent cash inflows and outflows for XRT, the fund has not paid a capital gain distribution since its inception.

Not only have the inflows and outflows not had a tax impact for XRT, it has also not significantly affected performance. In the months in which XRT saw its largest inflows and outflows, performance continued to closely track the index-typically performance was within four basis points (0.04%) in those months. (See Figure 7.)

FIGURE 7:SPDR S&P RETAIL ETF ( XRT ) NAV TRACKING ERROR IN MONTHS WITH GREATEST INFLOWS AND OUTFLOWS

ETFs_SS_fig8

Source:SSgA Global ETF Strategy & Research, as of 12/31/2010

Short Interest And Tracking Error

Short interest theoretically should have no impact on an ETF's performance. However, does that hold true for an ETF with short interest of more than 300%? We have already seen that XRT's performance over its history has closely tracked the index. What about during months with significant changes in short interest? Figure 8 demonstrates that short interest changes had little impact on the funds ability to track the S&P Select Retail Index-typically performance was within five basis points (0.05%) in those months.

FIGURE 8:SPDR S&P RETAIL ETF ( XRT ) NAV TRACKING ERROR IN MONTHS WITH GREATEST SHORT INTEREST CHANGES

ETFs_SS_fig9

Source:SSgA Global ETF Strategy & Research, as of 12/31/2010

In conclusion, the SPDR S&P Retail ETF has, in fact, provided an excellent investment experience for investors. XRT has closely tracked its index, the S&P Retail Select Industry Index since its inception, through market volatility and up and down markets and with high levels of short interest. The exchange traded fund structure, featuring in-kind creation and redemption, has allowed XRT to efficiently handle significant inflows and outflows without an impact of performance or tax efficiency. Lastly, the high levels of short interest in shares of the ETF have, as expected, had no impact on the fund's ability to closely track its index.

Definitions

Bid-Ask Spread

The difference between the ask (sell) price and the bid (buy) price shown in percentage terms.

S&P Retail Select Industry Index

The S&P Retail Select Industry Index represents the retail sub-industry portion of the S&P Total Market Index. The S&P TMI tracks all the US common stocks listed on the NYSE, American Stock Exchange, NASDAQ National Market and the NASDAQ Small Cap exchanges. The Index is an equal-weighted, market cap index.

S&P 500 Index

The S&P 500 Index is composed of 500 selected stocks, all of which are listed on the Exchange, the NYSE or NASDAQ, and spans over 24 separate industry groups. Since 1968, the S&P 500 Index has been a component of the US Commerce Department's list of Leading Indicators that track key sectors of the US economy. Current information regarding the market value of the S&P 500 Index is available from market information services. The S&P 500 Index is determined, comprised and calculated without regard to the Trust.

MSCI EM (Emerging Markets) Europe, Middle East And Africa Index

MSCI EM (Emerging Markets) Europe, Middle East and Africa Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of Europe, the Middle East & Africa. As of May 27, 2010 the MSCI EM EMEA Index consisted of the following 8 emerging market country indices:Czech Republic, Hungary, Poland, Russia, Turkey, Egypt, Morocco, and South Africa.

Tom Anderson, CFA, is the global head of ETF Strategy & Research for State Street Global Advisors

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: AP , XRT

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