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)
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 $675 million at that
month end. As a result of these flows, it has not been uncommon to
see the fund's assets double or drop by one-half from month to
month.
FIGURE 3:MONTHLY XRT NET FLOWS
(For a larger view, please click on the image above
)
Sources:Bloomberg, SSgA Global ETF Strategy & Research, as of
12/31/2010
Short Selling
Short selling involves someone selling a security that they do
not own with a view to repurchase it later at a lower price.
Covered short sales occur when the seller relies on a securities
lending arrangement and is able (at the time of the sale) to
deliver the securities that have been sold to the buyer. (For more
information on short selling, please
visithttp://www.sec.gov/spotlight/keyregshoissues.htm . The use of
short selling entails a high degree of risk, may increase potential
losses and is not suitable for all investors. Please assess your
financial circumstances and risk tolerance prior to short
selling).
ETFs are commonly used by investors to express both a long
(bullish) and short (bearish) view on an index, asset class, sector
or country. Short interest is measured in terms of the number of
shares held short, which can also be expressed as a dollar amount
(shares times share price) or percentage of total outstanding
shares. Typically, sector and industry ETFs are among the ETF
categories most often used for short selling. The retail stocks in
XRT's index are part of the consumer staples and consumer
discretionary sectors. While neither sector is among the largest in
terms of ETF assets, both are among the largest in terms of short
interest as a percentage of assets. (See Figure 4.)
FIGURE 4:SHORT INTEREST AS A PERCENTAGE OF
ASSETS
*Short interest represents the number of shares reported as held
short as a percentage of total shares outstanding.
Source:SSgA Global ETF Strategy & Research
The 20 largest ETFs by short interest ($) 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
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
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
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section.
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