Exchange-traded funds (ETFs) possess characteristics we believe make them attractive to investors seeking country, sector, industry or style exposure. Uses of ETFs include index tracking, gaining global exposure, implementing long/short strategies, cash management and implementing sector rotation strategies.
We discuss ETFs as they relate to indexing. Although we use examples from the US markets as the number of ETFs grows in Europe the issues that arise should be similar and implementation issues should be applicable.
Since the objective of many ETFs is to give exposure to a broad or narrow index of stocks, they may lend themselves to investors wanting to track an index passively. Certain factors, such as fees and expenses, corporate actions (mergers, acquisitions), differences in trading hours between the ETF and its underlying assets and changes to the underlying indices may introduce tracking error to the benchmark. However, an investor may find these risks offset by both the flexibility of trading the ETF as a single security at any time during a given trading day and the management of index changes by ETF fund managers.
As an example of tracking the S&P 500 index, we look at three alternatives: ETFs, a basket of 500 stocks or S&P 500 index futures. We compare factors such as the cost of implementation and maintenance considerations (Table 1).
The S&P 500 ETFs are competitively priced and simple to maintain and trade. In a stock portfolio, the investor needs to manage index changes and corporate actions. Futures involve margin requirements and unknown rollover costs. Additionally, futures have a minimum trade size based on their contract size.
Some key issues in using ETFs effectively for index tracking are:
q Investment strategy. Two types of investment strategy are used to track the indices: replication and representative sampling. ETFs that use replication attempt to track their underlying indices closely by holding substantially all of the index stocks in substantially the same weightings as the underlying benchmark. Most ETFs with broad-based benchmarks, such as the S&P 500 (SPDR) or the Nasdaq 100 Trust (QQQ) adopt the replication strategy. ETFs that use representative sampling hold a sample of stocks that have similar fundamental and liquidity characteristics, market capitalisation and industry weightings as the underlying index. This strategy is used when full replication of the underlying index is difficult. Examples of ETFs that use this strategy are the MSCI iShares. In general, funds that employ representative sampling tend to have more tracking risk than funds using replication.
q Portfolio rebalancing. Since many ETFs employ a replication strategy, the underlying portfolios have to be rebalanced in line with changes in the underlying index. For example, with the SPDRs and QQQ funds, the trustee initiates a rebalancing at least once a month unless a change in the underlying index is significant and requires immediate attention. Significant changes would include additions to the ETF fund or deletions of a security in the index. In these cases, adjustments would have to occur within three business days before or after the day the change is scheduled to occur. A delay in replication may increase the tracking error of the ETF portfolio.
q Composition guidelines. Many of the ETFs include guidelines for the composition of the portfolios. These provisions allow the fund manager flexibility in responding to corporate actions to best replicate the performance of the underlying. For example, iShares only require that 90% of the total assets need to be invested in the stocks of the underlying index. The other 10% may be in other stocks, cash and cash equivalents, futures contracts, options on futures contracts, options and swaps related to the underlying index. This may affect tracking risk.
q Dividend payout. The dividends earned by ETFs are paid in different ways. With iShares, dividends are immediately reinvested in the fund. Other ETFs hold dividends in non-interest-bearing accounts and pay them out periodically. For example, SPDR and QQQ fund holders receive quarterly cash dividends. These dividend payout policies may also affect the tracking of the ETF fund.
q Trading hours. Timing differences between the calculation of the closing net asset value of the ETF and trading hours for the underlying stocks can affect tracking.

ETFs do not have to be used as a stand-alone product. For instance, if a fund manager is tracking a particular index with stocks he may be able to use ETFs to manage cash inflows, index changes and fund redemptions. ETFs can be an alternative to using index futures as a way of gaining desirable market exposure and equitising cash that can eventually be invested in stock. While index futures require low commission costs to trade, there are situations where using ETFs may be more efficient. One when futures cannot be used because the incoming cashflows to be equitised are too small. For example, one standard S&P 500 futures contract has a nominal value of over $350,000. An S&P 500 SPDR or iShare S&P 500 can be bought for about $150 a share.
ETFs can also be used more efficiently when a futures contract does not exist for the index exposure required. An example is the S&P 600 Small Cap Index. The index exposure can be obtained by purchasing iShares S&P Small Cap. ETFs may also be preferred for longer-term holdings because futures must be rolled over periodically, incurring additional rollover risk and transaction costs.
ETFs may be used to manage index changes. For example, managers of portfolios indexed to the S&P 500 might keep a small portion of their portfolios in S&P 500 SPDRs. These managers generally rebalance their portfolios on a quarterly basis to correspond with S&P quarterly share changes. Changes to the portfolios may have to be made more frequently because of changes to the S&P 500 index. For instance, in the case of the addition of JDS Uniphase and deletion of Rite Aid (see Table 2), the manager of a $100m S&P 500 index fund would have had to purchase up to $941,519 worth of JDSU.
The manager can purchase JDSU with cash if he sets enough aside. But cash set aside produces tracking error with respect to the S&P 500 index unless there’s an overlay of S&P futures. If the manager sets aside no cash, he needs to sell a slice of the fund to raise enough money to purchase JDSU at the appropriate benchmark weighting. This leads to a transaction involving hundreds of stocks and their settlements. Of course, the manager may instead hold some S&P SPDRs in his portfolio so that he can sell the SPDRs to raise the cash necessary to purchase JDSU, again taking advantage of ETFs’ one-trade characteristic. Similarly in the case where selling a large name that is deleted from the index produces a surplus of cash, the cash can be invested in the SPDRs until the next scheduled rebalance, when the stocks are purchased and the SPDRs sold.
Yigal D Jhirad and Daixiong (David) Qian are with Morgan Stanley Dean Witter Quantitative Strategies in New York