Class Project

Work in your groups to develop the concept for a new ETF (exchange traded fund) offering. Write a summary presentation aimed at prospective investors and use this presentation as a reference to deliver a 10-15 minute proposal to an informed professional audience to market your strategy. Assume your audience is well-versed in both general finance and derivatives.

Background research, marketing and justification for your ETF will be 40% of the grade, quantitative accuracy of ETF construction will be 40%, and the remaining 20% will be the quality of the presentation. Good luck.

Background

ETFs reached a new record for assets under management in 2019, hitting $3.3 trillion globally, according to data from ETFGI, an independent research and consultancy on the ETF industry. Experts in derivatives, you will be using derivatives, at least in part, to manage the assets under management, based on the strategy you outline[1]. It is a requirement to use derivatives, and at this stage, you will be working with forwards and futures. This naturally means a derivatives market needs to exist in order for you to proceed, and historical data needs to be available on the derivatives so that you carry out empirical validation that your strategy is in fact delivering what you promise to your investors. Five years of empirical validation is sufficient, data permitting.

Some recommendations below, but please be mindful of the flow of your prospectus (i.e. it should not read as a set of questions and answers):

  • All ETF’s are evaluated against a benchmark, such as the S&P 500 Index (ETF: SPY), gold prices (ETF: GLD), VIX index (ETF: UVXY), and so on. You must select a benchmark. Be very mindful about your selection. This benchmark represents what your investors will expect from you.
  • For the benchmark, you may use an existing index, or construct your own (i.e. if you are trying to offer a 2x leveraged plutonium fund, you would multiply the plutonium price by 2, for instance, and this would be your index).
  • Regarding the benchmark, note, you will either be promising to ’replicate’ or ’outperform’ this index. This section should be thoroughly and explicitly explained. This is the main reason your investors pay a fee to have you manage their money.
  • Why will there be interest in your ETF? Why has this ETF not been offered before? Or is this a twist on an existing offering? You need to convince your investors, and me, why they should allocate capital to your idea.
  • What management fees will you charge? How do you justify these fees? Make sure you adjust the total return of your ETF by the fees that you charge. You may want to assign fees on a per-day basis for instance.
  • Note when using derivatives, you will need to reserve some capital to back up forward/futures trades or apply for a line of credit.

1

  • You will need to outline explicitly how the derivatives are priced. Are you using market prices? Or, are you deriving them?
  • How large do you expect your tracking error to be? Tracking error is the total return difference between the benchmark and your ETF measured over a particular time period. Note, tracking error takes on a different meaning if you are trying to replicate an index, as opposed to trying to outperform it. Be clear and explicit. Think of the following How does the bid/ask spread of derivatives impact the performance of your fund? How does the basis impact it? What else is contributing to tracking error? Track and quantify this.
  • Present equity curves for benchmark and ETF for a minimum 5-10 year period, with monthly visibility/markto-markets.
  • Be mindful about the risk side of the equation (volatility, sharpe ratio, etc.).
  • Are you using leverage to manage the assets? Explain.
  • Who are your clients? Institutional investors, small hedge funds, fund-of-funds, family offices, retail?
  • What can go wrong in managing this investment on behalf of your ETF investors? How will you handle large swings or drawdowns in the pricing of the benchmark assets? You may want to include practical examples from recent past to help illustrate your point.
  • Do ETFs in general present a systematic risk?

Before you do anything, do plenty of research on the ETF business. For background reading:

  1. com/watch?v=UVktl8lXxW8
  2. com/watch?v=O8Behdio5PI
  3. com/watch?v=kqr-h-pmky4
  4. com
  5. com/investing/products/ishares-etfs

[1] For example: https://www.sec.gov/Archives/edgar/data/1327068/000119312512265421/d335842d424b3.htm#rom335842_30