J. Parsons Interview By Jim Wiandt October 19, 2000

 

J. Parsons, Director of Sales for U.S. Individual Investor Business at Barclays Global Investors, talks to Jim Wiandt about how exchange-traded funds are traded.

Editor's Note: All terms in bold text are defined in a glossary at the end of the interview.

Jim Wiandt: When a creation unit for an ETF is first formed, is it a market maker who decides that unit is going to be formed and then approaches you?

J. Parsons: Yes. We use the term "market maker" with respect to the advertising, because it's emblematic in peoples' minds of what the function is. Technically, within the prospectus, you'll see the term "Authorized Participants."

And so those terms are synonymous. But the Authorized Participants have signed an agreement with us, allowing them to do the creation and the redemption. So they're set up. They would then, at some period during the day, call SEI (Simulated Environments Inc.) systems and say, "I'd like to place an order for X creation units of such and such a fund." That then triggers the whole process of the creation. Do you want me to run through the whole cycle for you?

JW: Please.

JP: At the end of the day, SEI then places the order with National Securities Clearing Corporation (NSCC), which is a part of the Depository Trust Company (DTC). And basically that kicks off the settlement process. And what the NSCC does is look into the DTC box of the authorized participant to make a match. Let's use the S&P 500 so I can actually discuss some real numbers. They would look in the box for the 500 securities that are needed to match up with the portfolio composition file. And they have to be in deliverable form - they could be borrowed shares - but they have to not be assigned. And they then post, if you will, that trade. So what the authorized participant will see is in effect a transfer out of their box of 500 securities and a transfer into their box of 50,000 iShares, one creation unit. And that would be for a three-day settlement forward.

JW: Where do iShares go ultimately?

JP: The underlying assets then go into the 500 securities that came out of the AP's DTC box and into the fund, into the [40-Act] fund that we have created.

JW: You're holding those?

JP: Correct. The fund is. So the iShares, the S&P 500 Fund, are organized under the iShares Trust Board family. The fund family is called the iShares Trust. And they're the actual holders of that, but obviously it stays with DTC also. And it requires for all 500 securities to be in transferable form for the issuance of the 50,000 shares of the underlying iShare.

JW: Then you issue that through the NSCC. Who holds all the paperwork?

JP: SEI is the fund administrator, so they're the ones that are basically keeping track of the net asset value, the shares outstanding, etc., just to make sure that the fund evaluation is correct.

JW: When the trading starts, do you select specialist firms who set the ask/bid?

JP: Correct, we work in conjunction with the exchanges to select what we feel are the best specialists for each type of market that we're looking at.

JW: So basically SEI is doing all the management?

JP: SEI is doing the fund distribution work. BGI, Barclays Global Fund Advisors, is the fund manager.

JW: So you're tracking the indexes and making sure that everything matches with the ETFs?

JP: Yes. In-house here, using the portfolio management team on both the domestic and the international fund side. They look at the fund itself to make sure it has the right stocks in it, that the dividends are being reinvested, and that it's being managed the way we manage an index fund. And they also then look at the changes that are going on in the indexes themselves and produce each night what's called the PCF, or the Portfolio Composition File, that then gets posted out to the NSCC that determines what we will accept for a creation or what we'll pass out for a redemption. So they're creating that file. And then in each, any rebalancing changes that need to be done with the portfolio itself to reflect the index changes are done by the portfolio managers here.

JW: Does the NSCC regulate to any degree the composition of the ETFs? Do you have to get out of one and in another one to fund composition changes within a certain time period?

JP: Yes, the NSCC has that rule. Basically it's the prospectus filing with the SEC that says that these are index funds that seek to track the return of the underlying index. And as the result of them being a [40-Act] registered investment company, they are managed funds. They are unlike a unit investment trust (UIT) structure, which is considered an unmanaged structure. So that's why we're able to reinvest dividends as opposed to holding them in a non-interest bearing account.

JW: Right, that's the whole angle, that's the tax angle that ETFs have, because it has a different structure from the open-ended in that way, that allows them to reinvest. And also you don't have the distributions issue.

JP: The reinvestment of the underlying securities is really a distinction between the 40-Act fund structure and the unit investment trust structure. A unit investment trust structure cannot reinvest the dividends [in] the underlying securities. So if you look at the "Spider" product, it's underperformed the index by its expense ratio plus about ten basis points. There are actually studies that show that's within a basis point of the exact calculation you'd get if you estimated what the return over that period of a dividend yield not being invested in the index.

JW: And under the registered investment trust company, are there certain limitations in terms such that you can't have one stock that makes up more than 25 percent of the fund?

JP: Right. We have the same diversification and rules that a standard traditional mutual fund would have. So there are two rules, which are also the IRS rules. The first is a quarterly measure of no stock over 25 percent. The second is what's called the 5/50 rule, which is all your holdings that are greater than five percent can't in total add up to more than 50 percent of the fund.

JW: Is that why the iShares in Sweden and Canada had to do a big distribution, because they had to re-balance?

JP: Re-balance to meet the diversification rules. Correct.

And also you'll see, in some of the funds, we'll run them as an optimized fund. Because, for instance, in the Dow Jones Energy Fund, Exxon represents some 43 percent of the total index. And we certainly don't want to buy up to 43 percent and sell down to 25 percent, buy up to 43, sell down, and buy up again, right? That turnover is just unacceptable.

So we'll run an optimized portfolio to keep the weights closer to 25 percent and still track the return of the underlying index.

Glossary of Terms

Market Maker: An options exchange member who trades for his or her own account risk and is charged with the responsibility of trading so as to maintain a fair, orderly, and competitive market.

National Securities Clearing Corporation (NSCC): Organization responsible for arranging a daily clearance of transactions for members by means of a continuous net settlement process.

Depository Trust Company (DTC): An independent corporation owned by broker/dealers and banks responsible for holding deposit securities owned by broker/dealers and banking institutions; arranging the receipt and delivery of securities between users by means debiting and crediting their respective accounts; and arranging for payment of monies between users in the settlement of transactions.

Unit investment trust (UIT): a "basket" that allows investors to directly own the underlying stocks in their portfolio.