Running head: WILL ETF’S ALTER THE WAY WE PLAN RETIREMENT?

Will Exchange-Traded Funds Alter the way we plan for Retirement?

Philip Zuffi

Senior Thesis

Wagner College

Author Note

This paper was prepared for Business 400, Section 01, taught by Professor DeSimone

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Abstract

This study has examined how Exchange-Traded Funds (ETF’s) are changing the way

wealth managers invest clients capital. It will show how exchange-traded funds will be an

intricate part of any retirement or pension fund in the near future. You will also discover if top

exchange-traded funds outperform, perform, or underperform the underlying indexes or sectors,

such as the Standard & Poor’s 500 and Dow Jones Industrial Average. This paper has also

examined the risk and return of exchange-traded funds and how diversification affects the

performance of the underlying exchange-traded funds. This study also revealed how

diversification alone helps you or your clients overall investment portfolio, and how it helps

protect capital and lower risk.

This study also goes into detail about the advantages and disadvantages of inverse

exchange-traded funds and how those compare to standard exchange-traded funds. The study

has also discussed how the exchange-traded fund market will continue to grow in the future; and

how they will replace mutual funds and potentially hedge funds. Exchange-traded funds have a

great outlook going forward and deserve a spot in retirement and pension accounts.

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Will Exchange-Traded Funds Alter the way we plan for Retirement?

The introduction of exchange-traded funds to the open market, offered portfolio

managers multiple benefits that were previously unavailable to them. These benefits will make

exchange-traded funds more attractive for pension and retirement planners in the future.

Exchange-traded funds allow for a more diverse allocation of funds, lower expense fees as well

as higher liquidity options, compared to its main competition, open-ended and close-ended

mutual funds. These benefits exchange-traded funds offer assist them in gaining market share

and popularity amongst individual investors and portfolio managers alike.

An Exchange-Traded fund, or an ETF, is simply a basket of various stocks that trade on

the open market. These stocks usually have something in common, whether it be the specific

sector the stock trades under, or type of stock, meaning if it is a growth or value play. Prather,

Chu, Mazumder, & Topuz, (2009) go into further detail by explaining that exchange-traded

funds allow for investors to purchases an entire portfolio through just one share of an exchange-

traded fund.

As Prather et al. (2009) study acknowledges that there has been excellent growth in the

exchange-traded funds market. From 1996 to 2007, expansive growth was experienced in

exchange-traded funds. Growth was seen in two important areas, total net assets as well as in the

total quantity of exchange-traded funds. Total net assets cultivated from $2.4 billion to a

noteworthy $608.4 billion (Prather et al., 2009). Total net assets under management experienced

a staggering 25,250% increase, throughout those 11 years Prather et al., 2009). Correspondingly,

the total amount of exchange-traded funds also experienced intensification, the number of

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exchange-traded funds available to investors increased by 3,210% (Prather et al., 2009). These

are considerable increases, as it just covers just an 11-year period. This is excellent growth

experienced by exchange-traded funds. The growth in assets under management is a

confirmation that an increasing amount of investors, individual and institutional a like, are

investing more capital into exchange-traded funds. Charupat and Miu (2013) show that this

growth is continuing in the exchange-traded market. By 2011, worldwide exchange-traded funds

total assets under management increased by 1,400% to $1.52 trillion. The total number of

exchange-traded funds across various exchanges also increase to close to 4,000. Charupat and

Miu (2013) elaborate more on exchange-traded funds as they have developed from an

insignificant investment vehicle to one of the most successful modernizations investing has ever

experienced.

One reason exchange-traded funds experienced such expansive growth was due in part to

the Securities and Exchange Commission altering trading regulations. As mentioned by

Sharifzadeh and Hojat (2012), in 2008, the Securities and Exchange Commission allowed for

exchange-traded funds to be actively managed for the first time. This meant that managers could

now add or remove any stock from the exchange-traded funds portfolio, as long as they remain

transparent with investors (Sharifzadeh & Hojat, 2012). Before the Securities and Exchange

Commission altered the trading regulations revolving around exchange-traded funds in 2008, all

exchange-traded funds were required to track an index specifically, such as the Standard &

Poor’s 500 (Sharifzadeh & Hojat, 2012). These regulation changes assisted in exchange-traded

funds continued growth, as now fund managers could essentially construct and mold their own

exchange-traded fund to their liking.

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The popularity of exchange-traded funds has not slowed down since its introduction.

According to Prather et al. (2009), the first exchange-traded fund was established and introduced

to the open market in 1993. The first exchange-traded fund, also referred to as Standard & Poor's

depository receipts (SPDRs, pronounced “spiders”), followed and correlated itself with the

Standard & Poor’s 500 index. This exchange-traded fund traded on the open market under the

ticker, SPY. Lower annual fees attract investors because lower fees lead to greater overall returns

for investors. Lower fees directly have an effect on investment returns for the investor, as they

are not spending a significant amount of capital solely on expense fees. Petruno (2013) goes into

further detail regarding exchange-traded funds and how they have grown since their inception.

As of 2013, exchange-traded funds have continued to grow. Internationally, exchange-traded

funds are now a $2 trillion business, with the United States accounting for $1.4 trillion of that

(Petruno, 2013). Exchange-traded funds now offer investors the ability to track almost anything

available on the market, ranging from stocks, bonds and even commodities. As the overall

investment interest in exchange-traded funds develops, there will be a direct correlation with an

increase in total assets under management as well as in the amount of exchange-traded funds

available to investors.

Exchange-traded funds are quickly becoming the way of the future for financial planning.

This is evident with the exponential growth experienced by exchange-traded funds in both net

assets as well as the number of exchange-traded funds available. With all the various advantages

exchange-traded funds have to offer over mutual funds, it will only be a matter of time before

exchange-traded funds emerge as the desired and preferred investment vehicle for many

professional portfolio managers. This is evident when Petruno (2013) mentions that traditional

funds, such as mutual funds, are “lumbering dinosaurs.” This means that with all the advantages

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exchanges-traded funds offer to investors, they will soon make mutual funds dissipate.

Exchange-traded funds are also just more cost-effective compared to a mutual fund. According

to David Kotok (as cited in Petruno, 2013) exchange-traded funds are simply the superior

investment option compared to mutual funds. This is evident when Kotok (as cited in Petruno,

2013), who oversees and manages over $2 billion for his clients, states that since 2000, he has

been implementing exchange-traded fund strategies to his portfolios. Kotok (as cited in Petruno,

2013) states, “‘I don't see any justification for traditional mutual funds.” This is evidence that

portfolio managers are now electing to invest in exchange-traded funds instead of mutual funds.

One of the most confusing and intricate parts regarding exchange-traded funds is how

they are actually created, purchased and sold. Exchange-traded funds offer a multitude of

benefits over various other investment vehicles. As Smith (n.d.) explains exchange-traded funds

advantages included lower costs and higher tax-efficiency. The formation and exchange

procedure for exchange-traded funds is completely different compared to the way shares of

mutual funds are formed. The process begins with a potential exchange-traded fund manager

who submits a plan to the Securities and Exchange Commission. Once the plans received

permission to precede, the fund manager than borrows securities, frequently through pensions

funds. An exchange-traded fund creation unit is usually made up of 50,000 shares per creation

unit.

Exchange-traded funds also trade in total contrast compared to mutual funds. Unlike

mutual funds, exchange-traded funds are traded on the open market, similar to stocks. This

means that exchange-traded funds offer better liquidity than mutual funds, since investors can

move in and out of positions intra-day (Smith, n.d.) This gives investors the ability to have more

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control over their investments and this is a huge advantage exchange-traded funds have over

mutual funds.

Exchange-traded funds offer investors the ability to replicate the returns of an underlying

index without owning all stocks within that index (Prather, 2009). Exchange-traded funds simply

track the returns of an Index, such as the Standard & Poor's 500, Dow Jones Industrial Average,

or even specific sectors of a market. Exchange-traded funds can range across various sectors as

well, such as technology, biotechnology, health care, financials, etc. They also trade like normal

stocks on the market, and unlike mutual funds (close-ended funds), one can buy or sell an

exchange-traded fund whenever one pleases.

While intraday trading is obviously an advantage to owning an exchange-traded fund, it

can hurt the investor as well. Liquidity could prove to be problematic when dealing with a less

popular exchange-traded fund, as this will lead to larger bid/ask spreads. Charupat et al. (2013)

mentions, “ETFs have a few disadvantages, one of which is that investors have to pay

commissions and bid-ask spreads when they buy/sell them.” Charupat et al. (2013) continues by

references more disadvantages associated with exchange-traded funds. Disadvantages, such as

increased fees, are evident when dealing with more actively managed exchange-traded funds.

Actively managed funds will obviously cost the investor more in fees, as the fund managers must

actively add and remove stocks to the exchange-traded funds portfolio.

The fee structure associated with exchange-traded funds is known as an expense ratio.

These fees lower the return to shareholders, as the fees are deducted from the fund’s assets. As

Investopedia (“Expense Ratio,” n.d.) states that an expense ratio is:

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A measure of what it costs an investment company to operate a mutual fund. An expense

ratio is determined through an annual calculation, where a fund's operating expenses are

divided by the average dollar value of its assets under management.

As Pareto (“Mutual Fund Or ETF: Which Is Right For You?,” n.d.) also goes on to state

that it is more common that an exchange-traded fund will have fees that are usually, though not

always, lower than that of a mutual fund. Pareto (n.d.) shows evidence of this by saying

exchange-traded funds charged anywhere ranging from .10% to a high of 1.25%. Alternatively,

the lowest mutual fund fees range from .01% to more than a remarkable 10% per year (Pareto,

n.d.). These fees will diminish returns to investors, as a portion of their investment is kept for

management, as operating expenses. Investors must always be aware of any fees associated with

an investment they have interest in, as the expense of fees could vary drastically from one

investment to another. These fees add up over time and will cut away at investor’s capital.

Expected returns will obviously vary between the numerous types of exchange-traded

funds that an investor can invest in. An investor in an exchange-traded fund that tracks the

Standard & Poor’s 500, should expect to receive the same return as that index, since they are

directly correlated. Returns will also vary from each exchange-traded fund, as some exchange-

traded funds are specifically designed for different trading ideals. Such as growth, dividend

income, value, or even blends of these. Exchange-traded funds revolving around more risky

assets, could expect larger price fluctuations compared to that that of a safe, defensive, low beta

fund. Investors should also take into consideration the risks associated with specific exchange-

traded funds. One major risk that comes with investing in exchange-traded funds is that if an

investor purchases an exchange-traded fund in a specific industry or sector, and if that sector as a

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whole performs badly, the underlying exchange-traded fund will obviously underperform. For

example, if one purchases the exchange-traded fund United States Oil Fund, L.P (symbol USO),

they would be experiencing losses as the price of oil has continued to drop. This occurs because

that sector specific exchange-traded fund is focused on oil. Investors can combine multiple

exchange-traded funds over various sectors, which will help remove some risk.

One way investors could protect themselves from this is by purchasing an inverse

exchange-traded fund. An inverse exchange-traded fund is a security that allows for investors to

gain financially from index price decline, similar to shorting a stock. (“Inverse ETF,” n.d.)

Inverse exchange-traded funds could be beneficial to investors, as they will profit in a bear

market. This also allows for investors to hedge themselves against positions already held in their

portfolio. However, there are some disadvantages to inverse exchange-traded funds. One major

disadvantage is that they rely on bearish markets to profit, if the economy is booming, inverse

exchange-traded funds will perform poorly.

Another risk revolving around exchange-traded funds, which many investors may not

have even considered, is the financial stability of the exchange-traded fund company. Pareto

(n.d.) explains that investors do their due diligence before investing in any exchange-traded fund.

Investors must be sure that the company they are investing in is a stable one. It is recommended

to stick to purchasing exchange-traded funds with a stable track record. If an exchange-traded

fund company defaults, this is force the unexpected liquidation of assets.

Exchange-traded funds enable individual investors, and institutional investors alike, to

vastly diversify their portfolios with less capital. Exchange-traded funds allow investors to

purchase a whole sector with just the purchase of one exchange-traded fund share. Which is

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clearly more efficient that actually purchasing each individual share that makes up an entire

sector or index. As Bassie (2012) explains in more detail:

ETFs are a popular financial product by both private and institutional investors. They

offer simplicity, liquidity and efficiency for a wide variety of investment strategies. First,

they provide an easy way to diversify your portfolio by a single trade. One ETF share

provides exposure to whatever sector, geographic location or investment style (value or

growth) the investor wants. They are traded as ordinary shares, what makes them liquid

and means that they can also be sold short and bought on margin. For many ETFs, there

are futures and options on that specific index that makes it very convenient for risk

management purposes.

Exchange-traded funds have multiple advantages that make it a more attractive

investment vehicle compared to a mutual fund. The most evident advantages exchange-traded

funds have over mutual funds are that they often offer lower expense ratios (Pareto, n.d.).

Exchange-traded funds also as give investors the ability to buy and sell throughout the course of

any trading day (Prather, 2009). The improvements of liquidity and lower expense ratios (which

eats away at investors profit) obviously make exchange-traded funds more attractive than mutual

funds.

Another advantage exchange-traded funds have over mutual funds is that they are more

tax efficient. Pareto (n.d.) explains how exchange-traded funds are actually more tax-efficient for

investors:

ETFs are more tax efficient than mutual funds… As a result, shareholders pay the taxes

for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the

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ETF doesn't sell any stock in the portfolio. Instead it offers shareholders ‘in-kind

redemptions’, which limit the possibility of paying capital gains.

The future of exchange-traded funds looks very promising, although it may come at the

expense of other financial intermediaries, such as close-ended funds and open-ended funds.

Investopedia (“Closed-End Vs. Open-End Funds”, 2012) goes on to break down the key

differences between Closed-End funds and Open-End funds. Open-end funds, also known as

mutual funds, differ from exchange-traded funds, as they do not trade intraday on the open

market. Mutual funds also have no constraints when it comes to issuing new shares. If an

investor wishes to purchases shares, new shares will be generated. Conversely, when an investor

wishes to sell out of a mutual fund, those shares are destroyed and not sold again. Mutual funds

will occasionally be required to sell some of their investments in an effort to disburse cash to the

investor. This commonly occurs when large investors, or institutions, wish to liquidate their

positions. Open-end funds, unlike stocks or exchange-traded funds, cannot be tracked

throughout the trading day. However, at the conclusion of each trading day, the funds price is

rebalanced. The funds price is grounded on the net asset value, NAV, of the fund.

This basically means that an open-end fund operates completely different compared to a

closed-ended fund. Closed-ended funds trade similarly to a security, as they trade on the open

market. This allows investors to buy and sell shares intra-day, which mutual funds cannot offer.

As mentioned earlier, exchange-traded funds offer various advantages over mutual funds.

Advantages include improved asset allocation with less capital, intra-day trading, lower fees and

more tax-efficient. According to Alex Gracian (as cited in Lau, 2014) the use of exchange-traded

funds “gives you more diversification in terms of strategy type at a lower cost.” Gracian is a

pension fund manager who oversees nearly 5 billion British pounds (about US$8.3 billion).

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Exchange-traded funds are more tax-efficient compared to various other investment options

(Anonymous, 2011). When a shareholder, whether it be a college student, Warren Buffet, or a

pension fund, liquidates any positions for a financial gain, they are required to pay capital gains

tax. Since exchange-traded funds track and correlate with specific indexes, they are not required

to consistently refresh and update their portfolios holdings. This allows for a low turnover rate

within exchange-traded funds. As passively managed exchange-traded funds entail fewer

transactions, this will lead to lower fees. Exchange-traded funds have even succeeded in

avoiding delivering capital gains tax upon its investors.

Exchange-traded funds have experienced excellent growth since their inception in 1993

(Prather et al., 2009). As mentioned earlier by Charupat et al. (2013) exchange-traded funds

experienced a 1,400% increase from 2001 through 2011. These increases show that the

exchange-traded funds market share has experienced significant growth. This growth rate also

raises some concerns for hedge funds. According to a study conducted by Forstenhausler, Kealy

and Kerr (2014), exchange-traded funds will continue growing over time. Over the next half-

decade, exchange-traded funds are anticipated to grow 15-30% worldwide (Forstenhausler et al.,

2014). With this growth, exchange-traded funds could eclipse hedge funds, in assets under

management, within a year to a year and a half. Growth is anticipated to come from the various

functions exchange-trade funds can offer to investors. These advantages offered by exchange-

traded funds will help deplete the market share of alternate investment options.

According to Forstenhausler et al. (2014), growth in the exchange-traded funds market

has decelerated from it average over the last decade, from 25% per year to a more sustainable

15%. Forstenhausler et al. (2014) continues by stating:

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It is also notable that a significant proportion of US ETF inflows represent inward

investment from Europe, Asia and elsewhere. In comparison to the US, ETFs in many

developing markets are still in their infancy. Growth rates in Asia Pacific are among the

highest in the world, with assets expected to continue expending at 20–30% per annum.

(p.4)

This shows that the exchange-traded funds market share is continuing growth at an

impressive rate with no plans to slow down. Forstenhausler et al. (2014), reiterates the multitude

of advantages exchange-traded funds hold over various alternate types of investments.

Forstenhausler et al. (2014) goes on to say, “although low cost and flexibility remain crucial to

the appeal of ETFs, liquidity is increasingly seen as the most distinctive and important feature of

the industry.” (p. 4) This is an essential factor for maintaining growth of exchange-traded funds,

as it allows for investors to move in and out of positions quickly.

There are various methods to gaining financially from exchange-traded funds. The

simplest way is via capital appreciation. Capital appreciation, according to Investopedia

(“Capital Appreciation”, n.d.) is defined as, “A rise in the value of an asset based on a rise in

market price” Essentially capital appreciation is experienced when an security is purchased at

certain price, then after purchasing that security, the market value of that said security increases.

An alternative way to gain financially through exchange-traded funds is through dividend

distribution. As stated by Investopedia (“Dividends”, n.d.) dividends are defined as, “distribution

of a portion of a company's earnings, decided by the board of directors, to a class of its

shareholders… dividends may be in the form of cash, stock or property.” A company’s dividend

is usually presented either as a yield (percent of the stocks current price) or in a dollar amount

(represents the dividend amount, in dollars, the investor will receive for each share they own.

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Dividends are the when a companies board decides to return capital to its shareholders. Investors

could combine these methods and gain financially through both capital appreciation and

collecting dividends.

Potential investors may want to enroll in a dividend reinvestment plan, or commonly

referred to as DRIP. Investopedia (“Dividend Reinvestment Plan – DRIP,” n.d.) describes a

dividend reinvestment plan as an alternate way for investors to gain financially through the

concept of dividends. A dividend reinvestment plan is a plan that offers investors the ability to

automatically turn cash dividends into the equivalent of common stock. The stocks would be

issued to the investors on the dividend payment date; the same date the investor would have

received the cash dividend. This essentially means instead of receiving a dividend in the form of

cash, that cash is converted in shares of common stock. This is beneficial to the stockholder, as

they will increase their position, over time, via the reinvested dividends. These new, accumulated

shares will amplify investor’s returns, as they will be profiting off owning more shares, at no

additional cost to the investor. Dividend reinvestment plans are based off the compounding

effect. Compounding, as defined by Investopedia (“Compounding,” n.d.) is, “the ability of an

asset to generate earnings, which are then reinvested in order to generate their own earnings.”

This accumulates to greater returns as investors gain shares and capital appreciation,

simultaneously.

There are various ways to hedge your risk while owning an exchange-traded fund. One-

way to hedge your risk is via inverse exchange-traded funds or options. As explained earlier by

Investopedia (“Inverse ETF,” n.d.) an inverse exchange-traded fund is “an exchange-traded fund

(ETF) that is constructed by using various derivatives for the purpose of profiting from a decline

in the value of an underlying benchmark.” This is similar to an investor shorting a stock, which

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is when the investor profits from a stocks price decline. Another way to insure ones investment is

by purchasing derivatives off the derivatives market, for example, options. There are two basic

types of options, a call option and a put option.

Options offer investors the ability to hedge themselves. An option is a legally binding

contract between two parties, the contract seller and the contract buyer. An options contract

encompasses a strike price, expiration date as well as a premium paid to the contract seller. The

strike price is the price at which the contract seller agrees to sell his/her shares to the contract

buyer. The contract buyer has the options to execute the option. The expiration date is the last

date in which the contract seller is obligated to sell the shares to you the strike price is reached.

In order for this ability, investors must pay a premium. This premium is paid to the contract

seller since they is the only party in this contract with an obligation. The contract buyer has the

right, not the obligation to execute the transaction. (As long as the underlying security is trading

at or above the agreed strike price, and if it is prior to the expiration date.) As Nath (2014)

mentioned there are two basic types of options, a call options and a put option. A call option

allows the investor to purchase a security at a set price per share. An investor would purchase a

call option if they were anticipating a price increase; the seller of the call is anticipating a decline

in the price. On the other hand, a put option allows the investor to sell a security at the strike

price. An investor would purchase a put option if they felt that the underlying security would

drop in value. Implementing derivatives to ones portfolio will certainly reduce an investor’s

market risk.

Exchange-traded funds, in combination with inverse exchange-traded funds and

derivatives, such as options, offer portfolio managers the ability to pay a premium for protection

against their positions. Portfolio managers may also hedge against positions they have in the

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market by purchasing an exchange-traded fund in an alternate sector. They may also consider

buying an entire sector through a share of an exchange-traded fund instead of attempting to

select individual stocks. Also with selecting individual stocks, investors need additional capital,

or in cases of mutual funds, will result in paying higher fees. Anonymous (2011) explains in

more detail and also reinforces this advantage exchange-traded funds have over mutual funds by

stating, “With a mutual fund, you have to pay your fund manager to choose the individual stocks

that go in your fund. But ETFs don't have fund managers because they automatically include the

same stocks with the same weighting as their underlying index.” Exchange-traded funds offer

lower fees due to fewer transaction cost. This is yet another reason why exchange-traded funds

have an advantage over mutual funds.

With all the benefits exchange-traded funds have over mutual funds, it was only a matter

of time before a fully exchange-traded fund 401(k) plan was announced. According to a

February 2014 Charles Schwab press release, Steve Anderson (2014), head of Schwab

Retirement Plan Services Inc. announced:

Using a patent-pending process, Schwab Index Advantage is the first 401(k) program that

fully integrates exchange-traded funds as core investments within the plan, including

commission-free intraday investing along with the ability to process partial share

interests.

This was a huge announcement as it was the first ever, all exchange-traded fund, 401(k)

plan. This is an innovative and promising area for continuing growth for exchange-traded funds,

as well as gaining entry into the previously untapped 401(k) market. An all exchange-traded

fund 401(k) plan has many benefits for the investor over a typical mutual fund 401(k) plan. One-

way investors benefit is from paying lower fees, which negatively affects returns. Another

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advantage is that exchange-traded funds allow investors to add diversity to any portfolio with

little capital. Anderson (2014) later goes on to explain why exchange-traded funds have not be

utilized by retirement planners:

Despite the obvious benefits of exchange-traded funds, mutual fund companies that

dominate the 401(k) industry have largely ignored them - simply because these

companies lack either the capabilities or the will to effectively accommodate exchange-

traded funds in the retirement plans they offer.

When planning for retirement, investors must use the power of diversification to their

advantage. Diversification will help mitigate losses during an underperforming market.

Diversification leaves investors less exposed to any one particular stock or sector. In the mist of

the dot-com market crash, this would emerge evident for former Enron employees. According to

Oppel (2001), the majority of Enron employees elected to keep a large amount of Enron shares

in there 401(k) retirement plans. This proved to be a drastic mistake for these employees as

Enron soon faced financial instability issues. Throughout all this, Oppel (2001) reported that Enron

stock had dropped most of its value, within weeks. Employees could do nothing but just watch their

entire savings to vanish, as all assets were frozen. Some employees also were denied the opportunity

to adjust the investments chosen for them, even when they requested less risky assets.

This should be a lesson to individuals planning for retirement, as well as institutional

investors. This was a huge wake up call for investors, but as we will discover in 2008, investors

did not learn from their mistakes. Retirement accounts, such as 401(k) plans, are formed to help

protect investors’ capital, while gaining from capital appreciation over time. Oppel (2001) puts

into prospective how much of retirement assets were actually lost during Enron’s downfall. By

the end of 2000, Enron’s 401(k) plan was valued at over $2 billion. No more than a year later,

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Enron’s stock had declined a remarkable 94%. This should wake up investors, as it was a clear

sign that being overexposed in a particular stock, or sector, was not an appropriate plan of action

for retirement planners to pursue.

Individuals can learn from this and should make sure to actively review their retirement

plans in detail. They should also understand what securities make up their retirement account.

Exchange-traded funds offer this, as they are required to be transparent, meaning they must

release their holdings and their respective weighting in the portfolio (Sharifzadeh & Hojat,

2012). Diversification could have played a huge role in minimizing many individual investors

retirement losses (Oppel, 2001). Relying on a single stock or single sector, leaves investors very

exposed. Employees of Enron got crushed for having their portfolio overexposed to Enron stock.

An efficient way to diversify and hedge an investment is by purchasing multiple exchange-traded

funds, covering various segments of the market. Investors could also add emerging market

exchange-traded funds if they believe they may be able to obtain better investment returns

outside of the United States of America.

Exchange-traded funds make it simple for investors to hedge themselves against risk.

This is especially true in times of economic crisis, such as in 2008. Exchange-traded funds could

have been used to help minimize substantial losses suffered through extreme bear markets.

Losses could have been minimized through the use of exchange-traded funds, as exchange-

traded funds offer the ability to vastly diversify through owning just a single share (Bassie,

2012). This market crash, however, was the worst crash the United States faced in 75 years

(Altman, 2009). Altman (2009) continues by mentioning that Americans have lost close to ¼ of

their total net worth. Even worse, these losses were experienced in a very short time frame, just

over 18 months. In 2008, investors also experienced a 22% decline in retirement assets, dropping

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from over $10 trillion to $8 trillion (Altman, 2009). Pension funds, as well as savings (including

investment) accounts lost a remarkable $1.3 trillion and $1.2 trillion respectively (Altman, 2009).

In total, a remarkable $8.3 trillion was lost due to the market crash of 2008. These significant

losses would immediately impact Americans.

Pension funds and retirement accounts alike experienced significant losses throughout

this recession. Due to these extreme losses, many Americans now needed to work additional

years before they could retire. According to a study conducted by McFall (2011), “The average

respondent would need to work an additional 2.38 years…while those in the most affected

quintile would need to work an average of 8.61 additional years.” Americans needed these

additional years of working, in order to be financially stable for retirement. Americans resorted

to this in an effort to recover what they lost during the economic crisis of 2008. However, these

losses could have been mitigated with the help of exchange-traded funds and their various

functionalities.

Portfolio managers could have hedged away some risk by adding an inverse exchange-

traded fund to their portfolio. An appropriate inverse exchange-traded fund a manager could

have added the inverse ProShares Short Standard & Poor’s 500 exchange-traded fund, SH, to

their portfolios. The ProShares Short Standard & Poor’s 500 inverse exchange-traded fund trades

inversely to the Standard & Poor’s 500 index. Since SH has an inverse relationship to the SPY,

this would have resulted in less severe losses, as the fund would profit off a decline in the

Standard & Poor’s 500.

Figure 1 (next page), compares the returns of both the Standard & Poor’s 500 and the

exchange-traded fund that tracks it, SPY, over the previous ten years. One can see how the

underlying index (Standard & Poor’s 500) and the exchange-traded fund that tracks this index

WILL ETF’S ALTER THE WAY WE PLAN RETIREMENT?

20

(SPY) are very strongly correlated (SPY being the blue line and the Standard & Poor’s 500 index

being the red line). After comparing the returns of SPY and the Standard & Poor’s 500 index

over the last ten years, it is evident that the exchange-traded fund, SPY, has slightly

outperformed the underlying index, the Standard & Poor’s 500. The SPY exchange-traded fund

returned 71.36% over the ten-year period, whereas the Standard & Poor’s 500 index returned

70.60% to investors.

Figure 1: SPY returns (blue) Vs. S&P 500 (red) over last 10 years (Yahoo Finance, 2014)

Since the SPY and Standard & Poor’s 500 are so strongly correlated, they both

experienced steep declines in market value during the crash of 2008. As discussed earlier, an

inverse exchange-traded fund would have helped keep losses to a minimum during a down

market, such as in 2008. If a portfolio manager invested in SH, the ProShares Short Standard &

Poor’s 500, an example of an inverse exchange-traded fund, they could have offset some major

deficits during the market crash. Over a one-year period, ranging from December 21, 2007 to

December 22, 2008, the exchange-traded fund, SH, has returned a staggering gain of 44.8% to

investors (“SH Historical Prices,” n.d.). Conversely, during this same time frame, the Standard &

Poor’s 500 exchanged-traded fund, SPY, experienced a 41.23% decrease in market value (“SPY

WILL ETF’S ALTER THE WAY WE PLAN RETIREMENT?

21

Historical Prices,” n.d.). As represented by these numbers, portfolio mangers of retirement

accounts could have added to their portfolio, a considerable position in an inverse exchange-

traded fund. While retirement mangers should not have an equal weight in an exchange-traded

fund and its inversely traded fund, they should hold small positions to mitigate losses. For

example, owning an equal amount in SH and SPY would just likely result in the gains being

offset by the others losses. However, if retirement planners held more shares of one exchange-

traded fund (SPY) compared to its inverse (SH), that portfolio will still strive in booming

markets. While this strategy will trim the portfolios overall return, due to the ownership of the

inverse exchange-traded fund, it allows for investor to hedge himself or herself from some risk,

which could be easily avoided.

Assuming the portfolio manager never owned the inverse exchange-traded fund (SH),

and just was long SPY, they would have reported higher returns to investors. While those

investor may be satisfied while the markets are booming and the Standard & Poor’s 500 index as

well as SPY continues to grow. Investors like this will eventually suffer from being overexposed

in a market and they could incur heavy losses because of this. These types of investors will

eventually encounter a market consolidation, or pull back, as every market will face a pullback at

one point or another. Owning a well-crafted blend of exchange-traded funds, inverse exchange-

traded funds as well as implementing some options off of the derivatives market, will help

investors keep risk to a minimum.

Exchange-traded funds are rapidly becoming a favorite amongst the investing public.

This is reflected by the extraordinary increases seen throughout the exchange-traded funds

market since they have been introduced over 20 years ago. With substantial increases in multiple

different areas such as total assets under management in conjunction with the quantity of

WILL ETF’S ALTER THE WAY WE PLAN RETIREMENT?

22

exchange-traded funds being available. Exchange-traded funds total assets under management

have experienced exponential growth, skyrocketing by over 25,000% during the 11-year span

ranging from 1996 up until 2007 (Prather et al., 2009). Since 2007, total assets under

management have still continued to show solid growth, although it may not be as significant as it

was once previously. Over the decade long period, ranging from 2001 until 2011, total assets

under management experienced growth of 1,400% (Charupat and Miu, 2013). Investors also can

conclude that exchange-traded funds are very successful, as the number of available exchange-

traded funds grows daily.

Exchange-traded funds are going to alter the way investors prepare for retirement.

Exchange-traded funds offer investors the ability to purchase entire indexes via just one share.

Exchange-traded funds range from all different types of sectors. An investor could purchase an

exchange-traded fund revolving around government bonds, corporate bonds (investment or junk

rating), currencies (i.e. USD/EUR) and even commodities, such as corn, oil, sugar, etc. Investors

can combine any of these exchange-traded funds and that will allow for better diversification

throughout the investors portfolio. Besides allowing for more accessible diversification methods,

exchange-traded funds also offer lower expense ratios to investors, compared to mutual funds. It

is imperative for investors, individual and institutional, to familiarize themselves with exchange-

traded funds as they will be the method for effectively planning retirement. These advantages

have assisted in propelling exchange-traded funds ahead of alternative investment vehicles, such

as close-ended and open-ended funds.

WILL ETF’S ALTER THE WAY WE PLAN RETIREMENT?

23

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