Note: Descriptions are shown in the official language in which they were submitted.
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METHODS, SYSTEMS, AND COMPUTER PROGRAM PRODUCTS FOR
PROVIDING RISK MANAGEMENT INFORMATION AND TOOLS TO
TRADERS IN FUND SHARES
Inventors: Gary L. Gastineau
Todd J. Broms
CROSS REFERENCE TO RELATED APPLICATIONS
100011 The present application claims priority to U.S. Provisional Patent
Application No. 60/907,283, filed on March 27, 2007, and is a continuation-in-
part of pending U.S. Patent Application No. 11/714,923, filed on March 7,
2007,
which is a continuation-in-part of pending U.S. Patent Application No.
11/141,243, filed on May 31, 2005, the disclosures of which are incorporated
herein by reference in their entirety.
BACKGROUND OF THE INVENTION
Field of the Invention
100021 The invention relates generally to financial services, and in
particular, to
the calculation of risk management and trading cost information for
traditional
and non-traditional markets.
Background Art
100031 The risk management tools and techniques available to market makers
and
other traders in financial markets have been either rudimentary or based on
well-
established models. Walrasian call markets, where traders enter bids and
offers at
a specified time to permit all market participants to see and react to the
bids and
offers of their peers, rarely attract market makers. A market clearing price
is
obtained quickly in these markets and any inter-temporal market making
activity
is limited. In the more complex continuous auction market model, buyers and
sellers enter bids and offers during a trading session for interaction with
other bids
and offers. The primary role of the market maker in a continuous auction
market
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is to trade with both buyers and sellers, providing liquidity when it is
needed and,
generally, dampening price fluctuations by intermediating transactions over
time.
[0004] A Wah-asian call market is used where trading volumes are light and
there
is little or no need for continuous liquidity and little or no foimal market
making.
The continuous auction market is the standard for most global securities and
futures markets. Market maker risk management in these markets is well
developed. At the most elementary level, a market maker's risk management
consists of position control. By limiting the size of a position, the market
maker
will limit its exposure to price risk by minimizing the size of its net long
or net
short position. At the next level of risk management complexity, the market
maker will hedge a long or short position by taking a risk-offsetting position
in a
return-correlated instrument in a related market. As markets have become
increasingly sophisticated, as trading hours have expanded, as the geographic
locations of trading venues for similar or identical items have become more
dispersed, and as electronic markets have reduced order pendency times and
direct human involvement in market making, the risk management function has
become more complex, more automated and, usually, more effective. Effective
risk management now includes management of exposures to price fluctuations in
particular markets, limitations on exposures to related risk categories and
protection from a variety of risks that are not directly linked to the items
in the
market maker's trading inventory.
100051 On balance, the availability of a growing number of traded items
with
differently correlated risks, longer trading hours, and more dispersed markets
has
stimulated the development of sophisticated computer-based aggregate risk
management techniques. Sophisticated systems facilitate better hedging of
individual risks and cross-hedging of similar risks in a variety of markets
world
wide. With specific reference to the products and markets considered herein,
the
hedging practices of market makers in exchange-traded funds and in most types
of
securities these funds hold have increasingly focused on reducing hedging
costs
by using low market impact portfolio risk management instruments rather than
specific security-by-security risk offsets.
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100061 Non-traditional market structures that depart in material ways from
the
Walrasian and simple instrument continuous auction market models are also
changing the nature of market maker risk management. The nature of the risks
market makers encounter in new products and nontraditional markets and the
tools market makers use to manage their risks have changed in important ways.
The introduction of new order types, new financial instruments and new
transaction processing features that permit electronic exchange trading at or
relative to a price to be determined in the filture require new kinds of
information
and new risk management tools. There is, therefore, a need for risk management
tools and information for market makers and other market participants trading
actively managed and non-transparent index exchange-traded funds in
traditional
continuous auction markets and in markets where the actual transaction price
is
contingent on a net asset value to be determined at a specified time under
specified conditions.
BRIEF SUMMARY OF THE INVENTION
[0007] Accordingly, the present disclosure introduces methods, systems, and
computer-program products for providing risk infonuation and cost estimation
tools to traders in exchange-traded fund shares.
[0008] According to various embodiments of the disclosed processes,
supplemental information is developed, calculated, and published to support
trading in exchange-traded funds with portfolios that are not totally
transparent
and that use portfolio composition files that are not identical to the fund
portfolios. In an embodiment, the supplementary trading information preserves
fund portfolio confidentiality while permitting market makers and other
traders in
these non-transparent exchange-traded fimds to estimate the costs and risks
associated with fund creation and redemption transactions of various sizes.
[0009] Further embodiments, features, and advantages of the present
inventions,
as well as the structure and operation of the various embodiments of the
present
invention, are described in detail below with reference to the accompanying
drawings.
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FEATURES OF THE INVENTION
[0010] 1. Information to support trading in non-transparent funds
[0011] a. With early creation/redemption cutoff and fund trading
between the commitment to creation or redemption and pricing of the fund
portfolio and creation/redemption baskets;
[0012] b. Use of a pre-trade transaction cost model to estimate
transaction costs that will be incurred by a trader or market maker in
creation or
redemption; and
[0013] c. PACT, PACT Variability, DEMI PACT, DEMI PACT
Varability calculations.
[0014] 2. Outperformance
[0015] a. Versus benchmark index and PCF; and
[0016] b. Versus combinations of indexes
[0017] 3. Calculate and publish trader support calculations for various
nunibers of creation units.
[0018] 4. Report actual transaction costs incurred by market maker(s) in
creation or redemption of ETF shares.
[0019] 5. Delivery of data
BRIEF DESCRIPTION OF THE DRAWINGS
[0020] The accompanying drawings, which are incorporated herein and form a
part of the specification, illustrate one or more embodiments of the present
invention and, together with the description, further serve to explain the
principles
of the invention and to enable a person skilled in the pertinent art to make
and use
the invention.
[0021] FIG. 1 is a block diagram of the systems used in the creation
process for
actively-managed exchange-traded funds (AMETFs, and improved indexed ETFs)
according to the present invention.
[0022] FIG. 2A is a flow diagram of the communications and control system
used
to implement and ensure compliance with early creation-redemption cut-off time
notification requirements.
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[0023] FIG. 2B is a flow diagram reflecting the portfolio and fund
management
process the portfolio manager uses to respond to early notice of a creation or
redemption.
[0024] FIG. 3 is a block diagram of the relationship of all share classes.
[0025] FIG. 4 is a flow diagram of the computerized system for conversion
of the
General Class of Fund Shares or ETF Share Class to and from Specialized Share
Classes.
[0026] FIG. 5 is a block diagram of the portfolio management and trading
system
dedicated to the management of a family of AMETFs and other funds.
[0027] FIG. 6 is a block diagram which illustrates a computer system and
databases used to estimate the optimum size of a fund for a cap calculation
which
may be used instead of embedding a fixed cap on the number of shares
outstanding in a fund prospectus.
[0028] FIG. 7 is a block diagram illustrating a system for calculating
changes in a
fund management fee in response to changes in fund perforinance and other
variables.
[0029] FIG. 8 is a block diagram of a computerized market for trading fund
and
other basket shares at prices linked to the future net asset value of the
share
classes.
[0030] FIG. 9 is an exemplary- system for trading financial instruments on
an
exchange or on an electronic communications network (ECN) in accordance with
an embodiment of the present invention.
[0031] FIG. 10 is a detailed overview of an exeinplary method for trading
financial instruments on an exchange or ECN according to an embodiment of the
present invention.
[0032] FIG. 11 is a detailed illustration of a method for executing an
order for a
financial instrument that may be used with the exemplary method of FIG. 10.
[0033] FIG. 12 illustrates an exemplary transaction in which an investor
purchases a financial instrument subject to a price-based contingency in
accordance with an einbodiment of the present invention.
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100341 FIG. 13
illustrates an exemplary transaction in which an investor
purchases a financial instrument subject to a volume-based contingency in
accordance with an embodiment of the present invention.
[0035] FIG. 14
illustrates an exemplary transaction in which an investor
purchases a financial instrument subject to a net asset value-based
contingency in
accordance with an embodiment of the present invention.
[0036] FIGs. 15A
and 15B illustrate an exemplary computer interface through
which an order for a financial instrument may be entered onto an exchange or
an
ECN in accordance with an embodiment of the present invention.
[0037] FIG. 16 depicts an exemplary process for calculating
Conespondence,
Portfolio Adjustment Cost of Trading (PACT), Portfolio Adjustment Cost of
Trading Variability (PACT Variability) and a one-sided transaction cost
estimate
(DEMI PACT), according to an embodiment of the present invention.
[0038] FIG. 17 is
a block diagram of an exemplary computer connected to a
network upon which the exeinplary methods and systems of the present invention
may be implemented.
DETAILED DESCRIPTION OF THE INVENTION
100391 This
specification discloses one or more embodiments that incorporate the
features of this invention. The disclosed embodiment(s) merely exemplify the
invention. The scope
of the invention is not limited to the disclosed
embodiment(s). The invention is defined by the claims appended hereto.
[0040] The embodiment(s) described, and references in the specification
to "one
embodiment", "an embodiment", "an example embodiment-, etc., indicate that
the embodiment(s) described can include a particular feature, structure, or
characteristic, but every embodiment cannot necessarily include the particular
feature, structure, or characteristic. Moreover, such phrases are not
necessarily
referring to the same embodiment. Further, when a particular feature,
structure, or
characteristic is described in connection with an embodiment, it is understood
that
it is within the knowledge of one skilled in the art to effect such feature,
structure,
or characteristic in connection with other embodiments whether or not
explicitly
described.
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Example 1: Methods and systems for improved fund investment and trading
processes
[0041] The preferred embodiment consists of major and several subsidiary
components implemented through a variety of separate and related computer
systems for the fund. These components may be used either individually or in a
variety of combinations to achieve the joint objectives of protecting finid
investors from the costs of providing liquidity to fund share traders,
increasing the
effectiveness of the portfolio management process and providing a new and
improved way to trade exchange-traded fund shares on a secondary market. A
number of the components of the preferred embodiment have more than one
effect (e.g., shareholder protection plus improved portfolio management
procedures). Each component can be implemented separately and is generally
beneficial to fund shareholders even if the other components are not
implemented
at the same time or to the ft111 extent described herein.
[0042] Certain components of the preferred embodiment improve expected
performance and offer other advantages for investors in both AMETFs with a
full
active management investment process and a new kind of indexed ETF. This new
kind of indexed ETF uses traditional indexing techniques but the index
composition changes are not disseminated to the marketplace until after the
fund
portfolio manager has had an opportunity to change the ffind portfolio to
reflect
any index changes. For the protection of investors, the portfolios of these
new
index funds are less transparent than the portfolios of existing benchmark
index
ETFs, but these funds are otherwise similar to other indexed ETFs. These funds
can benefit from the same components of the present invention as the fully
active
AMETFs principally described herein. Consequently, these new index fimds are
covered by the description and claims as an AMETF variant. The Securities and
Exchange Commission has indicated that these new index fimds will be
considered actively-managed ftmds for regulatory purposes. The secondary
market trading system that is a component of the preferred embodiment is a
useful
method for secondary market trading of any securities basket product including
existing index ETFs, HOLDRs (trust-issued receipts that represent beneficial
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ownership of a specified group of stocks), BLDRs (unit investment trust
portfolios of publicly traded Depositary Receipts) and structured notes linked
to a
multi-security index or basket as well as the AMETFs described herein.
[0043] In this Application, the ETF Share Class is sometimes referred to as
the
General Class of Fund Shares or Redeemable Shares to emphasize specific
characteristics. The terms are interchangeable. A Business Day is any day the
securities markets are open. Ordinarily a Business Day ends at 4:00 p.m.
Eastern
Time in United States securities markets, but some or all markets may close
earlier on occasion, usually on the day before a holiday.
Features of the Preferred Embodiment That Primarily Protect Investors From
Costs of Fund Share Trading
[0044] 1. Early cut-off times for orders to purchase and redeem AMETF
and
ETF shares.
[0045] 2. Entry and exit of investors through an ETF Share Class or an
equivalent process to protect ongoing shareholders from the cost of providing
liquidity to fund share traders.
Features of the Preferred Embodiment That Primarily Improve the Effectiveness
of the Portfblio Management Process
[0046] 3. Conversion of the ETF Share Class to and from Specialized
Share
Classes which, among other features, provide low-cost investment management
services to institutional investors and convenience to individual investors
who
want to pay their advisors in a tax efficient way.
[0047] 4. Less frequent intra-day dissemination of a precise AMETF
portfolio valuation proxy.
[0048] 5. Improving AMETF investor returns by concentrating portfolio
manager effort on controlled-size funds; capping the assets the manager will
accept for specific fund strategies and providing for a higher management fee
on
capped funds that perform well.
[0100] 6. Organization of the AMETF investment manager to concentrate
portfolio management efforts on the management of fund portfolios to reduce
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leakage of investment information by restricting the investment manager's
activities. Voluntary lagged portfolio disclosure may be made more frequently
than required.
The Secondary Market Fund Share Trading System Feature of the Preferred
Embodiment
[0101] 7. A trading system for AMETFs and other exchange-traded fund
shares and basket instruments that parallels the traditional method for
purchase
and sale of conventional mutual funds at Net Asset Value (NAV) without
compromising the investor protection provided by the exchange-traded fund
creation and redemption structure.
101021 FIG. 1 shows a generalized fund share creation system 10 which
allows
for the creation of an actively managed exchange traded fund (AMETF) and a
new type of indexed exchange traded fund (ETF). The overall system 10 includes
the actions of a portfolio manager 12 that manages the fund. The currently
available indexed exchange-traded funds are benchmarked to an index such as
standard published benchmark indexes including the Standard & Poors 500, the
Russell 2000 and a variety of other domestic and international equity and
fixed
income indexes calculated and maintained by an index provider 14. Changes are
made to such indexes from time to time and the changes are published widely.
Changes in the indexes used for the improved indexed ETFs covered by the
present invention will be communicated to the portfolio manager 12
confidentially by the index provider 14 or developed internally by the
portfolio
manager 12. If the fund is actively managed, or if the index is developed
internally, the portfolio manager will determine any portfolio changes inside
the
portfolio manager 12. The system 10 also includes authorized participants 16,
securities markets 18, a fund 20, broker/dealers 22 and investors 24.
[0103] The portfolio composition changes initiated by either the portfolio
manager 12 or the index provider 14 are entered into a portfolio composition
management computer 30 which is coupled to a fund management computer 32.
The index changes for the improved index fund are not published to the world
until after the fund has had an opportunity to implement the index changes in
the
portfolio. The portfolio composition changes to any AMETF including the new
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indexed ETFs need not be revealed except as required by regulators. The fund
portfolio composition management computer 30 manages the relative weighting
of positions in the portfolio and the fund management computer 32 translates
the
desired composition into creation and redemption baskets and orders to buy and
sell securities for the portfolio. The fund management computer system 32 is
also
designed to ensure compliance with the cut-off times for fund trading and to
provide an audit trail for the creation and redemption of fund shares as
explained
below. Links to and from the systems for monitoring and implementing creation
and redemption orders are not shown in FIG. 1. It should be noted that the
computer systems 30 and 32 and other computer systems described herein may be
different groups of networked computers spread out over different locations.
[0104] The portfolio manager 12 supervises the daily process of determining
Portfolio Composition Files (PCFs) reflected in the fund's published creation
and
redemption baskets. These creation and redemption baskets are published each
day in advance of the start of trading of shares in the fund. The authorized
participants 16 have a series of trading and trading management computers 34
that
allow the exchange of securities, fund shares, and cash between the authorized
participants 16 and the securities markets 18, broker/dealers 22 and the fund
and
fund operations 20. The authorized participants 16 each have a back office
computer system 36 that perfouns functions such as confirming trades,
accounting and risk management. The broker/dealers 22 each have a trading
computer system 38 that facilitates trading and record-keeping in a variety of
ways such as perfouning position management, billing and ensuring compliance
with market rules. All of the transactions described herein are completed
electronically via network connections including proprietary networks and the
Internet.
[0105] The authorized participants 16 may create shares in the fund by
depositing
a creation basket of securities (plus or minus a cash amount) in exchange for
shares of the General Class of Fund Shares or redeem shares by depositing some
of the General Class of Fund Shares in exchange for a redemption basket of
securities (plus or minus a cash amount). The authorized participants 16 are
broker-dealers and can include market makers and arbitrageurs. The market
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makers create and redeem shares to manage their inventories of fund shares
whereas arbitrageurs hope to profit from small pricing differences between the
price of the General Class of Fund Shares and the cost of creating or
disposing of
a creation or redemption basket. The authorized participants 16 have entered
into
agreements with industry transaction clearing organizations and agents of the
fund
whereby they agree to certain conditions in the creation or redemption of fund
shares. The authorized participants 16 transact in the securities markets 18
to
acquire the securities that typically make up part of the creation basket.
101061 New shares of the General Class of Fund Shares of the fund 20 are
created
when an authorized participant 16 deposits one or more creation baskets which
consist of securities designated by the portfolio manager 12 as a Portfolio
Composition File (PCF) and a cash balancing amount which may be a payment to
or a payment received from the fund. In return for a creation deposit, an
authorized participant 16 receives newly created fund shares from the fund 20.
A
variety of internal and external computer systems allow the authorized
participants 16 to deal in the secondary market for securities with other
broker-
dealers 22 or directly or indirectly with investors 24. The portfolio manager
12
uses the fund portfolio composition management computer 30 and the fund
management computer system 32 to make appropriate changes to the creation
basket reflecting desired changes in the basket of securities to be received
in a
creation. The portfolio manager 12 also distributes the creation and
redemption
baskets to the authorized participants 16, and a variety of market data
vendors
(not shown). This information is typically distributed through the National
Securities Clearing Corporation (NSCC), an industry utility which is a
subsidiary
of the Depository Trust and Clearing Corporation (DTCC). This industry utility
also distributes an intra-day net asset value proxy to market participants
through
market data vendors. The fund management computer system 32 also handles a
variety of accounting and operating functions including the generation of buy
and
sell orders for the fund's portfolio and generation of instructions for the
fund's
custodian and transfer agent functions, as subsystems linked to the computer
40 in
operations of the fund 20. A similar process (not shown) is used to develop
and
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disseminate the redemption basket and facilitate the fund share redemption
process.
[0107] The trading and trade management computers 34 facilitate the
exchange of
securities (including securities represented in the creation and redemption
baskets), fund shares and cash between the authorized participants 16 and the
securities markets 18, other broker-dealers 22 and the fund 20. The fund
management computer system 32, among other functions, initiates and confirms a
variety of transactions, and maintains records and appropriate information for
an
audit trail of all orders entered with and by the fund. The various features
of the
preferred embodiment of the improved fund will now be described.
Early cut-off times Pr orders to purchase and redeem AMETF and ETF shares
[0108] While the established ETF in-kind creation and redemption structure
provides inherent protection from the grosser foints of mispricing and
shareholder
abuse uncovered in the mutual fund trading scandals, an active fund manager
and
an astute index fund manager need greater flexibility in managing the
portfolio
than is inherent in the exchange-traded index fiind creation and redemption
process as it is used today. Specifically, the necessary and appropriate
publication
of fully transparent creation and redemption baskets discourages effective
implementation of portfolio composition changes by these index funds' managers
if the notice of intent to create or redeem does not come early enough to
permit
the portfolio manager to adjust the portfolio for the effect of creation and
redemption trades on the portfolio composition. In addition, the creation and
redemption baskets for actively-managed ETFs may not reflect the manager's
target fund portfolio as accurately as they typically reflect the composition
of a
benchmark index ETF. The manager of any exchange-traded fund needs the
ability to trade between the time the fund receives notice of an incoming fund
share creation deposit or an outgoing redemption basket and the time the net
asset
value is next calculated.
[0109] Thus the provisions of the preferred embodiment of the AMETF and ETF
require early notice of orders to purchase or redeem shares in the fiinds.
Early
notice permits the portfolio manager to adjust the portfolio composition and
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incorporate the market impact of the entry or exit of shareholders on the
prices
used to calculate the fund's net asset value (NAV). The entering or leaving
shareholders demand liquidity and ¨ with early notice to permit portfolio
composition changes ¨ they pay for it indirectly. The portfolio manager's
ability
to adjust the composition of the fund portfolio after receiving notice of a
creation
or redemption of shares using previously posted creation and redemption
baskets
is essential to transferring the costs of entering and leaving the portfolio
to the
entering and leaving shareholders and relieving the ongoing shareholders of
this
burden.
[0110] In the preferred embodiment, a time between 2:30 p.m. and 3:30 p.m.
is
listed as the cutoff for purchase or redemption of baskets on Business Days
when
the market closing is 4:00 p.m. Eastern Time. This time is only an example of
what might be an appropriate cutoff time for domestic equity portfolios. The
cutoff time range is selected to be an early enough cut-off notice to permit
the
portfolio manager to adjust the portfolio to an appropriate portfolio
composition
by the time the market closes. In specific cases, as governed by the
prospectus or
subject to approval by the fund's board, the fund might set an earlier or a
later
cut-off time to provide the best possible service to entering and leaving
shareholders without compromising the protection of ongoing shareholders. For
funds other than domestic equity funds, different cut-off times will be
required.
In the case of international equity funds, for example, the appropriate early
cut-off
time for funds holding more than 3% of their assets in stocks traded on one or
more primary markets outside the United States, could be 4:00 p.m. on any U.S.
Business Day for pricing at the net asset value next determined for the fund
after a
full trading day in the primary markets for stocks accounting for 97% of the
fund's equity portfolio. The 2:30 p.m. creation/redemption cut-off time for
domestic equity funds and comparable rules for other types of portfolios
solves
one of the fimd industry's greatest investor protection problems.
[0111] The early order cut-off system is illustrated in a flow diagram in
FIG. 2A.
In the preferred embodiment, the fund shares are exchanged for baskets of
securities and cash. The notice by an authorized participant 16 of its
commitment
to create or redeem fund shares before the posted cut-off time is communicated
to
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the communications computer module 52, which in turn confirms the receipt of a
notification to the authorized participant 16 and simultaneously transmits a
time-
stamped report to a fund compliance officer 54, an agent 56 designated by the
primary regulator or by the fiind board and the portfolio manager 58. The
portfolio manager 58 initiates any necessary portfolio modification
transactions.
The reports to the fund compliance officer 54 and to the agent 56 designated
by
the regulator or the fund board insure a record in a form which fund personnel
will not be able to tamper with to conceal late entry of creation or
redeinption
orders, thus providing protection from the late-arriving orders that have been
a
problem for conventional mutual fund shareholders.
[0112] The portfolio management response to a creation or redemption order
is
shown in FIG. 2B. The notice of creation or redemption carries with it
information about absolute and relative position changes that result from a
creation or redemption. The portfolio position changes that result from the
creation or redemption transaction(s) are broken out by the fund management
computer 32 and appear in block 60 of FIG. 2B. The revised portfolio 62 is
determined by the fund management computer 32 and a target portfolio 64 is
created and maintained by the fund portfolio composition management computer
30. The target portfolio 64 reflects the percentage of holdings in each
portfolio
position developed by the fund portfolio composition management computer 30
and represents what the fund management computer 32 has determined is the
appropriate portfolio the fund should hold at the end of the day. The fund
management computer 32 coinpares the revised portfolio 62 to the target
portfolio
64 and generates appropriate orders to buy and sell portfolio securities,
developing a trading plan 68 for execution by the trading desk 70, preferably
by
the time of the NAV calculation. The trading plans are entered by a trading
desk
70 (which is controlled by the fund management computer 32) into the
transaction
process in appropriate securities markets 18. Executions are reported as fiind
portfolio changes 74 and the updated portfolio 76, determined as of the close
of
the day's trading, becomes the then-current portfolio that is represented at
the
beginning of the process for the next trading day. Under this component of the
preferred embodiment, an active portfolio manager and the manager of an
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improved index fund are given necessary and appropriate flexibility in
managing
the portfolio. The publication of totally transparent creation and redemption
baskets which reflect the fill' fund portfolio composition discourages
effective
confidential implementation of portfolio composition changes by index fund
managers. In AMETFs, including the improved ETF index funds, the creation and
redemption baskets may not accurately reflect the portfolio manager's target
fund
portfolio. To protect ongoing shareholders, the manager of any exchange-traded
fund, whether actively managed or based on an index, needs the ability to
trade
between the time the fund receives notice of an incoming fund share creation
deposit or an outgoim,, fund share redemption basket and the time the net
asset
value is next calculated so that any transaction costs will be reflected in
the prices
used in the net asset value (NAV) calculations for the fund shares and the
creation
and redemption baskets.
101131 Early notice permits the portfolio manager to adjust the portfolio
composition and incorporate the market impact of the entry or exit of
shareholders
on the prices used to calculate the fund's NAV. The entering or leaving
shareholders are demanding liquidity and they are indirectly paying for it.
The
portfolio manager's ability to change the composition of the fund portfolio
after
receiving notice of creation or redemption of fund shares using previously
posted
creation and redemption baskets is essential to transferring the costs of
entering
and leaving the portfolio to the entering and leaving shareholders and
relieving
the ongoing shareholders of this burden.
Entry and exit of investors through an ETF Share Class or an equivalent
process
to protect ongoing shareholders from the cost of providing liquidity to flind
share
traders.
10114] Fully effective implementation of the improved fund requires that
all entry
of assets to and removal of assets from the fund is made through the
generalized
exchange-traded fund share creation and redemption process described above or
a
procedure providing equivalent protection for ongoing shareholders. This
process
protects ongoing ftmd shareholders from the costs of providing liquidity to
entering and leaving shareholders. The late trading and market timing abuses
uncovered at many mutual funds since September 2003 would not have been
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possible if the in-kind creation and redemption process, standard in exchange-
traded funds, had been in effect for conventional mutual funds. The general
requirement for in-kind creation and redemption not only protects fund
shareholders from the cost of providing liquidity to traders by creating a
clear
audit trail for the order entry process, redemption in-kind (or partly in cash
at the
option of the fund) offers substantial advantages for taxable shareholders
through
deferral of capital gains realizations until a shareholder decides to sell
fund
shares.
Conversion of the ETF Share Class, upon shareholder demand, to Specialized
Share Classes
[0115] A variety of Specialized Share Classes will be available for
conversion
from and back to the ETF Share Class used for fund shareholder entry and exit.
These Specialized Share Classes provide custom management fee and marketing
fee arrangements to accommodate different types of shareholders with
investment
objectives that coincide with the objective pursued by the fimd. Among other
features, these Specialized Share Classes are structured so that investors pay
marketing and management fees in a tax-efficient manner and receive
appropriate
management fee discounts if they are large investors.
[0116] Under the U.S. tax code, separately billed fees paid by individuals
for
investment management services and various other services provided by
financial
intermediaries are not fully deductible against ordinary income taxes. For
individuals subject to the Alternative Minimum Tax, separately billed fees may
not be deductible at all. To preserve as much deductibility as possible, the
most
tax-efficient way for individuals to pay marketing and management fees is to
pay
them as management or service fees deducted from the investment income
produced by funds in which they own shares. Separately billed marketing fees
would similarly not be fully, or perhaps even partly, deductible and thus are
often
paid more tax efficiently when they are embedded in the cost of the fimd and
deducted from the income distributed by the fund.
[01171 Large institutional investors have more negotiating power than
individual
investors and traditionally pay lower investment management fees. However, in
order to manage portfolios effectively and economically, it is best to bring
all
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types of investors into a single pool rather than manage institutional
portfolios
separately from individual mutual fund portfolios. Such portfolio
consolidation is
another part of the purpose behind the use of Specialized Share Classes as
explained below. Certain share classes would be available only to investors
who
were able to invest several million dollars or more in a particular fund. The
structure of the share class relationships is shown in FIG. 3 and the computer
system for share class conversion is illustrated in FIG. 4.
[0118] The share class relationships illustrated in FIG. 3 show an ETF
Share
Class creation and redemption system 100 similar to the creation side of the
system illustrated in FIG. 1, and a secondary market trading computer system
102
which includes functions reflected in the securities markets 18, the trading
system
34 of the authorized participants 16 and the trading computer systems 38 of
the
broker/dealers 22 in FIG. 1. Creation and redemption (entry and exit of assets
to
and from the fund) involves an ETF Share Class 104. Although the Specialized
Share Classes might be traded in a secondary market under some circumstances,
the only share class that is ordinarily directly creatable or redeemable in a
transaction with the fund is the ETF Share Class. Other share classes might
include, as examples, Specialized Share Class A, a front end load share class
106;
Specialized Share Class B, a back end load share class 108; Specialized Share
Class C, a level load share class 110; and Specialized Share Class D, an
institutional share class with a reduced expense ratio 112, for the
convenience of
various shareholders. Some users of these shares might want to facilitate the
payment of a marketing fee to an individual or organization that provides
sales
and marketing services or advice. Other Specialized Share Classes would
provide
a variety of embedded marketing and management fees. The share classes A-D
are intended to be illustrative, not exhaustive.
[0119] The share class conversions and exchanges in FIG. 4 are effected
through
the fund operation computer system 40 in FIG. 1. In FIG. 4, the process first
identifies the ETF Share Class in step 150. The net asset value (NAV) of the
shares to be exchanged is calculated in step 152. An administrative fee, if
any is
charged, is charged in step 154. A sales load, if any, associated with the
particular Specialized Share Class is charged in step 156. For example, if the
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share is a share of Specialized Share Class A (with a front end load), the
percentage charged for the front end load reduces the total value of the ETF
Share
Class shares entering into the calculation. The remaining value will determine
the
NAV available to be converted into Specialized Share Class A shares in step
158.
The number of whole and fractional shares for the designated share class is
then
calculated in step 160. The whole and fractional share amount in the
particular
share class is posted to the fund's shareholder accounts in step 162. Changes
in
the Specialized Share Class are posted to the fund's capital account in step
164.
Fractional shares will be available for all Specialized Share Classes. A
Specialized Share Class may be created as the equivalent of the General Class
of
Fund Shares or ETF Share Class for fractional share positions under certain
circumstances. When and if industry trading, clearing, transfer and custody
systems are modified to accommodate fractional shares of fully DTCC-eligible
securities, fractional shares of the ETF Share Class may be available. The
process
in steps 152 to 164 may be reversed to convert Specialized Share Classes back
to
the ETF Share Class. A table of NAVs of each share class is compiled daily by
taking information from step 152 and step 158 and updating these NAVs for
changes in the value of the underlying portfolio each day. These calculations
are
necessary because when a sales load or a different management fee is charged
to a
particular share class, the NAV of that share class will change in different
ways
than the ETF Share Class NAV changes, and subsequent transfers to and from
that share class must be at values consistent with charges to investors using
that
class. ETF share equivalents (which may- be needed in conjunction with the
implementation of a cap on the issuance of new fund shares) are calculated
using
the ratios of the Specialized Share Class NAVs to the ETF Share Class NAV and
adding all the ETF share equivalents of the outstanding shares.
[0120] Table 1 below shows the relationship of various alternative share
classes
to the ETF Share Class based on the ratio of their respective share classes'
NAVs
to the ETF Share Class NAV.
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Table 1
Number of Shares ETF Share-
Outstanding Equivalents
in Class Outstanding
ETF Share Class X Err X Err
Specialized Share Class
A X A a X A
Specialized Share Class
B b XB
Specialized Share Class
X c X c
Specialized Share Class X D
cl X D
D, etc.
Sum of ETF Share Equivalents =
101211 In Table 1,
a, b, c and d are equal to the ratio of their respective share
class's NAV to the ETF Share Class NAV. The sum of the various share class
ETF Share Class equivalent net asset values in total (Y) is compared to the
fund
share cap stated in a fund's prospectus or adopted by the fund board. If Y
plus the
ETF Share Class equivalents in a standard Creation Unit exceeds the designated
cap, no creations will be permitted until a redemption occurs or the cap is
increased under the terms of the fund prospectus.
Less frequent intra-day dissemination of a precise AMETF portfolio valuation
proxy
101221 Another
feature of the improved fund is an increase in the interval
between -precise" intra-day fund share net asset value (NAV) proxies
calculated
and distributed by NSCC, an industry utility, through electronic quotation
vendors
during the trading day. The net
asset value proxy is based on the
contemporaneous bids and offers for each security in the portfolio translated
into
a per-ETF Share Class share value expressed as a bid and offer or as the
midpoint
between the bid and the offer. The time interval between publication of these
precise net asset value proxies would be greater than the 15-second interval
common with today's index ETFs, say, between 5 minutes and 60 minutes in the
preferred implementation, and may vary within that range at the discretion of
the
fund's board of directors, subject to regulatory approval.
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[0123] The reason for reducing the frequency of net asset value proxy
dissemination is that dissemination every 15 seconds provides a total of more
than
1500 fund share values during the standard trading day. Given that AMETFs will
usually have fewer positions than a broad market index exchange-traded fund,
every 15-second dissemination provides a great deal of information and would
permit an astute analyst to back calculate the composition of the portfolio
and
learn inappropriate details about the fund's ongoing trading activities. The
appropriate interval for precise NAV proxy dissemination will vary for
different
funds depending in part upon the number and nature of the securities in the
portfolio. However, the appropriate time interval for publication of precise
indicative values does not bear a rigid relationship to the number of
securities in
the portfolio or any measure of portfolio turnover. The fund directors would
determine the interval between precise portfolio valuation proxies subject to
regulatory approval. Reducing the amount of information on the content of the
portfolio provided to the marketplace will protect the fund shareholders from
front-running of transactions the fund portfolio manager is making to modify
the
fund portfolio.
[0124] The fund management computer system 32 in FIG. 1 supplies data to a
secure market data server (not shown) that continuously updates the net asset
value proxy of the fund shares as bids and offers for the portfolio securities
change throughout the day. Net asset value proxies are published at an
interval
approved for each fund by the fund board. The current standard interval for
indexed ETFs is every 15 seconds. If an approximate indicative value is
required
at 15-second intervals for the use of investors and market makers, a
randomized
process will meet this need while reducing the portfolio information content
of net
asset value proxy calculations disseminated between precise calculations.
Specifically, the values between periodic releases of precise values based on
the
actual portfolio could be based on the 15-second interval precise portfolio
values
incremented or decremented by a number drawn at random from a disclosed
probability distribution. The random increments and decrements in these values
will eliminate the opportunity to use the net asset value proxy publication to
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determine portfolio composition, yet avoid an indicative price too far away
from
the actual portfolio value to be useful to market participants.
Improving AMETF investor returns by concentrating portfblio manager effort on
controlled-sizelimds; capping the assets the manager -will accept for specific
fund
strategies and providing Pr a higher fee on capped fimds that pet:form -well
101251 In the preferred embodiment, after the AMETF complex reaches a size
specified in its fund prospectuses, the investment process used by the
management company would be used almost exclusively for products using the
fund structure and process. A common set of directors will typically be
directors
of every fund managed using the fund family's common investment process and
the directors will be responsible for ensuring that the investment process has
adequate capacity to serve additional funds with different objectives without
a
detrimental effect on existing funds before the addition of funds not listed
in the
original documentation. In the preferred embodiment, the funds' prospectuses
do
not permit the fund manager to manage separate accounts or institutional
pooled
accounts except as share classes converted from ETF Share Classes. Rather than
manage investment products that present a conflict of interest for the ETF
Share
Classes and the Specialized Share Classes converted from them, the investment
manager might sell any excess research or idea capacity along a particular
dimension to another investment manger on terms to be approved by the fund's
directors. The manager could also have the opportunity to earn a higher fee on
a
capped portfolio.
[0126] FIG. 6 illustrates the structure of such an AMETF dedicated
portfolio
management and trading system 200 which is part of the systems maintained by
the portfolio manager 12 in FIG. 1. The portfolio management and trading
system
200 is based on an investment process 206 incorporated in an investment
management process 202 that also includes input from external research and
data
sources 204, internal research 208 and portfolio managers (PMs) 212 who are
the
essential and principal members of the investment process committee. The
investment process committee 206 produces approved and recommended
investment ideas 210 and a framework for portfolio management choices 214 to
be used in the management of the organization's AMETF products. The
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investment management process 202 prepares the periodic mandatory and any
voluntary fund portfolio disclosures 216. Voluntary disclosures could be made
available with greater frequency than regulators require with the approval of
the
fund board. The investment management process 202 delivers instructions for
changes to each fund through a portfolio composition trading process 218 that
manages portfolio composition trading using the filnd portfolio composition
management computer system 30. The portfolio composition trading process 218
is indirectly involved in the allocation of executions to the various funds
220
using the fund management computer system 32 in FIG. I. A tax management
computer 222 stores tax data and selects appropriate tax lots of securities
from
each fund portfolio for delivery against sales and redemptions. A trading desk
computer 224 links to various markets where trades are executed to complete
the
portfolio composition trading framework.
101271 In the preferred implementation, the size of certain funds will be
capped
by provisions in the fund's prospectus or by a fund board resolution. The
principal
purpose of capping the size of some funds is to improve the probability that
the
funds will enjoy superior long-term performance for the benefit of their
shareholders. In addition to or as a substitute for a fixed cap set by the
prospectus,
the fund could rely on fund board resolutions or use a computer system and
database to compute the optimal size of a fund to determine the fund asset
level at
which a cap should be imposed by the fund board.
101281 FIG. 7 is a block diagram of a computer system 250 designed to cap
the
size of a fund. It includes a fund size optimizing computer 252 coupled to a
trading cost database 254 which includes, among other features, databases that
link trading costs to the size of the positions which the family of fiinds as
a group
hold in individual securities with varying capitalizations and levels of
trading
activity. A separate trading style module 256 will contain information on the
various fund trading styles and the trading cost experiences of the fund's
portfolio
managers and traders under different market conditions. A cost module 258
contains fee and expense functions for different fund sizes and performance
functions based on industry experience and the experience of the managers
employed by the funds. In addition, the cost module 258 has functions relating
to
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the interaction between the fee structure and methods the funds are perinitted
to
use to require re-conversion of low management fee Specialized Share Classes
to
the ETF Share Class and an algorithm for changing the management fee on the
exchange-traded share class in response to perfomiance achieved by the fund's
portfolio management process. The fund size optimizing computer 252 produces
an appropriate cap and fee calculation report 260 for recommendation to the
fund
board.
[0129] The purpose of capping some funds is to create an environment which
eliminates the traditional conflict between the interests of investors and the
interests of investment managers which usually leads managers to accumulate
large pools of assets that make superior investment performance difficult or
impossible.
[0130] With the exception of some funds holding predominantly large
capitalization stocks, the investment manager will state in the fund
prospectus or
the fund board will detemiine the maximum number of ETF equivalent shares that
each fund in a family will issue. The manager may also use a controlled share-
growth formula to prevent growth that will swamp the manager's ability to
achieve superior perfomiance for the fund. The cap could be increased or the
forinula modified at a future date if the manager was comfortable with its
ability
to manage a larger portfolio and if the fund board or shareholders approved a
change.
[0131] One purpose of the computer system 250 in FIG. 7 is to provide fee
incentives for the fund manager to manage a smaller pool of assets more
intensely
and more effectively, providing better performance for investors and equal or
better compensation for the fund managers without increasing the size of the
fund
portfolios to the extent that superior performance is no longer possible.
[0132] The prospectus of a capped fund will state the maximum number of ETF
equivalent shares that the fund will issue or will otherwise describe the
process
for limiting the size of the fund. The Specialized Share Classes may have
share
prices different from the per share price of the ETF Share Class. The ETF
share
equivalent of a share in a Specialized Share Class will be equal to its net
asset
value (NAV) divided by the NAV of the ETF shares. If the maximum total ETF
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share equivalent issuance for a fund is reached, no more shares will be issued
unless shares are first redeemed or the maximum issuance is increased. In the
preferred embodiment, an authorized participant that redeems shares to reduce
its
inventory of shares in a fund that has reached its maximum size will have the
exclusive right to re-create those shares at net asset value (NAV) plus a
standard
creation fee for a period stated in the fund prospectus. If the redeeming
authorized
participant does not re-create within the stated period, the fund board could
shrink
the fund by lowering the cap.
101331 Capping fund size in some portfolios can solve the problem of
finding a
superior active manager and having assets managed by that manager over a long
period of time. Capping should permit portfolio managers to post better
performance records and, subject to the operation of a process to increase the
management fee as a reward for good performance, earn more income. With fund
management fee increases linked to multi-year performance and capped fund
shares trading at a premium to net asset value (NAV), both investors and
managers can eam as much or more than they might earn from larger portfolios
using traditional fund and fee structures. The new fee structure will provide
an
incentive for perfolinance more in line with the fund shareholders' interests
than
current fee structures.
[0134] FIG. 8 shows a computer system 400 and associated data sources used
to
determine the management fee for a capped fund according to one aspect of the
present invention. The computer system 400 includes a program based on an
algorithm described in the fund prospectus and approved by the SEC that
permits
the fund board to increase or decrease the management fee based on fund
performance during prior periods. The computer system 400 uses a fund
performance data source 402, a benchmark performance data source 404 and a
peer performance and management fee data source 406. The perfonnance data
will include traditional performance comparisons plus measures of average
premiums over NAV that the ETF Share Class achieves. Such premiums may
lead to an increased management fee in at least two ways. First, if the ETF
Share
Class trades at an average premium over NAV that exceeds a level stated in the
prospectus for a specified time, the holders of Specialized Share Classes with
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discounted management fees can be required to convert their shares to the full
fee
ETF Share Class. Second, if the premium persists at a designated level, the
management fee can be increased to a multiple of the base rate. Appropriate
terms to reduce fees if perfoimance drops below a specified standard are part
of
the algorithm. The algorithm reflects the fact that the manager is giving up
the
ability to increase assets beyond the cap on the strength of a superior
performance
record. Thus, the potential for fee reduction is more limited than the
potential for
a fee increase in some circumstances. The computer system 400 outputs
appropriate changes in the management fee for consideration by the fund board
or
automatic implementation under terms stated in the fund prospectus.
[0135] The creation and redemption rules are designed to encourage
occasional
redemptions after a fund reaches its cap in terms of number of ETF share
equivalents. The existence of a cap without modest variability in the number
of
shares outstanding forecloses redemptions and leads to much greater share
price
volatility in the secondary market trading of the capped funds' shares than is
necessary or desirable. The absence of redemptions could also reduce the tax
efficiency of the fund. It is appropriate that a market maker with a temporary
excess inventory of shares in a fund is able to redeem fund shares from time
to
time, bringing the size of the fiind below the stated ceiling on the number of
shares the fund would issue. This redemption permits the fund share market
price
to more closely reflect changes in the fund's net asset value and avoid
significant
fluctuations in any premium which the market price of the shares may carry
over
the fund's net asset value. Subsequent to such a redemption and for a period
designated in the fund's prospectus, the redeeming authorized participant has
the
exclusive right to re-create the shares it had redeemed under terms
established by
the fund prior to its closing to new creations. These terms are essentially a
re-
creation of the shares redeemed with an in-kind deposit priced at net asset
value
plus a normal creation fee. If the redeemer does not re-create within the
designated period, the fund has the option of either shrinking the cap on the
number of shares it would issue (to shrink the fund because inanagement has
determined that the capped size was too large) or permitting any authorized
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participant to create shares up to the share ceiling under standard (NAV)
terms for
fund share creations.
[0136] This redemption and re-creation provision helps market makers with
fund
share inventory management. It moderates fluctuations in any premium on the
fund shares' price in the secondary market once the ceiling on share issuance
is
reached. It also provides a mechanism whereby an occasional in-kind redemption
can enhance the fimd's tax efficiency. The expiration of the right to re-
create also
permits the fund board to reduce the fund's maximum capitalization if the
fund's
market space becomes less liquid or if the original ceiling on share issuance
was
not set low enough to protect the fimd from being overwhelmed with assets. Any
decision to shrink the market capitalization originates with the manager, with
the
fund board or with shareholders by petition.
Organization of the AMETF investment manager to concentrate porfolio
management eftbrts on the management of funds 10 reduce leakage of investment
information by restricting the investment manager's activities.
[0137] Another feature of the preferred implementation of the present
invention
preserves the value of the output of the investment process more directly.
With a
unified portfolio management and trading operation and limitations on product
offerings, shareholders are well-protected from inappropriate dissemination of
investment information. Specifically, the value of an investment idea is
preserved
until the funds managed by the organization have time to buy or sell as much
as
they want of a particular security.
[0138] One of the weaknesses of the typical active manager's investment
management process ¨ in which different types of accounts are buying or
selling
the same security ¨ is information leakage. With a single pool for each fund
and
funds as the manager's only product, there are no conflicts associated with
the
order in which transactions are made, and there is no leakage to outside
organizations from trade confirmations sent to owners of separate accounts and
individuals associated with institutional and non-public pooled portfolios. Of
all
possible structures for the collective management of investment portfolios,
pooling is accomplished most efficiently and most confidentially with multiple-
share-class funds that control publication of their portfolios.
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[0139] With the concurrence of a fund's directors, the investment manager
may
disclose a recent fund portfolio to the public at appropriate intervals by any
means
the appropriate regulatory authorities approve. These may include posting on a
website or other electronic dissemination. The disclosure process permits free
and equal access to the information by any investor with Internet access. When
implied portfolio disclosure is made through changes in creation and
redemption
basket composition, these changes are appropriately disseminated through
public
postings. Formal portfolio disclosure can be no less frequent than the
quarterly
disclosure with a 60-day lag now required of conventional mutual funds.
However, in many cases, fund managers will be encouraged by market forces to
make more frequent portfolio disclosures to increase the efficiency of
secondary
market trading in the fund shares without harm to ongoing fund shareholders
from
such disclosures. The computer model disclosed in FIG. 6 monitors both
portfolio construction and transaction plans and governs and implements any
portfolio disclosures that take place at shorter intervals than the interval
imposed
by regulators.
A trading system for ETFs and other basket instruments that parallels the
traditional method ft)r purchase and sale of conventional mutual funds at Net
Asset Value (NAV) without compromising the investor protection provided by the
exchange-traded fund creation and redemption structure
[0140] Licenses may be offered to appropriate trading venues to use
computer
systems designed to permit special intra-day auctions linked to periodic
disclosure
of the intra-day valuation proxy and the closing net asset value (NAV). These
auctions will provide a trading mechanism intermediate in some respects
between
those of mutual funds and today's benchmark index ETFs. FIG. 9 shows a
computerized market 300 allowing trading of ETF shares at prices linked to
future
NAV calculations which may be used as a pricing basis. The market 300 is
centered on a computerized trading system 302. The computerized trading system
302 matches orders in terms of their statement of a bid or offer below, at or
above
the NAV or NAV proxy to be calculated on prevailing bids and offers for
portfolio holdings and disclosed at a specified future time. The computerized
trading system 302 accepts orders from investors 304 and market makers 306.
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The computerized trading system 302 receives periodic NAV calculations and
NAV proxy calculations 308. The computerized trading system 302 produces
reports of executions in currency and at spreads relative to the daily closing
NAV
or NAV proxy values posted at specified times. The trading
system
accommodates trading in any fund, trust or structured product for which a net
asset value based on the prices of its holdings of securities or other
financial
instruments is periodically calculated.
101411 The NAV-linked executions at stated times permit investors to
place
orders with market makers through traditional financial intermediaries for
purchase and sale of shares at a price linked to an hourly posting of the
intra-day
net asset value proxy or at the official end-of-day net asset value. In some
cases,
these trades may be done at a spread and in others the market maker may
provide
a guarantee of a fill at net asset value with no spread or commission ¨ the
effective execution cost depending in part upon the time interval between the
entry of the order by the investor or the investor's agent and the price
calculation.
Instead of making a market at a specific price, the market maker bids and
offers at
a spread below, at and above the next reported hourly intra-day proxy value or
the
closing NAV. The spread away from the designated NAV determination will
generally widen as the time of price determination draws closer because the
market maker has less time before the price determination to hedge or offset
risk
with another trade.
101421 Using the closing NAV as the target in such a trading structure
makes the
pricing and trading of ETFs much like the conventional mutual fund trading
process. Market makers may be willing to guarantee execution with no
commission at the closing net asset value on orders received far enough in
advance. Obviously, an order for execution at today's NAV with no commission
is not acceptable to a market maker after a certain time. The cut-off time for
such
an order may vary among fiinds and among market makers.
101431 While mutual fund transaction systems are designed to
acconunodate
trades denominated in dollars with share positions expressed as whole and
fractional shares, stock and ETF trading systems and, most significantly,
clearing
systems do not accommodate fractional shares. Some firms show fractional stock
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or ETF shares in a customer's account but such fractional share positions
cannot
be transferred electronically to other firms. The trading mechanism of the
preferred embodiment converts part or all of a dollar-based transaction into a
Specialized Share Class with the same per share NAV as the General Class of
Fund Shares and the appropriate share position will appear in the customer's
account as a conventional fund share class position. This feature adds to the
similarity of this trading process to the traditional mutual fund transaction
process.
Cost Savings to Investors and Investment Managers
The following table, Table 2, compares estimates of the costs experienced by a
typical
long-term investor in an actively-managed domestic equity mutual find to the
costs of an
actively-managed domestic equity version of the new fund according to the
present
invention. The potential cost/perfoimance difference is as much as 4.10% per
year. The
new structure offers substantial advantages to investors, largely from
eliminating
unnecessary or inappropriate costs and fund size-related performance
penalties.
Table 2
New
Equity-
Equity-
Mutual
Fund
Fund
Expense Ratio
1.0% 1.0%
Portfolio Composition Trades Inside
1.5% 1,5%
the Fund
Fund Share Trading Liquidity Costs 1.4%
Leakage of Investment Info/Index
0.35%
Publication
Fund Supermarket vs. Multi-Share
0.350/0
Class ETF
Perfoimance Penalty from Oversized
Funds,
Up to
Net of Higher Performance Fee
2.00%
2.50 70
Annual Total 6.60%
101441 In Table 2, there are no recurring fund share trading liquidity
costs for the
new fund structure because any costs to enter and leave the ETF Share Class
are
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paid by the trading shareholder only when entering or leaving the fund. The
estimate of the cost of information leakage is based on an estimate of half
the
typical annual cost of the publication effect of S&P 500 composition changes.
The fund supermarket costs are usually annual costs to all of a fund's
shareholders in no transaction fee (NTF) shares, whether they use the fund
supermarket or not. Some annual supermarket fees paid by funds are higher than
0.35%. There are no annual marketing fees in the new structure without a
specific
agreement by the investor to pay them in connection with ownership of a
Specialized Share Class. The performance penalty associated with fund size is
an
estimate based on limited data from active fund managers and trading cost
analysts.
[0145] It will be apparent to those skilled in the art that various
modifications and
variations can be made in the method and system of the present invention
without
departing from the spirit or scope of the present invention. Thus, the present
invention is not limited by the foregoing descriptions but is intended to
cover all
modifications and variations that come within the scope of the spirit of the
present
invention and the claims that follow.
Example 2: Systems, methods, and computer program products for trading
financial instruments on an exchange
[0146] Additional embodiments of the invention shall now be described in
terms
of exemplary systems, methods, and computer program products for trading
financial instruments on an exchange or an electronic communications network
(ECN). Within such embodiments, financial instruments may include, but are not
limited to securities, mutual fimds, exchange-traded funds, open-end fimds,
closed-end fund, stocks, swaps, futures, and derivatives, either alone or in
combination. Further, the embodiments described herein may accommodate any
additional financial instrument that would be apparent to one skilled in the
art and
that may be traded on an exchange of ECN.
[0147] According to embodiments of the invention, a wide range of financial
instruments, trading techniques, and trading processes may be accommodated
with changes in exchange order formats, structures, and processes with the
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common element being a settlement price, a trade volume, or any coinbination
of
a settlement price and a trade volume to be determined in the future.
Embodiments of price- and volume-contingent trading processes include, but are
not limited to:
[0148] a. Volume-Weighted Average Price (VWAP), which represents a
total price of instruments traded during a period divided by the total number
of
instruments traded;
[0149] b. Time-Weighted Average Price (TWAP), which is a variant of
VWAP that weights the price using the time the price spends at each level
rather
than the volume traded at each level;
[0150] c. Target Volume (TVOL), which is a strategy used to trade a
specified percent or fraction of the actual market volume, usually at a
specified
relationship to the average price at which that volume trades; and
[0151] d. Net Asset Value (NAV)-based trading, which permits settlement
of
fund share transactions and transactions in other instruments for which net
asset
values are periodically calculated at prices linked to a specified posting of
a net
asset value calculation to be made after the time of the trade.
[0152] According to embodiments of the invention, each of the above-
described
execution forinats and processes may be characterized by settlement terms that
are determined by future trading prices, future trading volumes, future NAV
calculations, or some other variable or combination of variables that sets the
trade's specifications and settlement provisions once the determining
variables
have been calculated. Such other variables will be apparent to persons skilled
in
the relevant arts based on the teachings contained herein. Also, other
execution
formats and processes applicable to the present invention will be apparent to
persons skilled in the relevant arts based on the teachings contained herein.
[0153] In some embodiments, exchange transactions may utilize an arbitrary
base
number or proxy value, such as 100, as a centering point for either a price
measured in currency or in percent. Further, additional embodiments may
incorporate a root symbol with an extension or a special symbol to designate
both
the financial instrument and the order type.
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[0154] Further, in contrast to certain informal trading instructions or
trading
algorithms whereby a broker attempts to provide an execution as close as
possible
to a specified net asset value or as close as possible to a specified average
value
and/or fraction of total volume, trades and transactions described herein may
be
anonymously executed firm contracts for settlement at a specific relationship
to a
specified net asset value calculation, or to specified realized average prices
and/or
volumes.
[0155] Trades based upon volume-weighted average pricing are the most
commonly used over-the-counter transactions contingent upon future prices.
However, in spite of their popularity, VWAP trades have often been criticized
for
their effect on markets. By coupling traditional volume-weighted average
pricing
with exchange trading, the present invention provides an end-of-day
transparency
in VWAP trading that is absent from existing trading processes.
[0156] A volume-weighted average price (VWAP) is a ratio of a total value
of an
item traded to total voltune traded over a particular time horizon (usually
one
trading session or the remainder of a trading session after an order is
entered), and
as such, VWAP is the average price for a financial instrument over the
specified
time horizon with proportionately more weight given to periods of heaviest
trading. In equity markets, VWAP is a common measure of the average price a
stock traded at over the measurement period, and VWAP is often used as a
trading cost benchmark by investors who aim to be as passive as possible in
their
trade executions. Many institutional investors fall into this category. The
aim of
using a VWAP trading target is to ensure that the broker or market maker
executes the order in line with the volume and prices available in the market.
[0157] VWAP orders (and related orders described herein) may be based on
the
VWAP calculation for an entire trading session or for only a portion of the
trading
session. A common contract in the over-the-counter market may use the VWAP
calculation for the portion of the trading session that remains after an
agreement
to buy or sell at VWAP is made. Weaknesses of currently available over-the-
counter trading in these agreements include an oversimplification of remainder
of
session VWAP calculations, a lack of competition in pricing remainder-of-
session
trades, a need to renegotiate any change in an order with a specific broker or
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market maker, and an absence of a price or volume calculation subject to
regulatory oversight.
[0158] Even if the exchange does not introduce a remainder-of-session
contract,
the availability of competitive quotations throughout the session for full-
session
contracts on the exchange will enable an investor who wants to cancel or
offset
the effect of the remaining transactions in a ftill session contract to enter
into a
counter-trade that largely or entirely offsets the impact of remainder of the
session
trades that might be executed by the counterparty to a full session trade. The
full-
session contract will be competitively priced throughout the session. In less
formal anangements in the over-the-counter market, an investor is dependent on
the goodwill of a market maker when negotiating his way out of the remainder
of
a full session VWAP trade.
[0159] Order entry systems and quotation standards in financial markets
typically
reflect a price at which securities, commodities or other financial
instruments are
exchanged and the size of the position to be purchased or sold. If an item is
trading for around $20.00, a bid to purchase the item might be $19.95 and an
offer
to sell the item might be $20.05. The quotation structure also reflects the
respective quantities bid for and offered. This traditional exchange quotation
and
order entry structure has impeded the development of transaction mechanisms to
deal with prices and quantities to be determined in the future because there
is no
simple correlation between current prices and volumes, and prices and volumes
which may be determined by future trading or in some other manner.
[0160] Through the embodiments described herein, the needs of investors
using
these contingent orders are accommodated by stating transaction prices at or
relative to a price or volume or price and volume that is currently unknown,
but
that will be determined in the future. Bids and offers (and, in some cases,
trading
volumes) to be determined will be stated relative to an exemplary anchor
point, or
proxy value. The anchor point or proxy value can be any agreed upon value,
such
as but not limited to 100. The present invention is not limited to this
specific
numerical anchor point or proxy value, but its use provides a simple mechanism
by which market participants relate the present market to a price or volume to
be
determined in the future. One skilled in the art would recognize that a number
of
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numerical anchor points would be suitable for use within the ethbodiments of
the
present invention.
[0161] Using the example of the above-mentioned item trading at $20.00,
a price
that would be close to the future price might be transacted in terms of bids
at
99.95 (5 cents less than the proxy) and offers at 100.05 (5 cents greater than
the
proxy), representing the essence of the bid at $19.95 ($20.00 minus $0.05) and
the
offer at $20.05 ($20.00 plus $0.05) that was cited above. If there is a great
deal of
uncertainty as to the appropriate future price or an absence of active
liquidity
providers, the appropriate bid might be stated at 99.50 versus an offer of
100.50.
These quotations would suggest a bid at $19.50 and an offer at $20.50 in an
instmment trading at $20.00. In this example, a benclunark settlement price of
$21.00 would call for settlement of a trade at the bid side of 99.95 at a
price of
$20.95. The above examples represent currency applications. Percentage
applications where 99.95 and 100.05 translate into $19.99 (0.9995 x $20.00)
and
$20.01 (1.0005 x $20.00) with a benchmark settlement at $20.00 are also
possible
and fall within the scope of the invention, but seem less intuitive in most
trading
applications.
[0162] In the foregoing examples, the use of an exemplary anchor point
or proxy
value, such as 100, should be understood as a way to transact around the price
to
be determined in the future rather than absolute dollar amounts. Percentage
applications may be more appropriate for transactions based on trading volume
to
be determined in the future. However,
the present invention may employ
percentage applications to describe transactions based on any combination of
price and trading volume that would be apparent to one skilled in the art.
[0163] Further, while either a price reference standard or a percentage
reference
standard can be adopted for a given trading market, there is no necessary
reason
for all markets to adopt the same standard. For example, one market may use a
currency-based difference and another market can use percentages of the
determining price or volume. As described within the embodiments below, TVOL
trades may be entered to buy or sell a specific percentage of the instruments
traded on an exchange during the specified period, and VWAP trades may
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likewise be entered to buy or sell shares at a specific future price on the
same
exchange.
Symbols and Extensions for Contingent Trading of Financial Instruments
[0164] One feature of many U.S. markets is a limitation on the number and
type
of characters that can be accommodated in various data fields of a quotation
or
order entry system. In some cases, these symbology constraints are inherent in
the core system; in others, they might be accommodated in the core system over
time and at a manageable cost, but legacy feeder systems at customer locations
would also have to be modified. It can, therefore, be usefitl to use a root
symbol
which might have, in a typical case, three or four characters and an extension
consisting of additional characters which describe the nature of the
instrument
being traded in more detail and the basis for trading, i.e., trading at a
future price
or a percentage of volume during a designated period.
[01651 The root symbol of a financial instrument, such as the Standard &
Poor's
Depositary Receipts (SPDRs, pronounced spiders, trading symbol SPY), might be
followed by a decimal point and the letters VW for VWAP trading during a ftìIl
day's trading session. For time-weighted average price (TWAP) trading, the
letters following the decimal for a fill' session average might be TW. For
target
volume (TVOL) trading, a future volume determined trading strategy that calls
for
execution of transactions based on a targeted percentage of total market
volume,
the extension might be TV. For net asset value (NAV) based pricing, a type of
future price or value determined trading appropriate for exchange-traded
funds,
closed-end funds and other instruments for which a net asset value is
periodically
calculated, the end-of-session NAV extension might be NV. In additional
embodiments, these extensions may be further modified by changing letters to
distinguish between trades to be settled at the average price during the
entire daily
trading session, during the remainder of the trading session beginning with
the
next transaction after the VW,AP, TWA& or TVOL contract is executed or at an
NAV determined at a time other than the market close. Such conventions may
accommodate a range of innovative order variations with a readily understood
symbology useful to market participants.
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[0166] Table 3 outlines a number of exemplary extensions that may be
applied to
a root symbol of a financial instrument in accordance with embodiments of the
present invention. It is noted that the extensions shown in Table 3 as well as
others described herein are provided solely for purposes of illustration, and
not
limitation. Other means for denoting contingent trading as described herein,
whether involving symbols, extensions or some other approach, will be apparent
to persons skilled in the art based on the teachings contained herein.
[0167] In the example of Table 3, Standard & Poor's Depository Receipts
(SPDRs), rather than a common stock, are used to illustrate the application of
the
present invention to both NAV-based trading and order types that may be used
in
conjunction with any financial instrument.
Table 3
Full Session
Trade Rest of,Cap or Floor on
or End of Hourly AV
Type Session Price Permitted
Day
VWAP SPY.VW S PY. WR Yes
TWAP SPY.TW SPY.TR Yes
Yes
TVOL SPY.TV SPY.VR
SPY.NA,
NAV SPY.NV N/A Yes
SPY.NB, etc.
[0168] Table 3 outlines exemplary symbology and trading variations for
various
types of transactions. In a TVOL trade, for example, a VWAP price relationship
or a price cap or floor can be a condition of most orders. The cap or floor
can be
included or optional in the other order types. Investors may expect that some
orders entered with a cap or floor are both less likely to be executed and
less
likely to attract aggressive traders.
[0169] In the hourly NAV column, extensions .NA and .NB are used to suggest
NAV calculations that might be made hourly at, say, 10:00 a.m. and 11:00 a.m.,
respectively, if most U.S. financial markets continue to open at 9:30 a.m.
Eastern
Time. Although not outlined within Table 3, additional embodiments may
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incorporate VWAP, TWAP and TVOL executions based on hourly or other
specified periods.
[0170] In an embodiment described above with respect to Table 3, a basic,
or root
symbol of a security or other financial instrument has been combined with an
extension to describe the nature of the execution process. In an additional
embodiment, a newly specified symbol designates both the instrument and the
execution type. Further, a full session VWAP trade in the SPDR may be
described by a symbol such as SPY.VW, where the extension is used not only to
designate the execution process, but also the settlement process. In such an
embodiment, the settlement process may be described in terms of at least one
of
(i) transaction size; (ii) routing codes; (iii) instructions; (iv) price; (v)
order price;
(vi) time-in-force; (vii) settlement type; and (viii) limit price, as outlined
below.
[0171] The specifics of an exchange market order entry process are
constrained
by the systems in place at the exchange and on the computers of its customers.
One preferred embodiment of this invention modifies some order entry
conventions in use at the New York Stock Exchange (NYSE), and the
embodiments described herein describe functions that might be performed with
data in certain fields using NYSE terminology. The terminology and conventions
will be different to varying degrees on other securities exchanges and
significantly different on futures exchanges. While some unaffected fields
will be
described for clarity even if their use is not modified to accommodate the
price-
and volume-contingent orders described herein, the above description
illustrates
how the existing structure of exchange order entry might accommodate the types
of price and volume contingent trades described herein.
(i) Size
[0172] The size field carries the ntunber of shares or other units to be
bought or
sold. For most orders of financial instruments, including the transaction
variations described herein, the size represents simply the number of shares
covered by the order. With the exception of the NAV-based trades, these price-
and volume-contingent orders are designed primarily for use by institutional
or
other large investors. Consequently, trade entry may be restricted to round
lots
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for some order types. For example, an order for 100 shares is designated as
100,
but the last two digits are always zeros for order types limited to round
lots.
[0173] For TVOL trades, the order is not expressed in terms of a number of
shares because the number of shares is contingent on the number of shares
traded
during an interval. In one embodiment, an appropriate convention would fix the
size field for TVOL trades at 100, representing one percent of the day's or
other
relevant time period's trading volume. Traders would execute six separate
orders
for "100" to cover 6% of the session's volume. Alternately, the size of the
field
may be capped at 1,000 so that no more than 10% of the transaction volume
during a designated period or session can be contracted for with a single
trade.
With this convention, an order for -600" in the size field covers 6% of the
volume
in the specified time period. Further, one skilled in the art would recognize
that a
number of additional techniques may be employed to accommodate the volume
percentage term in a TVOL order.
(ii) Routing Codes
[0174] While routing codes are used principally to direct an order to a
particular
execution facility at the exchange, they might be used in contingent orders
for
trade designation or settlement control, either as a supplement to a special
symbol
or symbol extension or as a separate designator.
(iii) Instructions
101751 In the embodiments described above, three types of instructions may
be
appropriate: BUY (Buy), SL (Sell) or SSHRTAEXEMPT (sell short exempt from
the uptick rule). The sell short exempt instruction is used primarily for
trades in
exchange traded funds which are exempt from the uptick rule, but which still
need
to be designated as a short sale for other regulatory purposes. In trades
contingent
on a future price or volume, the instniction set for a securities trade cannot
reasonably incorporate a traditional non-exempt short sale because the initial
transaction merely engages the buy-side party to receive shares at a price or
in a
size (or both) to be determined. Similarly, the sell-side party contracts to
deliver
shares now owned or to be purchased on a timely basis to fulfill the contract.
Permitting a short sale in a non-exempt security or financial instrument in
this
manner would provide a potential regulatory end run around the uptick rule. At
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such time as short sale regulations change, what are now non-exempt short
sales
may be permitted to use the non-exempt short sale order type.
(iv) Price
[0176] For price-contingent trades, the core basis price may be a standard
set by
the exchange, which, as suggested above, might be 100 in a VWAP, TWAP or
NAV contingent order, with ultimate pricing in currency increments around the
settlement price. In the case of TVOL trades, a reasonable way to designate
the
price is also in increments or decrements around a VWAP basis calculated over
the same period as the TVOL. To the extent that a market participant desires
to
put a limit on the actual share price, the limit may be specified in the limit
price
field as described below.
(v) Order Type
[0177] Ordinarily, market, market-on-close, limit or other qualifications
or
extensions are used in stating an order. An order type not currently in use
might
be used alone or as a supplementary field to designate this order as a VWAP,
TVOL, NAV or other trade type.
(vi) Time-in-Force
[0178] Time-in-force variations from day orders are within the scope of the
present invention.
(vii) Settlement Type
[0179] The settlement default in most trades of securities in the United
States is
"regular way," i.e., settlement on the third day after execution. The
settlement
terms on the trades described herein are set when all price or volume
contingencies are determined, usually shortly after the market close on the
trade
date, making third day settlement a reasonable choice. However, VWAP-based
and NAV-based orders for "cash settlement" are expected to be common and cash
settlement can be the default or an available option in some of these trades
[0180] To meet processing requirements, one embodiment of the invention
uses a
new settlement type or types specifically for these executions or to trigger a
special transaction restatement and settlement process after capture of the
necessary contingent variables by the symbol, the symbol extension or a
routing
code. The contingent trades would be reported to the counterparties for
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comparison shortly after the execution, but the trades would have to be
restated to
incorporate contingencies. The restated trades would then settle. The
contingent
trades would not settle but a record of them would be retained for regulatory
purposes.
(viii) Limit Price
[0181] New York Stock Exchange orders and orders on many other exchanges
can have two price fields. The second price field usually states a limit such
as a
cap or floor. A limit is usually based on the dollar price of a share. In the
case of a
buy- order, the limit price would be a cap by default. In the case of a sell
order, the
limit price would be a floor by default and the price would be the dollar
price of
the underlying share, not the "100" or other basis price used in the primary
price
field.
Systems and Methods for Trading Financial Instruments on an Exchange
[0182] FIG. 9 is an exemplary system 900 for trading financial instruments
on an
exchange or an electronic communications network (ECN) in accordance with an
embodiment of the present invention. The exemplary system 900 comprises a
number of parties 902 that enter orders to trade financial instruments, such
as but
not limited to common stocks, mutual funds and exchange-traded ftmds (ETFs) on
an exchange or an electronic communications network (ECN). In the
embodiment of FIG. 9, the parties 902 may include an investor 904 and a market
maker 906, although in additional embodiments, the parties 902 may be
comprised of any number of investors, acting individually or through brokers,
and
market makers, depending on the nature of the market and the requirements of
market participants at any given time.
[0183] The investor 904 and market maker 906 may enter orders to trade the
financial instrument by electronically transmitting bids to purchase the
financial
instrument and offers to sell the financial instrument to a computerized
trading
system 908 that is associated with the exchange or ECN. The bids and offers
for
the financial instrument may be stated relative to a contingency based on a
future
price or net asset value and/or future trading volume of the financial
instrument.
The range of possible contingencies may include, but is not limited to, a
volume-
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weighted average price of the financial instrument (VIVAP), time-weighed
average price of the financial instrument (TWAP), a target trading volume of
the
financial instrument as a percentage of total volume in the market during a
specified period (TVOL), and net asset value (NAV) calculations of the
financial
instrument typically provided by fund issuers or service providers associated
with
the issuer of the financial instrument.
[0184] As described above in Table 3, the respective VWAP-based, TWAP-
based, and TVOL-based contingencies may be calculated over a fuII trading
session or, alternatively, over a portion of the trading session remaining
after a
trade is executed. NAV-based contingencies may be calculated more frequently
than once per day. In additional embodiments, the VWAP-based, TWAP-based,
TVOL-based, and NAV-based contingencies may be computed over any of a
number of time periods that would be apparent to one skilled in the art.
Further,
as outlined above with respect to Table 3, an extension may be applied to a
root
symbol of the financial instrument to indicate any combination of a particular
contingency, execution process, and settlement process.
[0185] The computerized trading system 908 then matches a bid to purchase
the
financial instrument with an offer to sell the financial instrument in order
to
execute the trade according to contractual terms set forth in the respective
bid and
offer. Once the trade has been executed, details of the executed trade (or
transaction) may be transmitted from the computerized trading system 908 to
the
preliminary reporting and comparison system 910 as a report stating the terms
of
the transaction and any price, volume, or price and volume contingencies to
which
the execution is subject. The transaction is not submitted to settlement until
the
contingent prices, volumes and/or other terms have been deteanined, and
depending upon the rules of the exchange, the first stage of the transaction
may or
may not be published on a trade reporting system.
[01861 The preliminary reporting and comparison system 910 prepares initial
reports that may be sent to trading parties 902 for comparison purposes and to
an
execution determination and calculation computer system 912 that accepts
contingency price and volume calculations (as well as other contingent
calculations, depending on the embodiment) from service providers 914 that may
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be operated by or associated with the exchange or ECN or other regulatory
authority. In the case of executed orders contingent upon NAV calculations,
the
execution determination and calculation computer system 912 may accept NAV
calculations from issuers 916 of financial instruments for which a net asset
value
is periodically calculated, and their service providers 918, including
calculation
agents. Once all
contingent terms have been received, the execution
determination and calculation system 912 computes the contractual terms of the
trade and reports the executed trade and the contractual terms to an exchange
transaction reporting system 920, to a trade settlement system 922, and to the
parties 902 to the trade, including investors 904 and market makers 906.
[0187] FIG. 10 is a detailed overview of an exemplary method 1000 for
trading
financial instruments according to an embodiment of the present invention. In
step 1002, a computer trading system associated with an exchange or ECN
receives at least one order to trade a financial instrument, such as but not
limited
to a mutual fund and an exchange-traded fund (ETF), from a potential party to
the
trade. Within step 1002, the parties to the trade may be investors or market
makers, depending on the nature of the market and the requirements of market
participants at any given time, and each party may enter an order on the
exchange
by transmitting the order electronically to the computerized trading system.
[0188] The order to trade the financial instrument may represent a bid
to purchase
the financial instrument or an offer to sell the financial instrument, and the
received orders may be stated in terms of prices, trading volume, and net
asset
values of the financial instrument that are contingent upon future events. In
one
embodiment, the contingency may be based on a net asset value (NAV) of the
financial instrument calculated periodically at specified time intervals
throughout
a trading day. For example, the NAV may be coinputed at 10:00 am and at 11:00
if an exchange were to open for trading at 9:30 am. In additional embodiments,
the contingency may be based on a volume-weighted average price (VWAP) or a
time-weighted average price (TWAP) of a financial instrument or other
financial
instrument calculated over a specified time interval. The contingency may also
be
based on trading volumes (TVOL) expressed as a percentage of the total volume
of a financial instrument or other financial instrument traded during a
specified
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time interval. The contingency may be stated in the order in terms of a proxy,
as
described herein.
[0189] In step 1004, once orders from the various parties to the trade have
been
received, the received bids and offers are stored, and the bids and offers for
financial instruments from the various parties are then matched to execute an
order between parties. The executed order matches a bid to purchase a
particular
financial instrument with an offer to sell the particular financial
instrument, where
both the bid and offer have been stated in terms of a compatible contingency
such
as but not limited to a future price, future trading volume, future net asset
value of
the financial instrument, etc. In some embodiments, the executed order may be
reported over the exchange tape at the time of execution (i.e. , during step
1004) as
well as after contingency determination.
[0190] In step 1006, terms of the executed order, including any future
price,
future volume, or future price and future volume contingencies to which the
order
is subject, are reported to the trading parties. The reporting process may
include
transmitting a report of the transaction to the individual trading parties for
review
and comparison with their bid or offer. By reviewing the report, trading
parties
may identify errors and may initiate actions to correct any errors. In
additional
embodiments, the tern's of the executed order may be transmitted to an
external
system, such as the preliminary reporting and comparison system 910 within
FIG.
9, and the external system may report the terms of the executed transaction to
the
trading parties.
[0191] In step 1008, the contingencies upon which the order has been
executed
are computed. In one embodiment, the computed values of the price-based,
volume-based, or NAV-based contingencies are provided to an external computer
system, such as the execution determination and calculation computer system
912
within FIG. 9.
101921 For executed orders contingent upon net asset value (NAV),
contingent
terms may be periodically calculated by at least one of an issuer of the
financial
instrument, a service provider associated with the issuer, the market, or a
regulatory authority. Contingent tenns based on price and trading volume, such
as VWAP-based, TWAP-based, and TVOL-based contingencies, may be
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computed directly by the computerized trading system associated with the
exchange or ECN or by service providers under the supervision of the exchange
or ECN. As the contingent terms are calculated by parties independent of the
trade, conflicts of interest may be substantially reduced or eliminated.
[0193] In step 1010, the contractual terms of the executed trade are
computed,
and the contractual terms of the executed trade are reported to the parties to
the
trade in a final report. In one embodiment, the contractual waits may be
computed by an external computer system, such as the execution determination
and calculation computer system 912 within FIG. 9.
[0194] In step 1012, the executed trade and the contractual terms
associated with
the executed trade will be reported to an exchange transaction reporting
system,
and the exchange transaction reporting system 920 will publish the executed
trade. The exchange transaction reports will be supplied to one or more
financial
reporting services.
[0195] Further, in step 1014, the executed trade will be reported to a
settlement
computer system for settlement under the computed, contractual terms. In an
embodiment, the settlement computer system is associated with the National
Securities Clearing Corporation (NSCC), a wholly owned subsidiary of The
Depository Trust & Clearing Corporation (DTCC). The NSCC provides
centralized clearance, settlement and information services for virtually all
broker-
to-broker equity, corporate bond and municipal bond, and exchange-traded fimds
trades in the United States.
[0196] In step 1016, the executed trade and the contractual temis
associated with
the executed trade may then be confirmed to the parties to the trade.
[0197] FIG. 11 is a detailed illustration of a method for executing an
order for a
financial instrument that may be incorporated into step 1002 of the exemplary
method of FIG. 10. In step 1102, a first party enters an order to buy (or
sell) at
least one share of a financial instrument, such as but not limited to a mutual
fund
and an exchange-traded fund (ETF), on an exchange or ECN that trades the
financial instrument. The bid (or offer) entered by the first party within
step 1102
may be stated relative to a future value of a first contingency using a proxy
value.
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[0198] In step 1104, a second party enters an order to sell (or buy) at
least one
share of the financial instrument, such as an exchange-traded fund (ETF), on
the
exchange or ECN. As described in reference to step 1102, the offer (or bid)
entered by the second party within step 1102 may be stated relative to a
future
value of the same contingency using a proxy value.
[0199] In one embodiment, the first party of step 1102 may be an investor
acting
through a broker and the second party of step 1104 may be a market maker.
However, in additional einbodiments, the first and second parties may be any
combination of investors or market makers or other market participants,
depending on the nature of the market and the requirements of market
participants
at any given time. Further, during steps 1102 and 1104, the first and second
parties enter orders by transmitting the orders electronically to a
computerized
trading system.
[0200] The contingency of interest to the parties 1102 and 1104 may be a
net
asset value (NAV), a time-weighted average price (TWAP) or a volume-weighted
average price (VWAP) calculated over a specified time interval. The
contingency
may be also based on a target volume expressed a percentage of total trading
volume of the financial instrument on the market during a specified time
period
(TVOL).
[0201] Once the orders from the first and second parties have been entered
into
the computerized trading system in steps 1102 and 1104, respectively, the
computerized trading system then accepts and stores the orders in step 1106.
The
computerized trading system stores not only the order for the financial
instrument,
but also any contingency upon which the order is stated. In additional
embodiments, steps 1102, 1104, and 1106 may be repeated for additional parties
that enter orders for the financial instrument stated in terms of price-based,
volume-based, and/or NAV-based contingencies.
[0202] In step 1108, the computerized trading system matches the order for
the
financial instrument from the first party to a corresponding order for the
financial
instrument from the second or some other party. In addition to matching bids
and
offers for the financial instalments entered by the first and second parties,
the
processes within step 1108 also determine whether the contingent terms of the
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orders are compatible. If the computerized trading system successfully matches
the bids and offers from two parties, then the order is executed in step 1110
subject to the stated contingencies on price (including NAV), trading volume,
or
price and trading volume of the financial instrument. The executed orders will
be
reported to the applicable parties as described above with reference to FIG.
10.
[0203] FIG. 12 illustrates an exemplary transaction 1200 in which an
investor
purchases a financial instniment that is subject to a price contingency in
accordance with embodiments of the present invention. In step 1202, an
investor
enters a bid to purchase 100 shares of financial instrument XYZ.VW at 100.02
(or
better) into a computerized tradinL, system associated with an exchange or ECN
on which XYZ.VW is traded. Purchasing shares of XYZ.VW at 100.02 or better
indicates that the investor will purchase the shares for no more than two
cents
($0.02) above a VWAP calculated for the trading session. The computerized
trading system matches the investor's bid with a corresponding sell order that
has
been stored by the computerized trading system, and the trade for 100 shares
of
XYZ.VW is executed subject to the stated VWAP contingency during step 1202.
[0204] An initial report is generated in step 1204 indicating that the
investor has
purchased 100 shares of XYZ.VW at 100.02 and, after it is inspected by the
investor as part of the comparison process, information on the trade is
transmitted
to the execution determination and calculation computer system 912 within FIG.
9. The executed trade is stored by the execution reporting mechanism pending
arrival of information on the contingent price on which settlement is based.
[0205] In step 1206, the exchange computer system or a service provider
engaged
by the exchange calculates a VWAP for the financial instrument XYZ.VW at the
completion of the trading session (a session VWAP). In the example of FIG. 12,
the session VWAP of XYZ.VW may be calculated as $20.00. The session
VWAP is then used in step 1208 to compute the contractual terms of the
executed
trade, and usinL, the example of FIG. 12, an execution of a trade at 100.02 on
a
$20.00 VWAP results in a buy price of $20.02. The investor has purchased 100
shares of XYZ.VW at a share price of $20.02. This information is then reported
on the exchange "tape" reporting mechanism and sent to settlement during step
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1210. Using the symbology outlined above, the executed trade may be confirmed
as "Bot 100 shares of XYZ @, $20.02."
[0206] FIG. 13 illustrates an exemplary transaction 1300 in which an
investor
purchases a financial instrument that is subject to a volume-based (TVOL)
contingency in accordance with embodiments of the present invention. In step
1302, an investor enters a bid to purchase 1% of the session trading volume in
XYZ at 100.02 or better (at no more than $.02 over the volume-weighted average
price (VWAP) for that session) into a computerized trading system. The
computerized trading system matches the investor's bid with a corresponding
sell
order that has been stored by the computerized trading system, and the trade
for
100 shares of XYZ.VW is executed subject to the stated price and volume
contingency.
[0207] An initial report is generated in step 1304 indicating that the
investor has
purchased 1% of the session trading volume in XYZ at 100.02 (i.e., "Bot 1% of
XYZ.TV at 100.02") and, after it is inspected by the investor as part of the
comparison process, information on the trade is transmitted to the execution
determination and calculation computer system 912 within FIG. 9. The executed
trade is stored by the execution reporting mechanism pending anival of
information on the contingent price and volume on which settlement is based.
[0208] In step 1306, the exchange computer system or a service provider
engaged
by the exchange computes a session VWAP at $20.00 and a session TVOL at
200,000 shares. In the example of FIG. 13, 1% of 200,000 shares is equivalent
to
2,000 shares and an execution at 100.02 on a $20.00 VWAP is a price of $20.02.
The session VWAP and TVOL are used in step 1308 to compute the contractual
terms of the executed trade, and using the example of FIG. 13, the investor
has
purchased 2,000 shares of XYZ.TV at a share price of $20.02. This information
is then reported on the exchange "tape" reporting mechanism and sent to
settlement during step 1310, and using the symbology outlined above, the
investor's report may read "Bot 2000 shares of XYZ at $20.02."
[0209] In contrast to informal volume-linked orders placed with brokers
today,
the executed trade described within FIG. 13 requires a locked-in commitment to
purchase the financial instruments based on the specified volume-based
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contingency, and this commitment occurs when the trade is executed in step
1302.
Both parties are bound to the settlement price and, in this case, volume of
the
order that will be determined as soon as the contingent price and volume are
known.
[0210] FIG. 14 illustrates an exemplary transaction 1400 in which an
investor
purchases a financial instrument that is subject to a net asset value-based
contingency in accordance with embodiments of the present invention. In step
1402, an investor enters a bid to purchase 100 shares of XYZ.NV at 100.02 (or
better) into a computerized trading system on which XYZ.NV is traded. The
order indicates that the investor will purchase the shares for no more than
two
cents ($0.02) above the net asset value (NAV) calculated at the end of the
trading
session. The computerized trading system matches the investor's bid with a
corresponding sell order that has been stored by the computerized trading
system,
and the trade for 100 shares of XYZ.NV is executed subject to the stated NAV-
based contingency within step 1402.
[02111 An initial report is generated in step 1404 indicating that the
investor has
purchased 100 shares of XYZ.NV at 100.02 and, after it is inspected by the
investor as part of the comparison process, information on the trade is
transmitted
to the execution determination and calculation computer system 912 within FIG.
9. The executed trade is stored by the execution reporting mechanism pending
arrival of information on the contingent price on which settlement is based.
[0212] In step 1406, the issuer of the financial instniment or a
calculation agent
engaged by the issuer calculates an NAV for the financial instriunent XYZ.NV
at
the completion of the trading session. In the example of FIG. 14, the end of
day
NAV for XYZ.NV may be calculated as $20.00. This value is used in step 1408
to compute the contractual terms of the executed trade, and using the example
of
FIG. 14, an execution of a trade at 100.02 on a $20.00 NAV results in a share
price of $20.02. The investor has purchased 100 shares of XYZ.NV at a share
price of $20.02. This information is then reported on the exchange "tape"
reporting mechanism and sent to settlement in step 1410. The trade is reported
to
the investor as "Bot 100 shares of XYZ @ $20.02."
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[0213] The example of FIG. 14 describes a transaction for XYZ.NV that
involves
a contingency based on an end of day NAV. As described above in reference to
Table 3, the NAV-based contingency is not limited to end of day NAVs, but may
also incorporate NAVs computed periodically during a trading session. In such
a
case, the example of FIG. 14 would be modified such that the investor would
purchase shares of XYZ.NA or XYZ.NB, orders of which would be contingent
upon NAV values computed at various times during the trading session.
[0214] The foregoing embodiments describe exemplary systems, methods, and
computer program products for trading financial instruments on an exchange or
an electronic communications network (ECN). Within such embodiments, the
financial instruments may include, but are not limited to securities, mutual
funds,
exchange-traded funds, open-end funds, closed-end funds, stocks, swaps,
futures,
and other derivatives, either alone or in combination. Further, the
embodiments
described herein may accommodate any additional financial instrument that
would be apparent to one skilled in the art and that may be traded on an
exchange
or ECN.
[0215] The embodiments described herein preserve the anonymity of tradin2-
parties and the confidentiality of their trading plans. Informal or direct
party-to-
party negotiation of contracts with price or volume contingencies in over-the-
counter markets often reveals information that a trading party might prefer to
keep
confidential. For example, direct negotiations with a market maker are
characteristic of most non-exchange future price or future volume-contingent
trade entry. Such negotiations generally require the customer to reveal its
identity
to the broker or market maker at some point in the negotiation process. In
contrast, with the present invention, if the parties use standard order
forniats and
procedures characteristic of exchange trading, there is no need for a market
maker
or any participant in the transaction to know the identity of the ultimate
parties to
the trade. One advantage of concealing a trader's identity is that an exchange-
based transaction need provide no infonnation about the total size of the
market
participant's trading intention. Confidentiality in a very high degree can be
assured by incorporating novel features into exchange systems such as the New
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York Stock Exchange's (NYSE) Anonymous SuperDOT (ADOT) order entry
system.
[0216] Further, the trades described herein may be used as part of a block
trading
program. For example, a seller of a block of stock might find a buyer using
any of
the trading techniques and order types described herein. By executing an order
with that buyer early in the block sale process, the seller might reduce the
market
impact of the sale by finding a natural buyer who might not be easy to find
directly in the typical block trading process. This interaction may reduce
transaction risks and costs for either or both parties to the trade.
Exemplar); Computer Interfaces for Trading Financial Instruments on an
Exchange
[0217] FIGs. 15A and 15B illustrate an exemplary computer graphical user
interface (GUI) 1500 through which an order for a financial instrument may- be
entered on an exchange according to embodiments of the present invention. The
example of FIGs. 15A and 15B is provided solely for purposes of illustration,
and
not limitation. Other means for entering an order for a financial instrument
will
be apparent to persons skilled in the relevant arts, and such other means are
within
the scope and spirit of the present invention.
[0218] In FIGs. 15A and 15B, the exemplary computer interface 1500 may
directly communicate with a computerized trading system associated with the
exchange or ECN, and computer interface 1500 allows a party to a trade, such
as
an investor, to enter information regarding a specific bid to purchase a
financial
instrument or a specific offer to sell a financial instrument on the exchange
or
ECN. The financial instruments may include, but are not limited to securities,
mutual funds, exchange-traded funds, open-end funds, closed-end funds, stocks,
swaps, futures, and other derivatives, either alone or in combination.
Further, the
embodiments described herein may accommodate any additional financial
instrument that would be apparent to one skilled in the art and that may be
traded
on an exchange or ECN.
[0219] In the example of FIGs. 15A and 15B, the investor first specifies a
particular financial instrument that will be subject to the bid or offer
entered
through the computer interface. In FIG. 15A, the investor enters the root
symbol
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of the particular financial instrument in field 1502, and the entered root
symbol
should correspond to the ticker symbol of the financial instrument. For
example,
to trade the Standard & Poor's Depositary Receipts (SPDR), the investor would
enter SPY in field 1502. In many embodiments, an extension would be entered in
the same field as the root symbol, but some additional embodiments might
require
the investor to enter an extension in field 1504 to indicate a specific price-
based,
volume-based, or NAV-based contingency (or some other contingency or
combination of contingencies) under which the order will be executed by the
computerized trading system. For example, the investor may specify VW in field
1504 to enter an order for the financial instrument that is contingent upon a
volume-weighted average price (VWAP) of the financial instrument computed at
the end of a trading session. In a similar fashion, the investor may enter TW
to
enter an order for the financial instrument that is contingent upon a time-
weighted
average price (TWAP) of the financial instrument computed for the trading
session. Further, TV may be entered into field 1504 to indicate an order for a
specific percentage of the trading volume (TVOL) of the financial instrument
over a specific time period. For a NAV-based contingency, the investor may
enter NV within field 1504 to indicate that an order for the financial
instillment
that is contingent upon a session NAV, or alternatively, the investor may
enter NA
or NB to indicate that the order is contingent upon a specific hourly NAV.
[0220] The investor or the investor's agent will then specify an
instruction in field
1506 to indicate the nature of the particular trade. For example, the investor
enters "BUY- in field 1506 to enter a bid to purchase the financial
instrtunent. In
a similar fashion, the investor could enter "SL in field 1506 to enter an
offer to
sell the financial instrument. Further,
the investor may also enter
"SSHRTAEXEMPT "within field 1506 to indicate that the order is exempt from the
uptick rule, but must be designated as a short sale for other regulatory
purposes.
[02211 The investor or the investor's agent will also specify a size of
the order to
be entered onto the computerized trading system in field 1508. In the case of
a
VWAP-contingent, TWAP-contingent, or NAV-contingent order for the financial
instrument, the investor will enter the number of shares to be transacted
within
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field 1508. In the case of a TVOL-contingent order, field 1508 may be filled
with
a percentage of the trading volume that will be subject to the entered order.
[0222] A share price associated with the order for the financial instrument
may
then be specified within field 1510. For price-contingent trades, the core
basis
price may be a standard set by the exchange that, as suggested above, might be
a
proxy value of 100 in a VWAP, TWAP or NAV contingent order, with ultimate
pricing in currency increments around the settlement price. In the case of
TVOL
trades, a reasonable way to designate the price is also in increments or
decrements
around a VWAP basis calculated over the same period as the TVOL.
[0223] Once the share price has been specified within the exemplary
computer
interface, the investor may specify a limit price for the order in field 1512.
The
limit may be based on the dollar price of a share. In the case of a buy order,
the
limit price would be a cap by default. In the case of a sell order, the limit
price
would be a floor by default and the price would be the dollar price of the
underlying share, not the "100" or other basis price used in the primary price
field.
[0224] Once the information related to the order for the financial
instrument has
been entered in fields 1502 through 1512, the investor may submit the order to
the
computerized trading system by selecting the "SUBMIT" button 1514. Once
submitted, the order is transmitted to the computerized trading system, which
attempts to match and to execute the order according to the exemplary methods
described herein.
[0225] FIG. 15B illustrates an exemplary set of entries into data fields of
a
computerized interface 1500 that would enable an investor to enter an order to
purchase 1000 shares of SPY.VW at 100.05 on an exchange that trades SPY. VW.
In FIG. 15B, the SPY.VW financial instrument is used for exemplary purposes
only, and the computer interface 1500 supports any number of financial
instruments that may be traded upon the exchange or ECN associated with the
computerized trading system. Assuming that a session VWAP for SPY.VW is
computed at$130.00, the entered order enables the investor to purchase 1000
shares of SPY.VW at a price of $130.05 per share, as the share price is below
the
specified limit price ofS131.00.
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[0226] In one embodiment, the computer interface 1500 within FIGs. 15A and
15B may be executed on a remote computer system that communicates with the
computerized trading system through a communications path, such as a wired or
wireless internet connection. In an additional embodiment, the computer
interface
is executed locally by the computerized trading system, and an investor on a
remote computer system must access the computerized trading system to utilize
the computer interface. Further, in the embodiments described above, the data
within fields 1502 through 1512 may be entered directly by the investor,
selected
from a menu, or entered through any means that would be apparent to persons
skilled in the art.
Example 3: Methods, systems, and computer program products for providing
risk management information and tools to traders in fund shares
[0227] Actively managed and non-transparent index exchange-traded funds,
hereinafter referred to as actively managed exchange-traded funds or simply as
active ETFs, carry risks and costs for market makers that differ materially
from
the risks and costs associated with trading the indexed ETFs with fully
transparent
portfolios that have been traded since 1993. In the present context,
"transparency"
means that both the current contents of a transparent portfolio and any
scheduled
changes in the portfolio can be learned in advance of the change by anyone who
cares to know. In an embodiment, the differences in disclosure between
transparent indexed ETFs and active ETFs are accommodated, thereby
facilitating
market making in active ETFs. In such an embodiment, systems, methods, and
computer program products provide risk management information and tools for
market makers and other users of active ETFs in traditional markets and for
market makers and other users of NAV-based active ETF secondary markets.
[0228] These tools may help market makers and other traders measure risks,
manage their costs of trading and assess their ability to make effective
markets in
an active ETF. The trading cost and trading risk information methodology
addressed herein is particularly useful because the preferred method and
process
for offering actively managed and non-transparent index exchange-traded funds
requires cutoff times for fund share creation and redemption commitments that
are earlier than the creation/redemption cutoff at the market close used for
the
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original index ETFs. The earlier
cutoff is necessary because the
creation/redemption basket for actively managed ETFs will ordinarily not match
the fund portfolio exactly and because the actively managed and non-
transparent
index exchange-traded fund portfolio manager will usually trade to make
changes
in the ftind's portfolio after a market maker commits to a creation or
redemption
but before the net asset value at which the creation or redemption is priced
is
determined. The fund portfolio manager will often sell some of the securities
that
are in a creation basket or buy some of the securities that are in a
redeinption
basket after the creation or redemption commitment is made. The portfolio
manager will also be buying or selling other securities to modify the fund
portfolio. At least some of these transactions impose an indirect cost on the
market maker that initiated the creation or redeinption transaction. Important
elements of the invention estimate the trading costs associated with this post-
commitment trading.
[0229] In contrast to active ETFs, transparent index ETFs feature
creation/redemption baskets that match the index fund portfolio very closely.
Consequently, any tracking error between the fund and the basket for
transparent
index ETFs is small and essentially random. Most actively managed and non-
transparent index ETF portfolio transactions made after the market maker
commits to creation or redemption of ETF shares have an expected cost to the
creating or redeeming market maker. From the market maker's perspective, the
expected transaction cost is experienced in the form of an adverse effect on
the
prices used to value the creation or redemption basket on one hand and the
fund
portfolio on the other hand.
[0230] A simple example will illustrate how an early commitment to
creation or
redemption and subsequent trading by the fund portfolio manager will pass the
cost of the trading from the fund to the market maker. Assume that the fund
has
sold a stock that still accounts for 15% of the assets in the creation basket
and has
replaced it with another stock that now accounts for 15% of the assets of the
fund.
The basket and the portfolio have identical percentage compositions, other
than
these two positions. After the market maker commits to a creation, the
portfolio
manager enters an order to sell the unwanted stock the ftind will receive in
the
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creation basket and to buy the stock that replaced the unwanted stock in the
fund.
On the margin, the sale from the creation basket will slightly depress the
price of
the stock being sold and the purchase in the fund will slightly increase the
price of
the stock being purchased. The sale Nvi11 slightly decrease the value of the
creation
basket and the purchase will slightly increase the value of the fund shares
when
the basket and the portfolio are priced in the 4:00 p.m. net asset value
calculation.
The relative price change is an indirect transaction cost "paid" by the market
maker.
[0231] In an embodiment, the indirect transaction cost "paid" by the market
maker is calculated. The economic viability of market making in active ETFs
depends partly on a market maker's ability to incorporate the expected cost of
the
portfolio manager's trading after a creation or redemption commitment into the
bids and offers the market maker posts in the markets it makes in the fund's
shares.
[0232] Transactions initiated by the portfolio manager in response to a
creation or
redemption commitment are likely to lead to a negative (unfavorable) tracking
error for the market maker between the value of the fund and the value of the
creation or redemption basket. Stated simply, the expected magnitude of this
negative tracking error is a function of (1) a percentage composition
difference
between the creation/redemption basket and the portfolio manager's target fund
portfolio and (2) an average transaction cost associated with the portfolio
manager's trades. This relationship and the method of the trading cost
calculation
is discussed in detail below.
[0233] Fund portfolio transactions that take place after the creation or
redemption
commitment permit the fund to pass the costs of adjusting its portfolio on to
the
market maker and, ultimately, to the market maker's customers ¨ the investors
who are entering or leaving the fund. The cost of these transactions is a cost
of
market making in active ETFs. The market maker needs to know the expected or
average magnitude of this cost. Knowing the expected cost, the market maker
can
develop a market making strategy that will reasonably assure that it can
recover
the negative tracking error it experiences in creating and redeeming active
ETF
shares when it trades with investors.
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[0234] Actively managed and non-transparent index exchange-traded fund
managers have a range of choices in the amount of information about portfolio
composition they choose to reveal. The minimum S.E.C. disclosure requirement
for all U.S. funds is that the portfolio composition must be disclosed
quarterly
with a 60-day lag. This means, for example, that the fund portfolio on March
31
must be disclosed by the end of May and the portfolio at the end of June must
be
published by the end of August. No fund can reveal less about its portfolio
composition than this standard, but some funds will reveal more.
[0235] The maximum disclosure policy a typical active ETF manager might
follow would reveal all "settled" positions in the fund. Specifically, to the
extent
that the portfolio manager has 5% of the fund's assets in a stock, and has no
intention of materially increasing or decreasing the relative size of that
position in
the near ten, that stock will occupy a settled 5% position in the
creation/redemption basket until such time as the portfolio manager elects to
reveal a change in the weighting of the position. As the position is sold, it
will
usually be maintained at 5% in the creation/ redemption basket until it has
been
liquidated entirely or, in some cases, reduced to a new equilibrium level.
[0236] In the most liberal disclosure of fund positions, a stock will
ordinarily not
be added to the creation/redeinption basket until such time as it reaches the
portfolio manager's target position in the fund. For example, if the portfolio
manager begins to purchase a stock with a target commitment of 3% of the fund
portfolio, the stock will not appear in the creation/redemption basket until
such
time as the 3% holding has been achieved. Unless the stocks in the portfolio
are
characterized by profound illiquidity or the portfolio manager is particularly
slow
in implementing changes, the creation/redemption basket should closely
approximate the actual fund portfolio most of the time under this policy.
Other
disclosure policies might adopt the foiniat of the SEC portfolio disclosure
rule ¨
quarterly, with a 60-day lag ¨ with either more frequent updates, shorter lags
or
some combination of the two. In various embodiments, the needs of market
makers and other participants trading funds are served using any of these
disclosure policies and other disclosure policies and construction
methodologies
for creation/redemption baskets.
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[0237] While mutual funds have sold and redeemed their shares at the net
asset
value (NAV) next calculated by the fund since 1968, mutual funds, exchange-
traded funds and other securities for which an NAV is periodically calculated
have not been traded on exchange or other (secondary) markets for settlement
at
or relative to a net asset value calculation. There is substantial evidence
described
in Edelen (1999), Green and Hodges (2002), and Gastineau (2004) that the
mutual
fund practice of offering free liquidity to permit fund share traders to buy
and sell
shares at net asset value in primary market transactions (trades with the
fund)
harms the non-trading shareholders of a fund by imposing a cost that the fund
can
never recover. The liquidity that has been provided freely by funds in the
past can
be priced efficiently in a secondary market that discovers prices at or near
net
asset value with investors and market makers supplying and demanding liquidity
at market-determined prices relative to the NAV. Experience with the NAV sales
and redemptions model used by mutual funds suggests substantial interest in
such
a secondary market trading mechanism for exchange-traded funds and for other
instruments for which an NAV is periodically calculated. For example,
retirement plan participants may readily adopt a secondary market NAV-based
trading and pricing process for exchange-traded funds in preference to the
intraday trading and pricing that has been characteristic of secondary market
ETF
trading since 1993. NAV-based secondary market trading in ETFs has been
described above in Examples 1 and 2, in U.S. Patent Application No.
11/141,243,
filed May 31, 2005, U.S. Patent Application No. 11/714,921, filed March 7,
2007,
and U.S. Patent Application No. 11/714,923, filed March 7, 2007, the
disclosures
of which are incorporated herein by reference in their entireties; and in U.S.
Provisional Patent Application No. 60/907,246, filed on March 27, 2007.
[0238] An alternate trading mechanism, like secondary market NAV-based
trading, will provide additional choices and additional risk management
opportunities to market participants. Secondary market NAV-based trading,
alongside a traditional ETF intra-day trading order book, will peintit traders
to
modify the size of a net long or short position at a price linked to the terms
on
which they can create or redeem shares or otherwise transact in ETF shares
close
to the end-of-day prices of the ETF's portfolio securities. The presence of
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additional market participants, trading methods and trading venues generally
increases liquidity. Volume rises and bid-asked spreads narrow. It is noted
that, in
contrast to the market on close (MOC) order type and informal trading
instructions or trading algorithms whereby a broker attempts to provide an
execution as close as possible to a market close or to a specified net asset
value,
the secondary market NAV-based transactions described herein are firm
contracts
for settlement at a specific relationship to an NAV calculation.
102391 For both institutional and retail investors, net asset value-based
trading in
exchange-traded funds permits fund investors accustomed to the net asset value
trading practices of mutual funds to trade exchange-traded fimd shares at or
relative to a net asset value to be determined in the future and for these
investors
to receive value indirectly for providing market liquidity by surrendering a
trade
timing option they have surrendered for no value in the past. Commitments by
investors to trade at or relative to a future NAV can be of value to a market
maker, encouraging tight markets early in the trading day for settlement
relative
to the end-of-day NAV. Furthermore, NAV-based trading can reduce trading
costs and make such costs more predictable and controllable for accounts in
employer-sponsored defined contribution plans, permitting the accounts to
trade
exchange-traded funds at low cost. These benefit plans can settle trades and
carry
exchange-traded fund positions in a manner similar to the way they trade and
carry mutual fund shares, as described in U.S. Provisional Patent Application
No.
60/907,246, filed on March 27, 2007.
102401 An important characteristic of NAV contingent price markets is that
risk
and position management for a market maker active in these markets is
different
from the risk management and position management model a market maker uses
when trading only in traditional markets. The interaction between traditional
markets ¨ e.g., the continuous auction market ¨ and NAV-based secondary market
trading can directly reduce some of the market maker's risks and enrich their
opportunities for risk management.
102411 If a traditional continuous auction market is the only organized
market for
an exchange-traded fund, the market maker focuses on the contemporary bids and
offers in that market throughout the trading session and manages its inventory
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primarily by hedging price risk. In some cases, market makers have hedged
price
risk with the specific portfolio components of indexed exchange-traded funds.
Increasingly, however, market making firms trade a number of different
exchange-traded funds that collectively reflect risk exposures that can be
hedged
most effectively and economically with broad market hedging tools such as
index
futures contracts, other portfolio-based securities including indexed ETFs or
derivatives covering diversified portfolios ¨ such as options or futures
contracts
on indexes or on ETFs. ETF market makers have increasingly used instruments
covering broad swaths of the investable universe that provide a high degree of
liquidity and exposure to broad market risks to manage their price risks on a
low-
transaction cost, macro (large-scale or broad) risk basis. These market makers
find that accepting some tracking error on price risk is an attractive risk
management choice if the magnitude of the transaction cost reduction is large
enough and the tracking error is random or predictable and manageable in size.
In
various embodiments, the tools described herein facilitate a market maker's
analysis and management of transaction cost/tracking error tradeoffs.
[0242] The risks and costs market makers face in secondary market NAV-based
trading of ETFs are different from the risks of providing liquidity in
traditional
ETF intraday trading. Traditional trading in exchange-traded funds under the
continuous auction market model calls for market makers to provide continuous
liquidity to buyers and sellers near the intraday value of the shares. The
market
maker extracts a spread between bids and offers over the course of a trading
day
and can create additional shares in the exchange-traded fund or redeem excess
shares at the fund's net asset value each day. The costs of trading
transparent
index portfolio baskets and the administrative costs of creation and
redemption
are generally low and consistent over the life of an index ETF.
[0243] Market making in the shares of active ETFs is more complicated. The
relationships among the market maker's risks and costs change with the
introduction of actively-managed and non-transparent index ETFs and with the
introduction of NAV-based trading. The availability of NAV-based secondary
market trading provides a direct mechanism for the market maker to adjust its
market risk exposure to a fund throughout the day. The market maker can offset
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ETF share transactions in the continuous auction market with transactions in
the
NAV-based market and virtually eliminate net exposure to the price risk of the
underlying portfolio. This new opportunity for price risk reduction does not
come
without its own costs and risks, however. In the case of any exchange-traded
fund
where there is not total portfolio transparency, the market maker's costs to
create
or redeem at the closing net asset value are predictable only with
supplementary
information provided by the fund or by one of the fund's service providers.
These
trading costs can be highly predictable and readily managed when the market
maker or any other trader has appropriate supplementary information. In a
market
for commitments to buy and sell securities or other financial instruments at a
price
to be determined in the future, the market participants need new kinds of
information on the variables that will detennine a contingent price and on the
costs to create or redeem shares of an active ETF to facilitate an estimate of
the
ultimate profitability of trading in both the traditional continuous auction
market
and around a contingent NAV. In an embodiment, the disclosed processes
develop this necessary information and make this information available to
market
makers and other market participants.
[0244] Because portfolios and recent and ongoing portfolio transactions by
active
ETFs are not transparent, the trading spreads for shares of these funds
typically
will be wider than bid-asked spreads for index ETFs. Wider spreads are an
appropriate characteristic of active ETF trading. However, shareholders in
these
funds will bear transaction costs associated with increasing or reducing the
size of
the fund only when they trade in the ftmd shares. The combination of the
earlier
creation/redemption commitment cut-off time and the transactions made by the
fund between the cut-off time and the later calculation of the net asset value
on
which both fund shares and creation/redemption baskets are priced will
transfer
the transaction costs associated with increasing or decreasing the size of the
fund
from the fund to the market makers and these costs will be passed on to
purchasers and sellers of fund shares in the secondary market.
[0245] In an embodiment, the risk management tools described herein are
designed primarily to meet the risk management needs of market makers and
other investors trading actively managed and non-transparent index exchange-
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traded funds in conventional markets and/or in non-conventional markets for
settlement at or relative to a net asset value calctilation. However,
reference to
any of these information items or combinations of several items as tools for
market makers does not suggest that this information will be restricted to
market
makers or that only market makers will find the information or tools useful.
Securities laws in the United States do not permit a fund or other issuer of a
security to limit distribution of information that is not calculable from
public
information to favored traders. Calculation of much of the active ETF trading
support information discussed herein requires use of confidential data from a
fund
and/or the fund's service provider or providers. Consequently, the results of
these
calculations Nvi11 be disclosed to all interested parties.
Correspondence
102461 Correspondence is a percentage measure of the degree to which the
portfolio composition file (PCF) ¨ the basket of securities used for creation
and
redemption of shares in an exchange-traded fund ¨ matches or overlaps with the
fund portfolio. Table 4 illustrates the concept of Correspondence or overlap
in a
simplified way by comparing hypothetical percentage holdings of a fund and the
portfolio composition file used in creation/redemption of the fund's shares.
The
first column shows the percentage held in each of four securities by the fund,
the
second column shows the percentage of the same securities in the PCF basket
used in creation and redemption transactions. The third column shows the
Correspondence percentage between the two portfolios.
Table 4. Percentage Holdings ¨ Calculation of Correspondence
(PCF)
Fund Correspondence
Basket
IBM 35% 35% 35%
GE 40 40 40
MSFT 20 25 20
GOOG 5 0 0
100% 100% 95%
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[0247] Correspondence is determined in this simple example by listing the
smallest of the two percentage positions in each row in the first two columns
in
the third column and adding the corresponding percentage positions in the
third
column. The positions in the fund and in the PCF in IBM and GE are identical.
Knowledgeable observers of investinent manager behavior would interpret this
fact as an indication that these are stable positions in the fund portfolio
where no
transactions to increase or reduce the relative size of these holdings are
under
way. In the case of Microsoft (MSFT), the fund holds less stock (20%), than is
reflected in the PCF basket, (25%). The smaller of these two numbers is
entered
in the third column to be used in the calculation of Correspondence because
Microsoft accounts for at least 20% of both the portfolio and the basket. An
appropriate interpretation of the smaller Microsoft position in the fund is
that the
fund is in the process of reducing or liquidating the Microsoft position. In
an
embodiment of an operation of an actively managed ETF, the Microsoft position
in the PCF has not been reduced because reducing it would inforin the market
that
the fund is in the process of selling Microsoft. In a preferred embodiment,
the
PCF would not be changed until after the Microsoft position change was
completed, or even later if the fund's portfolio disclosure policy requires a
further
delay.
[0248] The fund has a 5% position in Google (GOOG), which is not reflected
in
the (PCF) basket column. An appropriate interpretation of this information is
that
Google stock is being accumulated by the fund. The portfolio manager would not
add Google to the disclosed PCF before the purchase was completed, i.e. ,
until the
Google position reaches its target percentage of the fund portfolio. The value
for
Google in the Correspondence column is zero. The sum of the numbers in the
third column is 95%. Ninety-five percent is the Correspondence between the
fund
and the basket. The market maker who is told that the Correspondence is 95%
knows that 95% of the value of positions in the revealed PCF basket match the
value of corresponding holdings of the fund exactly.
[0249] In the example of Table 4, Correspondence is equivalent to a
complement
percentage of -Active Share," a measure of the extent a nominally actively
managed portfolio differs in composition from the portfolio's benchmark index.
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The notion of Active Share was introduced in Cremers and Petajisto (2006). The
applications of the two concepts are quite different, but both calculations
measure
the similarity or difference in two portfolios or securities baskets.
[0250] In an embodiment, the percentage Correspondence between the fund
portfolio and the portfolio composition file (PCF) will be calculated and
published at least daily. The percentage Con-espondence can be updated during
the clay as needed should the standard share net asset value calculation
procedure
in use by funds today be modified in the future. In an embodiment,
correspondence is the first stage in the calculation of some other trading
tools to
facilitate hedging and transaction cost management in active ETF trading and
market making. The first of these other tools is the Portfolio Adjustment Cost
of
Trading (PACT).
Portfolio Adjustment Cost of Trading (PACT)
[0251] Knowing the expected Portfolio Adjustment Cost of Trading (PACT),
and
how the PACT might vary, is a key element of trading cost management for any
market maker or other large trader in shares of an active ETF. A PACT estimate
is important to an ETF market maker because the active ETF manager can trade
for the fund portfolio between the time a market maker commits to a creation
or
redemption transaction and the determination of the end-of-day prices used in
calculating the fund's net asset value and in pricing the PCF used as the
creation
or redemption basket. PACT is an estimate of the cost of the portfolio
manager's
transactions that will be transfen-ed to the market maker who creates or
redeems
fund shares when the net asset values of the two portfolios are calculated.
[0252] In an embodiment, PACT is calculated from trading costs estimates
for the
securities to be traded, but it is expressed as a percentage of the value of
the
creation unit of fund shares. The reason for expressing PACT as a percentage
of
the value of the creation unit is that the PACT is a measure of the cost of
creating
or redeeming. Its relevance is that the cost of the trading it represents is
only
meaningful as a percentage of the value of the fund shares created or redeemed
in
a specific transaction on a specific day. The cost of this element of the
fund's
trading is an indirect expense of the market maker. Hence, the market maker
must
have a useful measure of these trading costs and take them into account in
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evaluating appropriate bids and offers to post when making markets for the
exchange-traded fund's shares.
[0253] Starting with a simplified formula for calculation of PACT to
illustrate the
process, we note that:
PACT =2 x (1 - Correspondence) x (average % adjustment transaction cost)
[02541 This simplified formula expresses the expected transaction costs for
creation or redemption of fund shares and associated trading by the fund as
the
average adjustment transaction cost associated with trading the securities
that are
unmatched between the fund and the portfolio composition file. Again, PACT is
expressed as a percentage of the value of the creation unit. The actual
calculation
is done on a position by position basis using the unmatched percentage
position of
each security times the estimated transaction cost associated with the
expected
transaction size and transaction method for trading that security. Reflecting
the
position by position transaction cost calculation, a more useful formulation
of the
PACT calculation is:
PACT, = 2(1 ¨ C) (V, = Evr),
where:
11= the number of creation or redemption units covered by the
calculation. Any transaction cost estimate must reflect the greater
market impact costs usually associated with larger transactions.
Thus, the calculation of PACTõ is the calculation for n creation
units. The market impact of portfolio adjustment transactions will
be smaller for one or two creation units than it will be for 10 or 20
creation units. Market makers and other market participants will
want to know how transactions consisting of different numbers of
creation or redemption baskets will impact the market maker's
costs to create or redeem. PACT will be calculated for different
numbers of creation or redemption baskets, as described in more
detail below;
C= Correspondence;
r= the securities (1.....i) for which the fund to PCF basket
match is
not exact. There is no reason for the number of securities subject to
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trading to be made public. The trading cost information that market
makers and other investors need is the PACT total for the number
of baskets that are actually being created or redeemed, not the
trading costs associated with any specific security;
Võ = For each security, r, a value percentage of the securities to be
transacted per creation unit (fund securities and PCF securities)
between the creation/redemption commitment at, say, 2:30 p.m.
and the net asset value calculation at the end of the day. In an
embodiment, PACT is calculated based on six securities, each
equal in value to 5% of the creation unit, and three of such
securities purchased for (sold from) the fund in a creation
(redemption) and three of such securities sold from (purchased for
inclusion in) the PCF by the fund manager in connection with a
creation (redemption); and
Ey, = Expected cost of transacting the V, in each security to be traded
under the trading policy chosen by the portfolio manager to adjust
the fiind portfolio for creation or redemption transactions. The
expected cost is expressed as a percentage of the value of the trade
and it is the cost of trading the number of shares of the security to
be traded for n creation or redemption units. In an embodiment,
the portfolio manager will either adopt a standard transaction
method for entry of adjustment orders or use the transaction cost
model's evaluation of possible order entry methods to minimize
expected transaction costs. In the case of small creation or
redemption orders in liquid securities, a market-on-close order
policy will usually be followed. For larger orders and less liquid
securities, the portfolio manager may base the transaction cost
estimate on placing a working order between, for example, 2:30
and 3:30 p.m., followed by completing the remainder of the
transaction with a market-on-close order.
[02551 The investment manager or a fund service provider calculatim! PACT
will
use appropriate transaction cost estimates for the transaction type and for
the
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quantity of the specific securities to be purchased and sold to get to the
target
portfolio for creation/redemption transactions of various sizes. In the
Google/Microsoft example, as described below in Table 5, the PACT estimate for
a creation unit is based on the estimated cost of selling a number of
Microsoft
shares equal to 5% of the value of the creation basket between, for example,
2:30
and 4:00 p.m., or in a market-on-close order, and purchasing a Google position
equal in value to 5% of the value of the creation basket over the same
interval.
Given the high liquidity, active trading and narrow spreads in these two
stocks,
the PACT for a single creation/redemption basket is unlikely to be material.
If the
value of a creation unit is about $1 million, the transactions in Microsoft
and
Google would be about 1,700 and 100 shares, respectively. If the positions to
be
traded are larger or the capitalizations of the stocks are smaller, the PACT
can be
much larger than the value indicated in Table 5 for a hypothetical 5% position
in
each stock.
Table 5 ¨ Calculation of Correspondence and PACT
Transaction
Fund
SecuritiesPCF Correspondence Cost Weight PACT
Holdings
(1 CU)
A 20 20 20
10 10
15 15
20 20
15 15 15
Microsoft 15 10 10 .0080% .05 .0004%
Google 5 10 5 .0152% .05 .0008%
Total 100% 100% 95% .0012%
Note: Value of 1 Creation Unit (CU) = $1 million
102561 The transaction costs in the 1 CU (one creation unit) column in
Table 5
reflect the cost borne by the market maker because the portfolio manager will
sell
about 1700 shares of Microsoft and buy about 100 shares of Google between a
creation commitment at 2:30 p.m. and the market close, probably at the market
close. These transactions will tend to slightly reduce the price of Microsoft
which
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is more heavily weighted in the PCF than in the fund holdings and slightly
increase the price of Google, which is not in the PCF at all, but is in the
fund
holdings. When both baskets are priced in 4:00 p.m. net asset value
calculations,
the market impact of the transactions will reduce the value of the PCF and
increase the value of the fund, each very slightly. These value effects will
be an
indirect expense to the creating market maker.
[0257] When the size of a creation or redemption transaction is large or
the
liquidity of the securities is limited, the PACT may have a significant impact
on
the bid-asked spread in the market for shares of the ETF.
[0258] In an embodiment, service providers for the fund will calculate PACT
estimates that market makers will incur for various sized creation and
redemption
transactions on a given day. If a single day's creation or redemption
transactions
in a fund total tens or hundreds of millions of dollars, there will be a
market
impact cost that goes substantially beyond the average quoted stock spread for
the
portfolio. Significant market impact is unlikely under most circumstances with
small creation and redemption transactions, but the methods and processes
described herein can be extended to incorporate very large creation and
redemption transactions. In an extreme case, if trading costs are too large to
permit market maker profitability with a non-transparent portfolio, market
makers
and investors will not participate in the market and the fund will fail.
[02591 The cost ranges in the illustrations offered herein do not include
extremely
large transactions for several reasons: first, smaller numbers are easier to
understand and utilize; second, creation and redemption transactions generally
affect a small fraction of the assets of the fund on any single day; and
third, the
Correspondence between the fund and the PCF will generally be 75 ¨ 80% or
higher, spreading the transaction costs associated with traded securities over
a
large creation or redemption transaction. Very large transactions in a single
security will be rare occurrences. The embedded transaction costs of any
active
ETF likely to be offered will not only be predictable, they will also be low
enough
to attract market makers.
[0260] In one embodiment, a distribution program for PACT information
provides an estimate of the PACT for one, five and 10 creation or redemption
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units for a typical actively managed ETF. The appropriate number of units for
the
calculation depends in large measure on creation/redemption activity in the
shares
of the fund. A market maker may face expected transaction costs of, say, 5
basis
points for a single creation basket. Should other market makers create on the
same day, the number of creation baskets on that day will be more than one and
the appropriate PACT estimate for each creating market maker on that day is
the
estimate for the net number of baskets created on that day.
102611 The PACT calculation for the Microsoft/Google example provides a
very
simple illustration of this calculation. In this example, the aggregate
transaction
cost associated with buying Google and selling Microsoft (each trade equal in
value to 5% of the value of the basket) would be .0012% of the value of the
unit.
This cost is 0.12 basis points or about a tenth of a cent on $100. Other
examples
below will illustrate larger PACT values associated with larger transactions
and
less liquid securities.
102621 Under the creation/redemption policies followed by exchange-traded
index funds, the funds can collect a cash transaction charge from a market
maker
when the fund transacts in connection with a creation or redemption. If the
fund
elects not to make one or more of the transactions covered by the PACT
estimate,
the fund could charge a cash transaction fee in the amount of the estimated
transaction cost for the securities it elected not to trade between the
commitment
and the NAV calculation. Such a fee might be collected as an alternative to
trading after the commitment was received if the fund was engaged in ongoing
transactions in some of the securities to be purchased or sold. A fee might be
charged as an alternative to trading if the portfolio manager believes that
entering
a market-on-close order would have an adverse effect on an ongoing trading
program in one or more securities and prefers to wait and execute the
transaction
covered by the PACT as part of the fund's ongoing trading in the security or
securities involved. The fund could charge the market maker cash in the amount
of a security's component of the PACT estimate for one or more transactions if
the fund manager chose to delay an execution. If the fund manager believed
that
the cost of accommodating the creation or redemption was reduced by the
patient
trading policy, the cash charge could be reduced.
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[0263] PACT estimates are developed from pre-trade transaction cost
estimates
produced by a trading cost analysis model. In the examples described herein,
the
pre-trade transaction cost estimates are computed using the ITG Logic pre-
trade
cost analysis model offered by Investment Technology Group (ITG) of New
York, New York. In additional embodiments, PACT estimates may be developed
from other trading cost analysis models, including, but not limited to, the
FlexTQM system developed by FlexTrade Systems of Great Neck, New York and
the T-Cost Pro system offered by Quantitative Services Group (QSG) of
Naperville, Illinois. The cost estimates produced by such models reflect
expected
transaction costs for specific types of transactions in specific securities.
Depending on the source of the model, these trading cost estimates incorporate
variables such as the size of an order, the size of the company's floating
share
capitalization, the average trading volume in the security, the typical bid-
asked
spread, the market impact associated with orders of different sizes, and the
trader's execution policy. These transaction cost estimates are highly
accurate on
average, but the cost of a specific trade may differ substantially from the
estimate
depending on the pattern of orders in the market for the security at a given
time.
[0264] The actual cost incurred by the market maker reflected in the
pricing of
the creation/redemption basket and the fund net asset value is not the PACT
estimate. It is the actual cost experienced. When creations and redemptions
occur, the fimd will publish the realized transaction costs reflected in the
implementation of the actual transactions made by the fund. Market makers will
be able to compare estimates to actual costs for the number of creation units
traded on a given day.
[0265] FIG. 16 is a flow diagram that illustrates an exemplary process 10
for
calculating Correspondence, PACT, PACT variability and DEMI PACT,
according to an embodiment of the present invention. FIG. 16 illustrates a
general way in which information on the differences between the fund target
portfolio and the portfolio composition file are extracted and used with data
from
the trading cost estimation model to calculate (1) composition differences
between the PCF and the fund portfolio (2) transaction costs and (3)
transaction
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cost variability for individual securities that will be traded after a
creation or
redemption commitment is received by the fund.
[0266] In step 20, the fund's actual target portfolio is compared with the
portfolio
composition file. A list of composition differences for unmatched securities
is
made in step 30, preparatory to the transaction cost calculation and to
develop the
Correspondence measure. Correspondence, PACT, PACT Variability and DEMI
PACT from individual security trading requirements and specific stock trading
cost estimates are computed for one, five, and ten creation units in step 40
using
ITG Logic pre-trade estimates of transaction costs or estimates from a similar
system, shown generally at 50. The combined trading cost estimates for all
securities to be traded and the combined distributions are assembled for
various
numbers of creation units and published in step 60. The numbers published in a
preferred implementation would include Correspondence, shown generally at 61,
and PACT, PACT Variability and DEMI PACT shown generally for one creation
unit at 62, for five creation units at 63, and for ten creation units at 64.
In
additional embodiments, other numbers of creation units are possible and may
be
employed if the number of creation units transacted in a fund were frequently
in
excess of ten units.
[0267] PACT cannot be calculated with any degree of accuracy from publicly
available information. PACT information must be furnished by or at the
direction
of the fund manager or a service provider to the fund as a risk and cost
management tool for market participants. This infomtation is useful to any
investor who understands that the trading spread in the shares of an ETF will
be
based in part on the costs that market makers in the shares of that fund incur
as a
result of portfolio adjustment trades made after the fund receives a creation
or
redemption commitment. When the market maker uses the PCF as a hedging
basket and the fund trades to get to its target portfolio by the time the NAV
is
calculated, the PACT is the best available estimate of the marker maker
trading
costs that will be embedded in the creation/redemption of fund shares.
PACT Variability
[0268] PACT Variability is a calculation related to PACT that estimates the
standard deviation of the single point PACT estimate. If the estimate of PACT
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for a specified number of creation units of a ftmd is 4 basis points (0.04%)
and the
PACT Variability is estimated at 16 basis points (0.16%), market makers will
expect the actual PACT to fall between -12 and +20 basis points (-0.12% and
+0.20%) about two-thirds of the time. This statement oversimplifies the
significance of PACT Variability because these trading costs are generally not
normally distributed. The fund may accommodate traders by providing additional
information on the shape of the distribution (i.e., skewness and kurtosis)
and/or
information on PACT percentile ranges (e.g., 25' and 75th percentiles).
Experience with the model suggests that information on the shape of the
distribution is unnecessary. The aggregation of a number of purchase and a
number of sale transactions into a single PACT calculation should reduce the
net
variability and, by the central limit theorem, bring the characteristics of
the
combined distribution closer to the characteristics of a normal distribution.
An
example of some effects of incorporating a number of trades on PACT
Variability
is provided in Table 6.
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Table 6 - Data for Trading Cost and Variability Estimates
A. Data for PACT, DEMI PACT and PACT Variability Calculations -
Stocks Used
Market Cap Price ti Shares per
Google GOOG $ 90.9 $460.48 109
Microsoft MSFT $258.3 $ 29.86 1674
Longview Fibre LFB $ 1.4 $ 21.95 2278
Republic Services RSG $ 4.6 $ 40.67 1229
Fossil Inc FOSL $ 1.0 $ 22.58 2214
LKQ Corp LKQX $ 1.0 $ 22.99 2175
B. Transaction Cost Estimates for 1, 5 and 10 Creation Unit
Size Transactions in Basis Points
Buy/Sell 1 CU 5 CU 10 CU
GOOG Buy 0.8 0.9 1.1
MSFT Sell 1.5 1.7 1.9
LFB Buy 6.5 9.4 12.7
RSG Sell 1.9 9.4 12.7
FOSL Buy 1.9 2.9 4.2
LKQX Sell 5.6 11.5 18.8
C. Transaction Cost Variability Estimates for 1, 5 and 10 Creation Unit Size
Transactions in
Basis Points
ICU 5 CU 10 CU
GOOG 40 51 55
MSFT 24 76 75
LFB 40 51 51
RSG 26 31 34
FOSL 49 55 57
LKQX 18 91 91
Aggregate (combined distribution) 18 22 22
Aggregate (two direction offset) 16 19 19
Source: 1TG - Transaction cost estimates are rounded to the nearest 0.1 basis
point and variability estimates to the
nearest whole basis point 10 simplify the example
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[0269] The examples in Table 6 show the data used for PACT and PACT
Variability calculations for two large, two mid-cap and two small-cap stocks.
These stocks are described summarily Section (A) of Table 6. Note that whereas
Microsoft, one of the largest companies, has a market capitalization of $258.3
billion, the market caps of Fossil and LKQ Corp are approximately $1 billion
each. The right-hand column of first table segment A shows the number of
shares
of each of the six stocks needed to constitute a $50,000 position. The
calculations
made here are based on a $1 million creation unit with a PCF of about the same
value. Each of these companies represents 5% of the creation unit value.
[0270] Section (B) of Table 6 describes average transaction cost estimates
for
one, five and 10 creation units transacted in each of the six securities in
basis
points on the market value of each security. Note that the smaller cap stocks
not
only start with a higher transaction cost estimate, but their transaction cost
tends
to rise more quickly as the size of the transaction increases. Section (C) of
Table
6 shows transaction cost variability estimates, again expressed in basis
points on
the share price of the specific securities to be traded.
[0271] In the examples of Table 6, transaction cost variability is much
larger than
the transaction cost estimate itself These distributions have very large
standard
deviations and the actual transaction costs in a specific instance can easily
be
negative, i.e., the transaction can occur at a price better than the price
estimated
by the transaction cost model. While the average transaction cost estimate is
a
good estimate, the variations can be very high.
[0272] In combined variability estimates at the bottom of Table 6,
variability
drops in two stages: first, simply combining trades in six securities reduces
the
variability of the total trading cost; And second, some transactions will be
purchases and some will be sales, removing some of the variability
attributable to
overall market movements and their effect on transaction costs. The fact that
some of these transactions are purchases and some are sales will tighten up
the
overall variability estimate. The effect is modest, however, because the model
assumptions used require a transaction within a narrow time window ¨ 2:30 to
4:00 p.m. Market movements in this short a period are typically modest. Note
at
the bottom of Section C of Table 6 that the aggregate transaction cost
variation for
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all of the six stocks together, and in two-way transactions, is less than the
transaction cost variability of the stock with the smallest stock specific
transaction
cost variability. To summarize, averaging the impact of trades in a number of
securities, regardless of any price behavior relationships the securities
might have
or not have with one another, will reduce the variation. When the fact that
some
trades are buys and some are sells is taken into account in the last line of
data in
the table, the transaction cost variability is even lower. Before using the
data in
Table 6 to make PACT and PACT variability calculations, we describe the most
important remaining PACT calculation, DEMI PACT, and several important
performance measurements that will provide additional information to support
trading and market making.
DEMI PACT
102731 DEMI PACT is not just half of PACT. Recall that PACT is an estimate
of
the transaction costs a market marker will incur in connection with the
creation or
redemption of an active ETF when the fund trades between the time the market
maker commits to a creation/redemption and the 4:00 p.m. net asset value
calculation when the securities in both the fund portfolio and the portfolio
composition file are priced for the creation or redemption. The PACT
calculation
assumes the market maker owns the PCF basket when it makes the creation or
redemption coinmitment. The subsequent transactions are necessary because the
portfolio composition file in an active ETF will not track the price
performance of
the fund portfolio to anything like the degree that an index ETF's PCF will
track
its fund's NAV. As a consequence of likely tracking error, market makers will
often prefer to use portfolio-based risk management tools and to purchase the
securities necessary to create fund shares or to sell the securities they will
receive
in a redemption of fund shares using market-on-close orders on the day of a
creation or redemption. An incentive for using such market-on-close orders to
accumulate or dispose of the basket is that the market maker will be trading
at the
same price the fund will use for pricing components of the portfolio
composition
file if the PCF basket is purchased or sold at the close on the day a creation
or
redemption occurs. If the market maker trades the securities in the basket at
the
same price that the fund prices them, the costs the market maker will incur
will
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not include costs associated with the fund manager's trading of any positions
in
the creation basket. These transaction costs will be absent because the market
maker buys at the same prices as the fund sells, or sells at the same price
the fund
buys in the case of a redemption. The stocks in the basket will be priced at
the
same price the market maker paid or received for them. The DEMI PACT, then, is
the trading cost estimate for the fund's purchase or sale of positions that
are in the
fund, but that are not in the creation/redemption basket. The market maker
cannot
avoid the market impact of these fund trading costs by trading at the close.
[0274] Like the PACT calculation, DEMI PACT will be calculated for various
numbers of creation and redemption units. While it will average close to half
of
PACT, there may be differences in the nature of securities newly added to the
fund and the unwanted securities in the basket. A DEMI PACT calculation will
be made just for the securities in the fund that are not in the PCF. A DEMI
PACT Variability calculation will show higher relative variability than a PACT
Variability aggregate combined distribution calculation because (a) there will
be
fewer securities on just one side of the portfolio manager's post-commitment
trading and (b) all transactions with impact will be purchases in a creation
or sales
in a redemption. DEMI PACT Variability is not discussed in detail or
separately
noted in connection with the discussion of the calculation process in FIG. 16
because the process is very similar to the PACT Variability calculation.
Outpedonnance of Fund vs. PCT and/or Indexes
[0275] Investors buy actively managed or non-transparent index funds
because
they want to achieve performance superior to what they might obtain from a
traditional transparent index fund. Many studies of the performance of active
managers relative to benchmark indexes and relative to index funds have
suggested that investors seeking better performance through active management
are likely to be disappointed. Recently, however, new approaches to measuring
the value that an active manager's securities selection process can bring to
investors have found that many active managers do add value with their
securities
selections and that it is often possible to detect manager skill.
Specifically, recent
studies have found that: (1) manager value-added is obscured by combining
results for true active managers with results for managers who are closet
indexers
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with active management costs (Cremers and Petajisto, 2006); (2) the ability of
managers to value securities can be obscured by flows of investor funds into
and
out of mutual funds (Green and Hodges, 2002 and Alexander, Cici and Gibson,
2006); and (3) managers with superior stock selection skills can be identified
and
their skills strongly persist (Harlow and Brown, 2006 and Wermers, Yao and
Zhao, 2006).
[0276] Information on the recent relative perfonnance of an actively
managed
ETF portfolio and the fund's PCF can be useful to market makers and other
investors. The fund's recent Outperformance relative to one or more indexes
will
also be useful to investors. The formal evaluation benchmarks for funds are
typically widely used indexes that can be traded in the form of index hedging
instruments, including index futures and index ETFs that market makers might
use to hedge their positions in the actively managed ETF. The market maker can
use Outperformance information the fund or its service providers publish to
measure the hedging risks associated with a fund's Outperformance or
widerperformance. (Underperformance is Outperfonuance with a negative sign.)
In an embodiment, Outperformance calculations can help market makers assess
the appropriateness of being net long or net short the shares of the actively
managed exchange-traded fimd relative to individual indexes, combinations of
indexes and the PCF. When combined with information on Correspondence,
correlation, tracking error, etc. to evaluate the suitability of the PCF and
financial
instruments based on specific benchmark indexes or combinations of indexes as
appropriate hedging tools, the Outperfonnance calculation can add an
additional
dimension to a trader's risk management calculations.
[0277] In an embodiment, outperformance of the fund versus (I) the fund's
benchmark index, (2) a weighted basket of indexes that has tracked the
performance of the fund's current portfolio closely in the recent past, or (3)
the
PCF can be calculated on an intra-day basis and at various greater intervals,
such
as one day, five days, one month or even longer periods, to indicate any
momentum characteristics that the fund manager might have succeeded in
incorporating (or failed to avoid) when constructing the fimd portfolio. The
relative performance calculations can reflect the fact that the fund bears
expenses
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that some index hedging instruments do not incur or all calculations can be
made
without expenses. In an embodiment of an Outperformance calculation similar to
a Correspondence calculation, tracking error and PACT calculations would
compare the current fund portfolio with both the current PCF and current
composition indexes. The reported or historic index compositions can
alternatively be used in the comparison.
[0278] Table 7 offers a sample of Outperformance calculations based on
current
composition for three portfolios or baskets: the fund, the fund's benchmark
index
and the portfolio composition file. The first column of data lists current
fund
portfolio performance for the current day at a specified time, prior day,
prior five
days, month-to-date, and prior 25 trading days. Similar calculations are made
for
the benchmark index and the PCF. Outperformance comparisons of the fund to
the benchmark index and the fund to the PCF are also provided. A comparison of
the fund to a basket of indexes is illustrated in a later table.
Table 7 ¨ Outperfonnance Calculation (Current Composition)
Fund Fund Benchmark PCF Fund Versus
Versus Index PCF
Benchmark
Performance
Current Day +1.0% +0.1 +0.9 +1.0
(at X:00 p.m.)
Prior Day
+1.5% +1.5 +1.4 +0.1
Prior 5 Days
+2.0% +2.0 -1.9 +0.1
Month-to-Date
+1.5% +0.1 +1.4 +1.4 +0.1
Prior 25
+2.5% +0.1 +2.4 +2.4 +0.1
Trading Days
[0279] If a portfolio manager is consistently outperforming or consistently
underperforming the portfolio composition file or the fund's benchmark index,
the relative performance has implications for a market maker in managing its
risk.
If the fund is consistently perfoaning better than the benchmark index and the
portfolio composition file, a market maker will be more inclined to be long
shares
of the fund. On the contrary, if the fund is performing poorly relative to the
PCF,
the benchmark index, or a basket of indexes, the market maker might use either
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the PCF or instruments linked to indexes in hedging and try to be short shares
of
the fund.
Publishing the Supplemental Trading Tools
[0280] In an embodiment, Correspondence, PACT, PACT Variability, DEMI
PACT, DEMI PACT Variability and Outperforniance relative to a benchmark
index, to the PCF, and to a combination of indexes will be published daily and
intraday with other information in tabular or other form for an actively
managed
exchange-traded fund. These tables will be accessible by fund and by data item
so
that a market maker or other trader can select items needed and incorporate
the
information into risk management programs. The PACT, PACT Variability,
DEMI PACT and DEMI PACT Variability calculations in Table 8 are based on
85% Correspondence and the Buys and Sells from Table 3 are each equal to 5%
of the portfolio. Note that in the calculations behind the data in Table 8,
the
PACT, DEMI PACT, PACT Variability and DEMI PACT Variability are all
based on the total value of the creation unit, not just on the value of the
specific
securities to be traded.
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Table 8 ¨ Supplementary Trading Data Summary
Fund: ABC PCF: ABC ver 11 Benchmark Index
Correspondence 85% 60%4
Correlation 98% 97%
Tracking Error2 +0.5% +0.1%
PACT and PACT PACT Var PACT 5 \Tar PACT \Tar
Variability5 1 CUA3 CUA3 10 CUA3
PACT 0.011% 0.027% 0.019% 0.032% 0.028% 0.033%
DE1\41 PACT 0.006% 0.023% 0.010% 0.027% 0.015%
0.028%
Outperformance of Current Day Prior 5 Days 20 Days
Fund (basis points)
Day
vs. current PCF +0.1 +0.2 -0.4 +1.0
vs. S&P 500 +0.1 +0.4 -0.2 +0.2
vs. best fit Index Basket +0.1 +0.2 -0.1 +0.1
1 Multiple
versions of the PCF are available for some funds. The standard version will be
used in
Correspondence calculations.
2 22-trading day moving average tracking error on current composition of the
fund portfolio and PCF (ex
expenses). Returns as reported on historic composition or based on current
composition as disclosed. Tracking error
is signed. A positive tracking error indicates better performance for the
fund.
3 CUA stands for Creation Unit Aggregation, the standard number of fund shares
exchanged for a single PCF
basket. The value ()fa CUA in the example is SI million
4 The Correspondence of the fund to the Benchmark Index is the complement of
the Cremers and Petajisto (2006)
Active Share calculation. This fund has a 40% active share relative to its
benchmark.
These calculations are based on the value of the CUA, not on the value of the
securities to be traded. The
relevant estimate is the trading cost borne by the market maker in a creation
or redemption, not the trading cost of
any single position.
102811 In one enibodiment, correlation (a measure of the tendency of two
values
to move together) between the fund and its PCF basket or its benchmark index
will probably be higher than 95% most of the time. Correlations in such
instances
will often approach 98-99% in well diversified portfolios, even with
Correspondence levels well below 90%. Market makers and other market
participants know that the risk of the portfolio composition file behaving
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materially differently than the fund (tracking error) is a function of
differences in
the positions that are not identical in the two lists. In an embodiment, most
of the
funds that use the disclosed processes will also publish correlations and
tracking
errors between and among fund portfolios, the PCF basket, benchmark indexes
and index combinations. Correlation and tracking error do not require new
methods or processes; and, in many cases, they do not require coordination
with
or knowledge of the actual fund portfolio.
[0282] By monitoring Correspondence, PACT, PACT Variability, DE1\4I PACT,
DEMI PACT Variability, correlation, tracking error, Outperfonnance, intraday
NAV proxy calculations and other supplementary information, the actively
managed ETF market maker Nvi11 be in an excellent position to assess the risks
of
being long or short the PCF or index baskets as hedges against a position in
the
fund shares. With these tools, the market maker will be well prepared to
manage
the risks and costs associated with an actively managed ETF market making
position
Exemplary Computer Systems
[0283] FIG. 17 is a diagram of an exemplary computer system 1700 upon which
embodiments of the present invention (or components thereof) may be
implemented. The exemplary computer system 1700 includes one or more
processors, such as processor 1702. The processor 1702 is connected to a
communication infrastructure 1706, such as a bus or network. Various software
implementations are described in terms of this exemplary computer system.
After
reading this description, it will become apparent to a person skilled in the
relevant
art how to implement the invention using other computer systems and/or
computer architectures.
[0284] Computer system 1700 also includes a main memory 1708, preferably
random access memory (RAM), and may include a secondary memory 1710. The
secondary memory 1710 may include, for example, a hard disk drive 1712 and/or
a removable storage drive 1714, representing a magnetic tape drive, an optical
disk drive, etc. The removable storage drive 1714 reads from and/or writes to
a
removable storage unit 1718 in a well-known manner. Removable storage unit
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1718 represents a magnetic tape, optical disk, or other storage medium that is
read
by and written to by removable storage drive 1714. As will be appreciated, the
removable storage unit 1718 can include a computer usable storage medium
having stored therein computer software and/or data.
[0285] In alternative implementations, secondary memory 1710 may include
other means for allowing computer programs or other instructions to be loaded
into computer system 1700. Such means may include, for example, a removable
storage unit 1722 and an interface 1720. An example of such means may include
a removable memory chip (such as an EPROM, or PROM) and associated socket,
or other removable storage units 1722 and interfaces 1720, such as a memory
stick or memory card, which allow software and data to be transferred from the
removable storage unit 1722 to computer system 1700.
[0286] Computer system 1700 may also include one or more communications
interfaces, such as communications interface 1724. Communications interface
1724 allows software and data to be transferred between computer system 1700
and external devices. Examples of communications interface 1724 may- include a
modem, a network interface (such as an Ethernet card), a communications port,
a
WIFI interface, a Bluetooth interface, a cellular interface, a PCMCIA slot and
card, etc. Software and data transferred via communications interface 1724 are
in
the form of signals 1728, which may be electronic, electromagnetic, optical or
other signals capable of being received by communications interface 1724.
These
signals 1728 are provided to communications interface 1724 via a
communications path (i.e., channel) 1726. This channel 1726 carries signals
1728
and may be implemented using wire or cable, fiber optics, a wireless link and
other communications channels. In an embodiment of the invention, signals 1728
comprise carrier waves modulated with control logic.
[0287] Any apparatus or manufacture comprising a computer useable or
readable
medium having control logic (software) stored therein is referred to herein as
a
computer program product or program storage device. This includes, but is not
limited to, the computer 1700, the main memory 1708, the hard disk 1712, the
removable storage units 1718, 1722 and the carrier waves modulated with
control
logic 1728. Such computer program products, having control logic stored
therein
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that, when executed by one or more data processing devices, cause such data
processing devices to operate as described herein, represent embodiments of
the
invention.
CONCLUSION
[0288] Embodiments of the present invention are directed to the
introduction of
methods, systems, and computer-program products to provide risk information
and cost estimation tools to traders in exchange-traded fund shares.
[0289] According to various embodiments of the disclosed processes,
supplemental information is developed, calculated, and published to support
trading in exchange-traded funds with portfolios that are not totally
transparent
and that use portfolio composition files that are not identical to the fund
portfolios. The supplementary trading information preserves fund portfolio
confidentiality while permitting market makers and other traders in these non-
transparent exchange-traded funds to estimate the costs and risks associated
with
fund creation and redemption transactions of various sizes.
[0290] While various embodiments of the present invention have been
described
above, it should be understood that they have been presented by way of example
only, and not limitation. It will be apparent to persons skilled in the
relevant art
that various changes in foini and detail can be made therein without departing
from the spirit and scope of the invention. Thus, the breadth and scope of the
present invention should not be limited by any of the above-described
exemplary
embodiments, but should be defined only in accordance with the following
claims
and their equivalents.
[0291] It is to be appreciated that the Detailed Description section, and
not the
Summary and Abstract sections, is intended to be used to interpret the claims.
The Summary and Abstract sections can set forth one or more, but not all
exemplary embodiments of the present invention as contemplated by the
inventor(s), and thus, are not intended to limit the present invention and the
appended claims in any way.
