# Comparison of Exchange Traded Funds. iShares MSCI Taiwan ETF and First Trust Taiwan AlphaDEX

Essay 2014 10 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting

## Excerpt

## 1. Introduction

ETFs, short for Exchange Traded Funds are traded on the stock market funds. ETFs have no maturity limit and can therefore be permanently traded like shares at the current market price. When buying a fund unit, the investor becomes a shareholder of the components contained in the Funds.

The index can be of a country, an industry, or even a global index. Therefore the investor participates identically in rising and falling markets according to the development of the ETF underlying index.^{1}

Unlike actively managed funds Exchange Traded Funds are mainly passively managed. An underlying index should be reproduced as exactly as possible.

ETFs combine the advantages of three asset classes: equities, certificates and funds. Like shares, ETFs can also be traded at the current market value at any time.

This Report compares and contrasts the two Exchange traded funds iShares MSCI Taiwan ETF and First Trust Taiwan AlphaDEX. It will discuss a number of key figures and will stress the strengths and weaknesses of each fund. The following key figures for the two funds are based on self-made calculation using Excel and data form Datastream. If any figures are used, which have another source, it will be clearly cited. The time period for all key figures is two years, expect for the Pricing efficiency, which has been calculated for one year. All estimated returns are log returns due to the reason they have the property that they can be interpreted as continuously compounded returns and are addable^{2}.

## 2. Overview of the Funds

### 2.1. Description - iShares MSCI Taiwan ETF

The iShares MSCI Taiwan Exchange Traded Fund (EWT) was launched on 20.06.2000. The ETF seeks to provide investment results that correspond generally to the price and yield performance of publicly traded securities in the Taiwanese market, as measured by the MSCI Taiwan Index (the Index). The Index seeks to measure the performance of the Taiwan equity market. Companies are included in the benchmark index weighted by market capitalization on free float-adjusted basis. Free float-adjusted means that in the calculation of the benchmark index only uses shares, which are available to foreign investors and not all issued shares of a company (101 Companies in total). The market capitalization of the free float adjusted basis is the product of the share price of a company and the number of shares that foreign investors are available. The index aims to capture 85% of the (publicly available) total market capitalization.

The EWT directly invests in securities of the Index. The current (21.11.2014) number of holdings is 108, total net assets are $3,292,548,343 and shares outstanding are 210,000.000^{3}. The EWT is traded at the New York Stock Exchange (NYSE) and follows a complete replication strategy. Dividends are paid semi-annually and the base currency of the Fund is US dollar. Only authorized participants (e.g. select financial institutions) purchase and redeem shares directly from the fund. Other investors can buy or sell shares daily through an intermediary on an exchange where the shares are traded. As the EWT is investing in an emerging country, investors face certain risk factors that are specific for emerging markets. Emerging markets are generally more sensitive to economic and political

conditions than developed economies. Additional factors include a higher "liquidity risk", restrictions on investment, transfer of assets and failed or delayed delivery of securities or payments to the Fund. The annual expense ratio is 0,61%, however it could change over time. Additional costs for investors are fees charged by their stockbrokers. Such charges are publicly available on exchanges on which the shares are listed and traded, or can be directly obtained from stockbrokers.^{4}

### 2.2. Description - First Trust Taiwan AlphaDEX

The investment objective of the Fund (FTW) is to replicate the performance of the Defined Taiwan Index. It is issued by First Trust since 14.02.2012. The index is the main difference to the EWT. It consists only of 40 companies and uses a different selection method as the MSCI index. It is provided by Standard and Poors and ranks shares form the “S&P Taiwan BMI universe on growth factors including 3-, 6- and 12-month price appreciation, sales to price and one year sales growth, and separately on value factors including book value to price, cash flow to price and return on assets“^{5}. The top 40 stocks are included and weighted by their ranking. The FTW exactly replicates the composition of the index. The MSCI Taiwan index functions as a benchmark of the complete Taiwanese stock market. As the main investment objective is still to provide exposure to the Taiwanese stock market, we will see later that the key figures vary substantially if we take the MSCI index as a representative of the complete market. In addition, the FTW is with its yearly expense ratio of 0,81% relatively more expensive than the EWT^{6}.

### 3. Risk/Return Profile

### 3.1. Sharpe Ratio

This risk-adjusted measure was developed by Nobel Laureate William Sharpe^{7}. It is computed by using standard deviation and excess return to determine reward per unit of risk.

Generally, the better the historical risk-adjusted performance of a fund, the higher the Sharpe Ratio. The 3 months U.S. Treasury Bill is used to calculate the risk free returns.

Abbildung in dieser Leseprobe nicht enthalten.

The Sharpe Ratio for the EWT is 0,32. The Sharpe Ratio for the FTW was estimated in the exact same way and is also very similar with SR (FTW) = 0,3. Therefore we can conclude, that the risk for the excess return of the two funds is comparable.

### 3.2. Beta

Another risk measure is the beta ([Abbildung in dieser Leseprobe nicht enthalten]). Beta compares an investment's volatility against a baseline benchmark such as the S&P 500. It shows how an investment's historical returns have fluctuated in relation to the broader market represented by the benchmark. The beta formula for the EWT is:

Abbildung in dieser Leseprobe nicht enthalten.

Where, rFund are the returns of the ETF over two year, rS&P500 are the returns of the benchmark and Var(S&P500) is the variance of the benchmark. The estimated beta is 0,823, which indicates that the EWT was approximately 17% less fluctuating over the last two years. However, the related R-squared of only 0,3418 indicates that the beta term is not very explanatory to measure the risk of the EWT. The calculated R^{2} for the EWT is only 0,3418, which indicates that only 34% of the performance of the EWT can be explained by the performance of the S&P500^{8}. The beta for the FTW is much lower with only 0,2919. Accordingly the R^{2} is also very low with 0,0357:

Abbildung in dieser Leseprobe nicht enthalten.

Where ESS stands for the explained sum of squares, and TSS fort he total sum of squares. R^{2} quantifies how much of the EWT’s performance can be attributed to the performance of the S&P 500 index. The value of R^{2} varies between 0 and 1 and measures the proportion of a fund's variation that is due to variation in the benchmark.

### 3.3. Standard Deviation

Since the beta term shows not a good explanatory power another risk measurement is the standard deviation, which reveals the volatility of an investment's returns over time, with a high standard deviation indicating greater historical volatility. Hence, if the standard deviation is high, the potential risk for losses is greater, however the chance for abnormal returns as well.

Abbildung in dieser Leseprobe nicht enthalten.

The annualised standard deviation of the EWT for the last two years is 9,58%, which indicates that that the volatility/risk of the EWT is approximately 3% higher than the risk for example of the S&P 500 (standard deviation = 6,79%). The FTW shows a slightly higher standard deviation of 10,52%, which can be due to the reason that it is less diversified than the EWT. However, due to the risk factors for emerging markets, it is not unusual that the volatility is higher^{9} and the difference between the two funds is relatively small.

## 4. Tracking Efficiency

### 4.1. Tracking Error

Vardharaj et al. (2004), define the tracking error as the standard deviation of the active returns:

Abbildung in dieser Leseprobe nicht enthalten.

Vardharaj et al. (2004) used the returns of the NAVs of the ETF, however in this report the returns of the ETF price itself is considered as it takes in account the costs, tax liabilities, asset liquidity an asynchronous prices more accurately. The tracking error for the EWT for the last two years is 0,0239%, which is in accordance to Vardharaj et al. (2004) who are sating that an index ETF should have a tracking error of 0. As the fund uses a complete replication strategy, which means that the ETF tries to replicate and include all securities of the underlying index, the tracking error is supposed to be very low. However, there are several factors like the trading costs, dividend payments, portfolio optimisation, taxes and management fees that cause the tracking error not to be exactly 0^{10}.

**[...]**

^{1} Gastineau, 2001

^{2} Brooks, 2014

^{3} iShares, 2014a

^{4} iShares ,2014a

^{5} First Trust, 2014a

^{6} First Trust, 2014b

^{7} Sharpe, 1998

^{8} Brooks, 2014

^{9} De Santis, 1997

^{10} Vardharaj et al., 2004