Prospects and Challenges Exchange Traded Funds Prospects and Challenges Sani-e-Mehmood Khan General Manager, Product Development, Research and Marketing psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Table of Contents Exchange Traded Funds What are ETFs How do ETFs work? ETF fees and costs 2. Liquidity in ETFs Where is liquidity found How can the liquidity be measured ETF Market participants Spreads Business What motivate A/Ps to make Market and maintain liquidity psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 What are ETFs? An Exchange Traded Fund (ETF) is a diversified portfolio of securities constructed using an index approach that can be readily traded on the Exchange (PSX) psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Exchange Traded Funds, Background What are Exchange Traded Funds? ETF is a security that tracks and Index or a Basket of Assets Classified like and Index Fund but TRADES like a Security on an Exchange Replicates performance of the benchmark index or a Basket of assets Pros Price Transparency, ETF certificates and associated assets can be bought/sold during trading Flexible gains, instant exposure to equity markets Consolidated View of investments Enhanced liquidity due to active participation of Market Makers Cons Are complex to understand Involve Tedious Calculations of Cash Component and real-time INAV during the operation of the market Involve unit creation and redemption process through market makers Investor Protection The Secondary Market Liquidity available to investors ensure their complete protection as Any investor can enter and choose to exit On the basis of real-time NAV displayed available on TWS psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 How do ETFs work? ETFs are constructed using an indexing approach, so their value moves in line with the index they track. For example, a 2% rise or fall in the index would result in approximately a 2% rise or fall for an ETF which tracked that index (all other things being equal).Buying an ETF is an easy, fast and low cost way for investors to own a slice of that underlying portfolio, and benefit from changes in its value. You can buy or sell ETFs at any time on the KSE throughout the trading day. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 ETF – Working, Creation and Units The requisite Units of ETF equalling the Creation Unit size or multiple thereof, have to be transferred to the Fund’s Depository Account and the Cash Component to be paid to the Trustee through bank transfer On confirmation of the same Portfolio Deposit will be transferred to the CDC account of the Authorized Participant. Alternatively the Trustee would pay Cash Component to the Authorized Participant by transferring funds into his account, in case where it is a Positive value. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

ETF – Working, Creation and Units Primary Market Secondary Market Authorized Participants Fund Seller Karachi Stock Exchange Buyer Sell Units Marketing Making Cash ETF Units ETF Units ETF Units Portfolio Deposit psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 ETF – Working, Redemption of Units The requisite Units of ETF equalling the Creation Unit size or multiple thereof, have to be transferred to the Fund’s Depository Account and the Cash Component to be paid to the Trustee through bank transfer On confirmation of the same Portfolio Deposit will be transferred to the CDC account of the Authorized Participant. Alternatively the Trustee would pay Cash Component to the Authorized Participant by transferring funds into his account, in case where it is a Positive value. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

ETF – Working, Redemption of Units Primary Market Secondary Market Authorized Participants Fund Seller Karachi Stock Exchange Buyer Buy Units Cash ETF Units ETF Units Portfolio Deposit ETF Units psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Liquidity in ETFs One of the primary advantages of ETFs is that there are two sources of liquidity. There is liquidity on the market as defined by the securities on issue and the depth of trading on-market. There is also liquidity that sits with the issuer and the ability to create or redeem ETF securities to meet investor demand - this liquidity reflects the open-ended nature of ETFs and the liquidity of the securities held by the ETF. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 ETF Market Participants The ETF market is made up of a primary and secondary market. Primary market The primary ETF market is made up of three participants: Issuers of ETFs Authorized participants / Market makers Secondary market The secondary market is made up of buyers and sellers of ETF securities on a securities exchange. Different parties include: Stock Exchange (PSX) Financial advisers and brokers Investors Share registrars psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 ETF market participants An A/P or Market Maker's role is slightly different. They provide liquidity to the market by quoting buy and sell prices throughout the trading day. Market makers seek to provide continuous liquidity to the market. The process begins with the issuer distributing the current fund composition to the market every morning, allowing market makers to price the basket of securities underlying the ETF. Market makers place a buy/sell spread around the true value of the ETF and send these prices to the stock exchange as orders. These orders are published to market, and investors can either 'hit' orders to trade with the market maker or send their own orders to the exchange and wait for someone else to 'hit' them. Market maker orders are updated continuously throughout the day to reflect price changes in the underlying securities. Often, participants in the market can fulfil both the market making and authorised participant roles. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 ETF Spreads The spread is the difference between the bid price and offer price. A market maker's role is to provide liquidity in trading volume and quote within agreed spreads. Market makers earn their revenue from trading and have a strong motivation to maintain tight ETF bid-offer spreads. Given below are some of factors which influence the spreads: Spreads can also be affected by market uncertainty. In the case where there is a very high degree of uncertainty in the share market, spreads on all trading securities in that market may be affected, including ETF securities. However, unlike shares, an ETF has a well-defined underlying value - the NAV. The NAV of the underlying Vanguard index fund is published daily on the Vanguard website. This provides both investors and market participants with daily information on the ETF's value. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Market Maker - Concept A market maker is a firm who quotes both a buy and a sell price in the underlined stocks or ETFs, hoping to make a profit on the turn or the bid/offer spread. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Market Maker – Playing on Spreads The spread, or difference between a stock’s BID and ASK price, represents the capital risk a market participant undertakes when buying or selling a stock. BID ASK 30.25 30.375 Spread = .125 psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 Market Maker – Multiple Market Maker and Spread This Slide shows multiple market makers and ECNs, in an open and transparent market, maintaining two sided order book at the spread of their CHOICE. BID PRICE POSITION TO BUY MM1……….25 MM2……….24.875 MM3……….24.875 ECN1………24.875 MM4……….24.875 ASK PRICE POSITION TO SELL 25.25……....MM4 25.5..………ECN1 25.5.……….MM3 25.5..………MM2 25.5…….….MM1 Market Marker 1 has positioned itself to buy stock. psx.com.pk | sani.khan@psx.com.pk | 021-111-001122

psx.com.pk | sani.khan@psx.com.pk | 021-111-001122 THANK YOU psx.com.pk | sani.khan@psx.com.pk | 021-111-001122