Journal of Financial Studies Vol.12 No.

3 December 2004

107

Is Taiwans First Exchange Traded Fund Efficient?

by Andy Lin and Fan-Ju (Christina) Meng Malaspina University-College, Canada

** Please address correspondence to: Andy Lin, Ph.D. Professor of Finance, Faculty of Social Sciences & Management, Malaspina University College, 900 Fifth Street, Nanaimo, BC Canada V9R 5S5 Tel: 250-753-3245 Ext. 2446 Fax: 250-740-6551 E-mail: lina@mala.bc.ca
** We are grateful to anonymous reviewers for their valuable comments and suggestions. Errors remaining are definitely our responsibility.

Abstract
Taiwans first ETF, TTT, was launched in June 2003. In addition to the characteristics and performance of TTT, this research examined whether ETF is a better choice for Taiwans investors by applying the mean-variance analysis and portfolio evaluation techniques. In the mean-variance analysis, the empirical result shows that TTT has a smaller standard deviation as compared to its fifty underlying stocks, which makes TTT an attractive investment tool for Taiwans conservative investors. However, further examination shows that the performance of TTT is relatively unsatisfactory in comparison with the market benchmark portfolio and a hypothetical portfolio. Evidently, TTT, based on the market capitalization in determining the allocation weights, does not yield the most appealing portfolio while the hypothetical portfolio, which applies the Markowitzs theoretical framework, is showing more attraction during the sample period. In an attempt to further validate the results, the examination was applied to an extended period. Statistical results prove that the hypothetical portfolio still outperforms TTT in two of three performance measures. After incorporating various costs of portfolio construction and rebalancing as well as transaction taxes, the hypothetical portfolio retains its dominance, suggesting another dimension for future ETF formation. Key words: exchange traded fund, portfolio theory, efficient portfolio, Sharpe ratio, Treynor ratio, Jensen Index.

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Is Taiwans First Exchange Traded Fund Efficient?

I. Introduction
Although exchange traded funds (ETFs) have a brief history, this market segment offers excitement because of its remarkable growth rate. According to Morgan Stanley Research, as of December 31, 2002, the size of ETFs increased 35% to US$131.56 billion and the number of ETFs grew 39% to 280, traded in 26 stock exchanges around the world as compared with the previous year. In 2002, there were 47 new ETFs issued in Europe, 15 new ETFs in the United States and 10 new ETFs in Japan (Cheng and Chang, 2003). In 2004, two new Chinese ETFs, one representing major stocks in Shanghai Stock Exchange and one incorporating ADRs, were launched in the U.S. markets. Currently, the United States, Japan and Europe are the three major ETF markets in the world. In terms of asset size and daily turnover, the United States represents the largest ETF market share at 72.25%, followed by Japans 14.83% and Europes 7.55% (Cheng and Chang, 2003). Financial Research Corporation of Boston also forecasted that ETFs would enjoy an average annual growth rate between 30% and 50% over the next five years. Moreover, the popularity of ETFs has increased so rapidly that ETFs account for over two-thirds of the daily trading volume on the American Stock Exchange (Fuhr, 2001). Taiwans economy has been growing dramatically over the past years. An incredible demand has been seen in the financial markets for good financing and investment products. After becoming a member of World Trade Organization, it is essential for Taiwan government to provide more financial products and expand the depth and breadth of equity and financial markets to cope with global challenges. Since equity investments are popular in Taiwan and individuals are the major investors in Taiwans stock market (Yang, 2003). Considering the feasibility of various financial products and the characteristics of Taiwans stock markets, the ETF concept was introduced to Taiwan in 2003, ranking Taiwan the 28th ETF trading market in the world (SFC, 2003).

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Polaris Taiwan Top 50 Tracker Fund (TTT), the first ETF in Taiwan, was launched by Polaris International Securities Investment Trust Co., Ltd. (PISIT) and began trading in Taiwan Stock Exchange on June 30, 2003. To increase liquidity for arbitraging and hedging traders, Taiwan Futures Exchange simultaneously launched a new futures contract, TX50 futures. TTT and TX50 futures represent the same underlying stocks. As of April 27, 2004, the total asset of TTT reached NT$46.8 billion and 9.16 million units, rocketing from NT$4.28 billion with 1.16 million units at its inception. Since ETFs have become one of the fast-growing investment classes in the global market recently, there are growing literatures on ETFs. Numerous scholars debated about advantages and disadvantages of ETFs by comparing ETFs with other investment tools. For instance, Papmehl (2001) and Zigler (2002) proposed ETF is a good investment tool for everyone, while Damato and Lucchetti (2000) argued that ETF is only good for specific investors. In addition, previous works also focused on comparing ETF returns to changes in their net asset value (Elton et al., 2002), analyzing the tax consequences of holding ETFs (Poterba and Shoven, 2002), studying the dynamics of price deviations from the underlying portfolios (Engle & Sarkar, 2002), comparing price discovery in the ETF cash market and index futures markets (Hasbrouck, 2003), and discussing the cost and the market structure of ETF trading (Boehmer & Boehmer, 2003).

Acting in response to the apparent importance of this market and development, this research concerns primarily the portfolio formation and capital allocation of ETFs and its suitability to individual investors in Taiwan. What are the characteristics of ETFs that have made them a popular investment product in the global financial market? Are ETFs really so advantageous as opposed to other portfolio type of investment tools currently available in the Taiwan market? Is ETF popular and acceptable in Taiwan too? Can new ETFs be designed to expand the investment spectrum in Taiwan? These are the questions that motivate this research. Therefore, the logical sequencing of this research falls in four steps. First

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of all, after the introduction, the development history and characteristics of ETFs, including TTT, will be discussed. Secondly, a quantitative method will be applied to examine whether Taiwans first ETF fits the investment needs in Taiwan. Markowitzs portfolio theory and the most common performance evaluation techniques, including Sharpe Ratio, Treynor Ratio and Jensen Index, will be employed to compare TTT to its underlying stocks, the general stock market as well as a hypothesized portfolio calculated based on the theory. Thirdly, if TTT is not an efficient portfolio, an optimal one will be proposed on the ground of the traditional portfolio theory. And finally, based on the findings, some regulatory and practical implications regarding new ETF innovations and future developments will be recommended.

II. Literature
1. Development and Types of ETFs The concept of ETF stems from the growth of index-linked investment products in the 1970s. Toronto Index Participation Shares (TIPS) and Toronto 100 Index Participation Units (HIPS) were launched in 1990 in Canada, and investors were impressive with the expense structure of these products (Wiandt & McClatchy, 2002). The real emergence of the ETF market was in the United States where the first successful ETF, the Standard & Poors Depository Receipts (SPDRs), debuted in AMEX in January 1993. The product can trace its roots to exemptions from the Investment Company Act of 1940 that were granted by the SEC to several other failed ETF introductions. SPDRs dominated the ETF market until the Nasdaq-100 Index Tracking Stock entered the market in 1999 (Freyre-Sanders et al., 2001).1 ETFs are structured as either unit trusts or mutual funds, and several differences between the two formats exist. Wiandt and McClatchy (2002) further divided ETFs into three major types: the management investment company, the unit

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investment trust and the grantor or basket trust. Management investment company type of ETFs is the major category in the market and is almost indistinguishable to a mutual fund. While it requires a board of directors, it can reinvest dividends back into the portfolio, thereby reducing the cash drag. In addition, it is allowed to lend securities, which is a possible source of additional income, to maximize performance and is allowed to optimize its portfolio, permitting mangers flexibility in tracking its benchmark by employing futures, options, or highly correlated substitute securities (Wiandt & McClatchy, 2002). The appeal of a unit trust structure is its low operation costs since a board of directors and its associated cost are not required. The target index must be followed rigidly through a full replication. However, dividends are kept in non-interest bearing accounts until those dividends are paid to investors quarterly. This will cause a slight cash drag, or tracking error to the index because cash is not fully invested. In addition, it is not allowed to lend holdings and to use derivatives when managing the portfolio (Wiandt & McClatchy, 2002). The last type of ETFs, grantor trusts, also called Holding Company Depository Receipts (HOLDRS), creates a static basket to provide thematic exposure to different market segments. It does not track a benchmark and will never be rebalanced (Wiandt & McClatchy, 2002). 2. Unique Features of ETF The ETF with the same underlying shares as the index is divided into smaller trading units. Investors can follow the trend of the index by trading beneficiary certificates, which represent the index funds, on the stock exchange (TSEC, 2004). Therefore, an ETF has the following unique features: 2.1 Passive management The purpose of ETFs is to target the profit of the trading index, so each ETF is designed to generally track broad-based, industry sector or country indexes. Under the concept of passive management, the only scenario for adjusting the constituents and weights of the portfolio is based on the changes of the constituents and weights of the underlying index.

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2.2 Combining features of both stock and index fund An ETF comprises both the features of stocks and open-end index funds; meanwhile, an ETF can be traded in both primary and secondary markets. The similarity between an ETF and a stock is that an ETF can be listed on the stock exchange and traded in margin throughout the day. The process of creation and redemption of ETFs is similar to that of the open-end funds and thus new shares can be continuously offered. 2.3 Creation and redemption mechanism The creation and redemptions mechanism is the process where authorized participants transact directly with the fund. It is on an in kind basis. An authorized participant is usually an institutional investor, specialist or market maker who has signed a participant agreement with a particular ETF sponsor or distributor (AMEX, 2004). Namely, in this mechanism underlying securities can be swapped for the ETF shares and vice versa. Since an ETF is of securitized index, the physical assets of an ETF are the index basket, which tracks the index. Creations and redemptions occur in creation unit aggregations or multiples thereof and involve delivering a specified basket of securities to the fund in exchange for shares and vice versa (AMEX, 2004). The in-kind creation of ETF is given to the index basket in exchange for a specific amount of ETF, while the in-kind redemption of ETF is given a specific amount of ETF in exchange for the index basket. To avoid dilution of existing fund shares, creations and redemptions occur after the market closing, or at the-end-of NAV of the fund (Ou, 2003a). 3. Advantages and Disadvantages of ETFs ETFs offer three main benefits: low fees and expenses, trading flexibility and deferred taxes (Wiandt & McClatchy, 2002). 3.1 Trading flexibility Exchange listing results in greater trading flexibility for ETFs. For example, ETFs in the United States can be shorted, purchased on margin, purchased by way of stop or limit orders, and not limited to the up-tick rule. Options can be written

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or bought on some ETFs, and, in most of cases, as few as one ETF share can be purchased. In addition, there are less short-term trading restrictions for ETFs. They can be used to equitize cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term. A wide variety of ETFs also exists, such as fixed income, industry sector and international diversification. The considerable breadth of ETF alternatives provides investors with the ability to invest in indexes that were previously unobtainable. 3.2 Tax implications With the ETF redemption process, lower cost basis securities are exchanged out of the fund first, leaving higher cost basis securities in the portfolio. Poterba and Shoven (2002) analyzed the tax consequences of holding ETFs and concluded that the ETF redemption process substantially reduces distributions of realized capital gains. In addition, since ETFs are passively managed, typically provides tax advantages versus actively managed funds. ETFs are not required to sell securities to meet investor cash redemptions, and thus will not potentially generate capital gains tax liability for remaining investors (Perrier, 1993). 3.3 Lower costs Three major costs are applicable to ETFs, including operating costs, the bid/ask spreads variances and royalties. Most of ETFs have extremely low operating costs because they are passively managed. The creation and redemption mechanism used by arbitrageurs has minimized variances, meaning lower discounts or premiums between the NAV and the market price. However, one area of weakness is claimed. Transaction costs, both visible and hidden, can be unacceptable high for the unwary investor to pay while buying and selling the actual ETF. Hidden costs are the most subtle to analyze and have produced the strongest debate in literature (Wiandt & McClatchy, 2002). For instance, ETFs can not be purchased for free from their issuers the way mutual funds operate. Moreover, an ETF, as with any stocks, also has a bid-ask spread.

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4. New Applications of ETFs There are many applications where ETFs can serve as an efficient vehicle. Fuhr (2001) listed several applications, including equitizing cash flows, implementing a US sector allocation or sector rotation models, executing US-style investment strategies, building an international portfolio, adjusting and hedging a sector, broad US market or international exposure. As well, the ETF has begun to put more sophisticated investment techniques at the hands of investors that were previously inaccessible due to cost or complication. Dresdner Kleinwort Wasserstein Research (2001) found that during the period September 10 to 17, 2001 when the global economic outlook was further weakened and investors were inclined to sell technology stocks further, the average volatility of large individual stocks was far greater than the whole index. If ETFs exist on every index or every style, investors can gain an array of risk controlled investment building blocks to any strategy (Freyre-Sanders et al., 2001). Core-satellite investment framework is now the foundation for institutional managed money, especially pension funds. They hold ETFs as core investments, which provide a broad market exposure for long-term holding that is easy to establish, easy to track, inexpensive, and efficient in tax planning. On the other hand, they actively manage some specific assets as satellite investments to increase performance. This strategy will reduce risks, but investors also can enjoy the opportunity of higher returns (Freyre-Sanders et al., 2001). 5. Polaris Taiwan Top 50 Tracker Fund (TTT) Taiwan Stock Exchange launched its first ETF on June 30, 2003. In the first three months of TTT listing, TTT assets soared from NT$4.3 billion at its IPO in the end of June 2003 to NT$29.23 billion by the end of September 2003, and the number of stock baskets increased from 116 to 654.2 The main contributor of the growth is Taiwans National Financial Stabilization Funds that released their holdings to TTT in late August 2003 (Sun, 2003). In the same period, the average daily turnover of TTT was 6,916 lots.3 And the average daily turnover rate was

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5.6%, lower than those of top 20 ETFs in the world of 11.9%. The major TTT players during this period were propriety dealers, accounting for about 50% of total trading volume, and institutional investors, representing local and foreign, taking another 20% (Sun, 2003). In collaboration with the FTSE Group, the Taiwan Stock Exchange compiled a new Taiwan 50 Index in October 2002 to replace the traditional Taiwan index. TTT is the first product linked to the Taiwan 50 Index. However, the Index is not compiled solely for the ETF, but also for other derivative products such as the Taiwan 50 Index (TX50) futures and options (TSEC, 2004). Currently, TX 50 futures contracts initiate trading with a value of NT$500 per point on the same day as TTT. The value of TX50 futures per contract is the largest among all futures with the underlying shares in Taiwans stock market. The 50 stocks in TTT are mainly selected based on the market capitalization. These constituent stocks are readjusted by a standard calculation procedure every quarter to closely monitor and exactly track the pulse of the market. Although more than five hundred stocks were eliminated during the selection process, it does not decrease the importance of the Index. In fact, it adequately reflects the essence of the market, accounting for 70% of the total market value, with a correlation coefficient of 98.9% to the benchmark weighted stock price index (TSEC. 2004). Though TTT grew very fast, the TX50 futures market performed dreadfully with the daily trading volume below ten contracts and relatively bigger spreads between the bid/ask prices of nearly 1% (TAIEX, 2004). Increasing TTT size from creation and trading volume show more institutional investors have gradually accepted this product, while individual investors and the secondary market need to be promoted further. In addition, the failure of TX50 futures mainly results from big contract values, which is not appealing and lacks suitability in Taiwans stock market where individual investors dominate. 6. Characteristics and performance of TTT Table 1 sets forth the characteristics of TTT. Like the ETFs in the United States,

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TTT encompasses the same characteristics, including passive management, the creation and redemption mechanism and the combination of merits of stocks and mutual funds. Since TTT has its base value determined by the Taiwan 50 Index, the return on TTT with the return on Taiwan 50 Index will be compared and the return differences will be decomposed and analyzed. In what follows, the TTT return is divided into two components: the return due to changes in the NAV of TTT and the return due to deviations of NAV from price. Table 1: Major Characteristics and Trading Regulations of TTT
Benchmark Index Stock Code Listing Issuer/Manager Technical Advisor Custodian Issue of Units Depository Net Asset Value (NAV) Total Expense Ratio (TER) Voting rights Distribution Commission Board lot Tax Bid/ask spread Limit up and down TSEC Information Disclosure Margin Trading Creation and redemption Portfolio Composite File (PCF) Tax Creation / Redemption Unit Issue / Redemption Price Creation consideration / Redemption consideration Types of creation Taiwan 50 Index 0050 Taiwan Stock Exchange Polaris International Securities and Investment Trust Company Ltd. State Street Global Advisors Asia Limited (SSGA Asia) Chinatrust Commercial Bank Scripless, units held in the Depository and not available for withdrawal in physical form Taiwan Securities Central Depository Co. Limited NAV will be calculated based on the market value of the assets of the Fund after income and expenses accrual and announced after 4:00 pm on each dealing day. TER includes Management fee, custodian fees, index license fees, etc. Such expenses will be accrued daily and subtracted from the NAV. Based on an estimated fund size of NTD 5 billion, TER will be approximately 40 basis points. The Manager will act in the unit holders interest and exercise voting rights for the shares held in the Fund. When the Funds investment performance exceeds that of the Benchmark Index by 5% or more, the Fund will make a distribution. Same as for ordinary stocks varies by broker but no higher than 0.1425% of the consideration 1,000 units, no odd lot trading 0.1% levied on the sale of the units, lower than 0.3% levied on the sale of regular stocks NT$0.01 if the price of the unit is below NT$50 NT$0.05 if the price of the unit is above NT$50 7%, same as that for stocks 1. Estimated NAV per unit every 15 seconds 2. Index level very 15 seconds 3. Transacted price of TTT and the 5 best bid/ask prices and volume 1. Available on listing 2. Short selling under margin trading is exempted from the tick rule (which requires short sales to take place at no lower than the previous days closing price) Creation to subscribe for units of the Fund using index baskets and cash component Redemption to redeem units of the Fund for index baskets and cash component Details of index baskets for creation and redemption will be disclosed through the TSEC website to all market participants No tax is levied on creation or redemption 1,000,000 units NAV per unit on the day of creation or redemption NAV per unit * number of units applied for in the creation or redemption order 1. Creation 2. Team creation 3. 90% rule creation 4. Creation and sale of ETF on the same day 5. 90% rule creation and sale of ETF on the same day 1. Redemption 2. Redemption and sale of stocks on the same day Varies by participating dealers but subject to the limit: 1. Creation fee cannot exceed 2% of the creation consideration 2. Redemption fee cannot exceed 1% of the redemption consideration

Types of redemption Creation and redemption fee

Source: Taiwan Stock Exchange Corporation

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It is important to note that the NAV of TTT per share is equal to the total market value of the securities that substantiate the TTT plus an accumulation value that is equal to accumulated cash dividends on the underlying shares minus accumulated management fees. As shown in Table 2, the mean daily return of the TTT NAV is 0.001813 from June 30, 2003 to April 14, 2004, or equivalent to 66.17% per annum. The result is better than the other two, but the differences among the three are very small and less than 1 basis point. The differences of accumulated return between them are larger between the NAV of TTT and market price of TTT. The difference between Taiwan 50 Index and the NAV of TTT is mainly by tracking errors and operating costs. The difference between the NAV of TTT and the market price of TTT, called deviation, results from expectations of investors. Table 2: Performance of Taiwan 50 Index, NAV and Market Price of TTT (Mean Daily Return: June 30, 2003 to April 14, 2004)
Taiwan 50 Index Mean Standard Deviation Accumulated Return 0.001753 0.013980 0.347118 NAV of TTT 0.001813 0.014001 0.358972 Market Price of TTT 0.001738 0.013230 0.344066

The difference in performance due to the tracking error is easy to estimate by directly comparing the NAV return of TTT and the price return on the Taiwan 50 Index. However, the NAV of TTT used here is from Polaris International Securities Investment Trust, which has subtracted the relevant expenses, such as custodian fees, management fees, index license fees and etc., from the NAV by a daily basis. Therefore, the real NAV should be theoretically higher than the NAV used here. Even though operating costs have been incorporated, on average, the TTT NAV daily return still outperformed the return on Taiwan 50 Index by 1.4037% over the examined period. What could account for the differences? The major contributor is the method of calculating the Taiwan 50 Index. Since the Taiwan 50 Index is weighted by market capitalization of underlying shares, only stock dividends are considered and cash dividends are not included in the Index (TSEC, 2004). In other words, if

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investors invest in the index futures, they will not receive cash dividends, while investors who invest in the index securities will receive cash dividends. Figure 1 shows the tracking errors of TTT. Evidently, the tracking errors increased significantly in June and July, the peak season of dividend distributions.

Figure 1: Tracking Errors of TTT

0.018 0.015 0.012 0.009 0.006 0.003 0 6/30/03 7/30/03 8/30/03 9/30/03 10/30/03 11/30/03 12/30/03 1/30/04 2/29/04 3/30/04

Above discussion assumes that all purchases and sales occurred at NAV. However, the TTT price can deviate from NAV, representing a cost and an opportunity to the investor. Figure 2 shows the pattern of premiums or discounts between daily NAVs and closing prices. This is expressed as the dollar difference divided by the NAV. According to empirical literatures, over a long period the difference between the price and NAV is insignificant because, through the creation and redemption mechanism, arbitrage limits deviations (Elton at al., 2002). This happened in Taiwan as well. On average, TTT prices lie above NAV by 0.000451. The range is between 0.016086 and -0.012110 during the studied period. In most cases, the difference doesnt yield any worthwhile arbitraging opportunity.

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Figure 2: Premium or Discount of TTT

0.018

0.012

0.006

0 6/30/03 7/30/03 8/30/03 9/30/03 10/30/03 11/30/03 12/30/03 1/30/04 2/29/04 3/30/04

-0.006

-0.012

-0.018

III. Portfolio Selection Prior to Markowitzs pioneering work on mean-variance efficient portfolios, investment strategies were decided by maximizing the discounted value of future returns without considering investment risks. Markowitz (1959) proposed that an investor can reduce risks by portfolio diversification; namely, an investor can remove unsystematic risks by the mean-variance analysis for securities. Based on his proposition, an efficient portfolio is defined as the one providing the largest return for a given level of risk or the smallest standard deviation of return for a same level of return. 1. The mean-variance model There are three major factors in the mean-variance analysis: expected return on individual securities, variance on individual securities and covariance or correlation between individual securities. The expected return and variance of a portfolio are represented by the following formulas:
E(Rp) =
n

WiE(Ri)
i=1

(1)

p2 = Wi2i2 +
i=1

WiWjij , i
i=1
j= 1

(2)

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where

E(Rp) : the expected return of portfolio E(Ri) : the expected return of security i Wi: the proportion invested in security i and
2

Wi =1
i=1

p : the variance of the return on the portfolio i2 the variance of the return on security i ij: the covariance between the returns of securities i and j n: the number of securities in the portfolio The expected return of the portfolio is the weighted average of the expected returns on individual securities included in the portfolio. The portfolio risk is a function of each individual securitys risk and the covariances between the returns of the individual securities. As n becomes larger and approaches infinity, the first item, average variance, becomes smaller and approaches zero. However, when the number of securities increases, the costs of diversification increase too. Statman (1987) proposed that investors should increase the number of securities for their portfolios as much as possible only if the marginal benefits are higher than the marginal costs. In the mean-variance framework, the portfolio with the smallest variance for a given level of expected return can be calculated. Given the minimum variance portfolios, the minimum variance frontier can be further obtained. The basic Markowitz model is solved by quadratic programming. Furthermore, the expected return-risk combination for a risk-averse investor is located at the tangent point by combining an individual investors personal preferences and the efficient set of portfolios. The efficient portfolio set can be further expanded by including a risk-free asset. 2. Critiques of Markowitzs portfolio theory Though the portfolio theory has a long history over 50 years, now numerous researches are still based on it because of its appeals (Change, 2002). However, the model is seen with some deficiencies. First, the model emphasizes greatly on statistics. It is known widely that the efficient frontier is very sensitive to

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expected returns, variances and covariances of securities. Black and Litterman (1990) also affirmed this view by studying the Germany bonds. Second, the procedure of calculating the optimal portfolio is complicated, but this problem has been solved by computer softwares. Third, the single-period analysis is not appropriate in the modern complicated economic environment. Koskrosidis and Duarte (1997) and Chopra and Ziemba (1993) concluded that the inputs selected from different periods will cause different empirical results. Finally, the model is built on the assumption that returns of securities are normally distributed, so it is not applied to those financial assets with asymmetric distribution (Change, 2002). Other researchers such as Elton et al (2003) provide alternative criteria for portfolio selection. The list includes the geometric mean return, safety first, stochastic dominance, and analysis in terms of characteristics of the return distribution. The first two criteria do not utilize the idea of expected utility, while the other two criteria, like the mean-variance analysis, make use of this scheme. The geometric mean criterion is to select optimum portfolios with the highest expected geometric mean return without considering the form of investors utility functions or the distribution of security returns. The safety first criterion stems from a belief that investors will employ a simpler decision model that concentrates on avoidance of bad outcomes, rather than complicated mathematics calculations. Stochastic dominance defines efficient sets of investments based on the assumptions about investor behavior of utility functions. The final criterion for selecting portfolios is proposed on the basis of three moments of return distributions, called skewness. 3. Evaluation of Portfolio Performance Over the last two decades portfolio evaluation has evolved dramatically. The modern portfolio theory has changed the evaluation process from crude return calculations to rather detailed explorations of risk and return (Elton at al. 2003). These measures seek to relate the return on a portfolio to its risk, but differ in their definitions of risk and the risk-adjusted performance. Recognizing the necessity of incorporating both return and risk into analysis, Treynor (1965), Sharpe (1966) and Jensen (1968) developed measures of portfolio performance in 1960s. These

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techniques are based on the concepts of capital asset pricing model (CAPM) and often referred to as the composite (risk-adjusted) measures of portfolio performance. 3.1 Reward-to-volatility measure Treynor Index Treynor (1965) introduced a risk-adjusted measure of portfolio performance called the reward-to-volatility ratio, or Treynor ratio. Treynor ratio assumes that portfolios are well diversified, so the undiversifiable risk is ignored and total risk can be represented by the systematic risk. Based on CAPM, Treynor ratio is the slope of the security market line. Therefore, the higher the slope, the better the portfolio performs. The ratio is defined as: Treynor ratio = (Rp Rf) /p where Rp : the return of portfolio during some period of time Rf : the risk-free rate of return during the period p : the beta of the portfolio (Rp Rf ): the excess return or risk premium of portfolio

3.2 Reward-to-variability measure Sharpe Index Sharpe (1966) argued that Treynor ignored the unsystematic risk of portfolio and thus introduced a risk-adjusted measure of portfolio performance called the reward-to-variability ratio (RVAR). Furthermore, Sharpe (1966) pointed out that Treynor Ratio is a better measure for the future evaluation due to the fact that the capital asset pricing model is ex ante, not ex post. The rationale is similar to Treynors ratio; that is, the higher the Sharpe ratio, the better the portfolio performs. The measure can be presented as: Sharpe Ratio = (Rp Rf)/ p where (Rp Rf ) is the excess return or risk premium of portfolio and p is the standard deviation of return for portfolio during the period.

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3.3 Differential return measure Jensen Index Like Treynor Index, Jenson measure is based on CAPM, while Jensen (1968) argued that Sharpe Index and Treynor Index only can be used for the performance comparison because they are not absolute indicators. Therefore, Jensen calculated the difference between the actual excess return on portfolio during some period and the risk premium on that portfolio that should have been earned based on CAPM, given its level of systematic risk. If the difference is positive, it means the portfolio performance is better than the market performance. The equation is given as: p = (RpRf) p(Rm Rf)

IV. Methodology

1. Design To formulate the research model and process, Markowitzs portfolio theory, Sharpe ratio, Treynor measure and Jensen index will be employed to examine whether TTT is an efficient investment tool for Taiwans investors. Though these methods have their own deficiencies, they are still the most commonly used ones in practice. This investigation involves three major steps. First, the mean-variance analysis is applied to examine the return and risk of Taiwans first ETF and its underlying 50 stocks in the sample period. Secondly, the portfolio theory is employed to construct an efficient portfolio which comprises the same underlying shares based on the outcomes of the mean-variance analysis. Finally, based on the portfolio performance evaluation criteria, the new hypothetical portfolio is compared to TTT and the market portfolio, represented by Taiwan Stock Exchange Capitalization Weighted Index (TAIEX). Three performance measures will be computed again in an out-of-sample period to further verify the examined hypothesis. It is expected that the hypothetical portfolio built on the

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ground of modern portfolio theory should be more efficient than its counterparts before taking into consideration of transaction costs. 2. Data The sample period extends from June 30, 2003, the first listing day of TTT, to April 14, 2004 with a total of 198 observations. Additionally, an out-of-sample test runs from April 15, 2004 to May 12, 2004, consisting of 20 observations. Since the data period is short, all of measurements used in this research are transformed to a daily basis.4 TTTs constituent list is adjusted every quarter to reflect new developments in the financial market, so the constituent list has been adjusted twice during the sample period.5 The closing prices of TAIEX, TTT and its underlying shares are obtained from Bloomberg database. All closing prices of securities have been adjusted for dividend payments. The risk-free rate adopted here is the yield rate of ten-year Taiwan government bond. The rate stood at 2.29% on March 31, 2004 (Allianz President Insurance, 2004). Since all returns in this research are based on a daily ground, the risk-free rate is also converted to a daily return. 3. Mean-Variance Analysis Pertaining to the assumptions of the portfolio theory, an investor will choose among investment alternatives by complying with the efficient portfolio principle. The means and variances of TTT and 50 stocks are computed and compared. The major results of portfolio theory follow directly from the assumption that investors like return and dislike risk (risk-averse attitude). Therefore, if TTT is an efficient investment tool for investors, it should possess a relatively high return and low risk as compared to other alternatives. 4. Establishment of the Optimal Portfolio With the initial return and risk results of TTT and its underlying shares, the next step is to identify the optimal portfolio based on the portfolio theory and then compare this new portfolio to TTT. Following Markowitzs theoretical

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framework, return maximization is the solution objective. The constraints include minimization of standard deviations, the capital allocation for each security is zero or positive, and the sum of these allocations is equal to one.6 Objective: maximizing E(Rp) = WiE(Ri)
i =1 n

Constraints: minimizing p2 = WiWjij , ij ; 0 Wi 1; and Wi = 1

n n i=1 j=1

i=1

The procedure of comparing TTT and the new portfolio has the following steps and calculations are entirely based on a daily basis. (1) Covariances (ij) are computed for every two individual securities. (2) Means and variances, obtained from the mean-variance analysis, are inputted for each security. (3) Covariances are entered for every pair of securities. (4) The risk-free rate is supplied. (5) Let the computer generate four thousand combinations. (6) The weights corresponding to the optimal capital allocation for each security is generated by the program. (7) The mean, standard deviation and beta are computed for portfolios. (8) The Sharpe ratio, Treynor ratio, Jensen Index are computed for portfolios. Comparing with other inferior portfolios, an efficient portfolio should characterize with relatively higher values in all three performance measures. Theoretically speaking, the new portfolio derived based on the portfolio theory is optimal and locates on the efficient frontier. As a result, the outcome should be that the new portfolio performs better than TTT and the market portfolio, TAIEX, which are constructed on the basis of market capitalization. 5. Out-Of-Sample Test The evaluation methodology employed in the previous section will be applied again to evaluate these portfolios during an extension period. Furthermore, the

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constituent list was adjusted during this second period based on new additions and deletions. To ensure that the calculation and portfolios are done at the same standards, these newly added stocks are applied same allocation weights as the old replaced stocks. There are three replacements; however, no specific match of the three pairs was announced. As a result, there will be six possible pairing matches. To make certain none of the matches is missing from investigation, all six matches will be studied and they are shown as six scenarios in Table 3.7 Table 3: List of the Scenario Analysis
Old Stocks (Code) 2105 2349 2356 Possible replacement Matches (New additions to TTT: 1605, 2888 and 3012) Scenario 2 Scenario 3 Scenario 4 Scenario 5 2888 3012 1605 2888 3012 1605 3012 1605 1605 2888 2888 3012

Scenario 1 1605 2888 3012

Scenario 6 3012 2888 1605

V. Empirical Results
1. The mean-variance analysis The means and standard deviations for TTT and its underlying shares are set forth in Table 4. The graphical relationship of mean and variance is shown in Figure 3. The point labeled TTT in Figure 3 illustrates the mean-variance position for TTT. Based on the portfolio theory, investors are risk averters when making investment decisions; as a result, a rational investor will prefer the portfolio with a lower risk. From the graph, it is evident that TTT significantly reduces the risk with the smallest standard deviations of 0.01323 among all. At the same return level of near 0.001738, TTT has the smallest variance. In addition, according to the portfolio theory, an efficient portfolio is the one locating toward the upper-left corner of the graph. It is obvious that TTT is relatively lying at the theoretically correct location as opposed to its underlying shares, confirming that TTT indeed achieves portfolio efficiency. Table 4: Statistics for TTT and Its Underlying Shares

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Security 0050 TT 1216 TT 1301 TT 1303 TT 1326 TT 1402 TT 2002 TT 2105 TT 2201 TT 2204 TT 2301 TT 2303 TT 2308 TT 2311 TT 2317 TT 2323 TT 2324 TT 2325 TT 2330 TT 2344 TT 2349 TT 2352 TT 2353 TT 2356 TT 2357 TT 2382 TT

Standard Deviation 0.01323 0.02558 0.01568 0.01607 0.01815 0.02652 0.01629 0.01864 0.01838 0.01977 0.01889 0.02372 0.01715 0.02623 0.02035 0.02399 0.02135 0.02952 0.02055 0.02719 0.02420 0.02079 0.02191 0.01850 0.02259 0.02070

Mean 0.001738 0.00320 0.00104 0.00181 0.00232 0.00342 0.00207 0.00134 0.00062 0.00032 0.00098 0.00255 0.00039 0.00344 0.00194 0.00098 0.00051 0.00298 0.00110 0.00152 0.00004 0.00120 0.00154 0.00113 0.00043 0.00126

Security 2388 TT 2401 TT 2408 TT 2409 TT 2412 TT 2454 TT 2475 TT 2603 TT 2609 TT 2610 TT 2801 TT 2880 TT 2881 TT 2882 TT 2883 TT 2886 TT 2887 TT 2890 TT 2891 TT 2892 TT 2912 TT 3009 TT 3045 TT 6505 TT 9904 TT

Standard Deviation 0.02452 0.02144 0.02672 0.02834 0.01408 0.02147 0.03017 0.02487 0.02238 0.02316 0.02387 0.02079 0.01907 0.02341 0.02167 0.02040 0.02262 0.02150 0.01817 0.02143 0.01983 0.02819 0.01725 0.02211 0.01956

Mean -0.00037 0.00362 0.00152 0.00628 0.00066 0.00173 0.00430 0.00178 0.00267 0.00283 0.00233 0.00181 0.00125 0.00225 0.00235 0.00226 0.00321 0.00220 0.00241 0.00155 0.00238 0.00596 0.00181 0.00326 0.00117

Figure 3: Means and Variances of TTT and Its Underlying Shares

0.00700

Return
0.00600

0.00500 0.00400

0.00300

TTT

0.00200 0.00100 0.00000 0.00000 -0.00100

0.00500

0.01000

0.01500

0.02000

0.02500

0.03000

0.03500

Variance

2. Portfolio Selection

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After the risk-free rate, mean, variance and covariance for each security are supplied to the Excel program, the new allocation for each security in the new hypothetical TTT is calculated based on the modern portfolio theory, while the proportion for each security in current TTT is obtained by weighting the market capitalization. The weights column dated as March 31, 2004 for securities in TTT are presented in parallel with those in the new hypothetical portfolio in Table 5. Significant discrepancies are seen across the table, showing the obvious results based on different approaches. A close examination reveals that a significant weights rebalance is required for almost all underlying shares if a different portfolio construction approach is to be adopted. Table 5: Weights Comparisons in TTT and the New Portfolio
TSE Code 1216 1301 1303 1326 1402 2002 2105 2201 2204 2301 2303 2308 2311 2317 2323 2324 2325 2330 2344 2349 2352 2353 2356 2357 2382 Weights in TTT (March 31, 2004) 0.006911 0.026896 0.032646 0.025263 0.007781 0.034188 0.004835 0.006635 0.009474 0.008720 0.050776 0.006563 0.013393 0.041874 0.009627 0.014309 0.006670 0.128613 0.008254 0.004873 0.009650 0.011271 0.004642 0.019211 0.022945 Weights in Hypothetical Portfolio 0.028266 0.010256 0.017515 0.041258 0.025927 0.016253 0.014078 0.019400 0.015661 0.010300 0.015788 0.028238 0.004688 0.008088 0.001431 0.007901 0.037612 0.005063 0.010517 0.038060 0.016176 0.011619 0.037719 0.011178 0.036061 TSE Code 2388 2401 2408 2409 2412 2454 2475 2603 2609 2610 2801 2880 2881 2882 2883 2886 2887 2890 2891 2892 2912 3009 3045 6506 9904 Weights in TTT (March 31, 2004) 0.005416 0.006463 0.010470 0.030927 0.058095 0.023179 0.014892 0.007619 0.008091 0.006073 0.010559 0.014665 0.030575 0.052681 0.023139 0.027677 0.013250 0.007071 0.023138 0.015324 0.005627 0.020130 0.016020 0.045956 0.006943 Weights in Hypothetical Portfolio 0.007852 0.030717 0.006656 0.045780 0.001733 0.037416 0.033024 0.022612 0.006841 0.042929 0.011425 0.022159 0.031595 0.001892 0.000390 0.009584 0.034009 0.020155 0.018459 0.024060 0.025823 0.042390 0.016172 0.032996 0.004280

Table 6, on the other hand, compares the risk-adjusted performance measures of these two portfolios and the market benchmark index. Evidently, the new portfolio based on the modern portfolio theory outperforms TTT and TAIEX in all three performance measures. During the sample period, TAIEX was in the uptrend with the positive average return of 0.001824. Among the three, the hypothetical portfolio has the largest mean of 0.002369 and the highest risk with the standard deviation of 0.013594 and the beta of 1.024509. After comparing the

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risk-adjusted measures of performance, the new portfolio still performs better than the other two with the largest Sharp Ratio of 0.166183, Treynor Ratio of 0.002205 and Jensen Index of 0.000502. According to the evaluation criteria of these techniques, the theoretical portfolio appears to be better than the other two. Table 6: Performance Evaluation in the Sample Period
Portfolios Measures Mean Standard Deviation Coeff. of Variance Beta Sharp Ratio Treynor Ratio Jenson Index TAIEX 0.001824 0.012652 6.9364 1 0.135521 0.001715 0 TTT 0.001738 0.013230 7.61220 0.970680 0.123085 0.001678 -0.000036 Hypothetical 0.002369 0.013594 5.73829 1.024509 0.166183 0.002205 0.000502

However, this preferential performance will be losing part of its shine if the transaction costs of establishing a portfolio, transaction taxes and portfolio rebalancing costs are to be factored in.8 After incorporating various costs, the daily mean return reduces to 0.002194 which is still higher than those offered by TTT and the market benchmark. In other words, investors will still be better off by forming the theoretically optimized portfolio and rebalancing the portfolio by themselves if practically applicable. Based on the coefficient of variation (CV), the hypothetical portfolio also shows a smallest value, suggesting that relatively the portfolio is more appealing. Unfortunately, TTT has the smallest return of 0.001738 though the second largest standard deviation of 0.013230 and the smallest beta of 0.970680 among the three portfolios. In addition, based on the comparison of the risk-adjusted measures, TTT has the smallest Sharpe Ratio, Treynor Ratio and Jensen Index at 0.123085, 0.001678 and -0.000036, respectively. In other words, TTT is showing the least attraction among the three. 3. Out-Of-Sample Test

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The results of out-of-sample runs for TTT, TAIEX and the six scenarios are presented in Table 7 when an extended period is applied. Chen Shin (2105), Ritek (2349) and Inventec (2356) account for 1.41%, 3.81% and 3.77% of the new portfolio, respectively. These weights are assigned to Walsin Lihwa (1605), Shin Kong Financial Holding (2888) and Quanta Display (3012), alternatively based on the six scenarios. The results for the scenario analysis post very small discrepancies. The means are in the range between -0.007224 and -0.007263, standard deviations between 0.02263 and 0.02269 and betas between 1.0478 and 1.0544. Taking a conservative approach, the worst scenario will be employed as the representative and to be compared with TTT and the market benchmark. In this case, Scenario Two with the worst performance (see Table 7) will be used as the comparison target.

Table 7: Portfolio Performance Evaluation in Out Of Sample Period

TAIEX Mean Std. Dev. Beta Sharpe Treynor Jenson -0.006944 0.021296 1 -0.331238 -0.007054 0 TTT -0.005905 0.018975 0.824976 -0.316956 -0.007290 -0.000195 Scenario 1 -0.007229 0.0226279 1.0478599 -0.324321 -0.007004 0.000053 2 -0.007263 0.022688 1.051334 -0.324950 -0.007012 0.000044 3 -0.007240 0.022690 1.054380 -0.323913 -0.006969 0.000090 4 -0.007229 0.0226282 1.0478172 -0.324333 -0.007004 0.000052 5 -0.007238 0.0226841 1.0543295 -0.323905 -0.006969 0.000090 6 -0.007263 0.022688 1.051428 -0.324945 -0.007012 0.000044

During the extended period, TAIEX has a negative mean, showing a downtrend market. As well, TTT and the new portfolio all have negative means, but TTT demonstrates the best performance with the smallest negative mean of the three. Meanwhile, TTT has the smallest standard deviation and beta among them. However, very different results are present in risk-adjusted performance measures and there is no consistent result for the three measure techniques. Generally, the new portfolio is the best in two of the three criteria with Treynor ratio standing at -0.007012 and Jensen Index at 0.000044, but the worst in Sharpe ratio of -0.32495. TTT only demonstrates a better performance in Sharpe ratio. To conclude, two of

three indicators show that TTT is not the optimal alternative.

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VI. Conclusions and Recommendations

In this research, whether the ETF is an efficient investment instrument for Taiwans investors is examined. ETFs characteristics and performance of ETF are first addressed. It is obvious that ETFs have become an overwhelming investment product in the United States with an average daily volume exceeding half of AMEXs total trading and its fast-growing asset size reached US$102.14 billion in 2003. The success of ETFs suggests that ETFs are a feasible and convenient investment vehicle. Taiwans first ETF, Polaris Taiwan Top 50 Tracker Fund, was launched in June 2003. The creation and redemption mechanism sustains a small deviation of NAV from market price and the design of TTT combines the merits of traditional securities and mutual funds. When examining differences in return based on the price of the TTT and its NAV during the first ten months of listing, it is found that the average difference in return is less than 0.000451 per day. The principal tool that restricts the deviation of price from NAV is the ability of investors to create or delete ETFs at the end of every trading day by turning in or receiving the physical bundle of securities that back up the ETF. In addition, the differences between the TTT NAV and the Taiwan 50 Index averaged at 0.014037 because cash dividends receiving from holding underlying shares were excluded from the Index while included in the TTT NAV. In addition to the characteristics and performance of TTT, this research further examined whether ETF is a better alternative for Taiwans investors by applying the mean-variance analysis, the portfolio theory and portfolio evaluation techniques. In the mean-variance analysis, the empirical result shows that TTT has a smaller standard deviation as compared to its fifty underlying stocks, which makes TTT an attractive investment vehicle. However, when the study explored further, it is found that the portfolio performance of TTT was worse than the market portfolio and the theoretical optimal portfolio. The empirical results suggest that TTT, based on the market

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capitalization in determining the allocation weights, is not the most appealing portfolio while the hypothetical portfolio, based on the Markowitzs theoretical framework, is showing more attraction during the sample period. In an attempt to further validate the results, the examination was extended to an out-of-sample period. Statistical results prove that the newly proposed portfolio is still better than TTT in two of three performance measures, implying that TTT is relatively less satisfactory. In other words, investors can employ Markowitzs framework to construct a better portfolio than the TTT. After factoring in the various costs of portfolio construction and adjustments and taxes, the adoption of the theoretical portfolio is still beneficial and preferred. In other words, an investor will be better off if the TTT could have been constructed on the ground of the theoretical doctrine instead of market capitalization. Practically, TTT does provide a diversification and other benefits; especially, when the Markowitzs doctrine is not well-known and the allocation weights are not easily accessible to investors. As well, it should be noted that it is never an attempted goal of any ETF to achieve an efficient portfolio. Therefore, from the perspective of investment, ETF is a good investment instrument by combining the merits of stocks and mutual funds; while based on portfolio theories, the constituents of ETF can be reconstructed and improved to achieve a more efficient goal. To expand Taiwans ETF market further and expect that Taiwans financial institutions can design a better financial instrument for investors, the following directions are proposed: First, Taiwan should establish a mechanism to govern share borrowings for those investors with an intention of ETF creation. There are fluctuation limits on securities in Taiwans stock market, causing a problem in carrying out the creation and redemption process. To illustrate, when some shares on the constituent list go up and hit the upper limit, e.g., +7%, basically the trading of these stocks will be very limited and thus investors can not buy enough shares for ETF creation. However, if the regulations about share borrowings exist, investors can borrow these shares through this avenue, further creating the flexibility and suitability of

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ETFs in Taiwan. Second, Taiwan should develop the ETF-related financial products in a more affordable way. To increase the liquidity of TTT and the hedging trading opportunity, Taiwan introduced TX50 futures and TTT at the same time. However, currently, the poor trading volume in the TX50 futures market has admitted the failure in the product design due to its unaffordable contract size. In the United States, ETF-related financial products, such as options and futures, are also traded. These derivatives and ETFs encourage and increase liquidity for each other. In Korea the development of ETF has encouraged the further developments in the option market, representing positive interactions between various financial products (Ou, 2003b). Third, various ETF products with different underlying indexes, markets and industries should be pursued. According to Taiwans regulations, the targeted indexes for ETFs have to be designed or approved by Taiwans Stock Exchange with the requirements of representation, transparency and tradability. However, those approved indexes are presently designed by MSCI, FTSE and so on. According to the empirical results in this study, these benchmarks in terms of market capitalization may not be the optimal portfolios. It is recommended that Taiwans regulatory authority should approve more benchmarks fitting the requirements and then the scopes and numbers of ETFs can be further expanded to create more trading strategies in risk management.

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Notes:
1. The Nasdaq-100 Index Tracking Stock was originally traded with a symbol of QQQ and was changed to QQQQ and moved to NASDAQ on December 1, 2004. One stock basket, the smallest amount for the creation or redemption in the primary market, is equal to one million shares in this case. 1 lot is equal to 1,000 shares. It is acknowledged and should be kept in mind that at the time of this study the data set is quite short given the fact of TTTs rather short history. It is not the intention of this research to generalize the results of this research to all ETFs. However, the results obtained from this study do provide some insights and add another dimension to future development and the design and research of ETF products. The first adjustment was done in January 2004 with Realtek (TSE code: 2377) being deleted and Formosa Petrochemical (6505) being added. The second modification was completed in April 2004. Cheng Hsin (2105), Ritek (2349), Inventec (2356) were deleted while Walsin Lihwa (1605), Shin Kong Financial Holdings (2888) and Quanta Display (3012) were taken into TTT (Polaris SITC, 2004). The program used here for finding an optimal portfolio is designed by Anthony Sun who employs the visual basic application in Excel. Please refer to the following website: http://www.geocities.com/wallstreet/9245/. For example, in Scenario One, Walsin Lihwa (1605) will take the place of Cheng Shin (2105), Shin Kong (2888) will replace Ritek (2349) and Quanta Display will substitute Inventec (2356). Other matching scenarios are presented in the same way with different pairings. The typical transaction cost of 0.1425% of the trading value and a 0.1% transaction taxes (See Table 1) were applied to the calculation. As well, since TTT is rebalanced every quarter, two complete portfolio adjustments were assumed and included in the hypothetical portfolio during the studied period.

2.

3. 4.

5.

6.

7.

8.

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