WO2008151295A2

WO2008151295A2 - Index replicating mutual or hedge fund and tradeable as etf

Info

Publication number: WO2008151295A2
Application number: PCT/US2008/065969
Authority: WO
Inventors: Phil Bak; Anthony Dudzinski
Original assignee: X-Shares Advisors Llc
Priority date: 2007-06-05
Filing date: 2008-06-05
Publication date: 2008-12-11
Also published as: WO2008151295A3

Abstract

A method for creating an index that replicates performance of a specified fund that includes a plurality of holdings issued by companies. The method includes defining plural subsets of the holdings in the specified fund, and, for each subset, determining correlation in performance between that subset and the fund. The method also includes selecting, as a replication index for the fund, one subset from among the plural subsets, based on the correlations in performance between the respective subsets and the fund. The method further includes creating an ETF based on the replication index, and making the ETF available for trading.

Description

TITLE

INDEX REPLICATING MUTUAL OR HEDGE FUND AND TRADEABLE AS

ETF

RELATED APPLICATIONS

[0001] This application claims the benefit of the filing date of provisional application no. 60/941,977, filed June 5, 2007, the entire contents of which are hereby incorporated herein by reference. This application also hereby incorporates by reference herein the entire contents of prior applications nos. 11/476,830, filed June 29, 2006, and 10/920,267, filed August 18, 2004.

BACKGROUND OF THE INVENTION Field of the Invention

[0002] The present invention relates generally to the field of financial investment instruments, and more particularly to creating one or more indexes to replicate one or more specific mutual and/or hedge funds.

Description of the Related Art [0003] An exchange-traded fund ("ETF") is an investment company which offers shares that are listed on a national securities exchange. Shares of ETFs, because they are listed on a stock exchange, can be traded throughout the day on that stock exchange at market-determined prices. ETFs typically invest predominantly in the securities of companies comprising an underlying index. As such, the ETF itself is an index fund. [0004] What is needed are improved techniques for creating indexes in order to expand upon the investment opportunities available to investors.

SUMMARY OF THE INVENTION

[0005] Accordingly, it is one object of the present invention to provide a method, apparatus, system, and program for converting actively managed mutual funds or hedge funds into passive replication indexes with the purpose of using those indexes to create exchange-traded funds (collectively, the "ETFs" and individually, an "ETF"). [0006] This object is achieved, according to the present invention, by providing a method for creating an index that replicates performance of a specified fund that includes a plurality of holdings issued by companies. The method includes defining plural subsets of the holdings in the specified fund, and, for each subset, determining correlation in performance between that subset and the fund. The method also includes selecting, as a replication index for the fund, one subset from among the plural subsets, based on the correlations in performance between the respective subsets and the fund. The method further includes creating an ETF based on the replication index, and making the ETF available for trading.

[0007] The subset that is selected may be the subset having the highest correlation with the fund. The determining and selecting may be repeated from time to time in such manner as to maintain the highest possible correlation between the currently selected subset and the fund.

[0008] Further features and advantages, as well as the structure and operation, of various example embodiments of this invention are described in detail below with reference to the accompanying drawings. BRIEF DESCRIPTION OF THE DRAWING

[0009] The features and advantages of the example embodiments of the invention presented herein will become more apparent from the detailed description set forth below when taken in conjunction with the drawings in which like reference numbers indicate identical or functionally similar elements.

[0010] Fig. 1 is a flow chart illustrating generally a method of creating an index according to a preferred embodiment of the present invention.

[0011] Fig. 2 is a schematic diagram illustrating a system for use in implementing such method.

DETAILED DESCRIPTION OF THE PREFERRED EMBODIMENTS [0012] The present invention will now be described in detail with reference to what are at present the preferred embodiments. It will be understood, however, that the invention is not limited to these embodiments.

[0013] An ETF is an investment vehicle traded on primary exchanges, as are stocks or bonds, but differs in being a collection or basket of assets such as stocks, bonds, or futures. Institutional investors are allowed to redeem shares of the ETF for shares of the underlying asset or, alternately, to trade shares of the underlying asset(s) for shares of the ETF. This feature makes it possible for such investors to engage in arbitrage and causes the value of the ETF to track the aggregate value of the underlying assets. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500. An ETF takes the form of a collective investment scheme and trades on a securities exchange at prices closely related to its net asset value. An ETF thus combines the valuation feature of a mutual fund or unit investment trust with the tradability feature of a closed-end fund.

[0014] It is particularly contemplated that the present invention is put into practice by using it to convert actively managed mutual funds or hedge funds (collectively, the "Funds" and, individually a "Fund") into passive replication indexes (collectively, the "Indexes" and individually, an "Index") with the purpose of using those indexes to create exchange-traded funds (collectively, the "ETFs" and individually, an "ETF"). The following description will be based on this as an illustration of the general method. [0015] Fig. 1 is a flow chart illustrating generally a method 100 of creating an Index, and, specifically, of converting Funds into Indexes with the purpose of using those indexes to create ETFs, according to a preferred embodiment of the present invention. Of course, while the method 100 of Fig. 1 contemplates an ETF-type structure, the present invention need not necessarily be limited thereto, and other structures may be applied.

[0016] The Index-Creation process allows one to verify the application of the process detailed below as it relates to a specific Fund and to quantify the effectiveness of the overall strategy. Through this process, it is possible to back-test the Index and perform correlation studies between the Fund and the replication Index. [0017] In step 102, historical quarterly reports are obtained that list the related Fund's holdings, including the percentage of total net asset value ("NAV") for each separate security held in such Fund. If the NAV is unavailable, the Market Value for each separate security held in such Fund is acceptable as it can be used to derive the NAV. [0018] Market Value is defined as: MV = Ps * N, where

Ps = Price of security at the end of the quarter, and N = number of shares held by the fund.

[0019] These holdings can be obtained, e.g., from the Fund's reports, from public 13F filings, or from the Fund company.

[0020] In step 104, the total percentage of the value from top holdings is summed. "Top holdings" is defined as the amount of holdings from which the highest correlation between Fund and the replication Index is reach. For example, if the replication has the highest correlation using 35 stocks, "top holdings" would be equal to the top 35 stocks in the Fund. In one embodiment, this process is repeated for every number of holdings between 25 and 40 (or a predetermined range) until the highest correlation between the replication Index and the related Fund(s) exists. The NAV for each security in the related Fund is calculated at the end of each quarter within the top holdings by dividing its respective security's NAV by the combined NAV of the top holdings (the "Top

NAV").

[0021] Replication weighting is defined as:

RW - = NAVs % NAVth, where

RW = Replication Weighting,

NAVs = Net Asset Value of each security, and

NAVth = Net Asset Value of the top holdings.

[0022] In step 106, the daily total returns for each of the replication Index holdings for the quarter that directly follows the date of the holding report are gathered. [0023] Daily total returns are defined as:

DTR = (Ps2 % PsI)-I, where

DTR = Daily Total Return,

Ps2 = closing price on a given day, and

PsI = closing price on the previous day.

[0024] In this embodiment, all dividend payouts are theoretically reinvested for the purpose of daily total returns. All corporate actions are taken into effect to accurately reflect daily total return prices.

[0025] In step 108, for the day following the date of the holding report, the daily total return plus one is multiplied by the replication Index weighting, times the value of a theoretical initial investment, using the equation:

Day val 1 = (DTRl + 1) * replication weighting * $value invested, where

Day val 1 = Value of the holding within the replication Index on the 1^st day of the quarter; DTRl = daily total return of the day following the date of the holding report; Replication weighting = Weightings of the top holdings found in steps 102 and 104; $value invested = An assumed investment (it can be any round number; typically it is

$1000).

[0026] In step 1 10, on days following the day following the date of the holding report, the daily total return plus one is multiplied by the previous value of each individual stock to allow for asset drift, using the equation:

Day val n = (DTRn + 1) * Day VaI n-1, where

Day val n = Value of the holding on a given day, DTRn = daily total return of a given historical day, and Day val n-1 - Value of the holding on the previous day.

[0027] Step 112 includes summing the values of the individual daily value in the replication fund for daily index values, using the equation:

Index Value = Σ top holdings n * Day val n, where

Index Value = Value of the replication Index at a given time, Top holdings n = The top holdings, per steps 102 and 104, on a given day, and

Day val n = Value of a holding on a given day, per step 110.

[0028] In step 114, the daily index value is divided by the previous day's index value minus one for the daily return of the replication Index, using the equation:

DTRri = (Index Value n % Index Value n-l)-l, where

DTRri = Daily total return of the replication Index,

Index Value n - Value of the cumulative investment in the replication Index on a given day, and Index Value n-1 = Value of the cumulative investment in the replication Index on the previous day.

[0029] In step 1 16, steps 102 and 104 are repeated on the first day of the following quarter, to derive new top holdings and weights from the related Fund's holdings. [0030] In step 118, the index value from the previous day replaces $ Value Invested on the first day of all quarters following the first one. As disclosed in step 108, $ Value Invested = Assumed initial investment, which is typically $1000. [0031] Step 120 includes correlating the daily total returns of the related Fund versus the daily total returns of the replication Index over the entire time period of the study. Such correlation is defined by the following equation:

COrTeI(XJ₁

X = the sample mean of the daily total returns of the replication Index, and Y = the sample mean of the daily total returns of the related Fund.

[0032] Step 120 provides a verification that the process has worked properly, and also gives the user a measure of the accuracy with which the replication has been achieved. [0033] It is of course to be understood that the method 100 is not limited to the details presented, and that various embodiments to the method 100 within the scope of the invention can of course be readily envisioned by a person having ordinary skill in the art.

[0034] The invention encompasses the method 100 itself as well as a software product for use in performing the method.

[0035] An example of a system that can be used by an advisor to create an Index, specifically, to convert Funds into Indexes with the purpose of using those indexes to create ETFs, according to the present invention, is shown schematically in Fig. 2. In the example shown, an interface 201 is connected to a source of relevant information, which may be received via the Internet (as shown) and displayed to the advisor. Alternatively, the interface 201 or other means can be used to receive the needed information from a local source. A processor that includes a CPU 202, memory 203 that includes a portion storing permanent software, including an operating system software and relevant application software, and also a portion that can be used to execute that software, can be used to perform certain functions in accordance with the methods of the present invention (for example the method 100 shown in Fig. 1). A display system 204 is provided, and may for example be any display system capable of changing display content in real time and of showing the required amount of information. An input means is provided as well, shown here as a keyboard 205, by means of which a user or operator may input instructions. The CPU 202 executes the necessary program software to receive data through interface 201 and store the data in the memory system 203, to cause information from memory system 203 to be displayed on display system 204, and to receive and execute instructions via keyboard 205. Elements 201-205 may for example be a conventional desktop or laptop computer system.

[0036] When the system illustrated in Fig. 2 is used by the advisor to convert Funds into Indexes with the purpose of using those indexes to create ETFs according to the present invention, the advisor causes the processor to obtain the necessary information from memory 203 or, if the information is not already present there, from a local or remote source. The advisor can use this information to perform the steps of the method 100 of Fig. 1.

[0037] The present invention or any part(s) or function(s) thereof may be implemented using hardware, software or a combination thereof and may be implemented in one or more computer systems or other processing systems. It is noted that the various components of the present invention may be controlled by one or more modules coupled to the various components. The modules can operate in accordance with software control programs and operating routines stored in an associated memory or memories. The modules and their sub-modules can write and/or read information to/from the memory or memories, and in this way, can perform operations in accordance with the system, method, and apparatus of the present invention. The modules may be implemented using hardcoded computational modules or other types of circuitry, or a combination of software and circuitry modules. Software routines for performing the modules can, in one embodiment, be stored as instructions in a memory and can be executed by a processor of a control module.

[0038] In an embodiment where the invention is implemented using software, the software may be stored in a computer program product, a computer program medium, or a computer-readable medium, and loaded into a computer system using a removable storage drive, a hard drive, or a communications interface. The control logic (software), when executed by a processor, causes the processor to perform the functions of the invention as described herein.

[0039] In this document, the terms "computer program medium" and "computer usable medium" are used to refer generally to media such as a removable storage drive, a hard disk installed in a hard disk drive, and signals. Also, "computer-readable medium" is used to refer generally to media such as a storage drive, CD, hard drive or other tangible object that can store a program. These computer program products provide software to the system.

[0040] While various embodiments of the present invention have been described above, it should be understood that they have been presented by way of example, and not limitation. It will be apparent to persons skilled in the relevant art(s) that various changes in form and detail can be made therein without departing from the spirit and scope of the present invention. Thus, 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.

Claims

WHAT IS CLAIMED IS:

1. A method for creating an index that replicates performance of a specified fund that includes a plurality of holdings issued by companies, the method comprising the steps of: defining plural subsets of the holdings in the specified fund; for each subset, determining correlation in performance between that subset and the fund; selecting, as a replication index for the fund, one subset from among the plural subsets, based on the correlations in performance between the respective subsets and the fund; creating an ETF based on the replication index; and making the ETF available for trading.

2. The method of claim 1, wherein, in the selecting step, the subset that is selected is the subset having the highest correlation with the fund.

3. The method of claim 2, wherein the determining and selecting steps are repeated from time to time in such manner as to maintain the highest possible correlation between the currently selected subset and the fund.

4. The method of claim 1 , wherein any one or more of said steps are performed using a computer.

5. A computer-readable storage medium storing control logic for causing a computer to create an index that replicates performance of a specified fund that includes a plurality of holdings issued by companies, the control logic comprising:

first computer-readable program code for causing the computer to define plural subsets of the holdings in the specified fund; second computer-readable program code for causing the computer to determine, for each subset, correlation in performance between that subset and the fund; third computer-readable program code for causing the computer to select, as a replication index for the fund, the subset having the highest correlation in performance with the fund from among the plural subsets; fourth computer-readable program code for causing the computer to create an ETF based on the replication index; and fifth computer-readable program code for causing the computer to make the ETF available for trading.