Read Response.indd text version

November 10, 2010

On November 8, 2010, the Kauffman Foundation released a report titled, "Choking the Recovery: Why New Growth Companies Aren't Going Public And Unrecognized Risks of Future Market Disruptions" that was highly critical of the exchange-traded fund (ETF) industry. Below is a response to that report from WisdomTree:

This week a study was released by the Kauffman Foundation that suggested that ETFs were responsible for a host of financial events including the "flash crash", the sluggishness in the IPO market and rising correlations across asset classes. The claims were so broad and misplaced that ETFs were lucky not to be associated with global warming and the BP oil spill. WisdomTree is taking the opportunity to respond because we believe the Kauffman report reflects a serious misunderstanding of the structure and operation of ETFs and the increasingly important role they play in world financial markets. We believe ETFs represent one of the most significant and investor-friendly financial innovations of the last 50 years. In our opinion, the growing popularity of ETFs has occurred because many investors believe ETFs offer a set of benefits not found in other financial products. ETFs offer retail, and other, investors daily portfolio transparency, intra-day liquidity, tax efficiency and relatively low fees. ETFs have been around for close to two decades. We believe they are structurally sound and have avoided issues that have impacted other financial products, such as market timing and late trading. Investors are entitled to accurate and informed analysis about ETFs and this letter is intended as a step in this education process. ETFs are open-end funds whose share count can increase or decrease on any day. In order to create shares, market makers typically deliver securities and cash to the ETF. Once the ETF has received the shares and cash it issues ETF shares of equal value to the market maker. The market maker, in turn, sells those shares into the secondary market. In order to redeem ETF shares the market maker must deliver those ETF shares to the ETF. In return, the ETF gives the market maker securities and cash of equal value. ETF shares trade in the secondary market at market prices. Like other securities, ETF shares can be sold "short." In a typical short sale, the seller sells a security that it does not own in anticipation that the price of the security will go down. The Kauffman Foundation report suggests that ETFs with significant "short" interest that exceeds the number of shares issued by the ETF might somehow be unable to honor their redemption obligations. This is absolutely incorrect. What Kauffman is missing when they fret over the short interest in an ETF is the distinction between the primary market for creating and redeeming ETF shares (the only time the ETF sponsor is involved in the transaction) and the secondary market for trading the shares (which has zero impact on the funds). The shares issued by an ETF are backed by the ETF's portfolio securities. An ETF cannot issue new shares unless it receives securities or cash of equal value. It goes without saying that an ETF can only redeem shares that have been created. Similarly, any short position in ETF shares must be satisfied by ETF shares that have already been created. Thus, significant short activity actually drives the creation of new ETF shares. There is simply no way that an ETF would be unable to honor valid redemption requests at net asset value.

As for the report's other claims, it is absurd to say that the ETFs caused the "flash crash" in May of this year. This was made very clear by the recent SEC and CFTC report on the "flash crash" which exonerated ETFs. Market events such as the "flash crash" generally affect all traded securities. Some ETFs were hard hit during the "flash crash" because they have taken a significant share of trading volumes and because the underlying securities in which they invest were impacted by market events. Are ETFs derivatives as the report claims? ETFs are, in fact, derivatives in the most basic sense: they derive their value from the securities that they hold. In this respect they are no different than other pooled investment vehicles, including mutual funds. It is hard to see why this raises any material issues or concerns. Are ETFs hurting the IPO market as the report claims? This one is hard to fathom as ETFs are some of the largest holders of listed securities. The goal of most IPO companies is for their shares to be widely distributed. If a company has an IPO and is chosen to be an index, an ETF based on the index would generally hold shares of the company. This would potentially increase demand for such shares and potentially benefit the issuing company. One additional claim in the report is that ETFs are leading to higher correlations among returns on securities. There is possibly some merit to this as investors purchasing ETFs are indirectly buying baskets of securities instead of stockpicking individual securities. ETF assets currently represent less than 10% of fund industry assets so the report's focus on ETFs is somewhat puzzling. In addition, there are many other factors at work including the globalization of securities markets, unusual Federal Reserve policy and a general compression of cycles in the investment world. At their core, ETFs are designed to deliver the following key benefits: · Intraday Liquidity ­ ETF shares trade at market prices like other listed securities. · Daily Transparency ­ allows investors to "know what they own" daily and enhances portfolio allocations. · Tax Efficiency ­ a hallmark of ETFs related to the creation/redemption mechanism has historically led to zero capital gain distributions in nearly all equity ETFs. · Relatively Low Fees ­ ETFs charge relatively low fees and are cost-efficient products. (Ordinary brokerage commisions apply.) · Flexibility - investors can buy and sell ETF shares through a variety of accounts and are not subject to holding period or minimum investment requirements.

So why are ETFs coming under attack at this time? First, ETFs have had a significant impact on the way institutions, and people, invest. In this sense, they are a disruptive technology that is changing the face of financial services. As part of the natural evolution of the product, ETFs will be subjected to scrutiny. The ETF industry should welcome such scrutiny and do its best to educate investors and correct any misconceptions. Second, the pace of innovation in ETFs is staggering as the industry has gone from traditional indexed equities to fixed income, currencies and active strategies in a very short time. Along with that pace, the ETF industry has a large responsibility to properly educate investors on the way ETFs work and the pros and cons of ETF investment.

In conclusion, we believe the ETF structure represents an important innovation and that ETFs offer investors a number of potential benefits. The ETF structure has been battle tested in many volatile market environments and has performed admirably. ETFs are often the most actively traded products on any given day and are used by both the most sophisticated investors on the planet as well as smaller, buy and hold investors. With over $1 trillion invested in ETFs worldwide it becomes clearer every day that ETFs are gaining acceptance. The processes of evolution and innovation are rarely free of discord. ETFs should be thoroughly prodded, poked and questioned by investors. We believe that doing this correctly will lead to better understanding of the unique features of ETFs and that investors will benefit from increased knowledge and understanding. Bruce Lavine President & Chief Operating Officer WisdomTree Investments

Bruce Lavine joined WisdomTree in May 2006 as President & COO. Prior to that, he spent 10 years with Barclays Global Investors (BGI), primarily in its exchange-traded funds business. During his tenure at BGI, Bruce held various leadership positions including, CFO and Director of New Product Development for Barclays iShares, where he lead the effort to launch more than 50 iShares products. Most recently, Bruce served as Head of iShares Europe based in London. Prior to joining BGI, Bruce worked as a plan sponsor helping to manage the assets of the Bristol-Myers Squibb pension plan. He holds a BS and an MBA from the University of Virginia as well as the CFA designation. Bruce Lavine is a registered representative of ALPS Distributors, Inc.


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The sources, opinions and forecasts expressed are as of November, 2010 and may not actually come to pass. This information is subject to change at any time based on market and other conditions and should not be construed as a recommendation of any specific security. Past performance is not a guarantee of future results There are risks associated with investing, including the possible loss of principal. Past performance does not guarantee future results. International investing involves special risks, such as currency fluctuation or political uncertainty. Investments in real estate involve additional special risks, such as credit risk, interest rate fluctuations and the effect of varied economic conditions. Funds focusing on a single country, sector and/or smaller companies generally experience greater price volatility. Carefully consider the Funds' investment objectives, risks, charges and expenses before investing. A prospectus containing this and other important information is available by calling 866.909.WISE (9473) or by visiting Please read the prospectus carefully before you invest.

WisdomTree Funds are distributed by ALPS Distributors, Inc. Glossary of Terms: Correlation is a statistical measure of how an index moves in relation to another index or model portfolio. A correlation ranges from -1 to 1. A correlation of 1 means the two indexes have moved in lockstep with each other. A correlation of -1 means the two indexes have moved in exactly the opposite direction. 100 Basis Points = 1 percentage point. SEC = Securities and Exchange Commission CFTC = U.S. Commodities Futures Trading Commission Market makers refers to a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds. © 2010 WisdomTree Investments, Inc. "WisdomTree" is a registered mark of WisdomTree Investments, Inc. WIS002880 11/2011



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