By: Guillermo Cano, Global Index Policy Manager, Russell Indexes AUGUST 2009

Barry Feldman, Senior Research Analyst, Russell Indexes

Joseph Smith, Associate Portfolio Analyst, Client Investment Strategies

ETFs, Swaps and Futures

Trade at Index Close (TIC) and the coevolution of financial markets1

Abstract
Trade at Index Close (TIC) is a new futures order type that allows
futures contracts to be traded at a price relative to the close of an
underlying cash (e.g., equity or fixed income) index. TIC allows a
significant reduction in the tracking error risk associated with using
futures to obtain market exposures. This risk reduction could allow some
ETF sponsors using derivatives-based architectures to shift from using
swaps to using futures when futures contracts that deliver the proper
exposures are available. This could facilitate the introduction and growth
of new futures contracts as well. ETFs obtaining market exposures
through futures contracts will have lower costs, increased transparency
and lower levels of counterparty risk. The expansion of the breadth of
futures markets will reduce the cost of swaps and allow swap providers
to more economically deliver targeted exposures.

Introduction
State Street’s SPDR S&P 500, a unit investment trust that perfectly mirrors the holdings of
the S&P 500 index, was the first successful ETF (exchange-traded fund) to launch, in 1993.
In the years since, the phenomenal growth in the number of ETFs and their assets under
management (AUM) has been paralleled by a steady evolution in the products’ structures.
Today’s standard holdings-based ETFs need not exactly replicate index holdings.
Additionally, synthetic ETFs that utilize swaps or futures to provide desired exposures are in
increasingly wide use. Derivatives allow ETF providers to more easily track an index and to

1
We wish to thank Rolf Agather, Rob Bishop, Lisa Cavallari, Ted Doukas, Grant Gardner, Jordan Farris,
Mary Fjelstad, Tom Fletcher, Sharon Hammel, Ethan Kahn, Suzanne Ropeta, Paris Smith, Lori Stoner,
Michael Thomas, Patricia Welch and Sara Wilson for their knowledge, help and time in completing this work.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets
provide leveraged and inverse exposures. The future evolution of ETFs is likely to involve
more, rather than less, derivatives exposure as new investment strategies—such as
leveraged, inverse, 130/30 and hedge fund replication—make their appearance as ETFs.
Swaps, contracts that oblige two parties to exchange return streams for a price, are the
primary method ETF providers use to obtain synthetic exposures. In the wake of the failures
of Lehman Brothers and Bear Stearns, two major swap providers, the increasing use of
derivatives products in ETFs gives rise to well-founded concern. We note, however, that in
a properly constructed ETF, only the return stream, and not the principal, is subject to
counterparty risk, the risk that one of the parties to the swap will not honor its obligation.
Swaps can be structured to deliver total return exposure, while futures deliver only price
return. An ETF sponsor using futures to gain market exposure thus has to provide the
dividend return component. The futures contract price is discounted by expected dividend
payments, but there is some risk of unexpected dividend changes. This is an added
operational complexity, and a source of some risk.
Providers of leveraged and inverse ETFs generally use swaps even when liquid futures
exist for the underlying index. This is unfortunate, for both ETF investors and futures
markets. ETF investors face higher expenses and increased counterparty risk. Futures
markets lose volume and outstanding interest that could increase the liquidity of futures
contracts and drive the success of new contracts. Going forward, swap providers can use
futures markets to offset or “lay off” more of their risk.
A natural model for ETF and derivatives coevolution is easy to describe. ETF products,
many of which are swap-based, are able to gather AUM if they can attract investment or
active trading interest. The most actively traded ETFs identify market exposures that may
be natural candidates for new futures contracts. New futures contracts, in turn, would
reduce the operating expenses of related ETFs by providing the direct market exposures.
New futures contracts would also reduce the costs of the more specialized swap exposures
correlated to these contracts.
This type of coevolution is not seen in derivatives markets today. Even leveraged and
inverse products based on the S&P 500 and the Russell 2000® typically use swaps, despite
the availability of highly liquid futures contracts for these indexes. It appears that providers
of leveraged and inverse ETF products are wary of using futures due to the difficulty of
tracking the underlying index with futures exposures. ETF sponsors need to track the index
close, and the closing price of the futures contract usually will not match the index close.
This constitutes the basis risk between cash and futures markets, and such risk could
introduce sufficient tracking error risk to induce ETF providers to favor swap contracts. The
swap provider absorbs this risk. ETF sponsors receive a return stream with less tracking
error, but at the cost of less transparency and greater counterparty risk.
This article considers the potential for a futures contract trading innovation—the Trade at
Index Close (TIC) order type—to alter the balance in favor of using futures contracts when
available to achieve more efficient exposures and thus mitigate basis risk. TIC allows a
futures trader to enter a buy or sell order that is priced relative to the closing price of the
underlying equity index. The ETF sponsor is able to receive a fixed price for the futures
contract relative to the close for a fee. Because this fee can be more competitively
determined in futures markets, there is every reason to believe that it will be lower than the
cost of an equivalent swap based on the equity index close.
In August 2008, Intercontinental Exchange (ICE) introduced TIC for trading Russell 1000®
and Russell 2000 futures contracts (ICE [2008] and Haughton and Smith [2008]). Russell
Investments has a patent pending on the TIC order type. As of this writing, TIC volumes are
very low, and trades must be arranged with brokers or market makers. We believe,
however, that TIC is a natural trade type and that once natural users, such as ETF

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p2
providers, make their interest known, it will quickly come into wide use. We also believe that
TIC could provide a dramatic increase in effective futures liquidity. This article explains why.
In Section 2 we review the evolution of product innovation in the ETF industry. In Section 3
we discuss current challenges and limitations ETF providers face in creating new products.
Section 4 is about Trade at Index Close. TIC is described in detail; it is compared to other
order types with which readers may be more familiar, and we illustrate the potential benefits
of TIC with some analysis of equity and futures contracts prices for the S&P 500 and the
Russell 2000. Section 5 is our consideration of potential innovations with future ETF
products and their structures. In the conclusion we summarize the potential for TIC to allow
a better coevolution of ETF and derivatives markets.

The evolution of ETF product innovation

Most investors are not aware of the evolution of ETF architectures that has taken place in
parallel with the well-known explosion in the numbers of ETFs and AUM. According to
Barclays Global Investors’ (BGI) ETF Landscape Industry Review for July 2009, there are
now 1,707 ETFs with 3,066 listings on 42 exchanges globally. Global ETF AUM also stood
at $862 billion at the end of July 2009, according to BGI. The United States remains the
largest market for ETFs, but the number of ETFs offered in Europe and Asia has increased
dramatically. While a significant portion of AUM will continue to be represented by the
earlier-stage, index-based ETFs, there has been a dramatic increase in the cash net inflows
into newer ETF structures focused on more specialized investment strategies.
First-generation ETFs initially focused on full replication of a broad index by holding the
underlying securities. The most popular of these ETFs include the United States-based
SPDR S&P 500 ETF (SPDRs), Dow Diamonds (DIAMONDs) and PowerShares QQQ
(QQQQ).2 These ETFs are structured as unit investment trusts (illustrated in Figure 1). ETF
sponsors who use this structure are not allowed to manage the underlying securities or
cash in the portfolio in any manner. In addition, these ETFs are bound to the strict
diversification limits set forth by the SEC in the United States. These restrictions by default
limited first-generation ETFs to investing in broad indexes.

Figure 1 / Structure for First-Generation ETFs

To address many of the inherent limitations, later-stage first-generation ETFs were set up
as open-end funds in the United States and as UCITS III funds in Europe to address the
standard in-kind creation and redemption process and the management of the portfolios.3
Many of these ETFs provide exposure through optimized sampling techniques geared
toward identifying a basket of securities that closely match the underlying index (this

2
These ETFs replicate the performance of the S&P 500, the Dow Jones Industrial Average and the NASDAQ
100 Index, respectively. Koesterich (2008) provides more detailed descriptions of each ETF legal structure,
including exchange-traded unit investment trust, exchange-traded open-end fund and exchange-traded
grantor trust. Exchange-traded unit investment trusts and open-end funds must be granted exemptive orders
by the Securities and Exchange Commission in the United States in order to operate.
3
More information regarding the in-kind creation and redemption process can be found in Gastineau (2002).

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p3
structure is illustrated in Figure 2). These ETFs are considered to be fully funded, although
there is potential exposure to counterparty risk through participation in securities lending
programs. This structure has provided for ETF sponsors a select number of ways to
enhance the value of their ETF offerings. Many ETF sponsors, including BGI, Vanguard and
Invesco PowerShares, have generated revenue through securities lending. This structure
can also help reduce ETF management fees, enhance liquidity and price discovery in the
underlying securities and the ETF shares, and build more granular ETF exposures that
access more asset classes and markets around the world.

Figure 2 / Structure for Later-Stage First-Generation ETFs

Second-generation ETFs use exchange-traded derivatives or OTC swaps to get their

market exposure. Such ETFs deliver both broad and focused exposures across virtually
every asset class, and they also attempt to replicate returns that mimic active (i.e.,
traditionally actively managed) investment strategies. This structure is illustrated in Figure 3.
Such examples include the leveraged and inverse ETFs offered by ProShares, Direxion
Shares and Rydex in the United States, and by Lyxor, Deutsche Bank and ETF Securities in
Europe. Futures and swaps offer leverage-oriented ETF sponsors greater flexibility to gain
quick access to desired exposures, efficiency with re-hedging portfolios from day to day and
reductions in implementation costs. A key part of this process is the need to lock in the
closing spot price of the index from day to day, in order to capture the desired return stream
the following day. ETFs trade continuously at market-determined prices, but ETF in-kind
creation and redemption transactions take place only at the end-of-day net asset value
(NAV) price. To date, swaps have been the preferred derivatives choice for implementation,
due to their potential for customization and for minimizing tracking error. Although such
enhancements have encouraged growth in second-generation ETFs, many questions have
arisen within the investment community about the amount of transparency provided and the
potential for counterparty risk embedded in these portfolios.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p4
Figure 3 / Structure for Second-Generation ETFs

Current challenges and limitations

Innovation in ETFs has resulted in product structures that are compliant with regulatory
guidelines, such as UCITS III (Undertakings for Collective Investment in Transferable
Securities). The original UCITS regulation, first introduced in 1985, defined a series of
investor protections which included independent oversight procedures, disclosure
requirements and a limit on investments restricted to transferable securities. UCITS III
introduced provisions that allowed companies to “passport”4 investment product throughout
all member states, which effectively created a single European market regulatory scheme.
UCITS III also broadened the range of financial instruments that could be held within a
portfolio. These included exchange-traded derivatives such as futures and options as well
as over-the-counter derivatives such as swaps. UCITS providers use derivatives to manage
risk and reduce transaction costs. As the types of eligible assets within UCITS have
increased, developers of investment products are creating sophisticated strategies that
were previously available only to large institutional investors.
While this article details the history and evolution of ETFs in Europe and the United States,
it is important to note that the UCITS regulatory framework has found growing acceptance
in Asia. According to the European Fund and Asset Management Association (EFAMA), in
2007 “90% of net sales of Luxembourg and Dublin based Ucits funds originated in Asia.”
EFAMA reported that “this has brought Ucits funds sourced from Asia to €110 billion, or
14.3% of total international assets.”5
The International Swaps and Derivatives Association (ISDA) describe the differences
between swaps or privately negotiated (OTC) derivatives and futures as follows:
First, the terms of a futures contract—including delivery places and
dates, volume, technical specifications, and trading and credit
procedures—are standardized for each type of contract. For swaps,
the same characteristics are subject to negotiation by the parties to
the contracts. Second, futures contracts are always traded on an
exchange, while swaps are traded on a bilateral basis. Third, those
who engage in futures transactions assume exposure to default by

4
The term “passport” refers to the practice in which a Ucits fund registered within one jurisdiction can be sold
throughout all EU member states without requiring any additional authorization.
5
See “Asian investors keep buying UCITS funds, while Europeans sell out,” Angus Foote (July 2008), at
Citywire: http://www.citywire.co.uk/selector/-/news/other/content.aspx?ID=307445 (accessed August 14,
2009).

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p5
 the exchange’s clearinghouse; for OTC derivatives, the exposure is
to default by the counterparty. Fourth, credit risk mitigation
measures, such as regular mark-to-market and margining, are
automatically required for futures but optional for swaps. Finally,
futures are generally subject to a single regulatory regime in one
jurisdiction, while swaps—although usually transacted by regulated
firms—are transacted across jurisdictional boundaries and are
primarily governed by the contractual relations between the parties.
Various products, including futures contracts and exchange-traded
options, fall within the generic category of futures, but all have the
common characteristics described above.6
One byproduct of UCITS III has been the growth in ETFs that use swaps to replicate a
benchmark index and decrease tracking error. From a structuring perspective, swaps are
attractive, because the expected cash flows are based on the benchmark index. Thus, the
swap’s performance will track the benchmark index inclusive of dividends before transaction
fees. Swaps are an attractive component of UCITS III–compliant ETFs, but current
regulations limit counterparty exposure to the swap provider to no greater than 10% of an
ETFs net asset value. In actual practice, ETF products such as those provided by iShares,
Lyxor and db x-trackers have their counterparty exposure capped at 7–8%, or, in late 2008,
to 4–5%, due to market volatility.
While swaps will continue to be used within ETFs, there is growing awareness that
counterparty risk, especially in inverse and leveraged ETFs, is a genuine cause for concern.
Some ETF sponsors have sought to mitigate counterparty risk by using several swap
providers. Inverse and leveraged ETFs that reset their swap positions and rebalance their
collateral daily can limit their exposure to one day’s performance. The increasing complexity
inherent in managing counterparty risk has prompted investors to demand more disclosure
and transparency.
In light of these concerns, we believe that futures can be an important complement to
swaps, since specific counterparty risk is significantly reduced by the futures exchange. The
use of futures alongside swaps should also be conducive to providing increased price
discovery for ETF sponsors in the OTC swap market.

6
See http://isda.org/educat/faqs.html.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p6
The Trade at Index Close (TIC) order type
Trade at Index Close, or TIC, is a specific order type that allows market participants to buy
or sell futures contracts during the course of the trading day at a price expressed as a
differential to the closing price of the underlying stock index7. Market participants can
transact prior to the day’s close at a known premium or discount to the unknown day’s index
(underlying benchmark) close.
For example:
• a TIC bid of +0.15 means the bidder wants to buy at the closing value of the
underlying index, plus 15 index ticks;
• a TIC offer of –0.25 means the seller wants to sell at the closing value of the
underlying index, minus 25 index ticks;
• a TIC order placed at zero means the buyer or seller wants to trade at the
underlying closing value of the index (the closing cash value of the index).
By buying or selling futures at the index close, ETF sponsors are able to match the closing
value of the underlying index and thus can manage the basis risk inherent in other order
types. Trading activity on Friday, August 7, 2009 provides some insight into the variability
among different order types.
Settlement Price — Russell 2000 Mini Futures (Sep): 568.90
Last Traded Price — Russell 2000 Mini Futures (Sep): 570.70
Underlying Benchmark Index Close — Russell 2000: 572.40
A market participant wishing to sell Russell 2000 futures contracts would have been able to
transact at a last-traded price of 570.70. A market participant using the TIC order type at the
index close, alternatively, would have been able to transact at a known premium or discount
to the index close.
The trade type most similar to TIC is the Market on Close (MOC) order. The MOC order
type is used in equity markets; it allows a trader to buy or sell at prices prevailing at market
close. While MOC orders are well established on most equity exchanges, placing an order
prior to the day’s close in one market (the futures market) and replicating a price relative to
the close in another market (the underlying equity market) is not currently achievable unless
the futures trade is transacted as a TIC order or if the futures trade is negotiated as a block
trade. A block trade is a privately negotiated trade subject to certain minimum size
requirements which is executed apart and away from the electronic markets.
The degree of variation between futures and index closing prices can be substantial. This is
partly due to the typically later closing times of futures markets.8 Tables 1 and 2 report data
on closing prices for the Russell 1000 and S&P 500 equity indexes and their respective
futures contracts. The tables are based on daily prices from Bloomberg covering the period
from December 2, 2004 to July 8, 2009. This period includes the very volatile time of the
financial industry crisis. For the futures contracts, both the last trade price and the
settlement price are provided. Prices are for the nearest futures contract. The last trade
price is effectively the closing price of the futures contract. The settlement price is the
volume weighted average price during the last minute of trading and is used for determining
7
See Haughton and Smith (2008) and ICE (2008) for further description of TIC and its uses. TIC was
originally developed by Kelly Haughton, former strategic director of Russell Indexes and creator of the
Russell United States equity indexes.
8
Currently trading in S&P futures at the CME closes at 4:15 pm Eastern time, 15 minutes after the close of
equity trading. Trading in Russell futures on ICE ends at 6:00 pm eastern time, two hours after the close of
equity trading. Settlement prices are, however, based on trading as of 4:15 pm Eastern time.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p7
daily margin requirements and for other accounting purposes. The tables report statistics
based on daily returns resulting from these prices.
The daily volatility (standard deviation) of index price returns and both last trade and
settlement price returns are very similar for both the S&P 500 and the Russell 1000,
hovering in the range of 145 bps. The daily volatility of the difference in return between the
index and the last trade and settlement price is also reported. It can be seen that the
volatility of the difference between the last trade and equity index return is greater than the
volatility of the settlement and equity index return, as might be expected. This difference is
more pronounced for the Russell 1000, which also has a last-trade to equity-index volatility
of 42 bps, compared to 32 bps for the S&P 500.9 This difference is a measure of the
additional liquidity provided by S&P 500 futures contracts. These levels of volatility are not
high. If returns were normally distributed, the 95% confidence interval for the difference in
returns would be about 60 bps for the ES1 (the S&P 500 E-Mini) and 60 bps for the RM1
(the Russell 1000 E-Mini).
In spite of the low average volatility, the maximum and minimum return differences between
the S&P 500 and the ES1 last-trade returns are greater than 300 bps. Although the largest
return differences occurred during the financial markets crisis, they still underline the risk
that realized futures exposures may not track underlying markets as tightly as desired. An
ETF portfolio manager may conclude that even S&P 500 futures are not sufficiently liquid to
avoid undesirable tracking error risk.
The maximum and minimum return differences between the Russell 1000 and the RM1
contract last-price returns are more than 500 bps. This statistic illustrates why many
managers who benchmark to the Russell 1000 today still hedge and equitize cash with S&P
500 contracts. The correlation of last-price returns with equity index returns is also high, but
not as high as might be desired for managing ETF market exposures.
The large absolute values of the maximum and minimum return differences relative to the
volatility of the differences are indicative of what are commonly called “fat tails” in a
distribution. This condition is described by excess kurtosis. Gaussian (normal) distribution
has excess kurtosis of zero. Daily equity returns typically have positive excess kurtosis.
Large daily price movements are significantly more common than would be expected with
common statistical assumptions. Tables 1 and 2 show that the kurtosis of the last trade
return is higher than that of the daily equity return for both the S&P 500 and the Russell
1000, and that the kurtosis evident in the distribution of return differences between the
equity and last trade returns is higher yet. This pattern is still more pronounced for the
Russell 1000.

9
The ES1 and RM1 futures contract indexes are based on the price of the nearest to expire futures contract.
Every quarter, the price series rolls from the nearest to next-nearest shortly before the expiry of the near
contract. This contract roll introduces some volatility into the aggregate time series results. Examination of
the data suggests that contract rolls are a secondary influence on the reported statistics. Part of the greater
volatility and excess kurtosis of the RM1 last trade price relative to the cash index is undoubtedly due to the
additional 105 minutes of trading for this contract in comparison to the ES1 (see footnote 8).

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p8
Table 1 / Return Characteristics for the S&P 500 Index and Associated Near Futures
Contract

ES1 Last ES1 Settle

Trade Return ES1 Return
S&P 500 ES1 Last Difference Settlement Difference
S&P 500 Return Trade Return with S&P 500 Return with Index
Daily standard deviation 1.45% 1.45% 0.32% 1.47% 0.30%
Skew 0.03 0.42 0.02 0.45 0.88
Excess kurtosis 11.59 16.52 21.23 16.17 15.06
Minimum return -9.03% -9.90% -3.42% -9.88% -1.93%
Maximum return 11.58% 14.26% 3.11% 14.11% 2.74%
Correlation with S&P 500 --- 97.49% --- 97.89% ---

Table 2 / Return Characteristics for the Russell 1000 Index and Associated Near
Futures Contract

RM1 Last
Trade Return RM1 Settle
Difference RM1 Return
Russell 1000 RM1 Last with Russell Settlement Difference
Russell 1000 Return Trade Return 1000 Return with Index
Daily standard deviation 1.45% 1.47% 0.42% 1.46% 0.28%
Skew -0.02 0.18 -1.56 0.25 0.19
Excess kurtosis 11.45 13.72 67.20 14.74 11.14
Minimum return -9.11% -9.55% -6.65% -9.56% -2.25%
Maximum return 11.67% 12.86% 5.02% 13.29% 1.94%
Correlation with S&P 500 --- 95.90% --- 98.10% ---

The maximum return differences, and the statistics on return differences between the last
futures contract trade and the equity market close, reflect the price variability between
equity and futures markets that TIC is designed to dramatically reduce. TIC trades will
reflect prices much closer to those of the equity market close. TIC returns will have lower
volatility, lower excess kurtosis and lower maximum differences with the equity return.
Using TIC gives traders and ETF sponsors a fixed trading price relative to the equity index
close. That price is determined by the market. In a perfectly efficient market, the price
difference would be the fair value differential, which reflects the cost of financing an
arbitrage position. This price can also be expected to include a premium, if one side of the
market is dominated by hedgers looking to lay off risk and the other side is dominated by
market participants looking to make a profit on this demand for reduced price uncertainty.
However, this price premium should never be higher than the swap premium. In contrast to
swap prices, TIC prices are competitively determined. Traders looking to the other side of a
trade, and competition between market makers, should lead to TIC prices’ closely tracking
the fair value differential. The TIC order type thus has the potential to greatly increase the
effective liquidity of futures markets and the coordination between cash and futures
markets, at least for the equity market close. This liquidity and coordination would help ETF
sponsors better manage their exposures.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p9
The future: product innovation with third-generation ETFs
For institutional investors, ETFs serve a number of purposes and needs. They can provide
exposures for transitions and flexibility in portfolio rebalancing. They can help with quick
cash equitization, portfolio completion and the making of tactical and long/short adjustments
in portfolios. ETFs can also give institutional investors building blocks for core and
opportunistic exposures for segments of their asset allocation. Product innovations within
the ETF industry have thus far responded with increasing sophistication to the demands of
institutional investors for more tools to manage risk and reach their investment goals. This
trend will continue for the foreseeable future. The key question now is, what will innovations
in ETF structure and portfolio construction look like going forward?
We expect that third-generation ETF products will deliver more risk-management tools for
portfolio construction and provide deeper access to the equity, fixed income, commodities
and currency markets. These tools will have two specific focuses. The first will be to
continue to expand diverse exposures along a risk continuum, from traditional passive
indexes to fully active strategies for various segments of investable markets.10 The second
will be to ensure that these exposures are more representative of both active and passive
asset managers’ investing styles, portfolio construction methods and trading behaviors. This
concept is similar to the idea that construction of a traditional portfolio normally reflects the
investing behavior of a manager who specializes in a particular style or strategy.11 Both
focuses will enable institutional investors and asset managers to approach investment
strategy and risk budgeting in new ways as they seek to reach their investment objectives
and financial goals.
We expect that the third wave of ETF products will also evidence a greater emphasis on
engineering the components of an index’s or investment portfolio’s return strategy, while
taking into account other implementation considerations. Portfolio engineering by ETF
sponsors will aim to further minimize tracking error, increase transparency, reduce fees and
diversify counterparty risk. To achieve these goals, ETF sponsors will increasingly turn to
combining baskets of securities with both futures contracts and swap agreements. Sampling
and optimization techniques will continue to provide broad and granular exposures with
baskets of underlying securities. Futures contracts will have a greater role in providing
access to market exposure at more reasonable cost and with reduced counterparty risk.
Swaps will play a supplementary role, as specialized vehicles for targeted access to highly
specific return-pattern and risk-premium opportunities. Securities lending will continue to
offset operational costs. The structure of the third-generation ETF is illustrated in Figure 4.

10
Anson (2008) describes the beta continuum as a range of risk premiums that can be captured as beta.
These forms of beta begin with classic or market beta and expand to more active forms of beta, including
alternative beta and active beta.
11
As defined in Christopherson, Carino and Ferson (2009), a normal portfolio is a set of securities that
contains all of the securities from which a manager normally chooses, weighted as the manager normally
weights them in a portfolio.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p 10
Figure 4 / Structure for Third-Generation ETFs

Third-generation architecture will support ETF sponsors’ efforts to replicate a desired index
or strategy through access to broad market exposures, customized baskets of return/risk
premiums and unique return outcomes. Innovations such as the TIC now provide new
opportunities for a greater use of futures contracts as ETF portfolio managers aim to deliver
more sophisticated exposures and return patterns while still mitigating risk, reducing fees
and increasing transparency. Such innovations will continue as TIC and other order types
and futures contracts become available for use on the major derivatives exchanges.

Conclusion
The Trade at Index Close order type allows futures contracts to become a viable and
economical alternative to swaps for obtaining market exposures for third-generation ETFs.
This does not mean that futures will replace swaps. Currently, futures contracts offer a very
limited range of market exposures. Even where futures do offer a desired exposure, ETF
sponsors will still need to weigh the contracts’ described advantages against the
disadvantages.
ETF architecture will continue to evolve with the demand for more innovative tools. The
ability to deliver components of market exposures through swaps and futures will facilitate
the development of new ETF strategies. TIC makes it possible for more derivatives
exposure to be supplied through exchange-traded futures products. Acceptance of TIC by
futures markets could expand the number of effectively liquid futures contracts and lead to
less-expensive ETFs with increased transparency and lower levels of counterparty risk.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p 11
Endnotes
There has been much scrutiny of leveraged ETFs as of late. Leveraged ETFs seek to
deliver the daily leveraged or inverse leveraged performance of the underlying index that
they track. To achieve this outcome, ETF sponsors must reset their exposure on a daily
basis to ensure the fund meets its stated objective. Due to how these ETFs are managed
and because of compounding effects, the returns may not reflect the assumed leveraged or
inverse leveraged return of the underlying index over long periods of time beyond one day.

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p 12
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Anson, M. (Winter 2008). “The Beta Continuum: From Classic Beta to Bulk Beta.” Journal of
Portfolio Management, 53–64.
Christopherson, J., Carino, D. Ferson, W. (2009). Portfolio Performance Measurement and
Benchmarking. New York: McGraw-Hill.
Gastineau, G. (2002). The Exchange-Traded Funds Manual. New York: John Wiley & Sons,
Inc.
Haughton, K., and Smith, J. D. (2008). “Trade at Index Close.” Russell Investments.
Available at https://www.theice.com/publicdocs/futures_us/Trade_at_ Index_Close_808.pdf
(accessed August 14, 2009).
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Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p 13
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Disclosures

This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization. Nothing contained in
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Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a subsidiary of The
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Copyright 2009, Institutional Investor. Inc. Reproduced and republished from "The Eighth Annual Guide to Exchange Traded Funds &
Indexing Innovations," Fall 2009. All Rights Reserved.

First use: August 2009.

CORP-5800

Russell Investments // ETFs, Swaps and Futures: Trade at Index Close (TIC) and the coevolution of financial markets / p 14