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Mark R. Parthemer, Managing Director and Fiduciary Counsel, Southeast US

Mr. Parthemer is Fiduciary Counsel, Southeast Region, of Bessemer Trust, an exclusive wealth management company providing services to families with investment assets in excess of $10 million. Mr. Parthemer heads the region’s estate and legacy planning team, who assists Bessemer’s client families to develop generational wealth transfer strategies.

Prior to joining Bessemer Trust, Mark was in private law practice in Pennsylvania and Florida and also spent several years at PricewaterhouseCoopers and was involved in private businesses.

Mr. Parthemer is a national lecturer and published author. He has been faculty at University of Miami’s prestigious Heckerling Institute, as well as NYU and Tulane Tax Institutes, was an Adjunct Professor at the Widener School of Law, and is a guest lecturer at the University of Miami’s Law School LLM Program.

He regularly contributes articles to tax and estate planning magazines and writes a regular column for the Journal of Financial Service Professionals.

Mr. Parthemer is vice chair of the American Bar Association’s Insurance and Financial Planning Committee, a member of the executive council of the Florida Bankers Association, as well as chair of their Trust Law Legislation Committee. He is a member of the board and ABA Liaison to Synergy Summit.

He received his J. D. from The Dickinson School of Law, Penn State University, and his B.A. and B.S. degrees from Franklin and Marshall College, has been awarded the Accredited Estate Planner designation and regularly recognized as one of The Best Lawyers in America (Trust and Estates) and a Florida Super Lawyer.

The ABC’s of ETFs: What You Need to Know about Exchange Traded Funds

Palm Beach Financial Planning Association

Boca Raton, FlMarch 24, 2011

Mark R. Parthemer, Esq., AEP

Managing Director

Fiduciary Counsel, Southeast US

Bessemer Trust

222 Royal Palm Way

Palm Beach, FL 33480

parthemer@bessemer.com

Copyright © 2011 by Bessemer Trust Company, N.A. All rights reserved.

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I. ETF Basics

II. Modern Portfolio Theory and the Prudent Investor Act

III. Case Studies – Four Thoughtful Planning Uses of ETFs

The ABC’s of ETFs: Easy as One-Two-Three

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ETF versus Mutual Funds

1993 Launched

1000 +* Current #

$1.004 Trillion Current AUM

*Three providers account for 84.7% of ETF AUM. Blackrock (iShares), State Street or SSGA (SPDRs) and Vanguard (formerly VIPERs)

1924

8,000 +

$11.874 Trillion

Registered funds and AUM as of January 2011. Investment Company Institute.

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ETFs versus Mutual Funds

On exchanges Shares Traded

No import to Fund Redemption

Intra-day Price/Traded

With Fund

Via cash in

Fund

After market

close

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Understanding Mutual Fund Investing

Mutual Fund

Investors

Exchanges

Step 1 – Cash for Mutual Fund Shares

Step 2 – Fund uses $ to buy Stocks.

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Understanding ETF Investing

ETF

InvestorsExchang

es

Broker/Dealers

Step 1 – Securities For Creation Unit

Step – 2 Creation Unit Severed; Pieces Sold

Step 3 – Investors purchase severed units on exchange.

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• Tax: Avoid Mutual Fund Capital Gain Distributions

• No Friction Costs to Accommodate Shareholder Purchases and Redemptions (but incurred to rebalance)

• Some Have Lesser Fees

• Often Lower Minimums (many ETFs have no minimums)

• Dividends Automatically Reinvested in Mutual Funds; Can Invest in Dividend-Paying ETFs

• ETFs Can be Traded Like Stocks (e.g., limit orders; short; hedge)

Potential ETF Advantages over Mutual Funds

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II. Modern Portfolio Theory and the Prudent Investor

The Wisdom (and Law) Behind the Adage:

Concentration to make wealth; diversification to preserve it.

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Understanding the Prudent Investor ActAs adopted in 44 states and DC, there are four

fundamental tenets:

1. Entire investment portfolio considered when determining prudence of an individual investment.

2. Diversification required for prudent fiduciary investing.

3. No category or type of investment is deemed inherently imprudent.• Suitability to the trust account's purposes and

beneficiaries' needs is the determinant.• Fiduciaries permitted/encouraged to develop

greater flexibility in overall portfolio management.

4. Delegation of investment management/other functions to third parties permitted.

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Understanding Modern Portfolio Theory

• Rational investors will use diversification to optimize their portfolios, as markets do not reward for financial risks that can be managed.

• The model assumes that investors are risk averse, thus seek best risk-return profile:

– If two assets offer the same expected return, investors will prefer the less risky one.

– Investors will take on increased risk only if compensated by higher expected returns. Conversely, investors who wants higher returns must accept more risk.

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Understanding Modern Portfolio Theory

Market will not reward for risks that can be managed:

1. Company specific risk

• Managed by exposure to among securities in the same asset class

• Think Enron, AIG, Lehman

2. Market risk

• Managed by exposure among several uncorrelated asset classes or sectors

• Think “tech bubble”

Employing “hedge” strategies that protect against market volatility also may reduce both types of risk.

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Satisfying the Obligation to Manage Risk with ETFs?

Possible, but issues include:

1. Many ETFs, including the biggest (SPDR), are cap weighted.

• As stock price surges or wanes beyond standard deviation:

• One buys when would rather sell (or hold), and

• One sells when it may be better to buy

– Reconciliation when value reverts to its mean

– Options include fundamental ETFs and equal weighting ETFs

• NASDAQ article March 7, 2011 concludes both add volatility to a portfolio

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Satisfying the Obligation to Manage Risk with ETFs?

1. Cap Weighting

2. Most ETFs currently are passive.

• SEC slowly permitting actively managed ETFs

• Yale study regarding how active managers can add value

• Yet passive investing carries own risks

3. Examples of indexing issues:

• Owners – holding can cause unintended over- and under-weighting

• Buyers – trading at the wrong time

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Yale School of Management Study: Conclusions

Study by Martijn Cremers and Antti Petajisto published August 7, 2006

Source: Yale School of Management

• Portfolios closely tracking index weightings generally underperform. “Closet indexing tends to destroy value.” Described 7% of non-index fund assets in 1995 and 32% in 2003.

• On the other hand, high tracking error hurts performance too. Generally achieved through sector rotation strategies. “Factor bets tend to destroy value.”

• To win, portfolio managers must develop convictions and emphasize those holdings. “Active stock pickers tend to create value for investors.” “The funds with the highest Active Share significantly outperform their

benchmark indexes, while the funds with the lowest Active Share underperform.”

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Sample S&P 3-Sector ETF: Initial Investment $300,000

Allocation July 1, 2007

$100,000

$100,000$100,000

Energy (XLE)Utilities (XLU)Financials (XLF)

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Sample S&P 3-Sector ETF: One Year Later, $278,690

Allocation June 30, 2008

$123,000

$98,310

$57,380Energy 26%Utilities (1.69%)Financials (42.62%)

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Passive Investing Can Result in Unintended Weighting

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101520253035404550

2007

Allo

catio

n

2008

Allo

catio

n

Energy (XLE)Utilities (XLU)Financials (XLF)

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7/1/07 – 6/30/08 Expectation of Energy SPDR ETF XLE

50

60

70

80

90

Jul-0

7

Sep-07

Nov

-07

Jan-08

Mar-08

May

-08

Jul-0

8

-1 SD+1 SDExpected Return

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7/1/07 – 6/30/08 Actual Energy SPDR ETF (XLE)

50

60

70

80

90

Jul-0

7

Sep-07

Nov

-07

Jan-08

Mar-08

May

-08

Jul-0

8

-1 SD+1 SDExpected ReturnActual

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7/1/07 – 6/30/08 Occidental Petroleum in XLE

50

60

70

80

90

Jul-0

7

Sep-07

Nov

-07

Jan-08

Mar-08

May

-08

Jul-0

8

-1 SD+1 SDExpected ReturnActualOXY

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Energy Stock Inside Energy Sector ETF

OXY Shares XLE

7/1/2007:

Price $57.28 $70.26

6/30/2008 (8% proj.) $61.86 $75.88

6/30/2008 (Actual):

Price $89.86 $88.48

Growth 57% 26%

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Wait: Isn’t It Supposed to be Buy Low and Sell High?

OXY Shares XLE

7/1/2007:

Price $57.28 $70.26

Percent of Sector 4.44%

3/18/2011

Price $98.33 $75.39

Percent of Sector 4.38%

Growth 58% 9%

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ETF Tinkering

• ETF “sequels” include commodity, bond, currency and actively managed

• ETF variation - ETNs

– Debt offering

– Note is traded on exchange

– Added tax benefit and lower costs; added risk (credit worthiness of issuer)

1. ETFs are viable vehicles to assist the passive investor achieve diversification.

2. ETFs may be less expensive and more tax efficient than mutual funds.

3. ETFs are not necessarily a “safe harbor” so be diligent in selection. Consider if the ETF itself properly diversified:

(a) A Russia ETF is 44% in 3 stocks – concentration issue?

(b) A China ETF is 42% financials – is this China’s strength?

Key Take-A-Ways

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III. Case Studies – Four Thoughtful Uses of ETFs

1. Income Tax Loss Harvesting – Planning around wash sale rules without losing asset class

exposure.

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III. Case Studies – Four Thoughtful Uses of ETFs

2. Single or Correlated Asset GRATs – Coordinated investment and estate tax

planning for mid-net worth individuals and clients whose portfolios are already

diversified.

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III. Case Studies – Four Thoughtful Uses of ETFs

3. The “Parking Space” – Use to invest cash from sale of stocks until replacement stock identified and buying conditions ripe.

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III. Case Studies – Four Thoughtful Uses of ETFs

4. “Gap” filler – As core or satellite strategy and individual security risk reduction, use ETF(s) to

fill “gaps” in asset allocation.

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