Patent Publication Number: US-2011060676-A1

Title: System and method for structuring, trading, and processing differential funds

Description:
BACKGROUND OF THE INVENTION 
     The present invention is in the technical field of structuring and administering trades, creations, and redemptions of securities. More particularly, the present invention is in the technical field of structuring and administering trades, creations, and redemptions of a novel form of exchange-traded fund. 
     In recent years exchange-traded funds (ETFs) have grown in popularity among investors. These funds are typically described as a hybrid between mutual funds and publicly traded securities, commodities, or other investable assets. In an ETF, assets are pooled in a trust according to the list of components and weightings of an index, index sector or sub-sector, some other identifiable array of securities or commodities, or at advisor discretion or criteria in actively managed portfolios. Shares of such ETFs trade on public exchanges. If one owns a sufficient number of such shares (“creation unit”), typically 50,000, he or she may redeem them with the trust and receive the underlying shares in-kind. Similarly, if one owns the actual assets underlying an ETF in appropriate proportion, these may be submitted to the trust in exchange for shares therein. 
     The recognized benefits of ETFs include cost-effective diversification, intra-day pricing, the ability to use hedging strategies, including put and call options, and smaller discount/premium spreads from net-asset value and management fees vis-a-vis traditional mutual funds. Several methods in the prior art provide for reducing downside risk in ETFs. These methods are similar to those available for individual securities and include protective puts and equity collar transactions. Negative aspects of the existing downside protection art include transaction costs and fees, conceptual complexity requiring sophisticated knowledge to use effectively, and the eventual expiration of protective features. A more general limitation of the prior ETF art, particularly pronounced in index or sector funds, is that investors, in order to participate in index- or sector-wide trends, forgo the relative gains of high-performing components vis-a-vis the index or sector to the extent that they use ETFs. The differential fund is envisioned as a solution to this limitation, wherein investors continue to participate in broad indexes or sectors, enjoy the downside protection of being invested in an index or sector underlying, and also enjoy potential upside potential for assets that outperform their index, sector, or other benchmark. 
     BRIEF SUMMARY OF THE INVENTION 
     The invention relates to a computing and manual system and method for structuring, trading and processing differential funds. Differential funds are publicly traded funds that allow investors to participate in the diversification and appreciation available to an index, sector, or other class of underlying assets, while also participating in enhanced potential appreciation and distributions from individual components or sectors of components of the underlying. 
     Embodiments of the invention improve upon the existing art by providing upside participation and downside protection as compared to investing in shares of ETFs or individual securities. Investors derive new benefit from combining the diversification qualities of an ETF with the higher appreciative potential of securities and commodities that investors expect to outperform the index or sector of which they are a component. Given that each share is backed by the entire underlying, capital losses on any share of the fund are limited to a lower-bound, i.e. the net-asset value or market price of the fund underlying. Moreover, investors benefit from a novel way to receive dividend or other income from shares of superior performing companies that retain all or a substantial part of earnings. In addition, the present invention lowers transaction costs and counter-party uncertainty associated with other downside protective methods, including protective puts and equity collar transactions, and, in contrast with options-based protective strategies, its protective feature has no expiration. 
     Finally, embodiments of the invention offer greater conceptual and transactional simplicity than existing art, allowing investors better to make and understand investment decisions and customize investment strategies. 
    
    
     
       BRIEF DESCRIPTION OF THE SEVERAL VIEWS OF THE DRAWING 
         FIG. 1 . is a block diagram representation of an embodiment of a differential fund holding shares in three individual equities and offering share classes linked to each individual company component and one linked to a sector consisting of two of the individual components. 
         FIG. 2 . is a block diagram representation of the computing, institutional and manual system for creating, redeeming, and trading shares of a fund, particularly how the invention interacts with the institutional and manual components of the system. 
         FIG. 3 . is a numerical representation of processing means and the financial indicator weighting process of the present invention. 
         FIG. 4 . is an embodiment of the invention wherein shares of a component are “stacked” in a share class in order to cause the linked component to have an out-weighted effect on the performance of the class. 
     
    
    
     DETAILED DESCRIPTION OF THE INVENTION 
     A differential fund is a form of and improvement on exchange-traded funds. It comprises an underlying index or basket of securities, commodities, or other investable assets, with share classes equivalent to the number of and linked to components or sectors of the underlying. The computing and manual system and method allocates dividends, distributions, or appreciation to each class by weighting some financial indicator of each component to each other and then applying dividends, distributions, or appreciation owed to the whole fund to individual classes based on the indicator weighting. Examples of possible indicators include share price and capitalization. Shares trade freely at a market premium over the net-asset value or market price of the fund. Premiums from new creations are used to re-weight the holdings of components in the fund. Since creation units of a differential fund may be redeemed for their underlying, the net-asset value or market price of the underlying establishes a natural lower-bound in the price of a share. 
     An embodiment of the invention is provided for structuring a differential fund and for managing it by processing and recording information and data flow necessary to effect trades, creations, and redemptions of shares of the fund. Such a system and method is used once a fund sponsor has established a differential fund.  FIG. 1 . depicts an embodiment of differential exchange-traded fund&#39;s holding trust  1  comprising equity components B  2 , C  3 , and D  4 . Additionally, and optionally, the fund offers a share class  5  linked to a sector consisting of components B and D. Within the figure thin lines indicate shareholding relationships; these shares are owned by shareholders represented by  6 ,  7 ,  8 , and  9 , who may be, for example, individuals, mutual and investment funds, authorized fund participants, broker-dealers, institutional investors, funds, or other investors. 
       FIG. 2 . depicts the broader computing, institutional, and manual trading system universe typically used to trade publicly-traded securities and commodities. Within the figure thin solid lines represent input and output regarding the functions of the present invention  11 . Dotted lines indicate shareholding relationships. Bold solid line indicate public or private trading activity. Fund sponsor  10  interfaces with its fund&#39;s  12  authorized participants  16  through a computerized and manual trading system embodiment of the invention  11 . Authorized participants offer their creation unit shares on a plurality of public and private trading systems  17  including, for example, alternative trading systems  18 , electronic communication networks  19 , over-the-counter trading facilities  20 , and public exchanges  21  to non-authorized participant investors  22  such as  6 ,  7 ,  8 , and  9 . In like manner the authorized participants purchase creation units from the open market to redeem with the sponsor. This embodiment interfaces with the trading systems described to continuously update trading, volume, premium, pricing, and other data so as to inform the fund sponsor and authorized participants of the data for automated and human-based decision-making. 
       FIG. 3 . is a numerical representation of the quarterly dividend payout for a differential fund based on the hypothetical “A-I” Index. The index comprises a plurality of components  11  each of which has a unique market capitalization  12  and each of which is linked to a class of shares of the fund. Without regard to the total monetary value of the holdings of the fund, the market capitalization of the index  13  is the sum of the capitalizations of each component of the index. The “A-I” Index is weighted according to market capitalization, though another financial indicator may be used. Therefore, the proportion of each component of the index in the index is determined by dividing the market capitalization of each component by the market capitalization of the entire index, producing the index weightings  14 . The market prices  15  of each component of the fund sum to an unweighted price to acquire a share of each component of the fund  16 . When the market share prices of each component are multiplied by their market capitalization weightings in the fund, the value of each component in the fund  17  is found. The values of each component in the fund sum to the price of the fund  18 . In this embodiment, the total dividends or distributions available to shares of the fund after a quarter sum to $1,000,000  19 , the financial indicator used to weight dividends and distributions is average quarterly price, and the average quarterly prices of each component and the fund are assumed to be the instant prices  17  and  18 . Therefore, dividing each component&#39;s value in the fund by price of the fund results in the proportion of dividends or distributions  19  owing to each class of the fund. In this figure, share class “B” receives approximately 234% of the mean dividend, while share class “A” receives only approximately 7.6%. 
       FIG. 4 . depicts an embodiment of a “stacking” differential fund. An index  20  weights all components equally, and is presented with components A, B, C, D, E, and F. A “stacked” DETF  21  is presented with identical components, but includes an additional unit of component F. The effect of this “stacking” is that the performance of the DETF shares will deviate, up or down, from the performance of the underlying index on the basis of F&#39;s performance. DETF  22  is similar to the proceeding fund, but adds even more units of F. Although the funds in this figure hold all units long, nothing prevents a “stacked” differential fund from having one or more short units. 
     The advantages of the present invention and its associated differential fund include, without limitation, a novel hybrid between investing in exchange-traded fund shares and individual securities or commodities, upside participation for components that outperform their index or sector, downside protection from declines in the value of individual securities or commodities, lower transaction costs vis-a-vis existing downside protection strategies, and transactional and conceptual simplicity. 
     CONCLUSIONS, RAMIFICATIONS, AND SCOPE 
     The invention is an improvement on exchange-traded funds. While it is not intended to replace the prior art completely, it does provide a superior alternative to consumers under certain circumstances. Among these circumstances are investment objectives which seek higher upside potential vis-a-vis an index or sector ETF, or to limit downside risk vis-a-vis investing in single equities, commodities, and other classes of assets. The invention provides a built-in hedge for the investment position a consumer takes, and does so in a conceptually and administratively simpler manner than existing hedging art. 
     While the foregoing written description of the invention enables one of ordinary skill to make and use what is considered presently to be the best mode thereof, those of ordinary skill will understand and appreciate the existence of variations, combinations, and equivalents of the embodiments, methods, and examples herein. The invention should therefore not be limited