Exchange Traded Funds

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1 Exchange Traded Funds Opportunities and Challenges November 17, 2015 Brett Eichenberger Ravi Singh YOUR INDUSTRY. YOUR ISSUES.

2 WHY ARE ETFs INCREASING IN POPULARITY? (SURVEY RESULTS) (U.S. ETF MARKET: OVER 1,700 FUNDS; $2 TRILLION AUM) Low cost Tax efficiency Can be traded throughout the day Ability to short Options trading on ETFs MORE PERSONAL. MORE SOLUTIONS. Page 2

3 AGENDA Overview Tax considerations Accounting considerations Operational aspects STRONG FOUNDATION. CONTINUED GROWTH. Page 3

4 OVERVIEW OF THE ETF INDUSTRY Various types of ETF structures Regulated/registered investment companies Grantor trusts Partnerships Unit investment trusts New kid on the block: ETMFs Covers all asset classes MORE DEPTH. EXPERIENCED LEADERS. Page 4

Partnerships Unit investment trusts New kid on the block:

5 UNIQUE CHARACTERISTICS OF ETFs Traded on stock exchanges like common stock As a result, ETFs can be shorted Similar to stocks, ETFs can have related put and call options Compared to regular mutual funds, ETFs have a lower cost structure Unlike a regular mutual fund, ETFs are priced throughout the day ETFs are subject to arbitrage throughout the day New ETF shares are issued through the creation/redemption process (which is usually In-kind ) upon requests made by authorized participants ( APs ) Creates and Redeems are set at a very high minimum (say, 50,000 shares) Page 5

throughout the day ETFs are subject to arbitrage throughout the day New ETF shares are issued through the creation/redemption process (which is

6 ACTIVE VERSUS PASSIVE ETFs An active ETF attempts to generate returns that exceed the target index Actively managed ETFs are required to be as transparent as passive ETFs with respect to disclosing their portfolio holdings Management fees and operating expenses are usually higher for active ETFs when compared to passive ETFs Both active and passive ETFs enjoy the same tax benefits Page 6

disclosing their portfolio holdings Management fees and operating expenses are usually higher for

7 ACTIVE AND PASSIVE ETF STRATEGIES An increasing number of ETFs share aspects of both active and passive management Enhanced or Intelligent indexing an advisor may use certain types of quant based strategies to enhance an index that is traditionally cap-weighted Alternative Weighting Strategy an advisor may construct a portfolio/index that may be earningsweighted, dividends-weighted or revenue-weighted Sampling-Strategy this would involve constructing a portfolio that is a subset of the benchmark index with better (in the opinion of the advisor) risk/return characteristics. Page 7

Strategy an advisor may construct a portfolio/index that may be earningsweighted, dividends-weighted or revenue-weighted Sampling-Strategy this

8 ETFs - START UP/LAUNCH TAX CONSIDERATIONS AND PITFALLS Initial transfer of securities to the ETF taxable or nontaxable? (if the ETF is structured as a RIC) Taxable transfer preferred because of cumbersome tracking if the transaction is nontaxable Structure the transaction such that it is taxable but has no tax consequences Selecting an ETF structure that best fits the ETF s investment objectives and shareholder reporting considerations Opportunities through alliances and/or acquisitions Page 8

nontaxable Structure the transaction such that it is taxable but has no tax consequences Selecting an ETF structure that

9 ETFs ONGOING TAX CONSIDERATIONS No gain or loss recognition at the ETF level for in-kind redemptions Lot selection for in-kind redemptions (IRS PLR) Issues associated with in-kind redemptions followed by pre-arranged subscriptions with the same AP Use of tax equalization The theory Practical approaches and methodologies Page 9

associated with in-kind redemptions followed by pre-arranged subscriptions with

10 ETFs AND WASH SALES Do in-kind subscriptions amount to an acquisition under the wash sale rules, giving rise to a wash sale? Will a wash sale reverse if the security lot, whose cost basis was adjusted because of a previous wash sale, is disposed of as part of a redemption in-kind? Page 10

Will a wash sale reverse if the security lot, whose cost basis was

11 ETFs ACCOUNTING CONSIDERATIONS Changes in shares outstanding is exclusively the result of activity with authorized participants (creation unit activity) Substantial in-kind activity (subscriptions and redemptions) Trading activity on the exchange in ETF shares does not impact the number of shares outstanding Pricing is done throughout the day (Indicative Net Asset Value or inav) No dividend reinvestments (all paid out of ETF) MD&A- includes returns based on market value of the ETF share and based on the net asset value of the ETF share Page 11

impact the number of shares outstanding Pricing is done throughout the day (Indicative Net Asset Value or inav) No dividend reinvestments

12 ETFs OPERATIONAL ASPECTS Compliance with stock exchange guidelines/requirements (similar to closedend funds) Rapidly evolving marketplace and first mover advantage in terms of introducing new ETFs. Innovation is key to growth and success Page 12

evolving marketplace and first mover advantage in terms of

13 ETFs OPERATIONAL ASPECTS Sponsor Activities Manages portfolio Assesses cash availability Rebalances index as needed Share quantities are calculated for securities in the creation and redemption baskets In-kind transactions are cleared and settled by National Securities Clearing Corporation (NSCC) upon communication from the sponsor/ sponsor s agent Stock Exchange Related Activities APs arbitrage ETF and underlying basket of securities Individual investors buy and sell ETFs through brokers who buy and sell ETF shares through APs Other Activities APs submit requests for creation or redemption units which are affirmed by the distributors Distributor notifies sponsor of these requests Based on information from sponsor, NSCC publishes portfolio creation file for the next day s trading Page 13

arbitrage ETF and underlying basket of securities Individual investors buy and sell ETFs through brokers who buy and sell ETF shares through APs Other Activities APs submit requests for creation or

14 ETFs SOME FINAL WORDS Growth of ETF AUM will continue to outpace traditional mutual funds As with any successful and popular financial investment, widespread use brings increased regulatory scrutiny Events of August 24, 2015, have further caused SEC to take a closer look at all Exchange Traded Products ETFs and traditional mutual funds will co-exist side by side death of the traditional mutual fund is greatly exaggerated But, ETFs are the next frontier for innovation and growth in the asset management industry. Ignore them at your own peril! Page 14

at all Exchange Traded Products ETFs and traditional mutual funds will co-exist side by side death of the traditional mutual fund is

15 Brett Eichenberger, Partner Ravi Singh, Partner Be sure to tune into our next webinar coming in January 2016! Page 15

1704 Ravi Singh, Partner rsingh@cohenfund.

Understanding ETF Liquidity

Understanding ETF Liquidity SM 2 Understanding the exchange-traded fund (ETF) life cycle Despite the tremendous growth of the ETF market over the last decade, many investors struggle to understand the