THE ETF. TOOLKIT The Professional s Guide to Exchange Traded Funds

Transcription

1 THE ETF TOOLKIT The Professional s Guide to Exchange Traded Funds Not FDIC Insured May Lose Value No Bank Guarantee For Institutional Investor Use Only Not For Use with the Public

2

3 THE ETF TOOLKIT The Professional s Guide to Exchange Traded Funds

4 Dear Valuable Clients: Invesco PowerShares is leading the Intelligent ETF Revolution and we are anchored on a vision of delivering innovative, value-added investment management strategies through the exchange-traded fund (ETF) structure. We believe that indexing can go beyond benchmarking and Invesco PowerShares seeks to empower financial professionals by providing them with the advanced building blocks for constructing precise investment portfolios. To best utilize PowerShares ETFs, it is important to have a thorough understanding of the ETF structure and the best ways to transact in each product. This ETF Toolkit is designed to walk you through the key topics related to the ETF structure and trading. The topics build upon each other and this guide is intended to help you become a more proficient user of ETFs. We hope that you find this guide useful as you explore the ETF landscape and we encourage you to use this in conjunction with the services offered by the PowerShares Global ETF Capital Markets team. John Hoffman Global Head of ETF Capital Markets Grayson Lipton Head of ETF Liquidity & Execution Services Sincerely, John Hoffman Global Head of ETF Capital Markets Tim Urbanowicz ETF Capital Markets Strategist For Institutional Investor Use Only Not For Use with the Public

5 Introduction to ETF Capital Markets The PowerShares Global ETF Capital Markets team is an integrated group of professionals that serves as the hub to the ETF ecosystem for PowerShares funds. This group manages relationships with market makers, authorized participants (APs) and various sell-side firms to support primary market ETF activity. In addition, our Liquidity & Execution Services team is focused on helping you enter and exit ETF positions as efficiently as possible. The PowerShares Global ETF Capital Markets Team provides three core functions globally: Liquidity & Execution Services: The Liquidity & Execution Services team is in place to help financial advisors and institutional clients through the ETF trading process. The team helps clients assess the potential liquidity of PowerShares ETFs, developing a client-specific trading strategy and evaluating the potential impact of a trade. Market Maker & Authorized Participant Relations: As ETFs trade in the secondary market and typically cannot be purchased directly through the ETF issuer, efficient trading is dependent on the ETF market making community. The PowerShares Global ETF Capital Markets team works with various market making firms, APs and other sell-side firms to ensure these parties effectively make markets in PowerShares products. In addition, the team continuously monitors secondary market activity, assessing and tracking market maker performance, evaluating spreads and monitoring trading activity. Research & Content: The PowerShares Global ETF Capital Markets team provides actionable market commentary to our clients. This involves assimilating and distilling high quality buy side and sell-side research into ETF investment strategies and providing market perspectives. If you are interested in utilizing any of the services described above, please contact the PowerShares Capital Markets team by phone or by . PowerShares ETF Capital Markets p: e: CapitalMarkets@powershares.com 3

6 For Institutional Investor Use Only Not For Use with the Public

7 Table of Contents Overview of the ETF Landscape 9 ETF Structure 13 NAV & IOPV 21 ETF Pricing & Valuation 33 Components of ETF Liquidity 37 Secondary Markets 43 Alternative Methods of Execution 47 Shorting ETFs 55 Contact Information & Resources 59 Glossary & Important Information 63 5

8

9 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

10 For Institutional Investor Use Only Not For Use with the Public

11 Overview of the ETF Landscape On Jan. 22, 1993, the SPDR S&P 500 ETF (SPY) became the first ETF to launch in the US marketplace. Today, SPY has $190 billion in assets under management (AUM) and trades an average of 120 million shares or approximately $23 billion notional per day. 1 Since the launch of SPY more than 20 years ago, the ETF landscape has grown tremendously in terms of AUM and number of products. New products have expanded to provide investors exposure beyond the US domestic equity space and now ETFs span virtually every asset class. Global ETF AUM have grown at a compound annual growth rate of 25% over the past decade as more investors have taken advantage of the low cost, liquid, transparent, and tax efficient nature of this benefit rich vehicle. 2,3 As of Jan. 1, 2015, there were more than 1,660 US-listed exchange-traded products and total AUM was greater than $2 trillion. 4 Exhibit 1: ETF Industry Growth $2,500 $2,000 18% 26% AUM ($B) $1,500 $1,000 $500 $0 43% -13% 27% 27% 5% 46% 39% 39% 48% 94% 28% 20% 47% Source: Bloomberg L.P., as of Dec. 31, 2014 With the increased utilization of ETFs across all investor segments and channels, the trading volumes in ETFs have also increased. In 2014, ETFs represented 27% of all equity volume in the US with total dollar average volume exceeding $70 billion daily. 4 Exhibit 2: US Equity Volume 4 ETFs Other 73% 27% 1 Source: Bloomberg L.P., as of March 23, Source: Bloomberg L.P., as of March 31, Transparency: ETFs disclose their holdings daily. Low Cost: Since ordinary brokerage commissions apply for each buy and sell transaction, frequent activity may increase the cost of ETFs. 4 Source: PowerShares Product Strategy Research, as of Jan. 1,

12 Despite this tremendous growth, ETFs are still a new investment vehicle for many investors and it is important to understand the ETF structure when evaluating and selecting positions for your client s portfolios. On the surface, ETFs are similar in many ways to mutual funds, separately managed accounts (SMAs), collective investment trusts (CITs) and other investment vehicles; however, there are a number of key differences which are critical to understand when comparing these investment wrappers. Most ETFs are established under the 1940 Act with exemptive relief. ETFs are also nuanced in their tradability and ultimately in the creation and redemption process. One of the key differences between traditional mutual funds, SMAs and collective investment trusts (CITs) when compared to ETFs is centered around how investors fund positions. ETFs are listed securities that trade on national exchanges, such as NYSE ARCA, NASDAQ and BATS. Investors buy and sell ETF shares through their brokerage accounts and trades are printed to the consolidated tape. Institutional traders make markets in ETFs by quoting bids and offers and managing ETF inventory positions. These institutional traders can then bundle up smaller ETF orders into larger positions and create or redeem shares of the ETF by dealing directly with the ETF manager and the custodial bank. ETF shares are created (issued) and redeemed (retired) in large, predefined block sizes by these institutional traders. Separately Managed Account (SMA): a pool of assets that is managed by an investment management firm for the benefit of an investor Act: Act of Congress passed in 1940 which represents the primary source of regulation for mutual funds, closed-end funds and ETFs. Exemptive Relief: regulatory order granted to ETF fund complexes to provide exemption from certain provisions of the 1940 Act necessary to operate within the ETF structure. Conversely, mutual funds, SMAs and CITs allow investors to deal directly with the fund manager, who accepts cash from the investor in exchange for new units issued by the fund at net asset value. Given the exchange-traded nature of ETFs, it is critical for investors to understand how to efficiently trade, as they must interact directly with the capital markets when buying and selling ETF shares. In the following chapters, the focus of this guide is to lay the educational foundation to help you become a more efficient and effective ETF user. For Institutional Investor Use Only Not For Use with the Public

13 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

14 For Institutional Investor Use Only Not For Use with the Public

15 ETF Structure Creation/Redemption: creation is the process by which new ETF shares are issued to the market. Redemption is the process of retiring existing shares of the ETF. Introduction to the Creation/Redemption Process To understand the ETF structure, we must first explore the creation/ redemption mechanism, which is central to the ETF. ETFs trade on securities exchanges similar to individual equities. Unlike stocks, ETFs have the unique capability of expanding or contracting shares outstanding on a daily basis, comparable to other open-ended investment vehicles, such as mutual funds. However, the creation/redemption process for the ETF is vastly different from other open-ended funds. When new money flows into a mutual fund (subscription), the fund manager either uses the cash to purchase securities in the open market or maintains this cash position. Exhibit 3: Mutual Fund Flow Subscription $ Cash Mutual Fund $ Cash Investor Units Stock Market When mutual funds experience redemptions, the fund manager must deliver cash back to the investor at Net Asset Value (NAV). As a result, the mutual fund manager may be required to sell securities in the open market to raise cash or maintain a cash balance in order to deliver cash back to the investor. Exhibit 4: Mutual Fund Flow Redemption Investor $ Cash Sell $ Units Cash Mutual Fund $ Cash Sell $ Stock Cash Market For illustrative purposes only. 13

16 ETF shares are created and redeemed in block sizes by large institutional traders called Authorized Participants (APs). The number of ETF shares that represent the block size that APs create/redeem is referred to as the creation unit and is defined in the prospectus of each ETF. Most ETFs in the United States create and redeem in predefined sizes ranging from 50,000 to 200,000 share blocks. The ETF structure, while still open-ended, can handle the creation/ redemption in one of two ways: through an in-kind process (in-specie) or via a cash process. (See Exhibits 5 and 6 below) With the in-kind process, APs will exchange a predefined basket of securities to the ETF issuer s custodial bank and receive a block of ETF shares. In the case of an in-kind redemption, APs will receive back a predefined basket of securities in exchange for ETF shares. In both the creation and redemption, the basket shares are exchanged in-kind between the custodial bank and the AP. Authorized Participants (APs): Market participants who have a legal contract (AP agreement) in place with an ETF trust and the custodial bank which permits them to create and redeem shares of the ETF. In-Kind Creation and Redemption: refers to the process which allows for shares to be created and redeemed by swapping ETF shares for the underlying constituents of the ETF. Exhibit 5: Behind the Scenes In-Kind Creation 2 Custodial Bank Basket of Securities 1 APs Exhibit 6: Behind the Scenes In-Kind Redemption 3 Custodial Bank Basket of Securities 4 APs Custodial Bank: ETF issuers utilize custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer. 3 4 ETF Units 2 1 ETF Units For illustrative purposes only. In certain ETFs, where it may be difficult to transfer securities in-kind, creation and redemption may be effected in cash. In cash creations, the AP will exchange cash to the custodial bank for a block of ETF shares equal to the creation unit. Similarly, in cash redemptions, the AP will receive cash equal to the redemption unit and the custodial bank will retire the ETF shares. While cash creations and redemptions are an alternative for certain ETFs, the majority of creations and redemptions in US-listed ETFs are affected in-kind. This in-kind creation and redemption mechanism is one of the sources of the tax efficiency provided by many ETFs. 3 The delivery of securities out of the ETFs as part of this in-kind redemption transaction is not considered a taxable event for the ETF, meaning that the ETF does not recognize any gain or loss for tax purposes from the securities removed from the portfolio. The primary source of the tax efficiency provided by many ETFs comes from that fact that majority of buy and sell activity of an ETF takes place on the exchange and away from the ETF, meaning the ETF does not need to buy or sell any securities in response to these trades. Cash Creation or Redemption/ Cash-in-Lieu (CIL): when an AP delivers cash to an ETF issuer to create new ETF shares, or receives cash back from the ETF issuer when redeeming shares. Cash-in- lieu may be done as part of an in-kind exchange in a basket with restricted securities or ID markets. For Institutional Investor Use Only Not For Use with the Public

17 Basket File: a file published daily by the ETF issuer, disclosing the securities and cash required for one creation unit. Market Maker: a dealer who undertakes to buy or sell in a security at specified prices by quoting bids and offers. Creation Unit: the specified number of ETF shares that represent one unit of the fund. This is the block share quantity that APs must deal in when interacting with the trust for creation or redemption. This is typically 50,000, 75,000, 100,000 or 200,000 ETF shares and is specified in the prospectus of each ETF. Mechanics of Creation/Redemption To meet the listing standards for Investment Company Units, ETF issuers must publicly disseminate a daily basket file for each ETF which discloses the securities and cash held for one creation unit. This basket file allows APs and market makers to be informed of the securities and/or cash that needs to be delivered to the custodial bank to establish one new creation unit. Conversely, this basket also represents the securities and/or cash the AP would receive when redeeming ETF shares. Exhibit 7: Sample Basket PowerShares BuyBack Achievers Portfolio Ticker PKW Component Count 168 CU Estimated Cash $1, Projected NAV $ Shares Outstanding 57,200,000 CU 50,000 CUSIP Standard CUSIP 73935X S3889 Securities CUSIP Name Basket Shares Price 00507V109 ACTIVISION BLIZZARD 1,008 $ J106 ADT CORP/THE 246 $ A106 ADTRAN INC 77 $ T100 AECOM 217 $ AIRGAS INC 105 $ ALBEMARLE CORP 110 $ G106 ALLIANCEBERNSTEIN HOLDING LP 137 $24.82 For illustrative purposes only. 15

18 When an ETF experiences buying pressure, liquidity providers may be able to meet demand by selling inventory positions. However, if the liquidity providers do not have inventory in the ETF, they may sell ETF shares short, while simultaneously buying the underlying basket of securities as a hedge. These offsetting trades allow the liquidity provider to reduce directional market exposure. Often the goal of the liquidity provider is to profit from the bid/ask spread while minimizing risk. Liquidity Provider (LP): a firm that is compensated through arbitrage or commission for the process of sourcing ETF shares for an investor. A liquidity provider may be a market maker or AP. Once APs have accumulated the requirements for a creation unit, they will exchange the underlying basket of securities for ETF shares with the custodial bank. The opposite process is true for redemptions. APs will buy shares of the ETF from investors while simultaneously shorting the underlying basket (or a correlated hedge). At the end of the day, they may redeem the ETF shares to the custodial bank and receive back the underlying basket, thereby flattening their position. Exhibit 8: Provide Liquidity. Lock in Spread. Hedge Exposure. Sell ETF* Buy Basket of Securities Liquidity Provider Buy ETF Buyer Creates ETF For illustrative purposes only. *These shares can be sold from inventory or sold short. For Institutional Investor Use Only Not For Use with the Public

19 ETF issuers utilize custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/ redemption orders from the AP on behalf of the ETF issuer. APs in the US are typically large financial institutions that must be self-clearing broker dealers, US-based and Depository Trust Company (DTC) members. Creation/Redemption Ticket Charge: the fee charged by the custodial bank to authorized participants creating and redeeming units of the ETF. An AP is charged a pre-defined fixed and/or variable fee by the ETF issuer s custodian to create or redeem shares of an ETF. This fee is paid by the AP and is called the creation/redemption ticket charge. The creation/ redemption processes and fees are unique to each ETF. As mentioned earlier, there are circumstances where creations/redemptions are handled via a cash create/redeem or, at times, a CIL process. With cash creations, APs are required to deliver cash equal to the NAV of the securities in the underlying basket in order to create new shares of an ETF. For cash redemptions, APs receive cash back for their ETF shares based on the NAV of the fund. The standard creation/redemption process of an ETF, whether in-kind or cash, is defined in the ETF prospectus. However, in certain circumstances, the ETF issuer may allow APs to use custom baskets. This may be done to help APs avoid restrictions they may face when transacting in a particular security. For example, if the AP is restricted in dealing in a particular component, they may seek to deliver the cash value for this security and use a custom basket which excludes the restricted security. DTC is an electronic bookkeeping system for the transfer of securities. 17

20 Fixed Income ETF Structure The fixed income market is generally an over the counter (OTC) market where trades are often negotiated privately between parties, and trade data may not be as readily available as it is for equities. Parties can have different viewpoints on pricing based on inventory, and the same instrument may trade at multiple prices in a short period of time. The fixed income market is more opaque and many bonds, such as corporate or municipal bonds, trade less frequently than their equity counterparts. Some corporate bonds may sometimes go days without trading, making them more difficult to price. Over the Counter (OTC): instruments that are traded off the exchange. ETFs holding fixed income instruments bring a new dynamic to the landscape, as the ETF is an instrument with full visibility as it trades on an exchange. Larger fixed income ETFs can trade millions of shares per day. With this type of volume, liquidity providers need to have an idea of what the portfolio of bonds is worth, regardless of how frequently the underlying bonds have traded. The ETF may act as a price discovery vehicle for the underlying basket of bonds, as the liquidity providing community determines fair value for the basket. Fixed Income Creation and Redemption The fixed income creation/redemption process is different from the equity creation/redemption process due to the OTC nature of the bond markets, and the disparate increments in which the bonds are transacted. With an in-kind fixed income ETF creation, it is rare that an AP would deliver all of the underlying securities in the basket, as fixed income securities typically trade by appointment. PHB, the PowerShares Fundamental High Yield Corporate Bond Portfolio, holds approximately 282 different bonds. For an AP to purchase all 282 bonds in the basket would be inefficient and difficult to facilitate due to the relative scarcity of certain bonds. Instead, the ETF portfolio manager will be in contact with the APs and market makers to request certain bonds in order to weight the ETF as close to its underlying index as possible. The AP would then deliver the requested bond(s) in-kind plus or minus cash to arrive at the NAV of the Fund for their creation. It may also be a practice with fixed income ETFs for an issuer to request the creation/redemption to be done via cash creation or cash redemption instead of in-kind. As an example, BKLN, the PowerShares Senior Loan Portfolio, is typically created and redeemed via cash. Instead of delivering the underlying securities for a creation, the AP delivers cash to PowerShares, the Fund provider, who will then purchase the underlying senior loans required for the Fund. For ETF liquidity purposes, it is important to note that the trading hours of most fixed income securities is between the hours of 8 a.m. and 3 p.m. EST. ETFs, on the other hand, will continue to trade until 4 p.m. EST. This difference in closing times can affect a liquidity provider s ability to hedge an ETF trade, as they no longer have access to the underlying bonds that comprise the ETF. For the last hour of ETF trading, liquidity providers may use futures and other highly correlated instruments to hedge their ETF trades. 5 5 Depending on circumstances, it may be possible to trade bonds after the close For Institutional Investor Use Only Not For Use with the Public

21 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

22 For Institutional Investor Use Only Not For Use with the Public

23 ETF Net Asset Value (NAV) and Indicative Optimized Portfolio Value (IOPV) Net Asset Value (NAV): is the value of all assets in the ETF minus any liabilities divided by total shares outstanding. NAV is calculated by the custodial bank and is disseminated once daily. In the US, there are additional requirements for meeting the listing standards for Investment Company Units beyond publicly disseminating the basket of securities. ETF issuers are also required to publish the value of the underlying basket using two different methods, a NAV and an Intraday Indicative Value (IIV) or Indicative Optimized Portfolio Value (IOPV). NAV For each ETF, the NAV must be publically disseminated on a daily basis as calculated by valuing the underlying securities in the fund, typically by their closing price. The NAV is calculated by taking all fund assets, subtracting any liabilities and dividing by total shares outstanding. This provides a daily snapshot of the value of the portfolio to the marketplace. Providing a NAV for the ETF based on the value of the underlying holdings is particularly useful for evaluating an ETF s value over a specific time period (i.e. day/ month/year). While the NAV calculation may be useful in providing a snapshot for end of day valuation purposes, it is not a trading tool for intraday valuation. As the underlying basket of an ETF fluctuates during the trading day, the value of the portfolio may deviate from the previous night s published NAV and appear to be trading at a discount or premium to NAV based on the basket s market movement. This should not be perceived as a discount or premium to the ETF s current fair value. Rather, it is the change in valuation based on the market movement of the underlying basket. For ETFs that have underlying basket components that close at times different from US equity market close (i.e., international equity, fixed income, futures based), the closing price of the ETF and the underlying basket value may deviate based on the market movement between when the basket closes and when the ETF closes. 21

24 ETF Net Asset Value Example: PowerShares S&P 500 Low Volatility (SPLV) As an example, Exhibit 9 shows the NAV for SPLV on Thursday March 19th 2015 at $ The order book for SPLV on March 20th at 2:22 pm, as shown in Exhibit 10, shows a bid/ask spread of $38.42/$38.43 and thus SPLV appears to be trading at a $.38-$.39 premium to NAV. Despite the appearance of a premium, SPLV was actually trading in line with the value of the underlying holdings; March 20, 2015 was simply a day when the underlying stocks in SPLV had appreciated, leaving the prior day s NAV stale intraday. Exhibit 9: SPLV NAV Source: Bloomberg L.P., as of March 19, For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public

25 Exhibit 10: SPLV Orderbook Source: Bloomberg L.P., as of March 20, For illustrative purposes only. 23

26 IOPV/IIV To help determine fair value of an ETF intraday, the Indicative Optimized Portfolio Value (IOPV), also known as Intraday Indicative Value (IIV) may be a helpful tool. The IOPV metric calculates a value of the ETF, based on the last print of each security contained in the ETF s basket and is mandated by the SEC to be published every 15 seconds. For ETFs comprised of US domestic equities, with constituents that trade frequently, the IOPV may be a reliable indication of ETF valuation. For ETFs comprised of international constituents, fixed income components or futures, the current market price of an ETF may deviate from the IOPV as the IOPV often utilizes last price which may be stale. For example, if an ETF that trades in the US holds constituents that trade in Japan, the constituents have ceased trading at the close of the Japanese market which is 3 a.m. EST, and will not trade again until 7 p.m. EST. Any implied market movement which has occurred since the last trade of the underlying basket will not be reflected in the IOPV calculation, as that IOPV is based on the securities last trade. Fair Value: the theoretical price at which the ETF is neither over priced nor underpriced. Intraday Indicative Value (IIV) or Indicative Optimized Portfolio Value (IOPV): the statistical value of the underlying holdings of an ETF published every 15 seconds and disseminated to the consolidated tape based on the last traded price of all the underlying constituents. This metric can be found on Bloomberg, as well as other financial sources. Due to the potential disconnect of trading times between certain international equity, fixed income, or futures-based ETFs, the IOPV may create the appearance of an ETF trading out of line with IOPV. In this case, the ETF s pricing in the secondary market may be a better indication of fair value than the IOPV. As many liquidity providers are often simultaneously posting markets in a particular ETF, a mispricing by one liquidity provider would lead to an arbitrage opportunity by another liquidity provider. ETF pricing and the arbitrage mechanism will be discussed in detail in the next section. As with the NAV, the IOPV is a useful tool as long as the IOPV calculation methodology and the limitations of the calculation are fully understood. Exhibit 11: Equity Market Schedules Domestic 9:30AM-4:00PM EST Mexico 8:30AM-3:00PM EST London 3:00AM-11:00AM EST Japan 7:00PM-3:00AM EST Europe 2:00AM-10:00AM EST Asia 5:00PM-1:00AM EST For Institutional Investor Use Only Not For Use with the Public

27 IIV/IOPV Domestic Equity Exhibit 12 shows the IIV/IOPV for SPLV at $38.07 on January 12, 2015, at 11:28:08. As you can see, this IIV/IOPV is in line with the bid/ask of SPLV on January 12, 2015 at 11:28:08 of $38.07/$38.08 as shown in Exhibit 13. Exhibit 12: SPLV IIV/IOPV Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. Exhibit 13: SPLV Bid/Ask Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. 25

28 IOPV and NAV for International Equity ETFs The IOPV for an international equity-based ETF often deviates from the bid/ ask spread of the ETF in the secondary market due to the differences in trading times. Exhibits 14 and 15 show the IOPV and the bid/ask spread for PXH of $18.56 and $18.48/$18.51, respectively. PXH is the PowerShares FTSE RAFI Emerging Markets Portfolio and is comprised of stocks listed in various emerging markets. Both screen shots were captured on Jan. 12, 2015 at 11:34:31 EST, a day where emerging markets were down roughly 1%. 1 The IOPV, in this example, is reflective of the last print of each of the securities in the basket. Despite the fact that the securities may have been closed for some time, the close price of that security is still used for IOPV calculation purposes. The IOPV price will not reflect any market movement that may have occurred after the corresponding component closings. The bid/ask spread of PXH in the secondary market, despite its appearance of being offered at a discount to IOPV, actually represents the most accurate fair valuation for the ETF. In this example, the ETF is acting as a price discovery vehicle for the basket given the various correlated instruments that are available to the liquidity providing community. Should one liquidity provider misprice the ETF, another liquidity provider may capitalize on this mispricing, trading the ETF until no additional arbitrage profit exists. Although the IOPV is often a reliable indication of fair value for ETFs comprised of domestic equities, it is important to understand the limitations of the IOPV for ETFs comprised of international components. We encourage you to contact the ETF capital markets desk to gauge fair value in these circumstances. Exhibit 14: PXH IIV/IOPV Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public

29 Exhibit 15: PXH Bid/Ask Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. 27

30 Fixed Income IOPV and NAV Unlike equity ETFs, with fixed income ETFs, the IOPV calculation may not be derived from the last price of all the underlying bonds in the basket. The IOPV calculation may use different swap or futures curves or bond valuation methods to determine an intraday value, which may cause the IOPV price to deviate from the ETF s trading price. As with equity-based ETFs, if a fixed income ETF is mispriced according to a liquidity provider s pricing model because of the arbitrage mechanism, that liquidity provider will trade the mispricing until the ETF falls back in line with fair value. With PowerShares fixed income ETFs, it is important to bear in mind that the calculation of the NAV is based on the midpoint between the bid and the offer of the bonds that comprise the ETF based on the bond close (typically 3 p.m. EST). If sentiment after bond close but before the ETF close (4 p.m. EST) is positive for bond prices, the ETF will appear to close at a premium to NAV on its 4 p.m. close; while with negative sentiment, the ETF will appear to close at a discount. It is important to understand the marking methodology for each fixed income ETF. For example, some fixed income ETFs utilize bid side marking for striking NAV while others may utilize mid marks. Balance of flows in and out of a fixed income ETF is a major factor in determining where the ETF will trade relative to its underlying basket of fixed income securities. If there is skewed demand to purchase (i.e., more buying than selling), most likely, liquidity providers will have to create shares of the ETF which will involve them transacting in the underlying securities by purchasing the bonds OTC at the bond dealers offer. This would cause the ETF to trade at a perceived premium to the mid-marked value of the underlying bonds. If demand is skewed to sell the ETF, liquidity providers may have to redeem the ETF, selling out of underlying bonds OTC at the dealers bid. This would cause the ETF to trade at a perceived discount to the mid-marked value of the underlying bonds. If however, inflows and outflows are balanced with activity both on the bid and offer, liquidity providers will be able to match up customer flow and avoid the need to transact in the underlying bonds and thus potentially reduce investor transaction costs. This balanced flow may also help reduce any premium or discount the ETF may experience to the mid-marked value of the underlying bonds. For Institutional Investor Use Only Not For Use with the Public

31 As shown in Exhibit 16 below, during the first quarter of 2014, BKLN traded at an average premium to NAV of 12 basis points. Over the period, BKLN, was in a consistent series of creations, with shares outstanding increasing 15%. As new shares were created, the underlying loans were sourced on or near the offer and thus the Fund was priced at a premium to NAV. BKLN Case Study: Fixed Income Premium Date: Jan. 2, 2014 March 28, 2014 Average Premium to NAV: 12 bps Series of Creations: when an ETF experiences skewed buyer demand and thus the need to create new shares. An ETF in a series of creates may trade near the offer of the ETFs underlying holdings. Exhibit 16: BKLN Average Premium to NAV BKLN US Equity Fund Percent Premium Fund Percent Premium Avg Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. 29

32 During the second quarter of 2014, as BKLN began to experience selling pressure, the fund entered a series of redemptions as shares outstanding dropped 3.4%. As shown in Exhibit 17, throughout this time period BKLN traded at an average discount to NAV of 9bps. Evaluating the first quarter premium to NAV of 12bps and the second quarter NAV of 9bps exemplifies the potentially cost efficient structure of the ETF. BKLN Case Study: Fixed Income Discount Date: April 1, 2014 June 30, 2014 Average Discount to NAV: 9 bps Exhibit 17: BKLN Average Discount to NAV BKLN US Equity Fund Percent Premium Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public

33 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

34 For Institutional Investor Use Only Not For Use with the Public

35 ETF Pricing Arbitrage: the process of buying or selling similar or identical instruments to realize a riskless profit. The Arbitrage Mechanism Arbitrage is the practice of simultaneously buying and selling similar or identical instruments for a riskless profit. Arbitrage is an integral facet to the ETF structure in that liquidity providers set their pricing around the cost to buy or sell an ETF s underlying basket plus carry costs, transaction costs and other frictions. In a US equity-based ETF, the liquidity provider may set their bid price lower than the price derived from the bids of all the constituents in the basket and set their offer price higher than the derived ETF price based on all of the offers of the constituents in the basket. If an investor sells at the liquidity providers bid price or buys at their offer price, the liquidity provider may simultaneously hedge their ETF trade with a trade in the underlying basket. Exhibit 18: The Arbitrage Mechanism Market Neutral Short Sell ETF Liquidity Provider Basket of Securities ETF Shares The Client Potential Creation of ETF Shares For illustrative purposes only. 33

36 If a liquidity provider s displayed offer is too high, other market participants will sell the ETF and simultaneously purchase the underlying basket, capturing an arbitrage profit from the mispricing. If a liquidity provider s displayed bid is too low, other market participants may purchase the ETF and short the underlying constituents. Exhibit 19: Arbitrage Basket vs. ETF Short ETF (higher cost) Long ETF Basket (lower cost) For illustrative purposes only. This arbitrage process may continue until the ETF price is driven back in line with the value of the underlying securities. It is important to note that the ETF price is not set based on supply and demand, as is the case for an individual security. Rather, due to this inherent arbitrage between the ETF and the underlying holdings, the ETF should trade close to the value of its underlying basket plus fees. For ETFs with underlying baskets with limited liquidity or ETFs with underlying baskets that trade during different hours than the ETF, liquidity providers often hedge ETF positions with instruments other than the entire underlying basket which will be discussed more detail in the next section: Components of ETF Liquidity. For Institutional Investor Use Only Not For Use with the Public

37 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

38 For Institutional Investor Use Only Not For Use with the Public

39 Components of ETF Liquidity When examining the potential liquidity of an ETF, it is important to once again look at the situation from the point of view of a liquidity provider, as they may be the party providing liquidity. From the liquidity provider s perspective, many times an ideal situation is to have traded ETF shares, lock in a spread and to finish the day with a flat or market neutral position. In order to do so, the liquidity provider may use one of three different hedges: The underlying basket constituents (as mentioned in ETF Pricing and the Arbitrage Mechanism), Related derivatives, and/or Other highly correlated instruments. Average Daily Volume (ADV): the average number of shares traded over a specified amount of time. ADV= total shares traded divided by number of days. If a highly correlated hedge can be constructed, liquidity providers can be active in providing tight, liquid markets in an ETF. The average daily volume (ADV) of the ETF itself can aid in liquidity helping natural buyers and sellers find one another in the secondary market and avoiding the need to create or redeem shares. However, ADV only begins to tell the story of the true liquidity that can be sourced for a particular ETF. The Underlying Basket and Implied Liquidity One hedge the liquidity provider can obtain is the underlying ETF basket, allowing arbitrage profit to instantaneously be captured. With this in mind, when determining the liquidity of a particular ETF, it is important to examine the liquidity of the underlying constituents of the ETF to gauge the number of ETF shares that may be traded without significantly impacting the price of the underlying components. Liquidity providers will likely hold their long/ short position until they are able to either zero out the position with a creation/redemption to the issuer (primary market liquidity), or flatten their position in the secondary market (secondary liquidity). Implied Liquidity: a daily measure of how many shares of the ETF can potentially be traded based on the underlying basket constituents. This measure is derived by taking a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks. To assess how liquid the underlying basket is, an investor may look at the implied liquidity of the ETF as a general indication. Implied liquidity is a statistical measurement that provides investors an indication of how many shares of the ETF can potentially be traded based on the liquidity of the underlying constituents. It is derived by calculating a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks. The implied liquidity figure allows an investor to determine the quantity of ETF shares that may be traded, while still remaining under 25% of the ADV in all underlying constituents of the basket. 1 The greater the trading volume of the underlying basket, the less the potential impact a sizable ETF trade may have. Implied Liquidity (30 day ADV x 25%) = x shares per creation unit (Least Liquid Constituent) Creation Size The implied liquidity function on a Bloomberg terminal uses 25% as a default 37

40 ETF Liquidity Beyond the Basket In the instance that a very large position is being established which may represent a high percentage of volume in the underlying constituents and thus be impactful, a liquidity provider may utilize a completion basket as a hedge. Completion baskets use many, but not all, of the constituents of the ETF basket and thus typically exhibit a high correlation to the ETF. The liquidity provider may then work into the more impactful trades over time seeking to minimize the impact. Related Derivatives Related derivatives, such as options, futures and swaps are common instruments used by liquidity providers to hedge their market risk and add another layer of liquidity to the ETF. These derivatives may often provide a quick, highly correlated hedge for an ETF trade. The liquidity provider may choose to implement a derivative hedge when the corresponding basket is closed or when it is more time efficient to trade one derivative as opposed to the entire basket. Unlike using the ETF s underlying basket, related derivatives may not be a perfect hedge and therefore may involve more risk for the liquidity provider. This increased risk may result in a potentially wider, less efficient market. To help reduce this risk, liquidity providers may seek derivatives with the highest correlation and then work out of the derivative hedge and into the basket over time. Other Highly Correlated Instruments Products, such as other ETFs, CEFs and UITs that have a high correlation with one another, allow liquidity providers to effectively hedge by trading one instrument against another. This is a very common practice when trading in US-listed ETFs with international constituents, where the ETF basket is closed while the ETF is actively trading. For example, if the liquidity provider sells an emerging market ETF and cannot source the basket at the time of the trade, they may use another highly correlated emerging market ETF to remain as close to market neutral as possible. Market Neutral: a hedged position that should not introduce positive or negative P&L or change in value due to market movement. For Institutional Investor Use Only Not For Use with the Public

41 For help assessing the liquidity of an ETF, please contact the PowerShares Global ETF Capital Markets team at: p: e: Secondary Market Activity in the ETF In addition to the liquidity that can be derived from the underlying holdings, the ETF s average daily volume in the secondary market can add an additional layer of liquidity. As natural buyers and natural sellers enter the market for the ETF, order flow can cross in the secondary market, providing an additional layer of liquidity. For an ETF, such as the PowerShares QQQ, which trades approximately 50 million shares per day, 1 it is very common that large share quantities can be traded without the need to utilize the methods previously described (i.e., primary market liquidity). Together, all of the components discussed contribute to the ETF s liquidity. A firm knowledge of the components of ETF liquidity may help alleviate fears of trading lower volume ETFs that do not appear to have significant depth in the secondary market. Exhibit 20: Components of Liquidity Underlying Basket & Implied Liquidity Secondary Market Liquidity ETF Liquidity Related Derivatives Other Highly Correlated Instruments For illustrative purposes only. 39

42 Components of ETF Liquidity Example SPLV Looking at SPLV, which is comprised of a subset of S&P 500 Index s securities, we can see an example of how this liquidity is sourced. As shown in Exhibit 21 below, on July 21, 2014, a 7,096,476 share block was printed near the screen offer of $ Just prior to this time, the secondary market showed available liquidity of only 3,800 shares. The trade happened at 10:48:22 EST when both the ETF and the underlying basket could be sourced during US market hours. With 30 ADV of 1,780,000 shares, a print of almost four times that amount underscores that additional ETF liquidity may be derived from the underlying basket. While a trade of this size may appear large relative to SPLV s ADV, it is only a small portion of the liquidity that can be derived based on the underlying holding. SPLV shows an implied liquidity of over 16.9 million shares. 6 SPLV Case Study: Components of ETF Liquidity Date: July 21, 2014 SPLV: 7,096,476 Share Block 30 ADV: 1,7800,000 shares Day Range: Exhibit 21: Components of ETF Liquidity (SPLV) Source: Bloomberg L.P., as of Jan. 12, For illustrative purposes only. 6 Source: Bloomberg L.P. as of Jan. 12, 2015 For Institutional Investor Use Only Not For Use with the Public

43 Overview of the ETF Landscape ETF Structure NAV & IOPV ETF Pricing & Valuation Components of ETF Liquidity Secondary Markets Alternative Methods of Execution Shorting ETFs Contact Information & Resources Glossary & Important Information

44 For Institutional Investor Use Only Not For Use with the Public

45 Secondary Markets National Best Bid/Best Offer (NBBO): the best (lowest) available ask price and the best (highest) available bid price posted on exchanges. Market Order: a buy or sell order placed for a particular security which will be executed immediately at the best available price. A market order prioritizes speed of execution over the price at which the order is executed. Exhibit 22: Order Book Security ABC Bid Ask Shares Price Price Shares 6,000 $25.21 $ ,000 20,000 $24.90 $ ,000 The process by which ETF trades are executed on US exchanges has changed significantly since the adoption of Regulation National Market System (Reg NMS) on Aug. 29, Reg NMS was established by the SEC in 2005 seeking to improve trading on the exchange. Since the implementation of Reg NMS, ETF (and equity) execution has become a more automated process where orders are electronically routed to the exchange at the National Best Bid or Offer (NBBO). This post-reg NMS environment makes it crucial for investors to understand the advantages and disadvantages of using market orders and limit orders. While a market order may be useful for a high urgency trade, it may leave an investor exposed to an unfavorable execution price. Particularly for thinly traded ETFs it may be beneficial to avoid using a market order, and to use a limit order. If a market order exceeds the size of the posted liquidity across all exchanges, the order will continue to be filled with any available posted liquidity on the screen until the order is completely filled. As an example, let s assume an investor wants to execute a market order to buy 25,000 shares of ETF ABC, which is thinly traded. For simplicity, let s assume the order book for ABC (see Exhibit 22) at the time of trade displayed 6,000 shares on the bid/ ask with a quote of $25.21/$25.55 and another 20,000 shares on the bid/ask with a quote of $24.90/$ If the market order to buy 25,000 shares is routed to the exchange, the order will give priority to the speed of execution and will be filled at the best prices available. In this situation, the investor will receive the first 6,000 shares at a price of $25.55, and if no other liquidity is displayed, the remaining 19,000 shares may be filled at $26.01, for an average execution price of $ Depending on the investor s goals for the trade, this may not have been the desired outcome. However, routing a market order to the exchange places priority on the speed to which the order is executed. It is important to note given the inherit risk, market makers rarely post on exchange the full depth of liquidity they are willing to provide in an ETF. Instead, they may post a limited number of shares in the secondary market with a tight spread around fair value. 43

46 Using limit orders instead of market orders can help avoid a deviation from the current bid/ask spread in the secondary market. A limit order puts the execution priority on price and will ensure that if the order is filled, it will be filled at the specified price or better. Depending on the objectives of the investor, entering a buy order at a cent or two above the current offer, or entering a sell order at or a cent or two below the current bid (often referred to as a marketable limit order), may be a viable alternative to entering a market order. In our previous example, with ETF ABC, had the client used a limit order, they would have protected the order from the deviation in the fill price by allowing the liquidity providers time to refresh their quote and offer up additional shares in the secondary market. 1 The technology used by liquidity providers allow quotes to refresh multiple times per second and may allow a limit order to be to be filled seamlessly at the specified price. Depending on the size of the order relative to the ADV of the ETF and the trading methodologies available, it may be advantageous to trade by using one of four alternative sources for ETF execution, discussed in the next section. Limit Order: an order to buy or sell shares at a set price or better. Limit orders do not guarantee an order will be filled. Marketable Limit Order: a limit order entered at or above the best offer (to purchase) or at or below the best bid (to sell) for a security. There may be a higher probability of execution than traditional limit order placed inside the NBBO. For questions on ETF trading, please contact the PowerShares Global ETF Capital Markets team at: p: e: capitalmarkets@powershares.com This is not a recommended trading strategy. However, using a limit order particularly for more thinly traded ETFs may help mitigate the risk of an undesirable fill price. For Institutional Investor Use Only Not For Use with the Public