EXCHANGE-TRADED FUNDS: What Fund Boards Need to Know when Considering ETFs

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1 EXCHANGE-TRADED FUNDS: What Fund Boards Need to Know when Considering ETFs Stacy L. Fuller Peter J. Shea May 26, 2016 Copyright 2016 by K&L Gates LLP. All rights reserved.

2 WHY BOARDS ARE DISCUSSING ETFS Source: ETFGI.com klgates.com 2

3 WHY BOARDS ARE DISCUSSING ETFS As of March 31, 2016* Assets invested in US-listed ETFs/ETPs reached a new record of US$2.17 trillion surpassing the prior record of US$2.15 trillion (May 2015). The US ETF/ETP industry had 1,863 ETFs/ETPs from 94 providers listed on 3 exchanges In March 2016, US-listed ETFs/ETPs:* Net inflows of $33 billion, including Equity ETFs/ETPs over $22 billion Fixed income ETFs/ETPs over $8 billion Commodity ETFs/ETPs approximately $1 billion * Source: ETFGI.com klgates.com 3

4 WHY BOARDS ARE DISCUSSING ETFS Net inflows for past three years ETFs:* 2013: $188 billion 2014: $243 billion 2015: $200+ billion Mutual Funds:** 2015: ($125 billion) Commentators expect positive 2016 for ETFs Growing investor acceptance Institutional and active managers entering market * Source: ETF.com (as of November 30, 2015) ** Factset klgates.com 4

5 WHY BOARDS ARE DISCUSSING ETFS Changing Distribution Landscape Rise of fee-based accounts Increased regulatory pressure on shareholder servicing fees E.g., distribution-in-guise initiative DOL Fiduciary Rule ETFs in this context -- Flight to passive? Flight to ETF structure? klgates.com 5

6 ETFS: A REFRESHER COURSE What are ETFs? Open-end funds whose shares trade on a stock exchange Hybrid of mutual fund and closed-end fund Only Permitted by SEC exemptive order that -- Allows sales/redemptions only in large aggregations of shares (Creation Units) Allows only institutional investors (APs) to purchase/redeem Creation Units at NAV Allows shares to be sold on exchange at market prices klgates.com 6

7 ETFS: A REFRESHER COURSE Hedging Futures/ ETFs Secondary Market Primary Market Subscription in kind The AP delivers a basket of securities and the ETF issues shares Private Investors Brokers Buy / Sell Order Stock Exchange Bid/offer Price Authorized Participants Securities ETF Secondary Market Redemption in kind The ETF delivers the securities and the shares are redeemed Primary Market 7

8 ETFS: A REFRESHER COURSE How do ETFs work? APs contemporaneously purchase ETF shares at NAV and sell individual shares on exchange APs contemporaneously redeem ETF shares at NAV and purchase individual shares on exchange Contemporaneous ability to purchase/sell on exchange and at NAV creates arbitrage opportunity Arbitrage opportunity causes convergence between market price and NAV klgates.com 8

9 ETFS: A REFRESHER COURSE How do ETFs work? Market Price at premium to NAV NAV NAV 1. Buy index portfolio, sell ETF short 2. Deliver index portfolio to create ETF at NAV 3. Close short by selling ETF at profit OR 1. Create ETF shares at NAV 2. Sell them for a profit in the open market Market Price at discount to NAV 1. Buy ETF, sell index portfolio short 2. Redeem ETF at NAV in exchange for index portfolio 3. Close short by selling index portfolio at profit OR 1. Buy ETF shares in the open market 2. Redeem block of ETF shares at NAV This ensures that the ETF trades close to its NAV The NAV does not change, the trading price does

10 ETFS: A REFRESHER COURSE Why are most ETFs index-based? Historical reasons ETFs were developed as a trading vehicle Not an investment vehicle First ETF was a UIT Arbitrage mechanism depends on portfolio transparency because APs that buy ETF shares to sell on exchange need to be able to hedge position in ETF shares while held APs that sell ETF shares short on exchange (prior to purchasing a Creation Unit) need to be able to hedge short position klgates.com 10

11 ETFS: A REFRESHER COURSE What strategies have been permitted by the SEC? Broad-based index ETFs Smart beta (index) ETFs Fully transparent actively managed ETFs Exchange-traded managed funds (ETMFs) klgates.com 11

12 BOARD CONSIDERATIONS FOR ALL ETFS Advisory fee comparison based on advisory services provided to ETF and comparable (mutual) fund Side-by-side management Competition for adviser s resources Preparedness of adviser for in-kind purchases/redemptions of Creation Units ETF structure bi-furcates portfolio trading between adviser s trading desk and APs Distribution strategy Volume; Premium-Discount klgates.com 12

13 OFFERING INDEX-BASED ETFS Advantages Regulation wellestablished; no surprises ETFs based on broadbased indexes have potential to attract institutional traders Generic listing standards permit most index-based ETFs to launch without additional SEC approvals Tax-efficiencies relative to comparable mutual fund Disadvantages Intense fee competition ishares (<0.07% adv fee) Schwab (<0.07% adv fee) Vanguard (similar) klgates.com 13

14 OFFERING SMART BETA ETFS Advantages Can package rules based active strategies as index methodologies Recent filers for smart beta: Fidelity, Franklin Templeton Regulation wellestablished; no surprises Generic listing standards permit most index-based ETFs to launch without additional SEC approvals Disadvantages Moderate fee competition Listing rules generally require -- Firewall between ETF PM and affiliated smart beta index provider Unaffiliated calculation agent Full portfolio transparency required Rules-based process required klgates.com 14

15 BOARD CONSIDERATIONS FOR INDEX-BASED AND SMART BETA ETFS Market saturation Availability of desirable indexes to track (Intense) fee competition Ability of sponsor to compete Financial resources Economies of scale NTF ETF platform participation Impact on comparable (mutual) fund For smart beta ETFs: Establishment of affiliated index provider Costs Feasibility of firewalls klgates.com 15

16 OFFERING FULLY TRANSPARENT ACTIVELY MANAGED ETFS Advantages Can use existing active strategy for ETF May be able to use performance record of current actively managed mutual fund to sell ETF Master-feeder structure ETF share class structure Related performance in prospectus of ETF 1940 Act regulation wellestablished; no surprises Disadvantages Full portfolio transparency required Secret sauce concern Front-running; free-riding No generic listing standards; every active ETF needs explicit approval from the SEC to list its shares on an exchange Lengthy process; delays due to ever-changing 1934 Act regulatory requirements klgates.com 16

17 BOARD CONSIDERATIONS FOR FULLY TRANSPARENT ACTIVE ETFS Full portfolio transparency Fiduciary duty concern Impact on comparable (mutual) fund Cannibalization Unique concerns if Master-feeder or ETF share class Capacity constraints ETFs may not be permitted to close (as mutual funds do when reaching capacity) Strategy dilution klgates.com 17

18 ARE NON-TRANSPARENT ACTIVE ETFS COMING? Challenge: Provide sufficient information for arbitrage mechanism to cause market price and NAV to converge, but not enough information to give away secret sauce Several proposals pending with SEC Real-time NAV disclosure (Precidian) Hedge portfolio/tracking basket (T. Rowe Price, Vanguard, NYSE) NextShares (currently available!) Side-step the challenge by using forward pricing klgates.com 18

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