ETF Due Diligence How to select the most efficient instrument Ursula Marchioni, Chief Strategist EMEA, ishares February 2016
The growth of index investing and of ETFs: Reasons, benefits, usages
The Growth on Index Investing In the U.S. and in Europe U.S. Domiciled Funds: AUM Split by ETFs, Index and Active Funds 100% 100% European Domiciled Funds: AUM Split by ETFs, Index and Active Funds 95% 98% 96% 90% 15% 94% 7% 85% 80% 17% 92% 90% 7% 75% 88% 86% 70% 65% 68% 84% 82% 86% 60% 80% Active Funds Index Funds ETFs Active Funds Index Funds ETFs Morningstar, as of 30 Nov 2015. Note: Fund categories include open-end mutual funds (excluding money market funds and fund of funds) and exchange traded funds (ETFs) domiciled in the U.S. and Europe, offered to both retail and institutional investors. Obsolete funds are also taken into consideration to calculate historical assets under management. 3
US$ billions Focus on ETF industry dynamics ETF Industry assets have been growing at more than 25% every year since 2009 Globally, ETFs have quadrupled in assets over the last 6 years Project the global industry assets under management will more than double by 2020 to over $5 trillion Global ETP Assets Projection $5tn 5,000 4,500 4,000 10-year CAGR for European-domiciled ETP assets is 25% 22% for Equity ETFs 37% for Fixed Income ETFs Forecasted CAGR for the industry assets 11% 3,500 3,000 Industry $2.9tn 2,500 2,000 1,500 1,000 500 ishares $1,107bn 0 2009 2010 2011 2012 2013 2014 2015 2020 Source: BlackRock. Estimates for 2020 based on PriceWaterhouseCoopers, ETF 2020: Preparing for a new horizon. Based on the projections of more than three out of four survey participants. CAGR: Compounded Annual Growth Rate. All calculations are as of 30 November 2015. 4
Exchange Traded Funds Structure and benefits ETFs are index funds listed and traded like a stock on major stock exchanges globally. They occupy a valuable position in the investment landscape: the intersection between an index fund and a flow product Like an index fund Exposure simplicity Transparency Investors can generally see the ETF composition at any given time Pricing is continuous throughout the day Benchmark returns Diversification Cost control Open-end Fund Cost- Effectiveness ETFs offer a cost-effective route to diversified market exposure Ability to estimate in advance the total cost of ownership using ETFs ETFs do not require the additional operation costs, settlement and reporting infrastructure that other index products require. Like a stock ETFs Diversification ETFs offer immediate exposure to a basket or group of securities for diversification through a single trade Broad range of asset classes, including equities, bonds, commodities, investment themes, etc. Nimble Ability to short Trading on exchange Intraday pricing Any transaction size Externalize transaction costs Flexibility Additional Liquidity ETFs are listed on exchanges and can be traded at any time the market is open No commitment, no minimum fee, only TER for the time the ETF is being held No notification of investment or withdrawal needed. Minimum size of one share (usually around 100) ETFs can be created and redeemed in kind. ETFs offer two sources of liquidity: Traditional liquidity measured by secondary market trading volume The liquidity of the underlying assets via the creation and redemption process 5
Exchange Traded Funds Portfolio applications Product use segments Low cost, broad building blocks for the core of client s portfolios Core investments Financial instruments Highly liquid tools to enable efficient trading and market access Precision exposures Easy access to targeted exposures to express a particular market view Over 700+ ishares globally Source: BlackRock 6
Usage of ETFs Shorter-term Longer-term Cash equitization Immediately deploy incoming capital and generate returns on excess cash Core allocation Gaining long-term exposures and implementing investment strategies Hedging Utilize variety of exposures to execute hedging strategies on existing positions Passive exposure in the core of portfolios as a longer-term strategy Interim beta Rebalancing Tactical adjustments Transition management Invest in the market while refining a strategic investment view Manage portfolio risk and beta tilts in between rebalancing cycles Over or underweight asset classes, regions or countries on the basis of short-term views Access beta exposure while providing time to thoroughly evaluate managers Liquidity sleeve Portfolio completion Easy ability to refine and rebalance portfolios, without the friction of moving assets around. Quick access to liquidity for unexpected and immediate needs Complete portfolio diversification by minimizing benchmark risk with pure exposure to specific areas of the market For illustration purposes only. 7
ETF Due Diligence: What to consider when investing in an ETF?
Key areas of consideration for ETF selection Index Various dimensions in benchmark selection Domiciled / Registration / Listing Being aware of different domiciles and product listings Structure and Risk Understand the ETP structure and structural risk Tax Tax considerations and implications Performance Evaluating ETF portfolio manager performance Assess the flexibility to trade when you need to Total Cost of Ownership How to analyse the true cost of owning an ETF Securities Lending Benefits and risks of securities lending in an ETF 9
Structure and Risk The alphabet soup Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Several tracking instruments are available to investors via stock exchanges: Exchange Traded Funds (ETFs) are often traded side-by-side with Exchange Traded Notes (ETNs), Exchange Traded Commodities (ETCs) and Exchange Traded Instruments (ETIs). Each of these products implies different levels of complexity and carry different structural risks. Exchange Traded Products (ETPs) Exchange Traded Funds (ETFs) Physically replicating ETFs: Fully replicating Optimised/partially replicating Derivative replicating ETFs UCITS-compliant Possible counterparty risk Exchange Traded Notes (ETNs)/Exchange Traded Commodities (ETCs) Not UCITS-compliant Non-fund debt structures Effectively unregulated Possible counterparty risk Exchange Traded Instruments (ETIs) Neither notes nor funds Non UCITS-compliant Source: BlackRock. For illustrative purposes only. 10
Structure and Risk ETFs: replication methodologies Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Indexing Strategies Securities Lending Physical, Full Replication Physical, Optimized Sampling Synthetic Replication All securities within an index are purchased according to their weightings. Seeks to ensure a minimal tracking error (deviations) of the portfolio. The full replication method may result in many positions depending on the index and requires a portfolio construction tool. It is used mostly for liquid and/or narrow defined indexes and for fixed income indexes without tax implications. A limited number of securities are considered. The number of securities determines the tracking error which can be forecasted. A minimum risk optimization is conducted by the use of a risk optimization tool. Ensures a controlled and low expected tracking error (deviations) of the portfolio eliminating economical unattractive investments. It is used mostly for indexes with illiquid investments and/or broad based equity and fixed income indexes. It is also used for fixed income indices with tax implications. Synthetic replication involves the use of derivatives (e.g. Equity-Linked Swaps ELS ). The manager receives benchmark performance in exchange of the substitute basket return from the counterparty (i.e. the ELS issuer). Through the ELS, the fund is subject to counterparty risk. Should the counterparty default, the investment objective may not be achieved. Source: BlackRock 11
Structure and Risk Replication methodologies: synthetic replication Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Synthetically replicated ETFs allow exposure to a broader investment universe Counterparty risk of max. 10% of ETF NAV (under UCITS structures) Due diligence needed for performance figures and swap structure (frequency of P&L clearing, # of counterparts, swap costs, etc.) Synthetically replicated ETF unfunded Synthetically replicated ETF fully funded Source: BlackRock 12
Tax for mutual fund investments in Equities Three levels to consider Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending LEVEL 3 Investors need to file tax returns, where required to per their jurisdiction of taxation LEVEL 2 No withholding tax on distributions except for US funds where there is withholding tax at up to 30% No tax on the funds portfolio income and gains Source: BlackRock. For illustrative purposes only. LEVEL 1 The fund purchases a portfolio of securities, for example an S&P 500 ETF will hold the constituents of the said benchmark When these stocks pay dividends e.g. Apple withholding tax can sometimes be applied to the dividends subject to the domicile of the fund and/or whether the jurisdiction paying the dividend applies withholding tax FOR INTERNAL USE ONLY 13
Understanding tax considerations when selecting an ETF US equities example Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Withholding taxes on ETFs investing in US equities Middle East investors $100 $70 $85 $85 $70 $70 Exempt Offshore Exempt Offshore Exempt Offshore 0% wht 30% wht 0% wht 0% wht 0% wht 0% wht US fund Irish fund German fund 0% withholding 15% withholding 30% withholding $300 $300 $300 US equities US equities US equities Withholding taxes on ETFs investing in US equities. Exempt Investors are investors who qualify for 0% US withholding tax such as sovereign wealth fund in Dubai Offshore investors are investors who pay the full 30% US withholding tax rate Source: BlackRock. For illustrative purposes only. FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY EMEAiS-1625 14
Performance Understanding Tracking Error and Tracking Difference Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending To evaluate Exchange Traded Funds (ETF) portfolio management performance, investors need to know how well an ETF tracks its underlying index. As part of the due diligence process, it is important that investors understand the sources of tracking, as well as how to estimate it accurately. Two metrics can serve this purpose: Tracking difference (TD): the total return difference between a fund and its benchmark index over a certain period of time. This metric measures the realized under-performance (or cost) suffered by / over-performance (or benefit) for the investor with respect to his/her objective of gaining exposure to the index. Tracking Error (TE): the volatility of TD (or the standard deviation of the difference in returns between a fund and its benchmark index). Average annualized tracking difference on an asset by asset basis Source: BlackRock, data as at July 2015. For illustrative purposes only. 15
Performance Key drivers of tracking Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Key drivers of TD and TE in physically and synthetically replicated ETFs Drivers of TE / TD Physical Swap-based Fund Holding vs. Index Yes No Cash management / Rebalancing Costs Yes No Swap spread* No Yes Tax treatment Yes In swap spread Securities lending Yes In swap spread *Sources of swap spreads can be positive (Securities lending revenue, potential favourable tax treatment on dividends) or negative (profit/coverage of fixed cost for swap counterparty, cost of hedging, cost of collateral, cost of capital) 16
Underlying Securities ETF Trading and Valuation Clients Can Place an Order in the Market Similar to a Stock Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Clients interact primarily on the secondary market, but the liquidity of an ETF extends beyond the secondary market. Securities Lending Buyers Sellers Liquidity Providers Broker Dealers Market Makers Authorized Participants Underlying Securities Creation and Redemption Activity ETF Shares Source: BlackRock. For illustrative purposes only 17
Underlying Securities ETF Trading and Valuation Market Participants are Behind the Scene Ensuring Liquidity Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Market participants will ensure that the liquidity exists in the ETF market by accessing the underlying securities to maintain the equilibrium of supply and demand. Securities Lending Buyers Sellers Liquidity Providers Broker Dealers Authorized Participants Market Makers Underlying Securities Creation and Redemption Activity ETF Shares Source: BlackRock. For illustrative purposes only 18
Layers of liquidity, fulfilling orders Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Exchange Liquidity (ADV) Compare volume and on-screen bid/offer data to total potential liquidity OTC Liquidity (Market Depth) Source liquidity through unique view on broker inventory management through Authorised Participant matching tool Primary Market (Underlying market) Continous monitoring of broker creation/redemption process and expertise to help identify best available liquidity 3 layers of liquidity 1) Exchange Liquidity 2) OTC Liquidity 3) Underlying Market Liquidity This is especially important to understand in the European market, where liquidity is more fragmented than in the US due to different exchanges, settlement entities, currencies The observed exchange average daily volume (ADV) represents only a fraction (estimated ~20%-30%) of the actual ETF volume (Including OTC & Primary Market activity) Source: BlackRock. For illustrative purposes only 19
bps Potential cost reduction Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending ishares ETFs generally offer price improvement, making the ETF less expensive to trade than the underlying securities of the respective index 100 90 86 83 86 80 70 60 50 53 60 50 40 30 20 10 3 3 3 29 12 13 12 25 17 23 0 FTSE 100 DAX MSCI Emerging Markets Corporate Bond Euro Corporate Bond Large Cap $ High Yield Corporate Bond Euro High Yield Corporate Bond J.P. Morgan $ Emerging Markets Bond Cost to trade ETF (bps) Cost to trade underlying basket (bps) For Illustrative Purposes Only. Source: BlackRock, Bloomberg as of October 2015 20
Total Cost of Ownership Index Domiciled / Registration / Listing Structure and Risk Tax Performance Total Cost of Ownership Securities Lending Assessing the cost of an ETF requires investors to look beyond the headline TER. While the TER is the most often quoted ETF expense indicator, there are additional components which influence the overall performance of an investment in ETFs such as, but not limited to, the bid/offer spreads paid to trade the product on the stock exchange; revenues from securities lending activities; swap spreads linked to synthetically replicated funds, and taxation. The concept of TCO captures them all. TCO is the combination of factors internal and external to the ETF instrument. Investors can think about a Proxy TCO (ptco), as per below Cost of purchasing Cost of holding Cost of selling Proxy TCO Assuming the ETF is bought on exchange, this will be approximately equal to ½ of the Bid/Offer spread of the ETF To estimate the total cost of this phase, we recommend using the Tracking Difference (TD) i.e. the difference in the fund and benchmark returns over the holding period. The TD includes: TER Securities lending revenues Swap spreads* Rebalancing costs* Assuming the ETF is bought on exchange, this will be approximately equal to ½ of the Bid/Offer spread of the ETF Source: BlackRock. 21
ETFs can save investors trading costs Index Domiciled / Registration / Listing Structure and Risk Tax Performance The ETF secondary market volume Total Cost of Ownership Securities Lending Extra layer of ETF liquidity Underlying BIDs ETF BIDs ETF ASKs Underlying ASKs Best Bid Best Ask Brings the ETF spread tighter than the underlying 100 80 60 40 20 0 53 3 3 3 29 12 13 12 FTSE 100 DAX MSCI Emerging Markets Corporate Bond Euro Corporate Bond Large Cap 60 50 25 $ High Yield Corporate Bond 86 83 86 17 Euro High Yield Corporate Bond 23 J.P. Morgan $ Emerging Markets Bond Cost to trade ETF (bps) Cost to trade underlying basket (bps) Source: BlackRock, Bloomberg, as at November 2015. Equity Fixed Income 22
TCO vs. TER Index Domiciled / Registration / Listing Structure and Risk Tax Performance The Irish domiciled S&P 500 ETF has a TER of 0.40% Tracking Difference (TD) = -0.07% 3m average spread = 0.03% The 12m TCO is noticeably lower and equal to -12m TD + spreads = -(-0.07)%+0.041% = 11.2bps 12m TCO = 0.11% Total Cost of Ownership Securities Lending 3m Avg Spread = 0.041% TER = 0.40% 12m TD = 0.68%-0.75% = -0.07% Source: BlackRock, Bloomberg. Data as at end of December 2015. TCO calculated over the 12 months. 23
To sum up: Comparing risk characteristics among different ETP structures Characteristic Physical Replicating ETF Derivative Replicating ETF Physical ETC Synthetic ETC Replication strategy Replicate the index by holding index constituents Swap agreement (unfunded or funded) to receive index performance Debt securities backed by physical asset Debt obligation issuing entity replicates index return through synthetic exposure Vehicle/issuer risk Assets held in ring-fenced segregated accounts or a ring-fenced company Assets held in ring-fenced segregated accounts or a ring-fenced company Unregulated private contractual arrangements None assets held in ringfenced segregated accounts within a ringfenced SPV Unregulated private contractual arrangements Credit exposure to the issuer reduced if notes collateralised Counterparty risk exposure Minimal counterparty risk Possible exposure within securities lending (can be reduced through over collateralisation) Credit exposure diversified with multi- swapcounterparties Risk exposure restricted to 10% (UCITS) can be reduced through collateralisation Minimal counterparty risk exposure Trustee has charge over physical, ringfenced assets No lending takes place Credit exposure to the issuer of the ETN or derivative contract reduced if notes collateralised Investors have full exposure to the risk of issuer default Can be reduced by collateral or guarantees Fee structure transparency Transparent all fees included in TER Securities lending reduces total cost of ownership Swap spread (positive or negative) and TER are reduced from the fund performance Transparent all fees included in TER Transparent fees included within the TER and benchmark replication fee Performance metrics Tracking difference result from trading, optimisation and rebalance costs from holdings Swap counterparty guarantees the index return TER and swap spread reduces index return The certificates/notes provide exposure to the spot price of the physical asset less the TER Return the index exposure less TER and benchmark replication fee plus any return from collateral Holdings transparency Holdings published daily Holdings, fees, risk exposure and collateralisation publishing varies Holdings (physical asset entitlement) provided daily Generally less transparent regarding SPV holdings Source: BlackRock. 24
Appendix: Highlights from the Greenwich Survey 2015
Greenwich Survey an overview The Greenwich Survey polled institutional investors on their usage of ETFs, in the US and in Europe Q) Are institutional investors using ETF? Q) What are the most common applications of ETFs by institutional investors? Q) Which asset classes are intuitional investors using ETFs for? Q) What are the main reasons institutional investors are using ETFs? In 2014, 19% of US In the US, ETFs are most Equity remains the main asset 77% said efficient market institutional investors used commonly used a core part of class that institutional access was the primary ETFs as part of their asset the asset allocation (69%). investors are using ETFs for. reason for using equity ETFs. allocation. In Europe the number one use Fixed income ETFs are an For fixed income, 92% said In continental Europe this was for ETFs was to provide area of growth with 27% of US ease of use was the primary slightly higher at 25%. international diversification institutional users and 33% of reason for using ETFs. (69%). European institutional users Additionally, lower trading now using ETFs for this asset costs vs cash bonds was also class. an important feature. Source: Greenwich Associates 2014 US and 2014 Continental European Institutional Investors Studies Note: Data based on responses from 673 in 2014, 591 in 2013, 526 in 2013 and 541 in 2011. 26
Greenwich Associates: the impact of Illiquid bond markets Institutions are struggling to source and trade bonds 43% of asset managers (AM) report bond markets are harder to navigate. 66% of AMs say their investment processes have been impacted. The volatility since 2008 makes us more concerned about when we need to sell things. What time of year? What quarter? Before the financial crisis it wasn t much of a concern. Pension fund manager Fixed Income ETFs are being used alongside individual bonds The 53% of ETF users who employ this approach say they do so for three main reasons: easy exposures, increased liquidity, and diversification. Trading environment over the past two years Have you faced challenges in trading, liquidity, or sourcing securities in fixed income markets? 1 More challenging About the same 34% 61% Have the challenges affected your investment process? 2 No 47% Yes 53% Fixed Income ETF liquidity is growing rapidly Since 2008, volumes for the top 5 FI ETFs are up 75x, significantly outpacing asset growth, which is up 17x. Less challenging 5% Source: Greenwich Associates 2015 US Fixed-Income ETF Study 1.Based on 119 respondents in 2015. 2.Based on 40 respondents in 2015. Source: Greenwich Associates 2015 US Fixed-Income ETF Study 27
Greenwich Associates: ETFs as a liquidity solution 59% of fixed-income ETF users have increased ETF usage since 2011 40% of investment managers plan to increase their use of bond ETFs in the coming 12 months 0% of users expect to decrease ETF allocations Reasons for using ETFs alongside cash bonds ETFs as substitutes for derivatives Ease of exposure 38% Do you use fixed income derivatives? 1 Are you considering ETFs as an alternative? 2 More liquidity 34% Diversification Duration management Placeholder/replacement 9% 19% 16% No 72% Yes 28% Yes 58% No 42% 0% 10% 20% 30% 40% 50% Based on 32 respondents in 2015. Source: Greenwich Associates 2015 US Fixed-Income ETF Study 1. Based on 128 respondents in 2015. 2. Based on 36 respondents in 2015 who use derivatives. Source: Greenwich Associates 2015 US Fixed-Income ETF Study 28
Greenwich Associates: The versatility of fixed income ETFs is driving demand One-quarter of the institutions in the study and 40% of the investment managers plan to increase their use of bond ETFs in the coming 12 months. Zero respondents said they expected to reduce their ETF allocations. Expected increase in ETF use Top reasons institutions use FI ETFs Over 20% 11-15% 9% 18% 15-20% (0%) Easy to use Quick access 97% 81% 93% 78% 6-10% 27% Single-trade diversification Liquidity 87% 73% 85% 80% 1-5% 45% Avoid need for single security analysis Lower trading costs vs. cash bonds 63% 41% 60% 56% 0% 25% 50% 75% 100% 2015 2013 Based on 58 respondents in 2015. Source: Greenwich Associates 2015 US Fixed-Income ETF Study Based on 60 respondents in 2015 and 59 respondents in 2013. Source: Greenwich Associates 2015 US Fixed-Income ETF Study 29
ishares EMEA Investment Strategy and Insights (ISI) Research, Asset Class strategy, Marco Outlook ISI serves clients at an arm s length to provide services around five main pillars: 1 2 3 4 ETP Research and Implementation: helps clients understand the broader ETP Market, with research and thought leadership around ETP global flows and trends; market structure and regulation; ETP due diligence and index research; ishares Equity Strategy: helps clients understand the ishares EMEA Equity product suite, including benchmark analyses; fund s replication strategy; fund s set up; fund s performance; taxation; risks etc. ishares Fixed Income Strategy: helps clients understand the ishares EMEA Fixed Income product suite, including benchmark analyses; fund s replication strategy; fund s set up; fund s performance; taxation; risks, etc. Investment Strategy: helps clients identify promising macro-themes and investment ideas, which can be implemented using ishares ETFs 5 ipas: Provides information to help clients build ETP portfolios that match their risk/return objectives Investment Strategy ETP Research & Implementation Asset Class Strategy: Fixed Income Asset Class Strategy: Equity & Commodity 30
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