The Evolution of Multi-Asset Strategies

The Evolution of Multi-Asset Strategies SERVING CLIENT NEEDS THROUGH EXCHANGE TRADED FUNDS For Financial Intermediaries and Institutional Investors Only - Not for Public Distribution

Table of Contents 01 Methodology 02 ETFs Gain Traction in Multi-Asset Portfolios 04 The History of ETF Managed Portfolios 06 Who s Using ETFs and Building ETF Managed Portfolios? 08 Key Drivers 12 Biggest Challenges 14 The Future of ETF Managed Portfolios 16 Connect with ishares

METHODOLOGY Our study of the size and potential growth of the Multi-Asset Portfolios and ETF Managed Portfolios markets consisted of two parts. PART 1 ishares Surveyed More Than 40 Asset Management Firms Global Asset Managers Boutique Asset Managers* Investment Officers/Consultants Retail Insurers They Represented Approximately $19 TRILLION In assets under management, including: $2.4 Trillion in MAS $117 Billion in EMPs $154 Billion in ETFs AUM as reported by clients The survey was conducted between September 18 and December 11, 2015, and included phone or face-to-face interviews and a questionnaire. SEP DEC * Boutique Asset Managers were the pioneers of ETF Managed Portfolio strategies. Their growth drivers, product development designs and distribution strategies are distinctly different from global asset managers. We define BAMs as having: Up to $50B under management More than one strategy built primarily with ETFs A robust ETF due diligence process A scalable EMP distribution model PART 2 Data on the size of the market is based on Morningstar, evestment and ishares Strategy, as of December 31, 2015. ishares [1]

02 ETFs Gain Traction in Multi-Asset Portfolios Both smaller institutions and retail advisors, especially since the global financial crisis of 2008, have been searching for a better way to provide more downside protection during volatile markets and offer clients goal-oriented products. Multi-asset strategies (MAS), particularly ETF Managed Portfolios (EMPs), have emerged as a good solution. As demand for MAS has grown, ishares embarked on what we believe to be first-of-itskind research to determine the size of the market and how large a role asset allocation strategies built with exchange traded funds (ETFs) play in the marketplace. We found that EMPs and MAS make up a much larger and growing part of the asset management industry, with more types of investors adopting them, than previously believed. According to our research: EMPs total an estimated $350 billion. This includes $60 billion in separately managed accounts of retail model portfolios, and $290 billion in variable insurance trusts, mutual funds, collective trust funds, institutional separate accounts and UCITS. 1 Currently at $2.8 trillion, we expect MAS to increase to 10% of the global asset management industry and represent over 25% of net new business in five years. We project the EMP market to double to over $700 billion by 2020, as institutional investors increasingly adopt this strategy through third-party managers and in-house development for larger pensions and endowments. We believe EMPs will account for 19% of MAS assets by 2020, growing from the current 12.5%. 12.5 % $350 Billion EMP MAS 2015 $2.8 Trillion 19 % $706 Billion EMP MAS 2020 $3.7 Trillion Source: Morningtar, evestment and BlackRock Corporate Strategy 1 UCITS stands for Undertakings for Collective Investment in Transferable Securities. A UCITS is a mutual fund based in the European Union that can be sold to any investor within the European Union under a harmonized regulatory regime. THE EVOLUTION OF MULTI-ASSET STRATEGIES

As part of our research, BlackRock interviewed clients representing nearly $19 trillion in assets under management across a wide range of channels, as well as industry observers. Our aim was to understand the growth and benefits of MAS, if and how they use ETFs in their strategies, and their views on EMP solutions. Among the growth drivers we uncovered: EMP growth is being driven by client demand for ETFs and the need for more innovative MAS solutions. The evolution of ETF products allows portfolio managers to deliver more precise exposure in asset allocation. With ETFs, portfolio managers can easily introduce goal-based solutions for smaller accounts, develop trading and time efficiencies, and stay competitive. Some MAS providers turn to ETFs in an attempt to reduce fee litigation risk, especially for retirement solutions. The participants also shared some of the challenges to incorporating ETFs in MAS. These included education and due diligence demands, active bias against ETFs, benchmarking, lack of desired ETFs, and confusion among consultants and database providers on how to categorize the MAS products. 25 % Boutique Asset Managers Firm $66 MAS $41 EMP $51 47 % Global Asset Managers Firm $16,151 MAS $1,943 EMP $46 13 WHO WE INTERVIEWED AUM in Billions 15 % Retail Insurer % OCIO/Consultants Firm $1,884 MAS $196 EMP $20 Firm $583 MAS $209 EMP $0.4 Source: BlackRock research. AUM as reported by clients. ishares [3]

04 The History of ETF Managed Portfolios The Rise of MAS Multi-asset strategies have been around for decades. Initially called balanced funds, these were created to address individual investors needs for solutions that can help them meet their financial goals. Asset allocation products provide professional and market-aware portfolio construction that seek to deliver institutional-quality outcomes for individuals. The trend toward MAS really gained momentum with the decline of defined-benefit pension plans and the need to provide retirement income for investors. With the U.S. Pension Protection Act of 2006, the Department of Labor made it clear that broad use of MAS like target date funds would benefit the financial health of American retirees. The global financial crisis of 2008 further spurred asset managers to build MAS with the ability to more tactically allocate across asset classes, including stocks, bonds, alternatives and cash. The global financial crisis was a wake-up call of how few truly low-correlated stocks there were, one allocator said in our survey. There will always be smart stock pickers, but empirical evidence shows there are very few managers who can consistently do that. WHAT IS AN EMP? ETF EMP EMPs are investment strategies with a minimum 50% allocation to ETFs MAS Many EMPs are themselves stand-alone MAS. However, some serve as a single-asset class or style-box-based solution that rolls up inside a broader MAS. EMP THE EVOLUTION OF MULTI-ASSET STRATEGIES

Enter EMPs When ETFs covering the basic asset classes proliferated in the early 2000s, a small number of boutique institutional money managers, registered investment advisers (RIAs) and turnkey asset management platforms saw an opportunity to implement their multi-asset allocation views in a new, more precise and low-cost way. These solutions became known as ETF Managed Portfolios, and the firms building them were called ETF investment strategists. Many EMPs are themselves stand-alone MAS. However, some serve as a single-asset class or style-box-based solution, such as emerging market equities, that rolls up inside a broader MAS. DIFFERENT WAYS CLIENTS CAN CONSTRUCT MAS WITH EMPs All ETFs Core of the Portfolio Precision Market Exposures These solutions gained traction in the retail sector, specifically with independent advisors, RIAs, and turnkey asset management platforms. In the same way that ETFs democratized access to asset classes that were previously only available to institutional investors, EMPs have made MAS accessible to a wider range of retail investors. At the peak, EMPs offered through investment strategies reached $89 billion in 2013. As the space has matured, however, demand for EMP solutions has also increased in the institutional sector, with large state pensions and endowments beginning to award mandates to asset managers with a track record in EMPs. For example, the Ohio Public Employees Retirement System was among the first pension funds to hire an ETF investment strategist when it allocated $525 million to Windhaven Investment Management in 2013. 2 2 Source: OPERS Board Meeting Summary June 2013 ishares [5]

06 Who s Using ETFs and Building ETF Managed Portfolios? ETFs have become the building blocks for global asset managers, retail insurers and consultants as a useful tool to implement asset allocation viewpoints. Some use ETFs tactically within a MAS to create alpha. Others build entire portfolios of ETFs to distribute as part of their own product suite or as models for advisors managing high-net worth portfolios. We found that EMPs are not simply confined to separately managed accounts. They are also being incorporated in model portfolios, variable insurance trusts, collective investment trusts, institutional separate accounts and mutual funds. Asset managers that are expanding globally also use ETFs within UCITS to offer them in Europe and Asia. A broad range of retail and institutional asset managers now build EMPs, including Global Asset Managers, Boutique Asset Managers, Retail Insurers and Outsourced Chief Investment Officers/Consultants. Asset allocators have especially taken to building EMPs as the expanding world of ETFs provides them with more options to easily express their views to achieve growth, income or capital preservation. Meanwhile, quant active managers are attracted to the ease of adding alpha by constructing rules- or factor-based, scientific solutions with ETFs. We want institutional risk management to be widely available, and EMPs are another wrapper that makes this available to people. Global Asset Manager How do we most efficiently deliver an exposure to investors, with liquidity and low cost? ETFs are the ideal vehicle to do that. Boutique Asset Manager THE EVOLUTION OF MULTI-ASSET STRATEGIES

Although active managers who remain focused on individual security selection are not building EMPs, they increasingly use ETFs strategically in their MAS, such as for equitizing cash or creating liquidity. For example, a small-cap mutual fund might use a small-cap ETF to put cash to work immediately while they source individual securities. As a long-term, open-architect, multi-asset provider, we feel more and more exposed that we don t have ETFs as part of a main component of our offerings, one active manager said. Passive investing is a component that we really need to offer, even if we think we have a superior solution in our active portfolio. However, some active managers said they limit the use of ETFs because they are still reluctant to use passive instruments and for regulatory reasons. One global asset manager, for example, said they restrict ETFs to no more than 10% of a portfolio. ETFs will continue to be a growing business because of fees. Retail Insurer ETF-based portfolios have generally outperformed active managers. OCIO/Consultant ishares [7]

08 Key Drivers We see the EMP segment growing hand in hand with the growth of both MAS and ETFs. Of the managers we spoke to, 83% said they believe EMP use will grow in the next two years, with 20% saying it could grow as much as 40%. HOW CLIENTS SEE EMP AND MAS DEMAND CHANGING OVER THE NEXT 2 YEARS Increase: Unspecified Increase >20% Increase between 5 and 20% No Change Decreasing 0 10 20 30 40 50 60 70 80 90 100 Percentage of Respondents Interviewed EMP MAS Source: BlackRock research THE EVOLUTION OF MULTI-ASSET STRATEGIES

OUR RESEARCH POINTED TO FOUR KEY REASONS FOR THIS GROWTH: 1. Client Demand Some asset managers, including active players, said they wouldn t have even considered using ETFs if clients weren t pounding the table for them. Half of the survey respondents indicated clients were requesting ETFs. With more than 1,700 different ETF products available in the U.S., professional investors and advisors seek help in the selection and management of these funds for their portfolios. EMPs allow managers to implement a multi-asset strategy at a lower cost and with trading ease. In addition to lower cost, there s greater demand for more dynamic management, and we view ETF managed portfolios as best suited for that. Investment Consultant 2. Increased Use of Goal-Based Strategies Managers are expanding their MAS investment options beyond just proprietary products to include goal-based strategies, and developing their expertise to include ETFs. Building multi-asset teams is becoming a higher priority with portfolio management firms globally. 3 One-third of asset managers currently not offering MAS have considered launching some. 3 76% of asset managers offering MAS products said they ve hired new investment staff to launch new products. 3 The earliest adopters of ETFs have already developed deep expertise. Nearly 40% of respondents have a designated ETF due diligence expert responsible for evaluating the funds and providers. 3 Source: FundFire Report Multi-Asset Arms Race, Spring 2015 ishares [9]

3. Active Asset Managers Growing Acceptance of ETFs Because ETFs provide trading efficiencies, active managers are finding them useful to build operational scale. ETF usage among asset managers has grown from $120 billion in the first quarter 2012 to $188 billion in the third quarter 2015, among 400 asset managers. 4 Per our survey, asset managers said they seek to enhance alpha by using ETFs: For liquidity or cash needs. To complete a portfolio strategy until desired individual securities become available. To access asset classes lacking good active sources, such as emerging market debt. In place of futures when futures are restricted or to reduce costs. 4. Industry Disruptions Various market changes serve as tailwinds for EMP growth. ETF-based robo-advisors are providing customized portfolios to a growing number of investors, at a lower cost. As asset managers, particularly those serving defined contribution plans, feel intensifying fee disclosure pressure from investors and regulators, some are drawn to the transparency and lower expense ratios of most ETFs to reduce litigation risk. ETFs help managers address new rules, such as the use of futures, fiduciary responsibility, and increased capital requirements set by regulators (e.g., U.S. Department of Labor) and legislators (e.g., Volcker Rule and Basel III). 4 Source: 13F Filings; BlackRock Business Intelligence Group [10] THE EVOLUTION OF MULTI-ASSET STRATEGIES

If you want to get that simplified exposure in the market, ETFs are the way to do it, rather than doing all the fundamental analysis of the underlying securities. Investment Consultant ishares [11]

12 Biggest Challenges Despite strong growth projections, respondents identified several obstacles in delivering strategies that incorporate ETFs. As we learn more about the specific needs of managers, BlackRock and the industry can work together to better meet those challenges. Education and Due Diligence Demands All interviewees acknowledge the longer due diligence required for both institutional asset owners and retail advisors. Investing in an EMP leads to a much higher allocation to a single provider and, in the case of retail advisors, this may be 100% of a client portfolio. It s always a hurdle, helping our clients understand ETFs. We have to educate them that ETFs can be a source of alpha, that ETF fees make sense on top of our fee, and how liquidity works. Boutique Asset Manager Active Bias Against ETFs For many active managers, incorporating passive funds is still against their culture for several reasons. Some see them as a blunt, retail instrument rather than an institutional one, despite the broad adoption of ETFs by the most sophisticated active asset managers. Also, some are reluctant to pay fees to a competitor, and they worry it will destroy their business model. These asset managers are still focused on debating active versus passive rather than seeing the strategies complementing each other. Industry observers said asset managers are more comfortable paying an embedded fee to a banker as opposed to paying a transparent fee to an ETF provider. Asset managers are a growing user of ETFs, but we still hear that some are hesitant. The concern is how they would justify holding an ETF of another asset manager in their portfolio. Industry Observer THE EVOLUTION OF MULTI-ASSET STRATEGIES

Benchmarking Because no two MAS providers offer the same products, benchmarking remains a challenge. What s the right peer group to compare to? Convincing an investment board to look at risk-adjusted returns helps, but it s not a perfect measure of performance. Software will have to evolve into searching for outcomes what is optimal risk budget, optimal mix of risk factors, portfolio characteristics and then find products that meet that, rather than benchmarks. Industry Observer Lack of Desired ETF Products Some micro-asset classes aren t available in ETFs, due to a lack of liquidity in the underlying instrument, lack of inventory, or difficulty pricing the underlying instrument (e.g., non-agency mortgages or collateralized loan obligations). Likewise, ETFs covering some countries or sub-sectors, particularly in bonds, are not available because of challenges in dealing with local markets. Category Confusion Both MAS and EMP product builders said consultants and database providers have had difficulty understanding where to bucket their strategies. As the product landscape has evolved, categorization has not kept up. Also, some of the consultants business models have to evolve to include ETFs as valid institutional funds for clients portfolios. A major pain point is that our focus is not traditional. When we meet with consultants, they don t know where to put the strategy. Portfolio Manager ishares [13]

14 The Future of ETF Managed Portfolios As end investors demand ETFs, financial regulations increase, and industry competition escalates, we see asset managers, insurers and consultants continuing to use ETFs inside their existing actively managed portfolios. We believe this will drive dramatic growth in EMP development alongside MAS: BlackRock estimates the EMP market could grow 15% annually to $706 billion in assets under management by 2020. Under more aggressive growth models, it could potentially reach as high as $940 billion. We see MAS growing 5.5% annually, nearly three times the overall industry and slightly ahead of alternative investments. The percentage of EMP assets held within MAS is expected to reach 19.2% by 2020, as the adoption rate of EMPs outpaces MAS as a whole. 5 5 Source: BlackRock Corporate Strategy THE EVOLUTION OF MULTI-ASSET STRATEGIES

Asset managers will likely continue to hold onto the lion s share of EMP assets under management, potentially jumping from $165 billion in 2015 to $293 billion by 2020. But retail platforms should also grow dramatically in the next five years an average 17% annually to an estimated $413 billion across various channels. Note that institutional investors also contribute to retail platform holdings. We expect most new strategies to be geared toward downside protection, income and tactical approaches, primarily developed by institutional investors. And as the use of ETFs and EMPs increases, it seems likely that more managers will build in-house due diligence teams to review and manage the selection of ETFs. EMP ASSET GROWTH PROJECTIONS BY CHANNEL 800 600 $ BILLIONS 400 200 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Wirehouses Independent Platforms Banks RIAs Small Platforms Direct / Robo Insurance Other Global Asset Managers Boutique Asset Managers Source: BlackRock Corporate Strategy, Morningstar, 13F and evestment Alliance As this market grows, ishares will continue to support asset managers and advisors in building EMP strategies through education, market insights, regulatory monitoring, and the development of next generation ETFs that cater to investor needs. ishares [15]

ishares RESEARCH 2016 Connect with ishares ishares has long been committed to partnering with clients to help them meet their investment goals and educate them about the ETF landscape. Commensurate with the rapid growth of ETF Managed Portfolios, ishares was the first firm to begin covering the segment in 2008 and looking at ways to connect asset managers with research and information to help them expand distribution of their ETF Managed Portfolio solutions. For more information, please contact your ishares sales representative or contact ishares at 1-800-743-9285. [16] THE EVOLUTION OF MULTI-ASSET STRATEGIES

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