Non-Transparent Actively Managed ETFsA Revolution in the Making

Exchange Traded Forum 2013Toronto

May 2, 2013

Jeffrey Shaul, CFA, FCSI, President and CEO

� Actively managed ETFs launched by traditional mutual funds could be the next wave of growth in ETFs

� Will revolutionize the mutual fund industry

� Multiple industry trends suggest 2013 could be turning point

� Transparency is key hurdle, especially for equity funds

� Rules in Canada differ from those in the US, so the revolution could start here before the US

The Coming Revolution in Actively Managed ETFs

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ETF Asset Growth in Canada Since 2000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

ETF AUM $6.0 $4.9 $5.4 $7.1 $8.9 $12.3 $15.1 $17.8 $19.1 $30.1 $38.2 $43.2 $56.4

# ETFs 3 14 15 16 16 20 25 45 76 108 157 227 265

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100

150

200

250

300

$0

$10

$20

$30

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$50

$60

# ETFs ETF AUM (C$ Billions)

Source: Canadian ETF Association (Investor Economics)

� ETF asset growth – $13.2 billion (30.6% increase) in 2012– current level $59.5 billion (Mar 31/13)

� ETF asset growth rate 3.3x that of open end mutual funds, mostly through new creations

� ETFs still only 6.6% of Canadian mutual fund assets (Mar 31/13) (compared to approximately 10% in US)

� Broker survey in 2012 – 52% of brokers reported ETFs represent less than 10% of client assets – potential for growth

ETFs in Canada – Current Stats

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Source: CETFA / IFIC

� Fee disparity mutual funds (2.3% MER) vs. ETFs (0.50% MER)

� Majority of Canadian ETF assets in equities

� Passive index based ETFs dominate – actively managed ETFs represent only 6% of industry AUM

� ETF investors in Canada – 65% retail / 35% institutional(and roughly 1/2 of retail is discount brokerage)

ETFs in Canada – More Current Stats

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� Increasing use of ETFs as core elements of buy and hold portfolio strategies

� Active strategies are growing rapidly – fundamental, smart beta,factor indices, covered calle.g. BlackRock new factor-based, ‘enhanced beta’

Wisdom Tree fundamental indices-based

ETF Industry – Trends

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� Mutual fund AUM in MFDA declining as % of total mutual fund AUM

� Number of mutual dealers declining

� Mutual fund reps moving to IIROC firms – greater flexibility, choicein investments

� Compliance costs forcing move to larger IIROC firms

Trends in Canada – MFDA vs IIROC

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� Trend towards advisor compensation based on assets – removesdisincentive to invest client assets in ETFs

� CSA looking at advisor compensation, particularly trailing commissions (CSA December 2012 Discussion Paper, planned June roundtable)

� There is support for dismantling the current structure of mutual fund fees – i.e. separate fees for fund management andinvestment advice (Steadyhand Investment Funds)

� Some argue for outright ban on embedded trailing commissions(FAIR Canada)

Trends in Canada – Trailing Commissions

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� Actively managed ETFs expected to be fastest growing segment of the ETF industry over the next 5-10 years

� McKinsey & Co. expects $500 billion AUM in actively managed ETFsby 2020, and some believe much higher

� Recent paper by SEI Investments predicts actively managed ETFs will ultimately compete with traditional active mutual funds for market share

ETF Industry Trends – Actively Managed ETFs

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� Daily disclosure of portfolio details mandated by SEC

� Designated brokers (authorized participants) need to know portfoliodetails for hedging and arbitrage, to ensure tight spreads

� Not an issue for passive ETFs – underlying index contents are known

� For actively managed fund, disclosure of portfolio exposes fundto risks of free riding and front running

ETF Transparency

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� Some US fund managers have applied to SEC to allow ETFs without daily disclosure of portfolio details:

BlackRock November 2011 Eaton Vance April 2013

� Others simply waiting for rules to change:T. Rowe Price Vice Chairman Edward Bernard stated at recentannual meeting that the company has no immediate plans to offeractive ETFs, as it would have to reveal too much about the stocksor bonds under current SEC rules, which would enable otherinvestors to put together their own portfolio of the same companies(as reported in Baltimore Business Journal, Apr 23/13)

ETF Transparency – (cont’d)

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� So far, active strategies in equity ETFs in US limited to greater useof derivatives, fundamental indices, factor indices

� SEC has granted relief in certain areas such as use of derivatives,but as yet has not allowed non-transparent ETFs

� The mutual funds that have entered the ‘true’ active ETF space, havedone so in the fixed income area

� T.Rowe Price Vice Chairman Bernard at annual meeting stated thatif it launches an active ETF, it may start with a bond portfolio thatwould be difficult for other investors to duplicate on their own

ETF Transparency – (cont’d)

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� Actively managed fixed income ETFs fast growing segment– PIMCO bond ETF has lower fee than its mutual fund

� Mutual funds themselves say transparency is threshold issue – howelse to explain BlackRock and Eaton Vance applications

� Arguably better to cannibalize, suffer some margin erosion, than lose assets to competitors’ ETFs

Some Say Cannibalization is Bigger Issue…However

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� Intraday liquidity and price discovery

� Lower fees vs. conventional mutual fund format

� Better access through discount brokerage accounts to fund classwith no broker trailing commission

� Greater fee transparency and simpler fee structure with ETFs – no front-end load, DSC, or low load charges

ETF Format Better for Investors

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� Perception that more liquidity always better than less

� Having intraday liquidity does not mean they will necessarily beused as trading vehicles – comforting even if not used often

� More flexibility to choose entry or exit strategy, and take advantageof potentially large intraday market moves

� More flexibility to manage risk, e.g. stop loss orders

Some Say Daily Liquidity Not Needed…However

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� More efficient format for mutual funds to administer – CDS vsFundSERV

� Better posted fund returns (in addition to lower fees) because withETFs the MF does not incur trading costs

� More efficient for brokers to execute bulk orders across multipleaccounts vs. separate orders for units through FundSERV

� However, mutual funds may see some fee erosion, brokers/dealersmay lose trailing commissions, and MF dealers cannot sell ETFs

ETF Format – Impact on MFs and Dealers/Brokers

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� Unlike in the US, actively managed ETFs in Canada are not requiredto disclose holdings daily

� There are a few actively managed ETFs in Canada – portfolio isdisclosed to designated brokers, but not to public – OSC isconcerned about this disparity

� In Canada the problem is a practical one – how to enable efficientmarkets in actively managed ETFs if designated brokers do not know portfolio details daily

Canadian Rules on Transparency

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� Proprietary systems have been developed, including Robson

� Avoid need for daily disclosure of portfolio contents

� Other features/benefits of ETFs are still present:– intraday liquidity– intraday price discovery– creations and redemptions in-kind

� Still enable efficient market pricing– hedging and arbitrage

Systems for Non-Transparent Actively Managed ETFs

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� ETF growth accelerating in past few years (AUM tripled sinceend 2008) – MFs now taking notice

� Mutual funds have enjoyed high margins

� Symbiotic relationship with dealers and brokers re fees

� MFs only now starting to see asset drain to ETFs hurting profitability

� MFs now coming to recognize that ETFs are here to stay and poseserious threat

Why Canadian MFs Have Not Yet Launched ETFs

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� Major Canadian mutual funds are closely examining ETFs

� At March 31, 2013 mutual fund assets reached $901 billion, roughly 60% ($500 billion) invested in equities

� On the assumption that 40%, or roughly $200 billion invested in large capitalization, high liquidity Canadian equities, the most applicable target for initial adoption non-transparent ETF system

� Market potential even higher when balanced funds are included

� Significant growth potential vs. current ETF AUM of $59.5 billion

Market Potential

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� Market for passive ETFs becoming saturated

� Future ETF growth likely to come from actively managed

� Transparency is key stumbling block for actively managed equity

� In Canada, problem is practical one, not regulatory

� Significant potential, could revolutionize the ETF and MF industries

The Revolution

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