The Rise of Active Indexing - CFA InstituteThe Rise of Active Indexing – How ETFs Have Disrupted...

The Rise of Active Indexing – How ETFs Have Disrupted Investing, Trading and Asset Management

Joanne M Hill, Ph.D. CBOE Vest, Chief Advisor for Research and Strategy Chair, Research Committee, CFA Institute Research Foundation

CFA Institute 71st Annual Conference, May 2018 CFA Society, Dayton, December 11, 2018

16-04074, 2016-5725

Agenda

The Rise of Active Indexing – How ETFs Have Disrupted Investing, Trading and Asset Management

A.  Fit of ETFs into the Evolution of Investment Strategies and Markets in the 21st Century

B.  ETF Mechanics, Features and Why They Appeal to Investors C.  The ETF Landscape in 2018 -Assets, Flows, Trading, and ETF

Managers D.  The New Active – Factor (Smart Beta) Strategies in ETFs. E.  Takeaways and A Forward Look at the ETF Industry

2

Content of this presentation is for CFA members and financial professional use only and not for further distribution without permission. It solely reflects the views of the author and can be quoted with permission. Contact information [email protected]. Many thanks to Elisabeth Kashner of FactSet, Victor Lin of Credit Suisse, Ben Johnson and Jackie Choy of Morningstar, and Eric Balchunas of Bloomberg for their insights and data assistance.

ETFs in Context: Historical Evolution of Index Strategies and Products

Early 1970’s Mid-to-Late 1970’s 1980’s 1990- 2000’s

Transaction Costs Sensitivity

Quantitative Equity Management

Global Asset Allocation

Risk Management

Block Trading

Index Futures

Index Options

Basket Trading

ETFs

International Futures

OTC Options/ Structured Notes

Equity Swaps

Portfolio Restructuring

Stock Options

Individual Stock

Selection Index Funds

Synthetic Index Funds

Tactical Asset

Allocation

Portfolio Insurance

Alpha/Beta Separation

Absolute Return

Risk Parity and Risk Target

Downside Risk Strategies

Growth Accelerates

For illustrative purposes only.

Investment Management

Equity Trading Tools

Factor- Based Strategies

3

Breaking Out of Asset Allocation Buckets and the Active-Passive Divide

After two deep bear equity markets in the last two decades the seeds of change came to investing and trading.

Index & ETF Investing Grows

Rules-based active strategies become available, especially in ETFs. Active management shifts toward a more top-down focus on risk factors and investment themes.

Risk Factors – Key Part of Process

Multi-Asset Class and Tactical

Expanded role for multi-asset class, inverse, and variable equity risk strategies with tactical opportunities and changes in market risk.

4

OUT: Discretionary active, hedge funds, OTC products IN: Transparent index strategies, lower fees, ETFs, quantitative investment approaches

ETFs have thrived in periods where investors have responded to the need for managing index exposure dynamically. In asset classes like fixed income and commodities, ETFs have transformed the way investors access exposure.

Greater Focus on Top-Down Investment Strategies Investment decision-making is changing: Active management used to mean stock or bond portfolio selection. Now there is more attention to top-down and risk factor-based investing. The Old The New

The New

More focus on: •  total portfolio and downside risk management •  contributions to return vs. risk.

5

Bottom-Up (micro)

Top-Down (macro)

Bottom-Up (micro)

Top-Down (macro)

Risk Factor

For financial professional use only. Not for public distribution. 6

ETFs as a Disruptive Innovation The success of ETFs is related to the application of technology to investment management as well as to how investors access to investment products. ETFs are central to the application of technology to market microstructure, strategy and portfolio construction, and access to investment products. .

Multi-dimensional

Impact

Trading & Exchanges

Portfolio Construction

Security Research & Screening

Investment Management Pensions

and Large Asset

Owners

High Net Worth and

Family Office

Insurance Retail

Investment Distribution


ETFs appeal to broad categories of investors & across a range of investment horizons

.

Range of Horizons

Days/Weeks

Months

Year Multi-Year

Individual

Financial Advisors

Asset

Managers Asset Owners

Broad Categories of Investors

Hedge Funds & Traders

ETFs uniquely have attracted investors across all channels of investing – most democratic and transparent form of investment product.


ETFs are valued differently by different investors

Financial Advisors

Asset

Managers

Hedge Funds & Traders

Asset Owners

Individual

Risk Management

Core Asset Class Exposure

Liquidity Management & Rebalancing

Smart Beta and Risk Factor Exposure

Tactical Views- Trading

Features

B. ETF Mechanics, Features and Why They Appeal to Investors

9

Basics of Exchange-Traded Funds – Combine features of stocks and fund products

Exchange-traded single shares that represent ownership in an underlying index, portfolio of securities, or bank note linked to the payoff of an index.

ETF sponsor or manager lists fund on an exchange the same way a company would list its stock.

•  Exchanges –Intra-day ETFs trade real-time, can be margined, lent and shorted like stocks. Dollar volume traded in ETFs is much larger than flows seen by fund managers.

•  Market makers engage in arbitrage to keep ETF prices in line with fund holdings during the trading day. Many of the largest ETFs have continuous buyers and sellers and tight spreads.

•  Fund managers see assets grow or fall daily based on net demand or supply by the end of the trading day. Shares creation and redemptions occur at the closing prices of the underlying securities through an authorized dealer (participant) – do not know end investor as in a typical fund product.

•  Cost - fund management fee that is withheld from dividends or reduces fund value along with any commissions paid to purchase and sell ETF shares.

10

Shares

Index/ Fund

The ETF Food Chain

ETF Manager/Sponsor

ETF Investors: •  Asset Owners •  Asset/Fund Managers •  Hedge Funds •  Insurance Companies •  Investment/Financial

Advisors •  ETF Managers •  Robo-Advisors •  Self-Directed Investors

ETF Distributor

Index Provider Authorized

Participant

Custodian

Brokers /Investment

Banks Exchanges

For illustrative purposes only. 11

§  Investors large and small access ETF strategies through brokers and exchanges. §  ETF managers license benchmarks from index providers and contract for custodian and

distribution services. §  Portfolio holdings are transparent and updated daily by ETF managers.

§  Authorized participants invest or divest in the ETF at the end of the trading day through the creation and redemption process at the closing prices of holdings. §  ETF exchange trading provides intra-day price discovery, facilitated by market-

makers and other off-exchange liquidity providers such as high frequency trading firms.

Lead and other Market

Makers.


ETFs Asset Growth Driven by Share Issuance and Redemption - A fraction of daily trading activity •  ETF Issuance (Creation) and Redemption occurs at the closing value of

underlying securities at the end of each trading day as Authorized Participants create or redeem ETFs with the ETF manager.

•  Shares created or redeemed reflect the expected net imbalance at the end of trading day by ETF liquidity providers, based on intra-day ETF trading.

Primary Market

Secondary Market

ETF Manager/Sponsor

Market Maker/Authorized Participant

Exchange

Cash or Securities ETF Shares

ETF Market Price

Buyer Seller

For illustrative purposes only.

ETF Creation and Trading Process

Investors trading through brokers.

Price Based on Value of Underlying Securities


Trading and Price Discovery

.

•  Traditional Fund Products -  Provide valuation and accept flows once a day or at longer intervals. -  Trading costs of portfolio management (commission and market impact of managing fund

inflows and outflows) are allocated to all current investors. -  No visibility of intraday volatility, buying and selling pressure from flow or holdings except for

once a quarter.

•  Capital markets staff at ETF sponsors and ETF specialists at brokerage firms can assist in developing trading strategies. -  Assist in setting up contacts with ETF liquidity providers and sharing information on trading

costs and strategies based on ETF liquidity features.

•  ETFs Trading Costs – Length of holding period is key to how important trading costs are in performance assessment. -  Commission -  ETF Bid/ask spread

-  driven by bid/ask spread of underlying securities, ease of arbitrage, market volatility -  Varies by asset class -  Ease of hedging and arbitrage with underlying securities; bid/ask spread of underlying securities is

the outer bound but many ETFs with regular two-way flow have tighter bid/ask spreads.

ETF are accessed like stocks - Facilitate use as tactical tools; but also means investors must understand how to trade effectively.


Why the appeal of ETFs? Benefit Features Access, Liquidity, & Price Discovery

On exchange via brokerage account - Can be bought, sold, & shorted like a stock, so simple to initiate and manage exposure over time. Creation/redemption process keeps prices in line with underlying holdings. NAV vs. ETF price available through trading day. Capital commitment from broker/dealers adds to product viability and breadth of offerings.

Lower Cost > Performance Advantage

Low cost comes from index structure. Management fee and turnover is lower than most fund products. Lower embedded sales fees. Visibility of strategies and fees fosters competition. Do need to pay commissions to brokers and exchanges.

Transparency Daily disclosure of holdings by ETF managers facilitates performance attribution, due diligence, understanding of investment objectives and risks. Index providers supply performance and investment information on strategies


Why the appeal of ETFs?

Benefit Features Used by All Classes

of Investors “Democratized” investing for the largest pension funds, RIAs, and individual investors. Provide needed tools for asset or sector allocation, factor-tilt strategies, smart beta, thematic and now active investing

Variety of Product Choices

Asset Class, Sector, Thematic, and Factor Strategies. Wide range of choices with easy access to analysis to compare features from sponsors, exchanges, and ETF websites (ETF.com, Morningstar, FactSet.)

Investor Protection Meet regulatory guidelines for stocks, fund products, notes in the country where they trade.

Tax Efficiency Lower turnover and capital gains distributions than most mutual funds from in-kind redemption feature

Click the icon to add an image. The photo will be cropped to fit the placeholder.

Strategy Road Map for ETFs – Applications Vary Across Investment Horizons

16

Tactical / Horizon: < 1 Year

Both Strategic And Tactical

Horizons

Strategic – Multi-Year Horizon

Invest cash inflows easily

Achieve Target Weight or Rebalance

Core or Enhanced Index Exposure as part of Strategic Investment Policy

Active or tactical view Over or Underweight index exposure:

Multi-Asset / Asset Allocation Strategy

Completion Strategies Risk Factor Management Strategy Index as Active/ Hedge Fund Manager Alternative

Portfolio Transitions Factor, Thematic or Style tilt investing

ETF Alloca*on to Improve Liquidity of Overall Por<olio


Strategy Road Map for ETFs: Short or Long-term

17

Both Strategic And Tactical Horizons

•  Achieve Target Weight or Rebalance to Asset/Factor Weights

•  Over or Underweight index exposure: Based on investment view, risk objective, or as hedge for active stock or fixed income strategies

•  Risk Factor Management – modify risk of equity or fixed income (beta or duration).

•  Thematic or style tilt investing •  Tilt to high dividend or dividend growth stocks •  Country exposure with currency hedge •  Fixed income exposure with interest rate hedge •  Capture premium in option or volatility pricing


Strategy Road Map for ETFs: Long-term

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Strategic – Multi-Year Horizon •  Core Index or Enhanced Index Exposure - Use ETFs to

implement components of strategic investment mix; liquidity allows for efficient implementation

•  Multi-Asset / Asset Allocation Strategy – Use stand-alone ETF strategy to allocate to mix of best performing top-down investment opportunities relative to risk target

•  Strategy Index as Active/Hedge Fund Manager Alternative - ETF- based strategy within an asset class or category, considering its investment return/risk profile, fees, transparency, or liquidity as the best choice versus a mutual fund or institutional manager

•  ETF Allocation to Improve Liquidity of Overall Portfolio – Keep a portion of asset allocation in ETFs to provide for ease in meeting cash obligations, funding new managers, investing cash in anticipation of capital calls for private equity.

Institutional Uses of ETFs: A Global Perspective

A combination of tactical strategies and efficiently managing portfolio exposure

*Source: ETFs: Active Tools for institutional Portfolios, Greenwich Associates, 2017 and ETFs: Valuable Versatility in a Newly Volatile Market, 2018 (U.S. data). 19

0% 10% 20% 30% 40% 50% 60% 70%

Interim Beta

Cash Equitization

Transitions

Risk/Overlay

Liquidity Management

Portfolio Completion

Rebalancing

International Diversification

Core Allocation

Tactical Adjustments

Institutional Investor ETF Strategies

U.S. Europe Asia

Greenwich Survey of RIAs, asset managers, institutional funds, insurers, and consultants.

C.  The ETF Landscape in 2018 Assets, Flows, Trading, and ETF

Managers

20


The ETF Industry Has Been Global from the Start

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

Assets US $b

n (Stacked

)

Americas assets Europe assets Asia assets Other Assets

Growth of Global ETP Assets (U.S.$Bil)

WEBs à breakthrough for ETF industry growth: •  Organized as mutual funds vs. UITs (Unit Investment

Trusts) •  Revealed power of ETFs for international investing and

price discovery while underlying security markets closed.

Growth rate ~25% since 2003 Largest issuers are global asset managers and global investors regularly invest in both home country and cross-border ETFs. First ETF listed in Canada in 1990 on TSX 35 Index – SPY launched in1993.

Morgan Stanley WEBs (World Equity Benchmarks -launched in 1996 on international and country stock indexes); core of iShares entry into the business in 2000.

ETFs in Europe and Asia started in early 2000s and asset growth rate as North America ETFs, but more fragmented markets. Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018


Exchange-Traded Products - U.S. Flows by Asset class

• Use of ETFs for fixed income exposure has been a key trend. •  2017 had significant flows with non-U.S. Equity representing the big shift.

Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018


Alternatives & Asset Allocation

Commodities & Currencies

Equity U.S.

Equity (Non-‐U.S. & Global)

Fixed Income U.S.

Fixed Income ex-‐U.S.

Leveraged & Inverse

16%

58%

21%

Most U.S. ETFs are Equity but Fixed Income is Growing

<5%>

U.S. ETF Assets: $3.59Trillion (% Breakdown as of 11/29/2018)

Source: FactSet, as of 11/29/18

Compares to $15.54 Trillion in Mutual Funds. ETF Assets are ~18% of Combined Mutual Fund and ETF Assets. (ETFs are held by both mutual fund and institutional investors).

2018 ETF Flows (through Nov.) $Mil% of Total

Alternatives & Asset Allocation 1,285 0.5%Commodities & Currencies (592) -‐0.2%Equity U.S. 120,361 45.5%Equity (Non-‐U.S. & Global) 53,007 20.0%Fixed Income U.S. 69,820 26.4%Fixed Income ex-‐U.S. 11,603 4.4%Leveraged & Inverse 9,186 3.5%Total 264,670

Largest 25 U.S. ETFs by Assets (as of 11/29/18)

Source: ETF.com 24

8 U.S. Equity, 3 Developed Non-U.S. Equity, 3 Emerging Market, 5 U.S. Factor, 2 Fixed Income, 2 Sector, 1 Precious Metals. Average Fee 0.15% (EQW), 0.12% (AW)

8 E

TFs-

25%

of

Ass

ets


Ticker Name CategoryAssets ($Bil) Fees Cum Weight

SPY SPDR S&P 500 ETF Trust Equity: U.S. -‐ Large Cap $265.05 9.45 7.4%IVV iShares Core S&P 500 ETF Equity: U.S. -‐ Large Cap $162.02 4 11.9%VTI Vanguard Total Stock Market ETF Equity: U.S. -‐ Total Market $101.86 4 14.7%VOO Vanguard S&P 500 ETF Equity: U.S. -‐ Large Cap $101.59 4 17.6%VWO Vanguard FTSE Emerging Markets ETF Equity: Emerging Markets $69.20 14 19.5%VEA Vanguard FTSE Developed Markets ETF Equity: Developed Markets Ex-‐U.S. $67.75 7 21.4%QQQ PowerShares QQQ Trust Equity: U.S. -‐ Large Cap $66.09 20 23.2%EFA iShares MSCI EAFE ETF Equity: Developed Markets Ex-‐U.S. $64.35 31 25.0%IEFA iShares Core MSCI EAFE ETF Equity: Developed Markets Ex-‐U.S. $54.66 8 26.5%AGG iShares Core U.S. Aggregate Bond ETF Fixed Income: U.S. -‐ Investment Grade $53.53 5 28.0%IEMG iShares Core MSCI Emerging Markets ETF Equity: Emerging Markets $49.77 14 29.4%IJH iShares Core S&P Mid-‐Cap ETF Equity: U.S. -‐ Mid Cap $47.35 7 30.7%IWM iShares Russell 2000 ETF Equity: U.S. -‐ Small Cap $45.72 20 32.0%VTV Vanguard Value ETF Equity: U.S. -‐ Large Cap Value $44.53 6 33.2%IJR iShares Core S&P Small Cap ETF Equity: U.S. -‐ Small Cap $42.88 7 34.4%IWF iShares Russell 1000 Growth ETF Equity: U.S. -‐ Large Cap Growth $41.34 20 35.6%IWD iShares Russell 1000 Value ETF Equity: U.S. -‐ Large Cap Value $38.88 20 36.7%BND Vanguard Total Bond Market ETF Fixed Income: U.S. -‐ Investment Grade $35.70 5 37.7%VUG Vanguard Growth ETF Equity: U.S. -‐ Large Cap Growth $35.02 6 38.6%VIG Vanguard Dividend Appreciation ETF Equity: U.S. -‐ Total Market $30.93 8 39.5%VNQ Vanguard Real Estate ETF Equity: U.S. Real Estate $30.92 12 40.4%LQD iShares iBoxx $ Investment Grade Corporate Bond ETFFixed Income: U.S. -‐ Investment Grade $29.87 15 41.2%GLD SPDR Gold Trust Commodities: Precious Metals Gold $29.70 40 42.0%EEM iShares MSCI Emerging Markets ETF Equity: Emerging Markets $29.57 69 42.8%XLF Financial Select Sector SPDR Fund Equity: U.S. Financials $29.50 13 43.7%

ETFs valued as trading tools for over a decade.

25

•  25% of value traded in U.S. markets since 2007.

•  Value traded has been steady in the last decade despite asset growth.

•  Components of trading

have shifted : •  Broad U.S. equity now just

50% of activity. •  Growth in international and

fixed income ETF trading evidence of how ETFs have changed market structure.

Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018

26

Large ETFs Most Valued for Tactical Trading Features

Source: FactSet, March 28, 2018

Top Trading ETFs (Turnover < 30 Days). Average 12 days

0 20 40 60 80

IAUVGKIEMGMDYVNQEFAGLDEZUEMBLQDEWJXLYXLKXLVXLFXLEDIAXLI

EEMIWMHYGSPY

QQQ

Turnover in Days ($Assets, 3/28/18 /Ave $Volm 45 days)

Highest Turnover* U.S. ETFs

Turnover Ticker Trading (Turnover < 30 days)9.67 QQQ PowerShares QQQ Trust10.05 SPY SPDR S&P 500 ETF Trust11.15 HYG iShares iBoxx $ High Yield Bond ETF12.90 IWM iShares Russell 2000 ETF13.12 EEM iShares MSCI Emerging Markets ETF13.35 XLI IndustrialSector SPDR Fund14.88 DIA SPDR Dow Jones Industrial Average ETF17.63 XLE Energy Select Sector SPDR Fund19.63 XLF Financial Sector SPDR Fund20.58 XLV Health Care Sector SPDR Fund22.90 XLK TechnologySector SPDR Fund23.03 XLY Consumer Discretionary Sector SPDR

27

ETFs- The New Stocks: Popularity of Thematic ETFs reflects role as active tools

Examples of U.S. thematic ETFs with large recent flows include themes such as focused technology (robotics and China internet), regional banks, natural resources, infrastructure, aerospace.

Ticker Thematic ETF Assets ($Mil)

2018 Flows*

12-‐Mth Flows*

1 BOTZ Global X Robotics & Artificial Intelligence ETF 2,501 1,046 2,387 2 GDX VanEck Vectors Gold Miners ETF 8,268 985 (3,135) 3 FDN First Trust Dow Jones Internet Index Fund 6,933 985 1,563 4 KRE SPDR S&P Regional Banking ETF 5,177 895 1,347 5 XBI SPDR S&P BIOTECH ETF 4,834 609 890

6 XT iShares Exponential Technologies ETF 2,174 574 951 7 ITA iShares U.S. Aerospace & Defense ETF 5,701 546 2,027 8 IGF iShares Global Infrastructure ETF 2,497 417 1,050 9 ROBO ROBO Global Robotics and Automation Index ETF 2,333 371 1,681 10 KWEB KraneShares CSI China Internet ETF 1,646 357 1,130 11 KBE SPDR S&P Bank ETF 4,104 336 530 12 ARKK ARK Innovation ETF 706 322 644 13 GUNR FlexShares Morningstar Global Natural Resources 5,327 288 681 14 SMH VanEck Vectors Semiconductor ETF 1,287 223 356 15 PICK iShares MSCI Global Metals & Mining Producers ETF 629 204 267

* Source: FactSet, $ Millions as of 3/28/2018


ETFs as an Asset Management Product – More joining the ETF party, but how large of a commitment?

U.S. Managers of ETFs include not only the original large institutional index asset managers but also ETF specialty firms. Asset managers that have focused on discretionary active fund products are now entering the ETF space.


Market Share of Largest U. S. ETF Issuers

Source: ETF.com and FactSet, as of 11/29/18

Three largest U.S. ETF managers control 82% of assets and have long history in index investing with other fund products.

Six traditional U.S. large active managers have had limited success in the ETF business – but small relative to largest providers and their other product lines.

Some ETF specialty managers have had success. May be candidates for consolidation or takeover. (Wisdom Tree, Van Eck, ProShares, Direxion, ALPS, Guggenheim now part of Invesco, Global X acquired by Mirae)

U.S. ETF Issuer AUM ($,M) % of Total Cum %

1 BlackRock 1,395.63 38.87% 38.87%2 Vanguard 904.95 25.21% 64.08%3 State Street Global 620.31 17.28% 81.36%4 Invesco 182.25 5.08% 86.44%5 Charles Schwab 121.92 3.40% 89.83%6 First Trust 66.98 1.87% 91.70%7 WisdomTree 38.53 1.07% 92.77%8 VanEck 33.63 0.94% 93.71%9 ProShares 30.12 0.84% 94.55%10 PIMCO 18.52 0.52% 95.06%11 JPMorgan 18.27 0.51% 95.57%12 Northern Trust 15.51 0.43% 96.01%13 ALPS 12.79 0.36% 96.36%14 Fidelity 12.45 0.35% 96.71%15 Rafferty Asset Management 12.23 0.34% 97.05%16 Deutsche Bank 12.10 0.34% 97.39%17 Goldman Sachs 10.41 0.29% 97.68%18 Mirae Asset Global 9.20 0.26% 97.93%19 UBS 6.76 0.19% 98.12%20 Barclays Bank PLC 5.27 0.15% 98.27%21 Exchange Traded Concepts 4.57 0.13% 98.39%22 Credit Suisse 4.31 0.12% 98.51%23 New York Life 4.06 0.11% 98.63%24 OppenheimerFunds 3.50 0.10% 98.73%25 Victory Capital Management 3.32 0.09% 98.82%

Other 42.45 1.18% 100.00%

D. The New Active – Factor (Smart Beta) Strategies in ETFs.

30


How Active Management is changing

Ben Johnson (Senior ETF Analyst, Morningstar) in the 10th Anniversary Issue of Morningstar Magazine, June/July 2017: “The Death of Active Management Has Been Greatly Exaggerated”

Active investing will never die, but it’s being forced to evolve. §  Investors are getting more active with passive.

–  Multi-asset /asset allocation funds/opportunistic allocations

–  Broker model portfolios

–  Robo advisors

–  Active managers using passive tools

§ Passive is getting more active –  Smart beta

–  Thematic strategies

–  Multi-factor and dynamic factor allocation


•  Investment strategies seeking to outperform risk-equivalent, cap-weighted indexes, modify risk, upside/downside capture, or portion of return from income.

•  Combine elements of indexing and active management

–  Uses rules-based strategies for stock selection and portfolio construction with regular rebalancing—Systematic active investing

•  May include single or multiple factors –  Value, dividend yield, earnings or dividend growth, quality, volatility,

momentum, etc. –  Some factors have academic support for long-term outperformance

(Fama-French factors)

•  Provides varying levels of active risk, mostly driven by weighting and number of stocks

•  Single factor approaches have periods of out- and underperformance relative to cap-weighted benchmarks; can be linked to a market view or used in a multi-factor approach to diversify.

Strategic (Smart) Beta: What is the Concept?


Investors face a wide variety of choices in factor/smart beta strategies.

Value

Quality

Minimum Volatility

Momentum

Dividend Growth

Factor-selection criteria à Ability to generate risk-adjusted alpha or modify risk: •  Over a range of market conditions •  Over a specific market environment based on an investment view.

High Dividend

Factor Return Access

Risk Modification

Alternative Weighting

Growth

Multi-Factor

Downside Risk Reduction

Low/High Beta

Income –Covered Option

Strategies Risk-Weighted

Fundamental-Weighted

Earnings-Weighted

Revenue-Weighted

Dividend-Weighted

Equal-Weighted


•  Continued challenges faced by discretionary active managers to deliver after-fee performance that beats benchmarks.

•  Recognition of returns for risk-premiums and systematic strategies beyond cap-weighting are a large component of traditional active management.

•  Risk factor allocation is next evolution of quantitatively-based strategies and aligned with more top-down investing.

•  Transparency and ability to do due diligence across historical market conditions with index return history.

•  Rules-based indexes have less vulnerability to behavior biases with very limited discretion in portfolio management process.

Why Are Factor/Smart Beta Strategies in Focus Now?


Smart Beta ETF Flows by Category

Slource: Credit Suisse Equity Trading Strategy, February 2018

Average Smart Beta ETF Fees*Assets > $1Billion 38Largest 25 ETFs 21Asset Weighted 26


Largest 25 Smart Beta U.S. ETFs ( ~ 55% of Assets)

Ticker Name Strategy Assets ($Mil)

Volume ($Mil)

Turnover (Days) Fees

IWF iShares Russell 1000 Growth ETF Growth $39,365 $245 161 20 IWD iShares Russell 1000 Value ETF Value $35,775 $201 178 20 VTV Vanguard Value ETF Value $35,347 $182 194 6 VUG Vanguard Growth ETF Growth $31,953 $147 218 6 VIG Vanguard Dividend Appreciation ETF Dividends $26,738 $87 309 8 VYM Vanguard High Dividend Yield ETF Dividends $20,011 $73 273 8 IVW iShares S&P 500 Growth ETF Growth $19,902 $130 153 18 DVY iShares Select Dividend ETF Dividends $16,537 $80 205 39 SDY SPDR S&P Dividend ETF Dividends $15,137 $53 285 35 IVE iShares S&P 500 Value ETF Value $14,440 $115 126 18 USMV iShares Edge MSCI Min Vol USA ETF Low Volatility $14,048 $91 154 15 VBR Vanguard Small-‐Cap Value ETF Value $12,574 $33 376 7 IWS iShares Russell Mid-‐Cap Value ETF Value $10,434 $32 321 25 IWO iShares Russell 2000 Growth ETF Growth $9,077 $81 112 24 EFAV iShares Edge MSCI Min Vol EAFE ETF Low Volatility $8,748 $40 218 20 IWN iShares Russell 2000 Value ETF Value $8,722 $99 88 24 AMLP Alerian MLP ETF Dividends $8,241 $157 53 85 IWP iShares Russell Mid-‐Cap Growth ETF Growth $8,504 $35 245 25 VOE Vanguard Mid-‐Cap Value ETF Value $8,296 $31 265 7 MTUM iShares Edge MSCI USA Momentum Factor ETF Momentum $8,108 $98 83 15 IJK iShares S&P Mid-‐Cap 400 Growth ETF Growth $7,785 $19 420 25 SCHD Schwab U.S. Dividend Equity ETF Fundamental $7,108 $48 147 7 VBK Vanguard Small-‐Cap Growth ETF Growth $7,260 $20 370 7 SPLV Powershares S&P 500 Low Volatility Portfolio Low Volatility $6,860 $95 72 25 DXJ WisdomTree Japan Hedged Equity Fund Currency Hedged Fundamental$6,583 $215 31 48


Where We Came From

•  Differentiated products, fees, regulation, & distribution by investor category. (Asset Owners, Insurance, Retail)

•  Distribution and discretionary portfolio management viewed as key to revenues.

•  Fundamental investing primary, quantitative investing more a niche business.

•  Portfolio managers and investment process is the focus of marketing and sales.

Where We Are Going To

•  ETFs are accessible by all classes of investors at same cost through electronic trading at brokers.

•  ETF revenue accrues to issuers, index providers, exchanges, and brokers – all involved in distribution.

•  Quantitative analysis key for both index providers and ETF sponsors.

•  Performance history is basis for investment decisions; portfolio manager secondary.

37

The Takeaway – ETFs Lead to Major Shifts in the Structure of Investment Management Business

Where We Came From

•  Distribution directly connected with investors, organized by channel. Able to manage and reward success.

•  Asset manager manages trading of strategy and flows.

•  Investor depends primarily on asset manager for performance measurement and strategy dynamics.

Where We Are Going To

•  More parties involved in distribution. ETF managers sales force, but also brokers, index providers, and marketing.

•  Investor must have some knowledge of trading to effectively use ETFs. Can receive assistance from broker or ETF manager’s capital markets staff.

•  Performance record easily accessible by investor. Risk of relying too heavily on real-time moves and very recent track record and assigning less weight to risk analysis.

38

The Takeaway – ETFs Lead to Major Shifts in the Structure of Investment Management Business

What Can We Expect Going Forward – ETFs Staying at the Forefront of Investment Innovation

•  Investors globally expand use of ETFs for global equity and fixed income diversification (beyond their local market)

•  Continued growth in access to fixed-income, commodity, and alternative market segments.

•  European and Asian ETP market growth continues with more factor and thematic products in all regions as more traditional active managers enter and expand their ETF presence.

•  Expanded use by Institutional investors, RIAs and financial advisors, and multi-asset and active fund strategies. More customized and advanced tools than the hammers and saws of the early ETF days.

•  Active management ETFs - more products – especially in fixed income, but not a transforming event.

•  Multi-asset, rules-based strategy ETFs gain institutional assets and become focus for new product offerings by ETF managers.

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What Can We Expect Going Forward – ETFs Staying at the Forefront of Investment Innovation

•  Continued interest in tactical strategies and high levels of trading activity – Thematic investing makes inroad relative to stock selection.

•  Smart beta factor and multi-asset investing – increasing component of ETF assets and institutional strategies, with lower fees.

•  Incorporation of ETFs into U.S. retirement saving strategies – Requires overcoming record keeper infrastructure impediments.

•  Market microstructure and regulatory frameworks adapt to ETFs as mainstream investment products.

•  Growth in services – o  Index providers to ETF managers for product innovation o ETF analysis, data, and research to evaluate investment

options more complex ETF strategies.

40

Thank you and look forward to questions and comments.

Contact information:

[email protected], [email protected]

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42

ETFs Serve as Both Investment and Trading Products

U.S. ETFs with Assets > $10BilNumber 72 Total Assets ($Bil) $2,264 65% of Total ETF AssetsEquities $1,892 84% of ETFs > $10BilFixed Income $324 14%Gold $49 3%

$ Assets/$Daily Volume DaysDaily Turnover 121Equities 117Fixed income 150Turnover by Asset SizeTop 10 > $50B 104$25-‐$50 B 126$10-‐$25 162

Average Fees BpsEqual Weighted 16.6Asset Weighted 14.4

Concentration: 2,162 U.S. ETFs 8 ETFs = 25% of Assets 35 ETFs = 50% of Assets 70 ETFs = 65% of Assets


Largest 25 U.S. ETFs by Assets (as of 3/28/18)

Source: ETF.com 43

8 U.S. Equity, 3 Developed Non-U.S. Equity, 3 Emerging Market, 5 U.S. Factor, 3 Fixed Income, 2 Sector, 1 Precious Metals. Average Fee 0.17% (EQW), 0.14% (AW)

Ticker Name CategoryAssets ($Bil) Fees

Assets/Volume Cum Weight

SPY SPDR S&P 500 ETF Trust Equity: U.S. -‐ Large Cap $255.01 9.45 10 7.4%IVV iShares Core S&P 500 ETF Equity: U.S. -‐ Large Cap $140.98 4 110 11.4%VTI Vanguard Total Stock Market ETF Equity: U.S. -‐ Total Market $92.80 4 236 14.1%VOO Vanguard S&P 500 ETF Equity: U.S. -‐ Large Cap $87.28 4 119 16.7%EFA iShares MSCI EAFE ETF Equity: Developed Markets Ex-‐U.S. $76.86 32 44 18.9%VEA Vanguard FTSE Developed Markets ETF Equity: Developed Markets Ex-‐U.S. $70.00 7 156 20.9%VWO Vanguard FTSE Emerging Markets ETF Equity: Emerging Markets $69.20 14 94 22.9%QQQ PowerShares QQQ Trust Equity: U.S. -‐ Large Cap $62.32 20 10 24.7%IEFA iShares Core MSCI EAFE ETF Equity: Developed Markets Ex-‐U.S. $55.26 8 123 26.3%AGG iShares Core U.S. Aggregate Bond ETF Fixed Income: U.S. -‐ Investment Grade $54.41 5 140 27.9%IEMG iShares Core MSCI Emerging Markets ETF Equity: Emerging Markets $49.65 14 63 29.3%IJH iShares Core S&P Mid-‐Cap ETF Equity: U.S. -‐ Mid Cap $44.18 7 191 30.6%IWM iShares Russell 2000 ETF Equity: U.S. -‐ Small Cap $43.29 20 13 31.8%EEM iShares MSCI Emerging Markets ETF Equity: Emerging Markets $42.78 69 13 33.1%IWF iShares Russell 1000 Growth ETF Equity: U.S. -‐ Large Cap Growth $40.24 20 164 34.2%IJR iShares Core S&P Small Cap ETF Equity: U.S. -‐ Small Cap $36.71 7 160 35.3%BND Vanguard Total Bond Market ETF Fixed Income: U.S. -‐ Investment Grade $36.63 5 202 36.4%GLD SPDR Gold Trust Commodities: Precious Metals Gold $36.78 40 43 37.4%IWD iShares Russell 1000 Value ETF Equity: U.S. -‐ Large Cap Value $36.16 20 180 38.5%VTV Vanguard Value ETF Equity: U.S. -‐ Large Cap Value $35.76 6 199 39.5%VUG Vanguard Growth ETF Equity: U.S. -‐ Large Cap Growth $32.69 6 224 40.4%LQD iShares iBoxx $ Investment Grade Corporate Bond ETFFixed Income: U.S. -‐ Investment Grade $31.55 15 37 41.4%XLF Financial Select Sector SPDR Fund Equity: U.S. Financials $31.65 13 20 42.3%VNQ Vanguard Real Estate ETF Equity: U.S. Real Estate $28.60 12 56 43.1%VIG Vanguard Dividend Appreciation ETF Equity: U.S. -‐ Total Market $27.18 8 313 43.9%

8 E

TFs

-25%

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