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

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© Copyright 2016 by K&L Gates LLP. All rights reserved.

Stacy L. Fuller Peter J. Shea

May 26, 2016

EXCHANGE-TRADED FUNDS:

What Fund Boards Need to Know

when Considering ETFs

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WHY BOARDS ARE DISCUSSING ETFS

(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

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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

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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?

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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

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Primary Market Secondary Market

ETFS: A REFRESHER COURSE

Private Investors Brokers Stock Exchange A ut hor iz ed P ar tic ipant s ETF Subscription in kind – The AP delivers a basket of securities and the ETF issues shares

Buy / Sell Order

Redemption in kind – The ETF delivers the securities and the shares are redeemed Bid/offer Price Secondary Market Primary Market Securities Hedging –Futures/ ETFs

(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

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ETFS: A REFRESHER COURSE

 How do ETFs work?

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

NAV Market Price at premium to NAV Market Price at discount to 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

This ensures that the ETF trades close to its NAV The NAV does not change, the trading price does

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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

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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)

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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

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OFFERING INDEX-BASED ETFS

Advantages

 Regulation

well-established; no surprises  ETFs based on

broad-based 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)

(14)

OFFERING “SMART BETA” ETFS

Advantages

 Can package “rules

based” active strategies as index methodologies

 Recent filers for smart

beta: Fidelity, Franklin Templeton

 Regulation

well-established; 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

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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

(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 well-established; 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

(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

(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

References

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