© 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
WHY BOARDS ARE DISCUSSING ETFS
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
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
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?
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
7
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
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
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
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
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)
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
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)
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
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
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
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
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