2017 US ETF Investor Survey Results A Race to the Top

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1 2017 US ETF Investor Survey Results A Race to the Top Global assets invested in ETFs continued to reach new records in 2017, surpassing $4 trillion in ETP assets. The US remains the largest ETF market, with assets totaling $3.25 trillion across more than 2,000 products. 1 This asset growth has resulted in a continuous stream of new product offerings from both established ETF managers and those launching ETFs for the first time. As the menu of ETF investment options keeps evolving, we continue to monitor trends in how investors are leveraging the ETF wrapper and underlying investment strategies. For the fifth consecutive year, Brown Brothers Harriman partnered with ETF.com to gain insight into these trends and the preferences of professional ETF investors in the US. CONTENT Key Findings... 3 Demographics... 4 ETF Selection... 7 New ETFs... 8 Active ETFs Investment Strategy Smart Beta ETFGI

2 Dear Reader, In our fifth year providing insight into the investor uses of ETFs, we were pleased to receive survey responses from 360 financial advisors and institutional investors. Their responses reveal key insights that solidify recent trends and highlight evolving nuances in the ETF market that may give ETF managers a running start to As we look ahead to the next year, one thing is certain: the race to introduce new ETF product shows no signs of stopping, and ETF managers will need to keep fine tuning their craft to stay relevant and competitive in the track meet that is the ETF market. In 2016, we saw investors employ ETFs tactically in their portfolio and this year s responses reinforce those findings, as we saw investors view smart beta ETFs as a key tool when it comes to portfolio construction. As runners swap out their shoes to accommodate the track surface and conditions, investors are continuing to use smart beta ETFs as a way to tilt their portfolio to certain exposures. The wide range of investment options available presents opportunities for managers to not only seek outperformance, but to reduce volatility, achieve specific factor exposure, or position a portfolio for down-side protection. Given the wide range of potential uses, it s not surprising that 65% of respondents said smart beta is a hybrid of traditional passive investing and active management. Smart beta allocations remain strong this year 97% of respondents plan to either maintain or expand allocations to smart beta in their portfolios. Increasingly investors are funding their smart beta purchases by selling off passive ETFs or mutual funds, or reducing allocations to active funds. This supports the evidence that investors see smart beta as an alternative to both traditional passive and active strategies. These applications of smart beta ETFs also mean that investors may shift their portfolio during the year and our survey shows these shifts by investors stated preferences for specific smart-beta strategies. Last year we saw appetite for smart beta ETFs that aim to reduce volatility and provide exposure to quality names. This year investors showed a desire for multi-factor strategies. 60% of investors are either using these types of ETFs or have plans to add them to their portfolios. This will be an interesting trend to monitor as investors clearly signaled expense ratios are a key element in their ETF searches. Multi-factor ETFs have typically maintained pricing premiums over vanilla indexes and other smart-beta strategies. It s important to recognize that not all investors are using smart beta. This year, we saw more than a third say they lack the familiarity with the products to use them in a portfolio. ETF managers should focus on continuing their education and advisor outreach efforts to promote these products and best understand how advisors are using them, or why they may be sitting on the sideline when it comes to these products. Perhaps one of the biggest changes this year is the dramatic increase in investor outlook for environmental, social, and governance (ESG) ETFs. Previously, only 37% of investors stated that ESG factors are important when selecting an ETF. This year, we saw 51% of respondents state ESG carried some level of importance in their selection criteria. This brings the US investor outlook for ESG closer to our 2016 findings for European ETF investors, where ESG appears to be more widely accepted. Fixed income liquidity continues to remain a key area of concerns for US investors. This year, 83% said liquidity for fixed income ETFs is somewhat or very concerning. This may be a result of media headlines suggesting there are issues in the fixed income ETF market, when in reality these ETFs have responded well to credit crunches. This may be another area where ETF managers can help mitigate some of these investor concerns through their marketing and education campaigns. We ve highlighted here only some of the key findings but there is more pertinent detail for ETF sponsors in the report that follows. Sponsors should consider the findings in terms of their product development plans, marketing, and distribution strategies, as well as on-going client service and education efforts to best propel them around the track as we enter Shawn McNinch Ryan Sullivan Managing Director, US ETF Services Vice President, US ETF Services shawn.mcninch@bbh.com ryan.sullivan@bbh.com US ETF Investor Survey

3 KEY FINDINGS Smart beta is a good cross-trainer 65% of respondents view smart beta as a versatile, hybrid strategy between traditional passive and active management. Investors need a course (or two) in smart beta Despite the increase in usage, about a third of respondents are simply not familiar with the smart beta product, suggesting further opportunities for ETF managers to promote education and product awareness. Expense ratio reigns supreme: ETFs are sought-out for their low expense ratios 6 of respondents view expense ratios as the most important element when selecting ETFs. That s not surprising, given 53% of respondents said their fiduciary obligation to clients was a key concern in their evaluation of the cost of investment products. 67% of advisors selected expense ratio as a very important factor when evaluating an actively managed fund. Most investors are waiting longer to add new ETFs to their portfolio In a big uptick from 2016, 36% of advisors preferred to wait 1 to 3 years after launch before considering adding it to their portfolio. Multifactor ETFs receive a boost Demand is up this year 60% of respondents are currently using or most likely to use a multifactor strategy. Investors are coming around on Environmental, Social, and Governance (ESG) ETFs This is a point of opportunity for ETF managers. 51% of advisors said ESG is at least somewhat important, up from 37% last year. Demand for active ETFs is on the rise We saw a large shift this year in advisor s outlook on active funds. 5 would use active ETFs for emerging markets and 45% for international exposure. Bond liquidity is a growing concern 30% of advisors said they re very concerned about liquidity. This continues to highlight the need for managers to educate advisors around ETF liquidity for both the ETF shares and underlying holdings. Third-party ETF models are on the rise For advisors who outsource their asset allocation, third-party models were the most popular (37%). 17% are already leveraging robo-advisors. 3 US ETF Investor Survey

4 DEMOGRAPHICS For the fifth year in a row, we partnered with ETF.com to gauge sentiment of professional ETF investors in the US. We surveyed 360 financial investors, RIAs, and institutional investors to identify emerging trends in the ETF market. 1. Which classification describes your business? 1% 13% Registered investment advisor/ 2% Registered rep/secuirties broker/cpa 5% Mutual fund/insurance company Endowment/Foundation/Family office/charity Hedge fund/private equity/venture capital 75% Pension fund/sovereign wealth fund Other (please specify) Other includes responses from consultants, investment research professionals, ETF strategists, and bank and trust company investment professionals. 2. If you are a registered investment advisor, what type of firm are you affiliated with or employed by? 2% 6% Independent RIA (Custody with Schwab, Fidelity, Pershing) National or Regional B/D (Ameriprise, Edward Jones, Raymond James) 21% Hybrid RIA (Independent RIA that also holds a B/D affiliation) 40% Wirehouse (Merrill, Morgan, Wells, UBS) 11% Independent B/D (LPL, Commonwealth) Insurance B/D (Northwestern Mutual, Lincoln) Retail Bank B/D (Chase, Citi) 4 US ETF Investor Survey

5 3. Please allocate your client AUM across the following investment types: 8% 20% 42% Index mutual funds or ETFs Actively managed mutual funds or separate accounts Individual securities Other (e.g., variable insurance products) 30% 4. Please indicate the percentage of your AUM invested in ETFs/ETNs: 20% 19% 16% 15% 13% 13% 5% 3% 5% 5% 5% 6% 0% % 21-30% 31-40% 41-50% 51-60% 61-70% 71-80% 81-90% % 36% of respondents this year allocate between 21-50% of their AUM to ETFs, reinforcing the theme of ETFs as a core tool for portfolio construction. 5

6 5. For an average client account, how many ETFs are held in your portfolios? 19% 28% 6% % 36% % 11% 3 28% % % 7% 3 30% Investors reduced the number of ETFs in their portfolio this year suggesting that fewer ETFs may have higher asset concentration. Over a third (36%) of respondents this year hold 1-5 ETFs in their portfolio, underscoring that ETF managers are competing for limited shelf space in investors portfolios. 6. For an average client account, how many trades do you make per month? % 7% 58% 26% % % % 8% 12% % Overall, respondents appear to trade ETFs infrequently, with 58% responding they make 1-5 trades per month on average. 6 US ETF Investor Survey

7 ETF SELECTION ETFs offer trading flexibility, transparency, and tax efficiency at a low cost. But what are the most important factors investors consider when selecting ETFs? We asked: 7. Please rate the following factors when selecting an ETF: Very important Somewhat important Not important Expense ratio 6 29% 7% Index methodology 52% 37% 11% Historical performance 48% 39% 13% Tax efficiency 42% 46% 12% Trading volume 3 50% 16% Trading spreads 33% 51% 16% 6 of respondents said the ETF expense ratio is very important when selecting an ETF. This was the largest result in the category, suggesting that investors are choosing ETFs with their wallet. Index methodology rated high, with more than 50% ranking it as very important. This suggests investors recognize the importance of diving into the underlying index to vet their ETF managers. Tracking error does not appear to be a key element of ETF selection. ETF issuer 33% 50% 17% Tracking error 33% 48% 19% 8. How important are the following in your evaluation of the cost of investment products? I have a fiduciary obligation to my client 53% 17% 8% 5% 7% Fees can be a drag on performance 18% 2 19% 15% 15% 9% Manager skill 12% 16% 17% 15% 17% 23% Lower investment management costs allow me to maintain my own fee 8% 13% 15% 1 18% 32% Competitive positioning 6% 15% 20% 2 22% 13% Client awareness of fees 15% 19% 23% 2 15% Fiduciary responsibility weighs most heavily on investors and fees were largely recognized as drags on performance. This further supports the results that investors are increasingly cost-conscious buyers of ETFs. 7

8 NEW ETFs Historically, our respondents have been focused on track record, liquidity, and AUM when evaluating new ETFs.* We wanted to know if investors are more comfortable bringing new ETFs into their portfolio. We asked: 9. How soon after a new ETF launches will you consider adding it to your portfolio? 40% 35% 36% 30% 25% 20% 21% 19% 15% 5% 8% 6% 0% Immediately 1-3 months 4 months to 1 year 1-3 years After 3 years I never buy new ETFs Half of respondents are comfortable buying an ETF within its first year of operations. This suggests that new products can gain market share against established players, provided they are priced competitively against their peer group. 10. How important are environmental, social, and governance (ESG) factors when making an investment? % 9% 7% Very important 42% 49% Not important Somewhat important Very important 63% 27% Important Somewhat important Not important 51% of investors say that ESG carries some level of importance, up 1 over last year saw a great deal of interest in ESG. This is good news for ETF managers, given the proliferation of ESG based strategies in recent years. * New ETFs, for the purposes of this study, are defined as ETFs launched within the last 12 months. 8 US ETF Investor Survey

9 11. What areas of the market do you think could use more ETFs? (Select all that apply) Alternatives 33% Active ETFs International equity 26% 26% International fixed income 2 US fixed income 20% Sector equity Factor/Smart beta Commodities Currencies US equity ESG Currency hedge Other 9% 12% 1 15% 15% 17% 17% 18% 0% 5% 15% 20% 25% 30% 35% Respondents are seeking more ETF choice in international and alternatives ETF strategies, suggesting an area of focus for ETF managers and their product development efforts. More than a quarter of responders want more active ETFs. We were surprised to see demand is up for international equity strategies, given that 683 international equity strategies are currently available. 2 2 ETF.com, November

10 ACTIVE ETFs Active ETFs represent only about 1% of the total AUM invested in ETFs, however we have seen demand for these products picking up in recent years. While these funds have primarily focused on fixed income asset classes in the past, we wanted to further explore investor demand for these products. We asked: 12. In what asset class would you use an actively-managed ETF? (Select all that apply) Fixed income 6% Emerging markets equity 5 Commodities 31% Other U.S. Equity International developed markets equity 4 45% 0% 20% 30% 40% 50% 60% 5 would use active ETFs for emerging markets. With only 6% of respondents citing demand for active fixed income, it appears investors are comfortable with current investment options available in this asset class. The demand for actively managed equity ETFs across emerging markets, international developed, and the US suggest these segments can support more choice for investors with the development of additional active ETFs. Other includes responses from small cap to real estate, alternatives and preferred stocks. 13. Please rate the following factors when evaluating an actively-managed fund: Very important Somewhat important Not important Expense ratio 3% 30% 67% Perfomance history 33% 63% Degree of transparency 6% 42% 52% Reputation of the firm offering the fund 47% 49% Reputation of the portfolio manager 8% 4 48% 0% 20% 30% 40% 50% 60% 70% Expense ratio still reigns supreme for investors when selecting active ETFs. Unsurprisingly, performance history closely follows signaling that track record is important. More than half of investors say transparency of active ETFs is very important to them. 10 US ETF Investor Survey

11 14. How concerned are you about liquidity of the underlying holdings in bond ETFs? % 8% 12% 30% Not concerned Somewhat concerned Very concerned 25% 55% The most important concern An important concern A somewhat important concern Not a concern at all 53% 30% of investors said they are very concerned about liquidity. This continues to highlight the need for managers to educate advisors around ETF liquidity for both the ETF shares and underlying holdings. 11

12 INVESTMENT STRATEGY 2017 has seen continued turbulence in the world of politics and economics, with surprise election results, interest rate increases and potential policy shifts from lawmakers. We wanted to understand how investors will leverage ETFs in response to evolving macro-trends. We asked: 15. In a low-rate environment, where do you look for income? Dividend-paying stocks 7 76% 73% REITs High-yield debt Investment-grade or governement-issued dept MLPs Foreign fixed income 19% 30% 3 28% 32% 28% 47% 46% 4 41% 47% 56% 53% 51% 56% Respondents appear to be rotating toward credit quality, given the drop in demand for high-yield debt and increases in investmentgrade and government issued debt. Other includes responses from active management, BCDs, closed end funds, preferred securities, preferred stocks, and total return. Infrastructure Other 12% 16% 13% 12% 1 12% 0% 20% 30% 40% 50% 60% 70% 80% 16. What percentage of your international equity investments are currency hedged? 0% 1-25% 31% 39% 4 46% This year, we saw an increase in investors hedging a portion of their portfolio, with 4 of respondents hedging 1-25% of their international exposure % 51-75% 7% 15% % 1% 3% 0% 20% 30% 40% 50% 12 US ETF Investor Survey

13 17. What percentage of your portfolio construction do you outsource? 17% 1-25% Almost 2/3 of respondents do not outsource portfolio construction. 65% 7% 7% 26-50% 51-75% 75%+ Do not outsource Of those who do, most only outsource a sleeve of their portfolio, reflecting investor preference in retaining asset allocation decision making. 18. Who are you outsourcing your portfolio construction to? (Select all that apply) Third-party models 37% For those respondents who do outsource, they favor third-party models. Home-office models ETF strategists 23% 3 This could indicate another point of opportunity. Demand for third-party models may open a door for ETF managers to gain market share by packaging ETFs into models for investors. ETF providers 21% Robo advisors 17% 0% 20% 30% 40% 13

14 19. How important is securities lending in your ETF selection process? 8% 60% 32% Very important Somewhat important Not important 20. Please describe your current and planned usage of the following ETF strategies for equity exposures over the next 12 months: 100% 80% 60% 40% 20% 0% 52% 76% 11% 13% Market capitalization 46% 27% 6% 67% Active management 43% 32% 3% Currently using Increase Decrease Stay the same 65% 39% 2 2% 7 38% 18% 78% Multifactor Quality Equal weighting 38% 21% 7% 73% Minimum volatility 36% 20% 2% 78% Fundamental weighting 28% 19% 8% 73% Currencyhedged exposure 23% 22% 7 Liquid alternatives 1 5% 91% None of the above Market cap weighted was the most heavily used product and few people expected to change next year, as 75% plan to maintain similar weights. 27% plan to increase active ETF usage and another 32% plan to increase multifactor ETF usage, providing another opportunity for asset managers. 14

15 SMART BETA While overall smart beta AUM still lags traditional market-capitalization weighted ETFs, investor adoption and portfolio construction continues to evolve. Smart beta has become a hybrid option for investors seeking traditional passive and active strategies. Whether investors are seeking improved diversification, lower costs or better returns, smart beta s growing menu of factors is seen as a potential solution. We wanted to learn more about investors sentiment toward smart beta to better understand how they incorporate them in their portfolios. We asked: 21. How would you best classify smart beta? 25% 65% Hybrid (in between active and passive) Active investment strategy Passive investment strategy The majority of investors view smart beta as the middle ground in the active/passive spectrum. This highlights the versatility of the product set for targeted beta exposure in either alpha generation or defensive positioning. The large number of respondents choosing a hybrid investment strategy demonstrates the swiss-army knife nature of smart beta ETFs. 22. What share of smart-beta products currently make up your AUM? 35% 33% 30% 25% 2 20% 18% 15% 12% 13% 5% 0% Do not use Less than 5% % Greater than 20% While a third do not use smart beta products, 43% hold at least 6% of their AUM in smart beta ETFs. 15 US ETF Investor Survey

16 23. How do you plan to change smart beta in your AUM over the next 12 months? 29% Increase 68% 3% Decrease Stay the same Few investors plan to decrease their positions, though almost 30% plan to increase their smart beta exposure in the next 12 months, signaling a growing opportunity for ETF managers. Asset managers should also be engaging with the 68% who plan to maintain their smart beta product allocation to better understand their usage and incorporation of these strategies in their portfolios. 24. Select the reasons you are not using smart beta. (Select all that apply) Cannot determine if strategies will produce alpha/outperform active management 36% Unfamiliar with strategies 3 Smart-beta objectives can be achieved through internal portfolio management 29% Strategies are costly compared to passive investment options 26% Strategies lack track record 21% Other (please specify): 8% 0% 20% 30% 40% More than a third of non-smart beta investors cannot see an alpha play with the strategy, suggesting that some holdouts view smart beta more as an active tool than a hybrid and may want to see longer track records to assess alpha opportunities. Another third of respondents simply lack familiarity with these product types, suggesting further opportunity for ETF managers in their outreach efforts. 16

17 25. If you purchased a smart-beta ETF in past 12 months, what did it replace in your portfolio? (Select all that apply) Index ETFs 41% Active mutual funds 35% Reallocation from other investments (e.g., stock, bonds) 27% Allocating new investment dollars 23% Index mutual funds 1 0% 20% 30% 40% 50% Most investors are swapping out cap-weighted ETFs. More than a third moved away from active mutual funds. We expect smart beta to continue to erode allocations to plain vanilla and active strategies, given its perception as a hybrid strategy and the potential benefits to a portfolio. 26. How often are you using/considering using smart beta for the following reasons? 50% 40% 41% 43% 46% 50% 48% 39% 4 47% 40% Always Sometimes Never 30% 30% 29% 29% 28% 28% 26% 26% 2 23% 29% 20% 17% 13% 0% Provide exposure to specific factors Enhance diversification Generate alpha Risk management Reduce portfolio volatility Cost savings Generate income 71% of investors would consider using smart beta to reduce volatility in their portfolio. Most respondents favored a sometimes response to the potential uses of smart beta, suggesting that smart beta has a great deal of versatility when it comes to portfolio management. 50% of investors are using smart beta as an occasional risk management tool. 17 US ETF Investor Survey

18 27. What types of strategies are you currently using/would you most likely use? (Select all that apply) 70% 60% 60% 50% 46% 43% 40% 37% 30% 20% 0% Multifactor Fundamentally weighted strategies Single-factor strategies Equal-weighted strategies Investor demand for multifactor products may open the door for more tactically oriented products and indices for investors, which may carry a premium to other smart beta products. 18 US ETF Investor Survey

19 BBH ETF SERVICES Brown Brothers Harriman is a leading provider of asset servicing for the global ETF market. With more than $500 billion 3 in ETF assets under custody, BBH works with both experienced ETF managers and new, innovative market entrants to introduce and grow their ETF products. IF YOU ARE AN: Asset manager considering your first ETF launch ETF sponsor entering new markets or channels Established ETF manager evaluating a new ETF service provider BBH is your partner. Think of us as your trusted advisors. We help asset managers launch, list, and cross-list ETFs across the globe. We possess deep ETF product expertise, the regulatory and local market knowledge, as well as the relationships to improve your business and enable your future growth. We look forward to collaborating with you. GLOBAL Shawn McNinch shawn.mcninch@bbh.com US Ryan Sullivan ryan.sullivan@bbh.com EUROPE Antonette Kleiser antonette.kleiser@bbh.com EUROPE Andrew Craswell andrew.craswell@bbh.com ASIA Chris Pigott chris.pigott@bbh.com 3 As of September 30,

20 NEW YORK BEIJING BOSTON CHARLOTTE CHICAGO DENVER DUBLIN GRAND CAYMAN HONG KONG JERSEY CITY KRAKÓW LONDON LUXEMBOURG NASHVILLE PHILADELPHIA TOKYO WILMINGTON ZÜRICH This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ( BBH ) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co All rights reserved. 11/2017. IS _17