How Institutional Investors are Changing the ETF Industry

Transcription

1 How Institutional Investors are Changing the ETF Industry Sue Thompson 09/22/2015 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION

2 Overview of ETFs

3 What is an ETF? Two great investment ideas brought together Like a stock Trading flexibility intraday on the exchange Long or short Options frequently available Like an index fund Constructed to track benchmark indexes Low expense ratios Low turnover What sets ETFs apart? The creation / redemption process enables the unique benefits of ETFs such as liquid access and tax efficiency Familiar ground best of both worlds With short sales, an investor faces the potential for unlimited losses as the security's price rises. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Transactions in shares of the ishares Funds will result in brokerage commissions and will generate tax consequences. ishares Funds are obliged to distribute portfolio gains to shareholders. Diversification may not protect against market risk or loss of principal. 3

4 Underlying Securities ETF Clients can place an order in the market similar to a stock Clients interact primarily on the secondary market, but the liquidity of an ETF extends beyond the secondary market. Buyers Sellers Liquidity Providers Broker Dealers Authorized Participants Market Makers Underlying Securities Creation and Redemption Activity ETF Shares 4

5 Underlying Securities ETF Market participants are behind the scene to help ensure liquidity Market participants will ensure that the liquidity exists in the ETF market by accessing the underlying securities to maintain the equilibrium of supply and demand. Buyers Sellers Liquidity Providers Broker Dealers Authorized Participants Market Makers Underlying Securities Creation and Redemption Activity ETF Shares ishares Capital Markets sources the underlying liquidity and liquidity providers to enable best execution 5

6 Multiple layers of liquidity $75M trade Exchange Liquidity (ADV: $100M) $75M executed on exchange OTC Liquidity (ADV: $300M) Underlying Liquidity (ADV: $100B) 100% of the trade settles on exchange $150M trade Exchange Liquidity (ADV: $100M) $100M executed on exchange OTC Liquidity (ADV: $300M) $50M executed in OTC market Underlying Liquidity (ADV: $100B) $100M of the trade settles on exchange and remaining $50M settles OTC $500M trade Exchange Liquidity (ADV: $100M) $100M executed on exchange OTC Liquidity (ADV: $300M) $300M executed in OTC market Underlying Liquidity (ADV: $100B) $100M of new shares created $100M of the trade settles on exchange, $300M settles OTC, and remaining $100M met by new shares created by an AP Schematic illustration 6

7 ETF market equilibrium ETF Creation When there is excessive ETF demand in the market, liquidity can be added by exchanging the underlying securities for a unit of the ETF Bid Offer The creation/redemption process helps maintain an equilibrium of liquidity in the market ETF Redemption When there is excessive ETF supply an AP can remove ETF shares from the market by redeeming a unit of the ETF for the underlying securities Secondary Market OTC Market Underlying bid Primary Market Liquidity (Underlying Basket) Underlying offer Although market makers will generally take advantage of differences between the NAV and the trading price of ishares Fund shares through arbitrage opportunities, there is no guarantee that they will do so. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 7

8 Different types of ETPs LEGAL STRUCTURE Open End Fund Grantor Trust Unit Investment Trust Most common structure; may allow dividend re-investment, securities lending and optimization Structure commonly used for concentrated, specialty exposures that don t meet diversification requirements of open end funds Early ETF structure; does not allow for portfolio optimization, securities lending or dividend re-investment UNDERLYING ASSETS Index Securities Securities held either as fully replicating index or optimized proxy Swaps Futures Physical Assets Mostly used in levered or inverse funds and exotic exposures; also common in Europe Futures contract or a basket of futures contracts held by the fund, most common for broad commodities Most common in metals ETPs Notes Exchange Traded Notes (ETNs) are debt obligations of the issuer to the holder "ETP" (or exchange traded product) as referred to above means any portfolio exposure security that trades intraday on an exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of

9 Growth of ETFs

10 AUM ($B) Growth of exchange traded funds in the U.S. Rapid adoption of exchange traded products (ETPs) 1 $2,500 $2,000 $1, year CAGR for US ETP assets is 24% 2 22% for Equity ETPs 2 43% for Fixed Income ETPs 2 $1,350 $1,701 $2,009 $2,118 $1,000 $500 $70 $87 $106 $157 $236 $311 $433 $619 $542 $789 $1,012 $1,061 $ Q Equity Fixed Income Other Source: BlackRock, Bloomberg, ICI as of 6/30/15. Other category includes alternatives, commodities, currency, target date, asset allocation, and fund of funds. Notable statistics 3 U.S. ETP AUM has risen from $70.6 billion in 2000 to $2.1 trillion as of 6/30/2015. U.S. ETPs had ~$97 billion of inflows in the first half of 2015 ishares is the largest ETP provider in the US, with $810 billion of the $2.1 trillion in as of 6/30/2015, representing a 38.6% market share ETFs represented ~25% of U.S. daily equity trading volume in "ETP" (or exchange traded product) as referred to above means any portfolio exposure security that trades intraday on a US exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of Statistics as of 12/31/14 unless otherwise noted year CAGR as of December 31, ETP flows and assets are sourced using shares outstanding and net asset values from Bloomberg. Inflows for years prior to 2010 are sourced from Strategic Insights Simfund. Asset classifications are assigned by the BlackRock based on product definitions from provider websites and product prospectuses. Other static product information is obtained from provider websites, product prospectuses, provider press. The 10-year CAGR for Equity and Fixed Income ETPs are calculated by BlackRock. 3. Source: NYSE Arcavision. 10

11 Record-breaking 2015 ETP flows Year-to-date asset gathering of $146.1 billion globally and $96.7 billion in the U.S. represented a new first-half record for the industry Flows in the U.S. came largely from investor demand for non-u.s. equities. This is a reversal from the Q all-time high concentrated in U.S. equities $138.0bn globally and $120.7bn in the US YTD 2015 U.S. ETP Flows ($bn) U.S. ETP AUM US Equity Large Cap Other Size and Style Sector Strategic AUM ($bn) Growth since year-end ,199 (-0.9%) Developed International Equity % Emerging Markets Equity % Fixed Income Short Maturity Other Durations % Commodities & Other % $2, % Source: Bloomberg, BlackRock, ICI as of 6/30/15. "ETP" (or exchange traded product) as referred to above means any portfolio exposure security that trades intraday on a US exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of Commodities and Other includes Alternatives, Asset Allocation, and Currency. 11

12 Total AUM ($B) Growth of fixed income ETFs U.S. fixed income ETF AUM is over $321B Assets have climbed 564% since 2008 as investor adoption has increased and existing users have broadened their usage YTD 2015 Government Inflation-Linked IG Credit High Yield Bank Loans Govt/Credit Aggregate Leveraged/Inverse Mortgage Municipals Active Short International/EM Money Market Term Maturity Fixed income ETF usage has grown significantly, solving many challenges of trading in the OTC market Growth in fund size, breadth of bond market exposures, and liquidity have continued to drive increased adoption of ETFs A wide cross section of investors, such as endowments and foundations, asset managers, insurance companies, and pension funds are now pioneering new investment approaches using ETFs Source: BlackRock, Bloomberg, as of 6/30/15. 12

13 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 U.S. Fixed Income Asset Flows Since 2002, cumulative asset flow into fixed income ETFs has been less than flows into fixed income active funds The first fixed income ETFs were launched in 2002 by ishares Fixed income index ETF net asset flows have exceeded open-end indexed fixed income mutual funds Cumulative Net Asset Flow 1,600 1,400 1,273 1,200 1, U.S. Fixed Income ETFs U.S. Fixed Income Active Funds U.S. Fixed Income Index Funds Source: Morningstar, BlackRock, from 7/1/2002 6/30/2015. Annual estimated net asset flows are defined by Morningstar as US Broad Asset Class: taxable bond and municipal bond and Active/Passive: Passively Managed, Long-term; Passively Managed, Sector; Passively Managed, Leveraged (Long); and Passively Managed, Leveraged (Short) 13

14 Institutional uses of ETFs

15 ETF applications in portfolios CORE ALLOCATION Invest long-term in a variety of market exposures in a cost efficient, exchange traded investment vehicle LIQUIDITY MANAGEMENT Maintain exposure in a liquid investment vehicle to meet cash flow needs 1 Reduce implementation time and t-costs to change exposures in asset classes LONG & LEND Seek index-like returns plus the potential for incremental return through lending ishares ETFs 2 CASH EQUITIZATION TACTICAL ADJUSTMENTS ETFs can provide an efficient solution for maintaining liquidity while minimizing low-yielding cash positions Minimize cash drag through targeted market exposures Over- or under-weight certain styles, regions or specific countries Target duration or credit quality on the basis of short-term views INTERIM BETA Maintain market exposure while refining a longer-term view RISK MANAGEMENT Mitigate undesired portfolio risk and hedge asset allocation decisions Ability to go long a sector s stocks and short corresponding ETF 3 1. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 2. There is no guarantee that there will be borrower demand for shares of ishares ETFs, or that securities lending will generate any level of income 3. With short sales, an investor faces the potential for unlimited losses as the security s price rises 15

16 ETFs as client solutions MORNING CALL Country and broad market ETFs enable global strategist calls to be actionable ETFs can be utilized for beta exposure to sectors while analyst due diligence is being completed LIQUIDITY Access liquidity for areas of the market where a liquid future is not available Depth of liquidity beyond the secondary market allows for large trades to be executed with potentially minimal market impact TACTICAL TRADE ETFs offer immediate exposure to a basket or group of securities for broad diversification through a single trade Broad range of asset classes, including equities, bonds, commodities, etc. SPECIALTY EXPOSURES Pair trade; ability to express conviction on a sector (long or short) relative to a single security Access to otherwise less-accessible, hard assets like alternatives and commodities in a single, diversified trade. MANAGE RISK ACCESS TO DIFFICULT-TO- REACH MARKETS ETFs are not subject to additional operational costs when managing risk, settlement and reporting that other derivative products require Gain exposure to markets when the local underlying market is closed Exchange traded access to less liquid markets (eg, China Small Cap) Enables transparency to over-the-counter markets, and improves liquidity relative to diverse basket of underlying securities There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Diversification may not protect against market risk or loss. With short sales, an investor faces the potential for unlimited losses as the security s price rises. 16

17 Greenwich surveys All channels

18 Institutional feedback: usage of ETFs STRATEGY CASH EQUITIZATION INTERIM BETA TRANSACTIONS REBALANCING CORE ALLOCATION LIQUIDITY MANAGEMENT TACTICAL ADJUSTMENTS RISK MANAGEMENT LONG AND LEND OBJECTIVE Minimizing exposure to cash while gaining market exposure in a specific asset class Invest short-term in the market, minimizing cash drag through targeted market exposure Invest short-term in the market, minimizing cash drag through targeted market exposure Manage portfolio risk/beta tilts in between rebalancing cycles Access to a variety of market exposures from broad market to niche in a cost-effective, exchange-traded investment vehicle Maintain exposure in a liquid investment vehicle to meet cash flow needs 1 Over- or under-weight certain styles, regions, or countries on the basis of short-term views Mitigate undesired portfolio risk and hedge asset allocation decisions Achieve index-like returns plus the potential for incremental return through lending ishares ETFs 2 Institutional feedback, 2014 Greenwich Survey 3 We have found a lot of new innovative products are available in ETF form. RIA It started out as a tactical tool to temporarily hold cash; over time our use has evolved into permanent holdings. An insurance company that relies on ETFs as a source of liquidity and a means of achieving long-term exposures ETFs allow me to diversify exposure to style, market capitalization and sectors that I would not be able to efficiently achieve trading individual names. The key word is diversification. Asset manager At times active managers have difficulty beating their benchmarks and ETFs are considerably less expensive. Institutional fund Our use of bond ETFs is likely due to increased liquidity, lower transaction costs and access to very precise segments of the market. RIA There are more ETFs tailored to specific investment strategies, liquidity is improving and expense ratios are coming down. Institutional fund 1. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 2. There is no guarantee that there will be borrower demand for shares of the ishares Funds, or that securities lending will generate any level of income. 3. Source: 2014 Greenwich Associates Reports, ETFS An Evolving Toolset for U.S. Institutions 18

19 Greenwich Associates: institutional usage of ETFs Key results of the Greenwich Associates 2014 Studies ETFs: An Evolving Toolset for U.S. Institutions ETFs: Broad usage increases amongst European institutional investors ETF allocations expected to increase across all institution types in the US Institutional funds 4% 6% 29% 8% Investment consultants 47% 5% Insurers 45% RIAs 3% 36% 23% Asset managers 3% 22% 19% -25% 0% 25% 50% 75% Decrease 1-10% Decrease > 10% Increase 1-10% Increase > 10% Source: Greenwich Associates. US data - ETFs: An Evolving Toolset for U.S. Institutions. * Institutional funds are defined as U.S. corporate and public pension funds, endowments, and foundations. 19

20 U.S. institutional usage of ETFs expected to increase Key results of 2014 Greenwich Associates Studies ETFs: An Evolving Toolset for U.S. Institutions ETF allocations expected to increase across all institution types in the US Institutional funds 4% 6% 29% 8% U.S. Institutional ETF Holding Periods > 2 years Investment consultants 47% 5% 1-2 years Insurers 45% 7-12 months RIAs 3% 36% 23% 1-6 months Asset managers 3% 22% 19% < 1 month % 0% 25% 50% 75% Decrease 1-10% Decrease > 10% Increase 1-10% Increase > 10% Majority of U.S. institutions expect to increase allocations over the next year 47% of institutional funds surveyed reported average ETF holding periods of two years or longer, up from 36% in 2013 Source: Greenwich Associates. U.S. data ETFs: An Evolving Toolset for U.S. Institutions.. * Institutional funds are defined as U.S. corporate and public pension funds, endowments, and foundations. 20

21 Greenwich Surveys - Fixed Income

22 2015 Greenwich Associates Institutional Investor Fixed Income ETF Study Greenwich Associates: Bond Market Challenges Continue to Drive Demand for Fixed Income ETFs Conducted during January and March 2015 Surveyed 128 U.S.-based institutional investors 60 users of fixed income ETFs 68 non-users of fixed income ETFs 2015 Greenwich FI ETF Study Research Goals: How have the structural changes in fixed income markets impacted institutional funds (i.e., pensions, foundations, and endowments), investment managers, insurers, and RIAs? How and why are institutions using FI ETFs? How has their usage evolved? How do institutions expect it to evolve? What are the barriers to ETF use, and how are institutions overcoming them? Composition of respondents RIAs, 21% Insurers, 11% Institutional Funds, 39% Investment Managers, 29% Source: Greenwich Associates 2015 U.S. Fixed- Income ETF Study. Based on 128 respondents. 22

23 Greenwich Associates Illiquid bond markets are affecting investment processes Institutions are struggling to source and trade bonds 43% of asset managers (AM) report bond markets are harder to navigate 66% of AMs say their investment processes have been impacted The volatility since 2008 makes us more concerned about when we need to sell things. What time of year? What quarter? Before the financial crisis it wasn t much of a concern. Pension fund manager Fixed Income ETFs are being used alongside individual bonds The 53% of ETF users who employ this approach say they do so for three main reasons: easy exposures, increased liquidity, and diversification Trading environment over the past two years Have you faced challenges in trading, liquidity, or sourcing securities in fixed income markets? 1 More challenging About the same 34% 61% Have the challenges affected your investment process? 2 No 47% Yes 53% Fixed Income ETF liquidity is growing rapidly Since 2008, volumes for the top 5 FI ETFs are up 75x, significantly outpacing asset growth, which is up 17x Less challenging 5% Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 1.Based on 119 respondents in Based on 40 respondents in Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 23

24 Greenwich Associates ETFs as a liquidity solution 59% of fixed-income ETF users have increased ETF usage since % of investment managers plan to increase their use of bond ETFs in the coming 12 months 0% of users expect to decrease ETF allocations Reasons for using ETFs alongside cash bonds ETFs as substitutes for derivatives Ease of exposure 38% Do you use fixed income derivatives? 1 Are you considering ETFs as an alternative? 2 More liquidity 34% Diversification Duration management Placeholder/replacement 9% 19% 16% No 72% Yes 28% Yes 58% No 42% 0% 10% 20% 30% 40% 50% Based on 32 respondents in Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 1. Based on 128 respondents in Based on 36 respondents in 2015 who use derivatives. Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 24

25 Greenwich Associates Institutions are successfully executing large trades 1 in 5 institutions have executed trades larger than $50 million 93% of FI ETF users were satisfied with their experience with their largest trade 98% would execute a trade of this size again Largest single trade using a fixed-income ETF ETF trading experience based on largest trade size $0-$5 million 33% 100% No, 7% No, 2% $6-$10 million 17% 75% $11-$50 million 31% 50% Yes, 93% Yes, 98% $51-$100 million 7% 25% More than $100 million 12% 0% 10% 20% 30% 40% 0% Where you satisfied with the trading experience? Would you trade the ETF again? Based on 60 responses: 10 institutional funds, 21 RIAs, 22 investment managers, and 7 insurance companies in Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study Based on 60 responses: 10 institutional funds, 21 RIAs, 22 investment managers, and 7 insurance companies in Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 25

26 Greenwich Associates barriers to ETF use are falling Concerns about low trading volume are becoming less acute as investors learn that exchange-reported volumes understate available ETF liquidity Greenwich expects institutions will continue to revisit internal limits and guidelines as they re-evaluate traditional portfolio management processes Innovative structures provide greater flexibility in institutional portfolios. Institutions report that they believe fixed-maturity ETFs could be even more useful than traditional bond ETFs in target-based strategies, duration management and bond laddering Top reasons institutions do not use FI ETFs Low trading volumes or assets 48% Internal limits Constant maturity pro file of ETFs 28% 27% Investment guidelines 20% Expenses Lack of familiarity 12% 15% Regulatory limits ETFs not supported on trading platform 8% 8% Based on 68 respondents in Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study 0% 10% 20% 30% 40% 50% 26

27 Price discovery and market stress case studies

28 VIX Index Level ETP Volume as % of All Equity Volume Investors have often turned to ETFs in times of market stress The liquidity and transparency of ETFs can be particularly appealing to investors during times of market stress Using the VIX Index as a proxy for uncertainty in US equity markets, there is a clear historical relationship between the dollar volume of ETPs as a percentage of all equity dollar volume and stress in the markets This could also be driven by increased investor focus on macro factors during times of stress, and their use of ETFs to express these macro views US ETP volume as a % of all equity volume vs. VIX Index % 40% 35% 30% 25% 20% 15% 10% 5% - 0% Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 VIX Index Level ETP Volume % of All Equity Volume "ETP" as referred to above means any portfolio exposure security that trades intraday on a US exchange. ETPs include exchange traded funds (ETFs) registered with the SEC under the Investment Company Act of 1940 (open-end funds and unit investment trusts or UITs) and certain trusts, commodity pools and exchange traded notes (ETNs) registered with the SEC under the Securities Act of Source: BlackRock, Bloomberg, NYSE Arca as of February 13, day rolling average is shown for each. 28

29 ETF price discovery case study: the financial crisis ishares iboxx $ Investment Grade Corporate Bond ETF (LQD) helped investors discover the fair value of the underlying US investment grade corporate bonds during the liquidity crisis of September PRICE ($) September 8-12 September September Underlying portfolio value: The value of the portfolio is calculated using the last price of each bond multiplied by the par held plus accrued interest and cash. Whenever a bond did not trade, the last trade is carried forward. Source: TRACE Corporate Bond Data. Price volatility of the underlying bonds in the portfolio: Value represents the additional risk premium and transaction costs that market participants must consider to create an actionable market price and is calculated as the rolling 10-hour cross-sectional volatility of the prices of the 100 securities in the portfolio. A cross-sectional average is calculated using a simple average (equally weighted). The volatility is graphed -1x and +1x around the value of the portfolio calculated using last trade price (blue line). Market price of LQD: Actionable price reflecting all current market information and sentiment. Source: Data Explorers Limited-information available on as of 9/30/08. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. This information must be accompanied by standardized returns. For standardized returns, see Appendix. For performance current to the most recent month end, visit 29

30 Value ($bn) Basis points Percent (%) Case study: HYG Global investment banks holdings of corporate bonds Bid-ask spreads vs. underlying bond trading HYG as percentage of high yield bond trading HY Basket IG Basket Lehman Inv Grade High Yield Commerical Paper CMBS RMBS Corp (Before 4/1/2013) Barclays Corp Index Market Value Source: BlackRock, Bloomberg as of 3/27/13. Primary Dealer Positions Outright Level of Corporate Securities Due Greater Than 1-yr HYG 1 LQD 2 Source: BlackRock and Bloomberg. Monthly average as of December Bernanke speech Source: BLK, Bloomberg as of 12/31/14. % Cash bonds = rolling 20-day average. Cash bonds are measured by FINRA TRACE Market Breadth High Yield and High Grade Bond Dollar Indexes and ETF volume is ADV. 30

31 ETFs and futures

32 Index investing in a changing beta landscape: focus on equity index futures and ETFs Tailwinds for ETFs and headwinds for Futures in the delta one space Generally, ETF fund sizes have increased, trading liquidity and spreads have improved The choice of ETFs available has grown Simultaneously, average roll costs for Futures have increased The ability to re-invest risk free cash at the implied futures rate has fallen Why have Futures become more costly? Futures face rising operational costs and an implied negative repo rate Increased capital costs for banks and regulatory changes have lowered arbitrage activity What evidence do we have of these changes? New regulatory frameworks are changing banks business models Trading data demonstrates the cost advantage of many ETFs vs. Futures A number of brokers have published research supporting the conclusions of our analysis Source: BackRock s ishares Research Group 32

33 Regulatory landscape: New regulatory frameworks are changing banks business models Holding costs of financing vehicles have been pushed higher by recent regulation Regulatory changes ushered in by the Dodd Frank Consumer Protection Act in the U.S. and the Basel Accords in the E.U. have driven up banks cost of capital by restricting balance sheets. Basel III Liquidity coverage ratio constraints Tier 1 core capital ratio requirements Restricts banks ability to warehouse risk on balance sheets Dodd Frank Consumer Protection Act Volcker Rule limiting proprietary activity Restricts banks ability to assume proprietary positions We believe this represents a distinct structural change in the market as mean reversion could only occur if: The current regulatory framework were rolled back, which appears to be an unlikely scenario. New synthetic suppliers of short futures positions appeared in the market. However, there are no candidates large enough to supply the synthetic short positions in a similar magnitude of that supplied by bank balance sheets. 33

34 Regulatory landscape: the cost of change The investor replaces use of its own balance sheet with that of the bank s Natural Long Investors Synthetic Short Investors Bank Balance Sheets Many global futures contracts exhibit a long bias, meaning demand for long exposure has historically outpaced that for short. However, because futures investments are a zero sum game, a short must exist for every long. In the absence of sufficient short investors, banks tend to take a net short position Less Natural Short Investors Hedging the resulting short position forces banks to deploy balance sheet The cost of bank balance sheet is passed back to the investor as roll richness 34

35 Conclusions 1 Rising trading volume and lower costs are making ETFs more efficient beta vehicles 2 Conversely, over the last 2-3 years, futures contracts have become more expensive, as banks grapple with a changing regulatory landscape 3 We expect further changes ahead, and urge investors to go beyond standard assumptions and carefully evaluate the relative cost of potential beta vehicles 4 We can help provide the data and due diligence tools investors require to react to the changing economic efficiency of index tracking vehicles 35

36 Important information regarding ishares ETFs Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be obtained by visiting or Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. A fund s income may decline when interest rates fall if most of the debt instruments held by the fund have floating or variable rates. There is no guarantee that dividends will be paid. When comparing stocks or bonds and ishares Funds, it should be remembered that management fees associated with fund investments, like ishares Funds, are not borne by investors in individual stocks or bonds. The annual management fees of ishares Funds may be substantially less than those of most mutual funds. Buying and selling shares of ishares Funds will result in brokerage commissions. Although market makers will generally take advantage of differences between the NAV and the trading price of ishares Fund shares through arbitrage opportunities, there is no guarantee that they will do so. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets, in concentrations of single countries or smaller capital markets.. Narrowly focused investments, including REIT, mining, preferred stock, factor and floating rate note funds may be subject to higher volatility and risks specific to those sectors. The ishares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index's strategy of seeking to lower volatility will be successful. Investment in a fund of funds is subject to the risks and expenses of the underlying funds. 36

37 Important information regarding ishares ETFs Actively managed funds do not seek to replicate the performance of a specified index and may have higher portfolio turnover than index funds. A fund's use of derivatives may reduce a fund's returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that any fund's hedging transactions will be effective. The ishares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, BlackRock ). The ishares Funds are not sponsored, endorsed, issued, sold or promoted by FTSE International Limited ( FTSE ), India Index Services & Products Limited, JPMorgan Chase & Co., MSCI Inc., Markit Indices Limited or S&P Dow Jones Indices LLC. None of these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with the companies listed above BlackRock. All rights reserved. ishares and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. Not FDIC Insured No Bank Guarantee May Lose Value 37