MMI NET MEETING Thursday, January 8, 2015 at 12 PM MEMBERS ONLY Exchange-Traded Managed Funds: The Future of Active Investing? Host: Christopher L. Davis, President, Money Management Institute Special Introduction by: John Jacobs, Special Advisor, Global Information Services, NASDAQ OMX Panelists: Steven W. Stone, Partner, Morgan, Lewis & Bockius LLP Richard F. Morris, Partner, Morgan, Lewis & Bockius LLP Stephen Clarke, President, Navigate Fund Solutions, an affiliate of Eaton Vance ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 1
Upcoming MMI Events ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 2
THE EVOLUTION OF ETFS
THE BEGINNING 1993 1999 QQQ Launched 2008 First ac*vely managed fully transparent ETF launched 2010 U.S. ETFs crossed $1 Trillion AUM November 2014 SEC approves non- transparent ac*vely managed ETF 1989 SPDR Launched Toronto Index Par*cipa*on Fund Launched December 2014 U.S. ETFs crossed $2 Trillion AUM 4 The Evolu*ons of ETFs
THE RETAIL MARKET ishares Q Q Q s The worlds largest family of Exchange Traded Funds (ETFs) from BlackRock. An ETF that tracks the NASDAQ-100 index. 5 The Evolu*ons of ETFs
ADVANTAGES Lower TER, no- load Tradable Easy re- balance of porpolio ETF ADVANTAGES Diversifica*on Tax- Advantaged Liquidity 6 The Evolu*ons of ETFs
EXPANSION The ETF market is expanding in several ways: Multiple asset classes Geography Smart Beta 7 The Evolu*ons of ETFs
THE FUTURE DEFINED BENEFIT NON- TRANSPARENT PLATFORMS WRAPPERS DEFINED CONTRIBUTION 8 The Evolu*ons of ETFs
Contact Us John Jacobs John.Jacobs@Nasdaq.com +1 301 978 8278 Jeffrey McCarthy Jeffrey.McCarthy@Nasdaq.com +1 212 231 5814 9 The Evolu*on of ETFs
The Non-Transparent Future of Investing: Regulatory Developments and Non-Transparent ETPs Richard F. Morris www.morganlewis.com
Overview v ETP Regulatory Milestones v Overview and comparison of proposed models v actions taken on proposals v SEC s concerns about non-transparent ETFs v Distinguishing features of ETMFs v Potential Future Developments 11
ETP Regulatory Milestones 1993 State Street launches the SPDR Trust, a UIT that tracks the S&P 500 Index; other UITs followed, including Mid Cap SPDRs (1995), Diamonds (1998), Nasdaq 100 Trust (1999), and BLDRS (2002). 1996 First managed open-end ETFs launched WEBS (now MSCI ishares). 2000 Barclays launches ishares and Vanguard launches Vipers. 2002 ishares launches first fixed income index based ETF. 2003 SEC issues relief to ishares to permit mutual funds to invest in ishares ETFs beyond the Section 12(d)(1) limits. 2004 First Commodity ETPs. 2006 ProShares launches first leveraged and inverse index based ETFs; WisdomTree launches first ETFs based on affiliated indexes. 2008 SEC issues orders to permit first actively managed ETFs. 2010 SEC issues order to permit first ETF organized in Master-Feeder structure. 2013 First modified affiliated index orders. 2014 SEC issues order permitting ETMFs.
Proposed Non-Transparent Exchange-Traded Products ( ETPs ) v What are Non-Transparent ETPs? Actively-managed strategies employed by a registered investment pool, with shares traded on an exchange, but with concealed portfolio holdings v October 21 - SEC indicated that it would deny two applications that requested exemptive relief for non-transparent ETFs (IC-31300; IC-31301) Both applicants sought to use a blind trust model (One applicant subsequently re-filed on 12/22/14 with an amended blind trust structure) v November 6 SEC indicated that it would grant exemptive relief to Exchange-Traded Managed Funds ( ETMFs ) (IC-31333) v November 7 SEC approved new listing rule for ETMF shares (34-73562) v v December 2 SEC issued order approving ETMF (IC-31361) Two other applications for non-transparent ETFs are pending that propose to use a set of proxy data, deliverable to the market daily, in lieu of daily portfolio holdings disclosure 13
Blind Trust ETPs v The Blind Trust model sought to maintain portfolio confidentiality by using a trust as an intermediary between the ETF and each Authorized Participant ( AP ) Blind Trust would have been maintained by ETF custodian acting as trustee Underlying securities to be delivered to APs upon redemption would be kept at the Blind Trust and the position would either be liquidated or managed by the custodian on the AP s behalf, pursuant to the instructions of the AP Creation orders would be effected in cash v Would have relied on the 15-second Intraday Indicative Value ( IIV ) to facilitate intraday trading v In place of daily portfolio disclosure, the proposed Blind Trust models would have used quarterly portfolio disclosure, similar to mutual funds, and relied on investment strategy disclosure in the ETF prospectus 14
Blind Trust ETPs v SEC concluded that the Blind Trust structure would not be capable of keeping non-transparent ETFs trading sufficiently close to NAV v The Blind Trust model would have needed arbitrage in order to maintain secondary market prices at or close to NAV. However, the SEC was not confident that use of the IIV alone would foster necessary arbitrage activity v SEC was not convinced that in the absence of portfolio transparency, even with a backstop provision, the Blind Trust structure would be capable of preventing material deviations from NAV The proposed Blind Trust structures would have, in times of market turbulence, permitted shareholders to place redemption orders in less than creation unit size but would have charged a 2% fee The SEC worried that the costs associated with the backstop would dissuade its use 15
Proxy Data Models v Proxy data models argue that portfolio transparency is not a requirement of ETFs if there is an alternative set of information that can keep share prices trading close to NAV v One proposed proxy data structure would disclose portfolios on a 30-day lag and would disclose daily a trading basket of representative ETFs, which would be designed to closely track the portfolio of the non-transparent ETF v Proxy data could be used by market makers to hedge intraday risk in the ETF v The two current proposals differ in terms of the data that would be provided, with one of the proposals offering to provide a more robust set of metrics v SEC approval will turn on its comfort that APs and retail investors will trade at substantially the same price 16
ETMFs v Only APs can transact with an ETMF, and only in creation unit size Creation Units will range in size from 5,000 shares to 50,000 shares v ETMF will disclose daily a creation basket in the form of a composition file Creation orders and redemption orders would be effected in-kind plus a cash component Creation baskets of deposit securities will not reflect a pro rata slice of the ETMF s portfolio v ETMFs will trade at values relative to NAV (e.g., NAV +/- 0.05) Trading will take place at NAV-Based Pricing and then be closed out at an absolute price after NAV is struck at the end of the trading day v An intraday indicative value will be published for each ETMF every 15 minutes v In place of daily portfolio disclosure, ETMF will disclose its portfolio quarterly, similar to mutual funds, with up to a 60-day lag 17
An ETMF s Composition File v Published daily; reflects the basket of securities and cash that the ETMF will accept for creations and redemptions All APs will transact in same composition file each day Exemptive relief limits use of cash in lieu May consist entirely of cash which may have negative tax implications v Each security in the composition file will be a current holding of the ETMF, but a security s weighting in the composition file will not necessarily be consistent with its weighting in the ETMF s portfolio v Composition file may exclude securities that the ETMF intends to add or remove from its portfolio (helps prevent inadvertent disclosure of strategy/ reverse engineering of strategy) 18
ETMF Pricing and Trading The defining characteristic of an ETMF is its unique secondary market pricing and trading mechanisms v Unlike ETFs, which trade in the secondary market on an absolute dollar basis that is typically within a few basis points of the fund s NAV, ETMFs trade at a price relative to NAV v Like ETFs, end of day NAV will be used for pricing creations and redemptions v Unlike with ETFs, the end of day NAV will also be used to finalize the prices of secondary market trades executed during the trading day 19
ETMF Pricing and Trading v The following factors may impact an ETMF s intraday price: Supply and demand for ETMF shares Transaction costs associated with creations/redemptions Liquidity (i.e. Market Maker competitiveness and inventories) v ETMFs IIVs will be absolute dollar estimates of ETMF shares, the primary purpose of which will be to assist market participants in determining the approximate cost of the number of ETMF shares they wish to purchase/sell v Nasdaq will implement a new NAV-Based Trading protocol where all bids, offers and execution prices for an ETMF will be expressed as a premium or discount to the next-determined NAV ETMF ticker symbols will have a unique identifier Nasdaq s proprietary data feed will use the NAV +/- format Consolidated tape will use a proxy price to stand in for the ETMF s nextdetermined NAV (i.e. NAV of +0.02 would print as 100.02 ) 20
Speaker Biography Richard F. Morris New York, NY tel: 212.309.6650 fax: 212.309.6001 Mr. Morris focuses his practice on ETFs, ETPs, mutual funds, and investment advisers. He advises clients on the full range of legal, regulatory and compliance matters applicable to ETFs, ETPs, mutual funds, indexes and investment advisers. He is a former General Counsel and in-house attorney at two of the top five ETF completes. He was a Senior Counsel in the SEC s Office of General Counsel. Mr. Morris has more than 20 years of experience as an asset management lawyer and chief compliance officer. He has been at the forefront of ETF representation since 2000 when he helped launch the ishares ETFs. He has significant experience working with the SEC and has helped his clients obtain innovative SEC exemptive orders that have since become industry standard. 21
international presence Almaty Beijing Astana Boston Beijing Brussels Boston Brussels Chicago Chicago Dallas Dubai* Dallas Frankfurt Dubai Frankfurt Harrisburg Harrisburg Houston Irvine Hartford London Houston Los Angeles London Miami Los Angeles Moscow Miami New York Moscow Palo New Alto York Paris Orange Philadelphia County Pittsburgh Paris Philadelphia Princeton San Pittsburgh Francisco Princeton Tokyo Washington San Francisco Wilmington Santa Monica Silicon Valley Tokyo Washington Wilmington *In association with Mohammed Buhashem Advocates & Legal Consultants
TM The Next Evolution of Fund Investing 23
Agenda 1. What are NextShares 2. Performance and tax advantages 3. Mechanics of buying and selling 4. Trading cost transparency 5. Protection against front-running 6. Launch plan 24
What are NextShares? A new type of actively managed exchangetraded product 25
NextShares performance and tax advantages Lower operating expenses Many mutual fund shares pay significant 12b-1 fees and TA fees. NextShares will not pay 12b-1 fees and have minimal TA expenses. Less cash drag Mutual funds may hold extra cash in connection with shareholder inflows and outflows, which can be a drag on performance. NextShares seek to minimize flow-related cash drag. Lower trading costs Mutual funds often incur extra trading costs when investors buy and sell shares. NextShares are structured to avoid most flowrelated trading and associated costs. 26
NextShares performance and tax advantages Active mutual funds face built-in structural costs that can erode returns distribution and service (12b-1) fees transfer agency (TA) fees flow-related trading costs cash drag According to a new study* of active equity funds over 2007-2013: 12b-1 fees averaged approximately 15 basis points per year TA fees, flow-related trading costs and cash drag together averaged approximately 63 basis points annually *available for download at nextshares.com Navigate Fund Solutions LLC, Avoidable Structural Costs of Actively Managed Mutual Funds, November 2014. The indicated averages are the asset-weighted averages of equity mutual funds offered to retail investors for which data was available for the years included in the study. 27
NextShares performance and tax advantages Outflows can trigger taxes for mutual fund shareholders from selling appreciated securities to raise cash Using in-kind redemptions to meet outflows can reduce fund capital gains and lower shareholder taxes NextShares can benefit from in-kind redemptions similar to ETFs 28
Buying and selling NextShares A typical trading day Due to the use of NAV-based trading, costs to buy and sell NextShare are expected to be low. In addition, advisors and investors can control their trading costs using limit orders. 9:30 a.m. Opening bell. Market opens. NextShare begin trading on exchange. Bid Price: NAV -$0.01 Offer Price: NAV +$0.02 2:30 p.m. Buy order executed at current offer. Lock in trading cost. Investor receives notice showing number of shares bought and amount of trading cost (= executed premium or discount to next daily NAV). Buy at: NAV +$0.02 4:00 p.m. Market closes. Final trade price set. Fund NAV is determined at market close. Investor receives final confirmation showing purchase price (= NAV plus or minus executed premium/discount). NAV: $20.00 Trade Price: $20.02 (NAV +$0.02) 29
NextShares trading cost transparency NextShares offer built-in trading cost transparency buying at NAV +$0.02 means trading cost of two cents a share selling at NAV -$0.01 means trading cost of a penny a share (plus commissions that apply) ETFs do not provide similar trading cost information most ETF investors cannot measure the quality of their trade executions 30
NextShares protect against front-running of fund trades Unlike active ETFs, not required to disclose all current portfolio holdings each day Managers can structure creation/redemption baskets to avoid telegraphing current fund trading activity generally avoid adding new positions until purchases completed may avoid removing sold positions until sales nearly completed Avoid resulting dilution of shareholder returns Compatible with full range of active strategies 31
NextShares launch plan Ensure marketplace readiness Introduce NextShares funds mirroring existing Eaton Vance mutual funds License IP and provide related services to other fund sponsors to support their offering of NextShares 32
Disclosure The U.S. launch of NextShares is conditional upon fund regulatory approval, the likelihood and timing of which cannot be predicted. Commercial success also requires completion of enabling implementation technology and acceptance by market participants, which cannot be assured. NextShares will not offer investors the opportunity to buy and sell intraday based on current (versus end-of-day) determinations of fund value. NextShares trade execution prices will fluctuate based on changes in NAV and may vary significantly from anticipated levels during periods of market volatility. Although limit orders may be used to control differences in trading costs, they cannot be used to control or limit trade execution prices. There can be no guarantee that an active trading market for NextShares will develop or be maintained, or that their listing will continue unchanged. Buying and selling NextShares may require payment of brokerage commissions and expose transacting shareholders to other trading costs. Market trading prices of NextShares may be above, at or below NAV, will fluctuate in relation to NAV based on supply and demand in the market for shares and other factors, and may vary significantly from NAV. The return on a shareholder s NextShares investment will be reduced if the shareholder sells shares at a greater discount or narrower premium to NAV than he or she acquired the shares. The performance of actively managed NextShares will depend in part on the portfolio manager s successful application of analytical skill and investment judgment. A NextShares fund is not a complete investment program, and there is no guarantee that it will achieve its investment objective. It is possible to lose money on an investment in NextShares. Investors in NextShares should have a long-term perspective and be able to tolerate potentially sharp declines in value. An investment in NextShares is not a deposit in a bank and is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency, entity or person. 33
The Next Evolution of Fund Investing 34