ETFs: Asian Institutions Broaden Applications

Q1 Month 20172015 Cover Headline Here (Title Case) ETFs: Asian Institutions Broaden Applications Cover subhead here (sentence case)

CONTENTS 3 Executive Summary 4 New Users, Bigger Allocations 6 The ETF Attraction: Liquidity, Quick Access, Ease of Use 7 ETFs Find New Roles in Institutional Portfolios 8 Shift in Rate Environment Fueling Demand for Bond ETFs FIXED-INCOME ETFs ARE INCREASINGLY POPULAR AND MORE VOLATILITY WILL ACCELERATE GROWTH METHODOLOGY CURRENT ASIAN INSTITUTIONAL ETF ALLOCATIONS AVERAGE OVER 17% OF TOTAL ASSETS IN THE FUNDS 9 Local Opportunities for Growth 10 The Smart Beta Innovation 11 ETFs Displacing Derivatives 12 Demand for Multi-Asset Funds Fuels Demand for ETFs 13 Liquidity is Key to Decision-Making 14 Fewer Obstacles to ETF Investing Between October and December 2016, Greenwich Associates interviewed 59 Asian institutional investors for its 2016 Asian Exchange-Traded Funds Study. Insurance companies and asset managers make up the largest proportion of study participants, with the remainder composed of a diverse mix of family offices, commercial and trust banks, corporate defined benefit and defined contribution plans, and central banks. Most of the participants are large institutions. Forty-two percent of the institutions in the study have AUM of $5 billion or more, and about a quarter manage more than $20 billion. Relative to institutions in other parts of the world, these investors manage sizable shares of their assets in-house. Across all Asian institutions in the study, nearly 60% of assets are managed internally. RESPONDENTS Managing Director Andrew McCollum advises on the 2015 2016 investment management market globally. 31% 40% Asset managers Insurers Institutional funds 31% 36% 29% 34% 2 GREENWICH ASSOCIATES

Executive Summary Exchange-traded funds continue to attract new institutional users and assets in Asia, driven by significant growth among asset managers, institutional funds and insurance companies. The results of the Greenwich Associates 2016 Asian ETF Study reveal a steady increase in ETF allocations among existing institutional users in the region and the continued entrance of new users, as more institutions make their initial forays into ETF investing. Fueling this growth in Asia and indeed around the world is institutions continued adoption of ETFs for an expanding list of functions within their portfolios. Most Asian institutions started investing in equity ETFs, often in U.S. and international equites. Within these markets, most early Asian users employed ETFs as an efficient and cost-effective means of obtaining core strategic investment exposures. In relatively short order, institutions began using ETFs to gain strategic exposures in other equity markets and in fixed income and other asset classes. While many Asian institutions view ETFs primarily as a means of obtaining strategic exposures, the results of the 2016 study show they are broadening their use into portfolio applications ranging from strategic priorities like portfolio diversification, liquidity management and risk management to shorter-term tasks such as making tactical adjustments to portfolios, taking on interim beta, and cash equitization. This advance of ETFs into new areas and applications will continue to drive growth in both equities and fixedincome. Forty-four percent of fixed-income ETF investors plan to increase allocations to bond ETFs. Half of current equity ETF investors in the study say they plan to increase allocations to these funds in the year ahead, with the majority of those expecting increases of more than 10%. Several additional findings from the 2016 study suggest that the pace of ETF growth in Asia could actually accelerate in coming months. Among the most significant: JJ JJ JJ Increasing volatility and rising rates should stimulate fixed-income ETF use. Asian institutions say they employ ETFs largely because they are easy to use, offer quick access and provide liquidity benefits. These characteristics become ever more valuable during periods of volatility. In particular, institutions with plans to increase allocations to fixed-income ETFs cite expectations for a shift in the interest-rate environment as the primary reason they plan to step up their use of bond ETFs. Multi-asset funds are accelerating demand for ETFs. Consistent with a global trend, Asian asset managers are building multi-asset funds using ETFs. Well over half of the asset managers in the study incorporate ETFs in their multi-asset funds, and some will use ETFs for more than 80% of the assets in the fund. Smart beta ETFs are gaining ground. Use of non-market-cap weighted/smart beta ETFs has nearly doubled in the past 12 months as the range of fund types used expanded. Looking ahead, 54% expect to increase their allocations to smart beta even further with investments in dividend/equity income, sector smart beta, smart beta commodities, and smart beta fixed income, among other categories. 3 GREENWICH ASSOCIATES

New Users, Bigger Allocations Institutional ETF allocations are increasing in Asia. Institutions identifying themselves as current users of ETFs in 2016 invest an average 17.6% of total assets in the funds. That average reflects significant expansion over the past 12 months to a level well above allocations found in other institutional markets around the world. For example, institutional ETF investors in Europe allocate an average 7.6% of total assets to the funds. On the other hand, U.S. ETF investors have the world s highest average, with ETF allocations of 21.2% of total assets. EXPECTED CHANGE IN ALLOCATIONS TO ETFs IN NEXT 12 MONTHS Decrease Increase Equity ETFs 4% 50% Fixed-Income ETFs 11% 44% Note: Based on 35 responses. It is worth noting that the 17.6% allocation average among Asian investors is up dramatically from the 2.1% reported in the 2015 study. This jump likely reflects the addition of several large Asian asset managers to the 2016 research sample. These asset managers invest upwards of 80% and in cases more than 90% of total assets in ETFs likely as part of multi-asset funds managed for clients. (The impact of these big ETF users can be seen by looking at median allocations among active ETF investors in Asia, which increased, but at a more modest rate, to 5% of total assets in 2016 from 1% the year before.) However, additional research findings confirm the trend of strong growth and suggest it will continue in 2017. Half of equity ETF investors in the study say they plan to increase allocations to these funds in the year ahead, with the majority of those expecting increases of more than 10%. Among fixed-income ETF investors, 44% plan to increase allocations to bond ETFs in the next year, with about 1 in 10 planning a decrease. These expectations are much more bullish than results from the previous year, when only 14% of investors were planning to increase allocations to fixed-income ETFs and an equal 14% were planning to reduce allocations. Three-quarters of investors planning to boost bond ETF allocations next year expect increases of 5% to 10%, with the remaining investors predicting larger increases. 4 GREENWICH ASSOCIATES

PERIOD OF TIME INVESTORS HAVE USED ETFs Fixed-Income ETFs Equity ETFs 40% 50% Adopted in past year Adopted 1 2 years ago Adopted more than 2 years ago 63% 30% 7% 10% Note: Based on 37 responses. Fueling this growth is the fact that many of these investors are relatively recent adopters of bond ETFs. Half the fixed-income ETF users in the study have been investing in the funds for a year or less a finding that suggests allocations have ample room for further growth as these investors get more comfortable and integrate ETFs more deeply into their fixed-income portfolios. INSTITUTIONS ADOPTING ETFs IN NEW ASSET CLASSES Total Equity Portfolio 94% 97% Total Fixed-Income Portfolio Total Other Allocations 32% 41% 32% 32% 2015 2016 2015 2016 2015 2016 2016 2016 2016 U.S. equity 62% International goverment bonds 30% REITs 24% International developed equity 57% International investment grade 24% Commodities 22% International emerging markets equity 54% International high yield 24% Cash and cash equivalents 8% Domestic equity* 51% International credit 19% Other 3% European equity 46% Domestic high yield 11% International developed ex-u.s. equity 41% U.S. municipal bonds 11% Asian equity 41% Domestic investment grade* 8% Domestic government bonds* 5% Mortgage-backed securities 3% Note: *Respondent s country. Based on 31 responses in 2015 and 37 in 2016. 5 GREENWICH ASSOCIATES

At the same time, the entrance of new institutions adopting ETFs will continue to boost overall investment in the region. In Asia and around the world, institutional investors usually first start employing ETFs in equites. In fact, 97% of ETF investors in the 2016 Asian study use the funds in equities. Usage is most widespread in U.S. equities (62%) and international developed market equities (57%). However, about 40% of the investors use ETFs in Asian equities, and about half employ the funds in the domestic equities of their home countries. In the year ahead, about a quarter of the relatively small number of study participants not currently investing in equity ETFs say they are at least somewhat likely to start investing in these funds. The number of fixed-income ETF investors is also growing rapidly. In 2016, 41% of Asian institutions identified as current ETF users invested in bond ETFs a 9% increase from the previous year. These investors show a strong preference toward international bonds, including governments, investment grade and high yield. Of investors not currently using bond ETFs, 26% say they expect to start investing in the funds in 2017. This is a dramatic increase from the 8% of non-users planning an initial investment in fixed-income ETFs in the 2015 study. Finally, institutions are adopting ETFs in asset classes beyond equities and fixed income. Approximately a quarter of Asian institutional ETF investors now use the funds in REITS, and 22% use ETFs in commodities. INCREASED ADOPTION EXPECTED IN BOND ETFs IN 2017 8% 26% 2015 2016 The ETF Attraction: Liquidity, Quick Access, Ease of Use Investors globally are being attracted to ETFs by a wide range of potential benefits and perceived advantages over other investment vehicles. Investors in the Asia study cite speed of execution to gain diversified exposure, liquidity and market access as their primary reasons for using equity ETFs, followed by ease of use, single-trade diversification and attractive management fees. In fixed income, investors say they use ETFs primarily for their ease of use and quick access. Investors also cite relatively low trading costs, liquidity, low management fees, and the ability to avoid single-security analysis as benefits. 6 GREENWICH ASSOCIATES

ETFs Find New Roles in Institutional Portfolios Asian institutions are expanding how they use ETFs across their portfolios. As noted in last year s report, institutional investors generally first use ETFs for tactical tasks within their portfolios and gradually expand their use to more strategic purposes. Over the past 12 months, Asian investors have experienced a similar progression but in reverse. After initially using ETFs to achieve strategic investment exposures, many Asian institutions are now discovering the wide variety of additional, often tactical ways ETFs can be used in their portfolios. The 55% of Asian institutions saying they use ETFs to make tactical adjustments to their portfolio in 2016 is, in fact, the highest for any ETF application measured in Asia. Next on that list are the critical strategic functions that first attracted many Asian institutions to the funds: 42% of investors use ETFs to obtain investment exposures in their core allocations, and 34% use ETFs to achieve international diversification. Beyond those, Asian institutions are incorporating ETFs into a growing variety of applications, ranging from interim beta and portfolio completion to liquidity management, risk management, rebalancing, and cash equitization. KEY USES OF ETFs IN ASIAN PORTFOLIOS Tactical adjustments 55% Core allocation 42% International diversification 34% Interim beta Portfolio completion Liquidity management Rebalancing Interim beta and not transition management Cash equitization Risk management/overlay management Transition management Interim beta and transition management 26% 26% 21% 18% 18% 13% 13% 13% 8% Note: Based on 38 responses. 7 GREENWICH ASSOCIATES

Nevertheless, the study results strongly suggest that Asian institutions view ETFs first and foremost as an effective vehicle for obtaining important investment exposures. For example, three-quarters of the institutions in the study believe equities will be the best performing asset class in 2017 in terms of absolute returns, with 44% of all participants citing developed-market equities and 33% picking emerging-market equities. When asked what investment vehicle they will use to implement those views, 46% of institutions in the study named ETFs. Shift in Rate Environment Fueling Demand for Bond ETFs Fixed-income ETFs are growing in popularity among Asian institutions, and the shift to a rising and more volatile interest-rate environment could accelerate the pace of growth in 2017. Asian institutions with plans to increase allocations to fixed-income ETFs point to the shift in interest-rate conditions as a primary driver of that decision. As noted earlier in this report, the use of fixed-income ETFs TOP REASONS FOR USING FIXED-INCOME ETFs Easy to use 43% 80% Quick access 57% 80% Single-trade diversification 40% 60% 57% Lower trading costs vs cash bonds n/a 40% Liquidity Avoid need for single security analysis 29% 40% 40% 57% Low management fees 2016 2015 14% 40% Note: Based on 10 responses in 2016 and 7 in 2015. 8 GREENWICH ASSOCIATES

increased to 41% among Asian institutions in 2016 from 32% in the 2015 study. Among current investors, ETFs make up 6.6% of all fixed-income assets, up from 4.6% in 2015 and topping the 2.7% of assets currently invested in index mutual funds. (The bulk of Asian fixed-income assets approximately 59% are still invested in individual bonds.) Overall, usage of fixed-income ETFs is highest in international government bonds, in which 30% of the institutions employ ETFs. That share is up from 19% in 2015. Approximately one-quarter of institutions use ETFs in each of international investment grade and international high yield, and about 20% employ ETFs in international credit. The 44% of current bond ETF investors planning to increase allocations to fixed-income ETFs in the coming year say their decision to do so is driven by a list of considerations, ranging from ETF liquidity and portfolio diversification to low costs and ease of implementation. By far the No. 1 factor cited is the changing interest-rate environment. Given the fact that institutions in the study rank quick access and ease of use as their top reasons for using ETFs overall, it s logical to assume that expectations for increased volatility in fixed-income markets are playing a role in the plans of the 26% of non-users in the study that expect to start investing in bond ETFs in 2017. Local Opportunities for Growth Institutional ETF investments in Asia will increase, as new opportunities emerge for institutions to use the funds in local and domestic markets especially in fixed income. As one might expect, Asian institutions trade ETFs most frequently in the U.S. market, and 78% of Asian ETF users report doing so. About 30% trade ETFs in the U.K. market. Perhaps more surprising is that nearly half (46%) of these investors trade ETFs in their local markets. It makes sense that fixed-income ETF use is centered on international products, given the size and liquidity of those markets. However, locally domiciled assets make up approximately half of Asian institutions active portfolios and about a third of passive assets in both equity and fixed income. Therefore, any new opportunities to use fixed-income ETFs in these markets could accelerate growth. Where Asian Institutions Trade ETFs 78% U.S. 46% Local Markets 30% U.K. 9 GREENWICH ASSOCIATES

Currently, between 40% and 50% of Asian institutions use ETFs in Asian or domestic equities, and about 1 in 10 are using fixed-income ETFs in domestic investment grade and/or domestic high yield. Greenwich Associates expects all of those shares to increase with the continued development of these markets. The Smart Beta Innovation Growing numbers of Asian institutions are introducing smart beta ETFs into their portfolios. Non-market-cap weighted/smart beta ETFs were used by 44% of Asian institutional ETF investors in 2016, up from just 25% the prior year. The rising demand for non-market-cap weighted/smart beta ETFs likely reflects shifting conditions in financial markets. In 2015, minimumvolatility ETFs were by far the biggest draw in the category. In 2016, dividend/equity-income ETFs replaced min-vol ETFs as the most popular fund type, a shift that was not consistent across global markets. Institutions in both years made use of both multi-factor and single-factor ETFs. Over the past 12 months, institutional usage has picked up for a range of additional non-market-cap weighted/smart beta ETFs, including equal-weighted ETFs, sector smart beta, smart beta commodities and smart beta fixed income. GROWTH OF SMART BETA ETFs 25% 2015 44% 2016 Note: Based on 28 responses in 2015 and 34 in 2016. Source: Greenwich Associates 2016 Asian Exchange-Traded Funds Study MOST WIDELY USED SMART BETA ETFs Dividend/Equity income 50% Multi-factor ETFs 29% Minimum volatility ETFs Equal-weighted ETFs Single factor ETFs Sector smart beta Smart beta commodities 21% 21% 21% 14% 14% Smart beta fixed income Environmental, social and corporate governance (ESG) 7% 7% Note: Based on 14 responses. 10 GREENWICH ASSOCIATES

Among institutions currently investing in smart beta products, 54% expect to increase allocations to these funds in the next year. That s nearly double the percentage of users who projected allocation increases in the 2015 study. Of investors planning increases for 2017, 70% expect to boost allocations by 5% or more. On the surface, demand in the coming year appears in line with 2016 investment patterns: 54% of institutions planning allocation increases expect to add dividend/equityincome ETFs. However, institutions are also signaling intentions to invest in several emerging strategies, most notably sector smart beta, smart beta commodities and smart beta fixed income. Going forward, changes in portfolio management philosophy that depart from the traditional active/passive framework could lead to additional increases in demand for smart beta ETFs. Only 25% of Asian institutions in the study explicitly allocate assets to either passive or active strategies. About another quarter of the institutions monitor and target alpha and beta components across their entire portfolio, without specific individual allocations to passive and active. Smart beta ETFs can be valuable tools for institutions adopting the latter approach, as they help investors isolate individual risks within their portfolios. PLANS FOR INCREASING SMART BETA ETF ALLOCATIONS Plan to Increase 1 Expected Percent Increase 2 57% 54% plan to increase smart-beta allocations 1 29% 14% 1 4% 5 10% >10% Note: 1 Based on 13 responses. 2 Based on 7 responses. ETFs Displacing Derivatives Approximately 70% of the Asian institutions participating in the 2016 study use futures to access market beta. These investors use futures mainly for hedging, but 27% of them say they also employ the products to achieve fully funded long positions. 11 GREENWICH ASSOCIATES

These data are relevant to the conversation about ETFs because Greenwich Associates research reveals that institutional investors around the world are weighing the performance of derivatives products against that of ETFs and, in cases, replacing existing positions in futures and other products with ETFs. A full 22% of the Asian institutions participating in the 2016 study switched from a derivatives position to an ETF in the past year. Half of those investors said they made the switch for operational simplicity. Institutions also replaced derivatives with ETFs for regulatory purposes and for securities lending. In the year ahead, 13% report plans to replace existing equity or fixed-income futures positions with ETFs. These institutions say the replacements will be driven by both performance and cost benefits offered by ETFs a finding consistent with feedback from institutions in Europe and North America that have made the same switch. 22% of the Asian institutions participating in the 2016 study switched from a derivatives position to an ETF in the past year. Demand for Multi-Asset Funds Fuels Demand for ETFs Active use of ETFs by asset managers running multi-asset funds continues to drive institutional demand for ETFs. Multi-asset funds have been growing in popularity among investors globally for the past several years. As asset management firms create multi-asset products to fill this demand, they are incorporating ETFs into their investment portfolios. Among asset managers participating in the 2016 study, 60% use ETFs in multi-asset funds a share that ranks second only to the 73% using ETFs in straight equity funds. ASSET MANAGER ETF USE BY PRODUCT Equity funds 73% Multi-asset funds 60% Fixed-income funds 20% Commodity funds 7% Note: Based on 15 responses. Within multi-asset funds, these asset managers invest an average 21% of total assets in ETFs. That s the same share they invest in mutual funds. Only individual securities get a bigger allocation, at 30%. 12 GREENWICH ASSOCIATES

Liquidity is Key to Decision-Making When it comes to Asian institutions selection of ETFs for investment, liquidity is key. Eighty-two percent of Asian institutional ETF users name liquidity as an important consideration in selecting a specific ETF. Half these institutions say liquidity is the single most important metric in their ETF due-diligence process a share that tops that of any other consideration by nearly 30 percentage points. Among the other top criteria named are how well an ETF matches institutions exposure needs, ETF performance/tracking error, expense ratio, ETF assets under management, and perceptions about the fund company and management behind the funds. MOST IMPORTANT FACTORS WHEN SELECTING AN ETF Liquidity/Trading volume 82% Matches exposure needs Fund performance Expense ratio of fund ETF provider ETF AUM Benchmark used/benchmark provider 55% 53% 53% 47% 47% 35% Breadth of ETF offerings ETF s country of domicile 21% 19% ETF provider s quality of service 11% Note: Based on 38 responses. 13 GREENWICH ASSOCIATES

Fewer Obstacles to ETF Investing More than half of institutions in the study that do not use ETFs say they have refrained from investing in the funds not due to any decisions made about the efficacy of ETFs as an investment vehicle or portfolio management tool, but rather because they are not allowed to do so. Of non-users in the study, 54% say they are prohibited from investing in ETFs, including 31% reporting that portfolio investment guidelines/ methodologies do not permit usage, and 23% saying that ETFs are simply not an approved vehicle within their organizations. Greenwich Associates believes institutional use of ETFs will grow as these institutions revise internal guidelines to allow investment. This process will unfold naturally as institutions see how and how well their peers are employing ETFs, both to achieve investment exposures and to accomplish a wide range of strategic and tactical tasks within their portfolios. However, there is also an opportunity for ETF providers to help remove these structural barriers by taking a proactive role and providing investment committees with information about how and to what extent ETFs are being employed by institutions in Asia and around the world. Greenwich Associates believes institutional use of ETFs will grow as institutions revise internal guidelines to allow investment. Providers can also help stimulate demand by continuing successful efforts to educate portfolio managers and other professionals about ETFs. Approximately two-thirds of Asian institutions in the study say they need more education about ETFs. Forty-two percent say they need more education about how ETFs can help them meet their investment objectives, and 26% say they require more information about ETF mechanics. Approximately a quarter of ETF non-users say they lack understanding or familiarity with bond ETFs. However, the fact that this share is down meaningfully from 2015 shows that Asian institutions are becoming more comfortable with and knowledgeable about ETFs. 14 GREENWICH ASSOCIATES

Cover Illustration: istockphoto/yongyuan The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. 2017 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. greenwich.com ContactUs@greenwich.com Ph +1 203.625.5038 Doc ID 17-2002

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