ETF Mechanics Matthew Tucker, CFA Managing Director, Head of ishares Fixed Income Strategy
The Changing Fixed Income Market
As the corporate bond market grows, trading volume declines Since 2005, the size of the corporate bond market has grown 1.2x, but trading volume has declined from about 0.7% of the market value to around 0.3% Size of Corporate Bond Market vs. Trading Volume as % of Market Value 6,000 0.80% Market Value ($bn) 5,000 4,000 3,000 2,000 1,000 0.70% 0.60% 0.50% 0.40% 0.30% TRACE Volume as % of Market Value - 2005 2006 2007 2008 2009 2010 2011 2012 2013 0.20% Total Market Value in $bn (LHS) Volume as % of MV (RHS) Source: Barclays, Bloomberg, TRACE as of August 2013. The size of the corporate bond market is the sum of the market value of the Barclays US Corporate Index and Barclays US High Yield Index. TRACE volume of the corporate market is the 20-day average of the sum of the IG and HY market volumes as reported by TRACE. FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
The changing sources of corporate credit exposure Constructing broad beta portfolios from bonds available at dealers can be challenging given low inventory levels and market fragmentation Corporate bond ETFs represent a significant pool of single-trade beta assets with the added layer of exchange-traded liquidity 250,000 200,000 Primary Dealer Positions Credit ETF Assets Value ($M) 150,000 100,000 50,000-2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: BlackRock, Bloomberg as of August 2013.. Primary dealer inventory is measured by the primary dealer positions outright level of corporate securities due greater than 1 year. Credit ETF assets include US listed corporate bond ETFs, excluding leveraged or inverse funds. is-9518 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
What is an ETF? Two great investment ideas brought together Stock Like a Mutual Fund Tradable during the day ETFs Diversified Diversified funds that trade like stocks is-10031 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Fixed Income ETFs allow investors to trade bonds like stocks Fixed Income markets Equity markets Broker A Customer A Broker B Customer B is-10419 is-10419 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Liquidity ishares ETFs help address challenges with bond trading Most bonds do not trade daily The underlying bond market can be very illiquid and individual bonds can trade very infrequently Most investment grade and high yield corporate bonds have historically traded fewer than half the days each month (see below) Average number of days bonds in the indexes traded each month Percent of Index Constituents 2% 27% Investment Grade High Yield 11% 16% 25% 25% 36% 23% 26% 1-5 6-10 11-15 16-19 20+ Number of Trading Days Source: BlackRock, Markit iboxx, TRACE. Data from 1/1/2012 to 12/31/2012 for the Markit iboxx $ Liquid High Yield Index ( high yield ) and Markit iboxx $ Liquid Investment Grade Index ( investment grade ). There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 9% ishares bond ETFs can trade millions every day LQD (ishares iboxx $ Investment Grade Corp) and HYG (ishares $ High Yield Corp) traded $270 mm and $347 mm in February 2013 alone (see below) Because ETFs trade on an exchange, investors can access bonds as easily as they can access stocks 30-Day Average Volume ($MM) $400 $350 $300 $250 $200 $150 $100 $50 LQD HYG $0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Bloomberg as of 8/31/2013. is-9499 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
ishares ETFs offer low-cost market access ishares ETFs generally offer price improvement, making the ETF less expensive to trade than the underlying securities of the respective index 160 150 140 ishares Bid/Offer Basket Bid/Offer* (est.) Bid/Offer Spread (bps) 120 100 80 60 50 40 35 20 0 15 15 5 1 1 2 1 2 3 2 4 TLT HYG LQD SHY TIP AGG EMB Barclays 20+ Year Treasury iboxx $ High Yield Corporate iboxx $ Investment Grade Corporate Barclays 1-3 Year Treasury Barclays TIPS Core Total U.S. Bond Market ETF J.P. Morgan USD Emerging Markets ishares ADV($M)** 997 435 275 100 82 92 86 ishares AUM ($M) 3,086 15,211 17,190 8,351 14,109 14,449 3,970 *Market Bid/Offer spread refers to the underlying securities of the respective index **30-day average as of 9/30/2013 For illustrative purposes only. Source: BlackRock, Bloomberg, Barclays, NYSE Arca, as of 9/30/2013. FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
The majority of ETF trading occurs on the exchange HYG Secondary to Primary Market Ratio 30 Secondary to Primary Ratio (20-Day Rolling) 25 20 15 10 5 0 1/2/13 1/23/13 2/13/13 3/6/13 3/27/13 4/17/13 5/8/13 5/29/13 6/19/13 7/10/13 7/31/13 Sources: BlackRock and Bloomberg. Secondary to Primary Ratio (20-Day Rolling) HYG Secondary to Primary Market Ratio on Large Volume Days Date Redemptions ($MM) Exchange Volume ($MM) Secondary to Primary Ratio Amount Crossed on Exchange ($MM) 5/29/2013 -$180.06 $1,028.63 5.71 $848.57 6/3/2013 -$216.15 $1,320.47 6.11 $1,104.32 6/6/2013 -$64.57 $1,088.42 16.86 $1,023.85 6/20/2013 $0.00 $1,009.32 N/A $1,009.32 6/24/2013 -$18.17 $1,079.23 59.39 $1,061.05 Sources: BlackRock and Bloomberg, as of 7/31/13. is-10763 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
The innovative mechanism of ishares ETFs The creation / redemption process distinguishes ETFs from mutual funds and closed-end funds and enables the unique benefits of ETFs Investor / Buyer Brokerage Account ETF Cash Market Maker / Authorized Participant Two Sources of Liquidity On Exchange ETF Liquidity Underlying Portfolio Liquidity Deliver ETF Shares In-kind delivery underlying portfolio basket ishares The creation / redemption process is the conductor of liquidity between ETFs and their underlying assets 1. Authorized Participants are typically large institutional organizations, such as market makers, who are responsible for sourcing the underlying assets needed when creating units of an ETF/receiving underlying assets when redeeming units of an ETF. 2. Must occur in creation/redemption unit standard sizes, generally in multiples of 50,000 shares. 3. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained is-9499 is-9499 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
ETFs trade with the bonds that are trading HYG Market Price, NAV and Frequently Traded Holdings (scaled to $100) $101 $100 Dollar Value Scaled to $100 $99 $98 $97 $96 $95 6/18/13 6/19/13 6/20/13 6/21/13 6/22/13 6/23/13 6/24/13 6/25/13 6/26/13 6/27/13 6/28/13 Sources: BlackRock and Bloomberg, from 6/18/13 6/28/13. HYG NAV Frequently Traded Bonds HYG market price based on Bloomberg closing prices; NAV as reported by BlackRock and Bloomberg. Prices for frequently traded bonds consist of the last trade of the day (in order to better align timing with the closing market price and NAV of HYG) for a transaction (buy or sell) of $1MM face value or greater as reported by TRACE. Prices were then weighted and normalized by the security s representative weight in HYG. For illustrative purposes only. The performance quoted represents past performance and does not guarantee future results. is-10763 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
ETFs trade with other exposure vehicles Market Value of Barclays HY Index, HYG, HYT and CDX.HY (scaled to $100) $105 Dollar Value Scaled to $100 $100 $95 $90 $85 4/30/13 5/8/13 5/16/13 5/24/13 6/1/13 6/9/13 6/17/13 6/25/13 7/3/13 HYG Barclays HY Index CDX HY 5-Yr HYT Source: Bloomberg, from 4/30/13 7/5/13. is-10763 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Fixed Income ETF Applications
ETF applications in institutional portfolios A recent Greenwich Associates survey indicates that 40% of the pensions, foundations and endowments polled plan to increase their use of ETFs over the next year1 Institutions which were once using ETFs solely for transitions or rebalancing are now using them for increasingly strategic purposes with longer holding periods Greenwich survey highlights: How institutions are using ETFs today Transitions 38% 55% Rebalancing 24% 52% Tactical adjustments 50% 45% Cash equitization / 31% 44% Portfolio completion 24% 42% ETF overlay / 3% 31% Core / Satellite 27% 28% Hedging 0% 11% Other 21% 3% 0% 10% 20% 30% 40% 50% 60% 2012 2010 Liquidity overlay strategies have surged in popularity among institutional funds, where the % of institutions implementing these strategies has increased from 3% in 2010 to 31% in 2012 1 <1 month 1 6 months 7 12 months >1 2 years > 2 years Typical ETF Holding Period 7% 12% 15% 15% 19% 21% 24% 24% 26% 36% 0% 10% 20% 30% 40% 2012 2011 Further demonstrating the shift from tactical to strategic is holding period, where 51% of institutions averaged ETF holding periods of one year or longer, up from 36% in 2011 1 1. Source: 2012 Greenwich Associates US ETF Research. Base: 62 pensions, foundations and endowments. Interviews conducted between February and April 2012. FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
ETFs for quick beta Put cash to work quickly. Declining bond liquidity makes investing large cash balances more challenging ETFs can provide quick beta exposure to minimize execution risk This can be particularly useful in HY where volatility is high and bond liquidity is low Cumulative TE (bps) 70 60 50 40 30 20 10 0 Potential Cumulative Tracking Error 20% Allocation Per Day 1 2 3 4 5 Trading Days Elapsed 75 bps Vol 100bps Vol 125 bps Vol.Then add bonds strategically With an ETF providing short-tem beta exposure, a manager can patiently wait for opportunities to add bonds This greater flexibility provides more control over the impact of flows on the portfolio For illustrative purposes only. Source: BlackRock. Volatility levels shown in the chart are yield volatilities. Phase 1: Get invested (T) Cash ishares ETF Phase 2: Transition to bonds (T+1-15) ishares ETF Glo bal Ca pita l Mar ket s Cash Bonds Cash Bonds FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
ETF for targeted exposure Access hard-to-reach markets ETFs open up new areas where PMs can invest US-listed funds provide diversified, one-trade exposure to non-us corporates or sovereigns ETFs also provide exposure where PMs may not have research coverage such as CMBS or global high yield Exposure ishares Ticker ADV ($m) High Yield HYG $435.0 Emerging Markets (USD) EMB $85.6 Commercial MBS CMBS $1.0 International Developed IGOV, ISHG $5.1, $1.8 Emerging Markets (Local Cur.) LEMB $2.9 Emerging Markets Corp. CEMB $0.4 Emerging Markets HY EMHY $1.4 Manage smaller subsidiaries and separate accounts Bring scale to management of smaller accounts through on-exchange trading simplicity ETFs offer single trade diversification, even at low notional amounts ETFs often provide cost efficient exposure through low bid-offer spreads and low management fees For illustrative purposes only. ADV as of 9/30/13. Source: BlackRock, Bloomberg is-9518 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
ETFs can provide liquidity and help protect alpha Utilizing HYG to manage cash could have improved 3-year performance by 51 bps vs. holding cash This includes ETF management fees and transaction costs Rolling Annualized Alpha with 5% Liquidity 3-Year Alpha (bps) Cash -58.7 ETF -8.2 Difference 50.5 Rolling average 1 year alpha w/ cash: -58 bps Rolling average 3-year alpha w/ cash: -64 bps Cash Port assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in a money market fund, rebalanced monthly. No additional transaction costs are assumed. ETF Port assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in ishares iboxx $ High Yield Bond ETF (HYG) using ETF market price total returns, rebalanced monthly, and includes 2bps of roundtrip transaction costs for the ETF investment per month. Sources: Morningstar, BlackRock as of December 31, 2012. For illustrative purposes only. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Past performance does not guarantee future results. For standardized ishares Fund performance, please refer to the end of this document. FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Implement your macro views in fixed income View Applied to stocks Applied to bonds Related Fixed Income ishares ETF Economic recovery starting Consumer cyclicals Growth stocks High yield bonds Investment grade corporate bonds Commercial mortgage backed securities HYG LQD CMBS Economic growth declining High quality stocks Consumer staples Dividend or value US Treasuries Agency bonds High quality corporate bonds GOVT MBB QLTA Reduce home country bias Developed markets Emerging markets Developed market Treasuries Emerging market bonds IGOV, ISHG EMB, LEMB ishares ETFs allow you to easily express your views across different asset classes The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. is-9499 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Avoiding Pitfalls
Key Criteria for Selecting the Right ETF Manager How well do you know your ETF manager? Exposure What s inside your ETF? Structure What are the implications of structure? Liquidity Can you trade when you need to? Costs What does it really cost? is-10772 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Layers of Liquidity As a result of the unique creation / redemption mechanism, liquidity in a fixed income ETF is not limited to the fund s average daily volume Secondary Market ADV An ETF s average daily volume (on screen liquidity) is not the extent of its liquidity ETF Market Depth Market maker Indications of liquidity Liquidity can be sourced in the secondary market by using execution strategies, such as limit orders Primary Market Creation / redemption liquidity (underlying basket) New shares of the ETF can be created by accessing the underlying bond market For illustrative purposes only. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. is-9499 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Understanding ETF Trading Behavior ETF Creation Cost ETF Premium to NAV Arbitrage Region Sell Pressure Buy Pressure Arbitrage Region Portfolio Bid (NAV) Portfolio Mid-market Portfolio Offer ETF Bid/Offer (Liquidity Layer) Arbitrage activity anchors ETF pricing to underlying value If the ETF price moves too far above the offer side of the underlying portfolio, market participants can short the ETF and purchase the underlying securities If the ETF price moves too far below the bid side of the underlying portfolio, market participants can purchase the ETF and short the underlying securities Although market participants may generally take advantage of differences between the NAV and trading price of ETF shares, there is no guarantee that they will do so. With short sales, an investor faces the potential for unlimited losses as the security s price rises. is-10419 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Price Discovery in Action: S&P 500 ETF (IVV) Source: BlackRock and Bloomberg as of July 31, 2013. For illustrative purposes only. There can be no assurance that an active trading market for ETF shares will develop or be maintained. Past performance does not guarantee future results. FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Price Discovery in Action: Short-term US Treasuries (SHY) Source: BlackRock and Bloomberg as of July 31, 2013. For illustrative purposes only. There can be no assurance that an active trading market for ETF shares will develop or be maintained. Past performance does not guarantee future results. FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Price Discovery in Action: High Yield (HYG) Source: BlackRock and Bloomberg as of July 31, 2013. For illustrative purposes only. There can be no assurance that an active trading market for ETF shares will develop or be maintained. Past performance does not guarantee future results. FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION
Standardized Performance as of 9/30/2013 Fund Name Fund Inception Date 30-Day SEC Yield (as of 9/30/13) ishares iboxx $ High Yield Corporate Bond ETF (HYG) 4/4/2007 5.30% YTD 1 Month 3 Months 6 Months 1 Year 3 Years 5 Years 10 Years Fund NAV Total Return 2.49% 1.09% 2.17% 0.26% 5.69% 8.34% 10.48% -- 6.38% Fund Market Price Total Return 2.25% 0.72% 2.23% 0.08% 5.57% 7.99% 10.78% -- 6.31% Index Total Return 2.50% 1.08% 2.28% 0.37% 5.86% 8.49% 11.20% -- 6.81% Since Inception The performance quoted represents past performance of specific funds and does not guarantee future results for such funds. 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. Performance data current to the most recent month end may be obtained by visiting www.ishares.com or www.blackrock.com. Shares of ishares Funds are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. Market returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. eastern time (when NAV is normally determined for most ishares Funds), and do not represent the returns you would receive if you traded shares at other times. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Carefully consider the ishares Funds investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds prospectuses, and, if available, summary prospectuses, which may be obtained by calling 1-800-iShares (1-800-474-2737) or by visiting www.ishares.com. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higherrated securities of similar maturity. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Diversification may not protect against market risk or loss of principal. When comparing 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 bonds. Buying and selling shares of ishares Funds will result in brokerage commissions. Shares of the ishares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy. FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
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 ), JPMorgan Chase & Co., MSCI Inc., Markit Indices Limited, Morningstar, Inc., National Association of Real Estate Investment Trusts ( NAREIT ), Russell Investment Group or S&P Dow Jones Indices LLC, nor are they sponsored, endorsed or issued by Barclays Capital, Inc. None of these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with the companies listed above. Neither FTSE nor NAREIT makes any warranty regarding the FTSE NAREIT Residential Plus Capped Index or Industrial/Office Capped Index; all rights vest in NAREITAll rights in the FTSE Developed Small Cap ex-north America Index vest in FTSE. FTSE is a trademark jointly owned by the London Stock Exchange plc and The Financial Times Limited and is used by FTSE under license. 2013 BlackRock. All rights reserved. ishares and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. is-10909-1013 Not FDIC Insured No Bank Guarantee May Lose Value FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION
Thank You. Questions?