how institutional investors are changing the etf...

How Institutional Investors are

Changing the ETF IndustrySue Thompson

09/22/2015

FOR INSTITUTIONAL USE ONLY – NOT FOR PUBLIC DISTRIBUTION

Overview of ETFs

3

What is an ETF?

Familiar ground…best of both worlds

Two great investment ideas brought together

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.

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

iS-14594 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION

4

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.

Un

derl

yin

g S

ecu

riti

es

ET

F

Underlying

Securities

Buyers Sellers

ETF

Shares

Liquidity Providers

Market MakersBroker Dealers

Authorized

Participants

Creation and Redemption Activity

5

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.

Un

derl

yin

g S

ecu

riti

es

ET

F

Underlying

Securities

Buyers Sellers

ETF

Shares

Liquidity Providers

Market MakersBroker Dealers

Authorized

Participants

Creation and Redemption Activity

iShares Capital Markets sources the underlying liquidity and liquidity providers to enable best execution

6

Multiple layers of liquidity


Schematic illustration

Exchange Liquidity

(ADV: $100M)

OTC Liquidity

(ADV: $300M)

Underlying Liquidity

(ADV: $100B)

$75M executed on

exchange

100% of the trade settles on

exchange

$75M trade

Exchange Liquidity

(ADV: $100M)

OTC Liquidity

(ADV: $300M)


(ADV: $100B)

$100M executed

on exchange

$50M executed in

OTC market

$100M of the trade settles

on exchange and remaining

$50M settles OTC

$150M trade

Exchange Liquidity

(ADV: $100M)

OTC Liquidity

(ADV: $300M)


(ADV: $100B)

$100M executed

on exchange

$300M executed in

OTC market

$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

$500M trade

7

ETF market equilibrium


Bid Offer

ETF RedemptionWhen 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

The creation/redemption process helps maintain an equilibrium of liquidity in the market

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.

ETF CreationWhen there is excessive ETF

demand in the market, liquidity can

be added by exchanging the

underlying securities for a unit of the

ETF

Secondary

Market

Underlying

offer

Underlying

bid

Primary Market Liquidity

(Underlying Basket)

OTC

Market

8

Different types of ETPs


LEGAL STRUCTURE

Open End Fund Most common structure; may allow dividend re-investment, securities lending and optimization

Grantor TrustStructure commonly used for concentrated, specialty exposures that don’t meet diversification

requirements of open end funds

Unit Investment TrustEarly 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 Mostly used in levered or inverse funds and exotic exposures; also common in Europe

FuturesFutures contract or a basket of futures contracts held by the fund, most common for

broad commodities

Physical Assets 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 1933.

Growth of ETFs

10iS-14594 FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION

$-

$500

$1,000

$1,500

$2,000

$2,500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Q2 2015

AU

M (

$B

)

Equity Fixed Income Other

Rapid adoption of exchange traded products (ETPs)1

Growth of exchange traded funds in the U.S.

Source: BlackRock, Bloomberg, ICI as of 6/30/15. “Other” category includes alternatives, commodities, currency, target date, asset allocation, and fund of funds.

$70 $87 $106$236 $311

$433

$619

$157

$542

$789

$1,012$1,061

$1,350

$1,701

10-year CAGR for US ETP assets is 24%2

▸ 22% for Equity ETPs2

▸ 43% for Fixed Income ETPs2

$2,009

1. "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 1933. Statistics as of 12/31/14 unless otherwise noted.

2. 10-year CAGR as of December 31, 2014. 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.

Notable statistics3

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 20143

$2,118


-60 -40 -20 0 20 40 60 80 100

Commodities & Other

Fixed Income

Emerging Markets Equity

Developed International Equity

US Equity

U.S. ETP AUM

AUM

($bn)

Growth since

year-end 2014

1,199 (-0.9%)

383 +31.7%

146 +5.82%

314 +6.1%

76 +3.5%

$2,118 +5.4%

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 1933.

1. Commodities and Other includes Alternatives, Asset Allocation, and Currency.

YTD 2015 U.S. ETP Flows ($bn)

Short

Maturity

Other

Durations

Large CapOther Size

and Style

Sector

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 Q4 2014 all-time high

concentrated in U.S. equities—$138.0bn globally and $120.7bn in the US

Strategic


0

50

100

150

200

250

300

350

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD2015

To

tal A

UM

($

B)

Government Inflation-Linked IG Credit High Yield Bank Loans

Govt/Credit Aggregate Leveraged/Inverse Mortgage Municipals

Active Short International/EM Money Market Term Maturity

Assets have climbed 564% since 2008 as

investor adoption has increased and

existing users have broadened their usage

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.

Growth of fixed income ETFs

U.S. fixed income ETF AUM is over $321B


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

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)”

310

1,273

302

0

200

400

600

800

1,000

1,200

1,400

1,600

Jul-0

2

Oct-

02

Jan-0

3

Apr-

03

Jul-0

3

Oct-

03

Jan-0

4

Apr-

04

Jul-0

4

Oct-

04

Jan-0

5

Apr-

05

Jul-0

5

Oct-

05

Jan-0

6

Apr-

06

Jul-0

6

Oct-

06

Jan-0

7

Apr-

07

Jul-0

7

Oct-

07

Jan-0

8

Apr-

08

Jul-0

8

Oct-

08

Jan-0

9

Apr-

09

Jul-0

9

Oct-

09

Jan-1

0

Apr-

10

Jul-1

0

Oct-

10

Jan-1

1

Apr-

11

Jul-1

1

Oct-

11

Jan-1

2

Apr-

12

Jul-1

2

Oct-

12

Jan-1

3

Apr-

13

Jul-1

3

Oct-

13

Jan-1

4

Apr-

14

Jul-1

4

Oct-

14

Jan-1

5

Apr-

15

Cumulative Net Asset Flow

U.S. Fixed Income ETFs U.S. Fixed Income Active Funds U.S. Fixed Income Index Funds

Institutional uses of ETFs


ETF applications in portfolios

CORE ALLOCATION

LIQUIDITY

MANAGEMENT

Maintain exposure in a liquid investment vehicle to meet cash flow needs1

Reduce implementation time and t-costs to change exposures in asset classes

LONG & LEND

CASH EQUITIZATION

TACTICAL

ADJUSTMENTS

INTERIM BETA

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

RISK MANAGEMENT Mitigate undesired portfolio risk and hedge asset allocation decisions

Ability to go long a sector’s stocks and short corresponding ETF3

ETFs can provide an efficient solution for maintaining liquidity while minimizing low-yielding cash

positions

Minimize cash drag through targeted market exposures

Invest long-term in a variety of market exposures in a cost efficient, exchange traded investment

vehicle

Seek index-like returns plus the potential for incremental return through lending iShares ETFs2

Over- or under-weight certain styles, regions or specific countries

Target duration or credit quality on the basis of short-term views

Maintain market exposure while refining a longer-term view


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 ETFs are not subject to additional operational costs when managing risk, settlement and reporting that

other derivative products require

ACCESS TO

DIFFICULT-TO-

REACH MARKETS

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.

Greenwich surveys – All channels


Institutional feedback: usage of ETFs

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

Institutional feedback, 2014 Greenwich Survey3

“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

“We have found a lot of new innovative products

are available in ETF form.” – RIA

CASH

EQUITIZATION

INTERIM BETA

TRANSACTIONS

REBALANCING

CORE

ALLOCATION

LIQUIDITY

MANAGEMENT

TACTICAL

ADJUSTMENTS

RISK

MANAGEMENT

LONG AND

LEND

Invest short-term in the market, minimizing cash drag

through targeted market exposure

Over- or under-weight certain styles, regions, or

countries on the basis of short-term views

Manage portfolio risk/beta tilts in between

rebalancing cycles

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

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 needs1

Achieve index-like returns plus the potential for

incremental return through lending iShares ETFs2

Mitigate undesired portfolio risk and hedge asset

allocation decisions

STRATEGY OBJECTIVE


Greenwich Associates: institutional usage of ETFs

ETF allocations expected to increase across all institution

types in the US

Key results of the Greenwich Associates 2014 Studies

• “ETFs: An Evolving Toolset for U.S. Institutions”

• “ETFs: Broad usage increases amongst European institutional investors”

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.

3%

3%

6%4%

22%

36%

45%

47%

29%

19%

23%

5%

8%

-25% 0% 25% 50% 75%

Asset managers

RIAs

Insurers

Investment consultants

Institutional funds

Decrease 1-10% Decrease > 10% Increase 1-10% Increase > 10%


U.S. institutional usage of ETFs expected to increase

Majority of U.S. institutions expect to increase

allocations over the next year

3%

3%

6%4%

22%

36%

45%

47%

29%

19%

23%

5%

8%

-25% 0% 25% 50% 75%

Asset managers

RIAs

Insurers

Investment consultants

Institutional funds

Decrease 1-10% Decrease > 10% Increase 1-10% Increase > 10%

Key results of 2014 Greenwich Associates Studies

“ETFs: An Evolving Toolset for U.S. Institutions”

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.

ETF allocations expected to increase across all

institution types in the US

47% of institutional funds surveyed reported

average ETF holding periods of two years or

longer, up from 36% in 2013

U.S. Institutional ETF Holding Periods

0.07

0.24

0.19

0.15

0.36

0

0.2

0.19

0.25

0.36

0.04

0.1

0.18

0.1

0.47

0 0.1 0.2 0.3 0.4 0.5

< 1 month

1 - 6 months

7 - 12 months

1 - 2 years

> 2 years

2014 2013 2012

Greenwich Surveys - Fixed Income


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

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?

2015 Greenwich Associates Institutional Investor Fixed Income ETF Study

Composition of respondents

2015 Greenwich FI ETF Study

Source: Greenwich Associates 2015 U.S. Fixed-

Income ETF Study. Based on 128 respondents.

Institutional Funds, 39%

Investment Managers,

29%

Insurers, 11%

RIAs, 21%


5%

61%

34%

More

challenging

About the

same

Less

challenging

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

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

Greenwich Associates –

Illiquid bond markets are affecting investment processes

Trading environment over the past two years

Have you faced challenges

in trading, liquidity, or

sourcing securities in fixed

income markets?1

Institutions are struggling to source and trade bonds

Have the challenges

affected your

investment process? 2

1.Based on 119 respondents in 2015.

2.Based on 40 respondents in 2015.

Source: Greenwich Associates 2015 U.S. Fixed-Income ETF StudySource: Greenwich Associates 2015 U.S. Fixed-Income ETF Study

Yes53%

No47%


No72%

Yes58%

No42%

Yes28%


ETFs as a liquidity solution

1. Based on 128 respondents in 2015.

2. Based on 36 respondents in 2015 who use derivatives.

Source: Greenwich Associates 2015 U.S. Fixed-Income ETF Study

Reasons for using ETFs alongside cash bonds ETFs as substitutes for derivatives

9%

16%

19%

34%

38%

0% 10% 20% 30% 40% 50%

Placeholder/replacement

Duration management

Diversification

More liquidity

Ease of exposure

Based on 32 respondents in 2015.


59% of fixed-income ETF users have increased ETF usage since 2011

40% of investment managers plan to increase their use of bond ETFs in the coming 12 months

0% of users expect to decrease ETF allocations

Are you considering

ETFs as an alternative?2

Do you use fixed income

derivatives?1


12%

7%

31%

17%

33%

0% 10% 20% 30% 40%

More than $100 million

$51-$100 million

$11-$50 million

$6-$10 million

$0-$5 million

Yes,93%

Yes, 98%

No, 7% No, 2%

0%

25%

50%

75%

100%

Where you satisfied with thetrading experience?

Would you trade the ETFagain?


Institutions are successfully executing large trades

Based on 60 responses: 10 institutional funds, 21 RIAs, 22 investment managers,

and 7 insurance companies in 2015.


Largest single trade using a fixed-income ETF ETF trading experience based on largest trade size

Based on 60 responses: 10 institutional funds, 21 RIAs, 22 investment managers,

and 7 insurance companies in 2015.


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


8%

8%

12%

15%

20%

27%

28%

48%

0% 10% 20% 30% 40% 50%

ETFs not supported on trading platform

Regulatory limits

Lack of familiarity

Expenses

Investment guidelines

Constant maturity pro file of ETFs

Internal limits

Low trading volumes or assets

Greenwich Associates – barriers to ETF use are falling

Top reasons institutions do not use FI ETFs

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

Based on 68 respondents in 2015.


Price discovery and market stress case studies


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

"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 1933. Source: BlackRock, Bloomberg, NYSE Arca as of February 13, 2013. 20-day rolling average is shown for each.

US ETP volume as a % of all equity volume vs. VIX Index

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

-

10

20

30

40

50

60

70

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 ET

P V

olu

me a

s %

of

All E

qu

ity V

olu

me

VIX

In

dex L

ev

el

VIX Index Level ETP Volume % of All Equity Volume


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 2008.

80

85

90

95

100

105

PR

ICE

($)

September 8-12 September 15-19 September 22-26

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 www.dataexplorers.com, 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

www.iShares.com.

http://www.dataexplorers.com/

http://www.ishares.com/


0

2

4

6

8

10

12

14

2007 2009 2011 2013

Source: BlackRock and Bloomberg. Monthly average as

of December 2014.

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

Va

lue

($

bn

)

0

15

30

45

60

75

HY

Basket

50

IG

Basket

25

Lehman

Bernanke

speech

Source: BlackRock, Bloomberg as of 3/27/13. Primary

Dealer Positions Outright Level of Corporate Securities

Due Greater Than 1-yr.

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.

HYG

1

LQD

2

Ba

sis

po

ints

Pe

rce

nt (%

)

0

1000

2000

3000

4000

5000

0

50

100

150

200

250

2002 2004 2006 2008 2010 2012 2014

Inv GradeHigh YieldCommerical PaperCMBSRMBSCorp (Before 4/1/2013)Barclays Corp Index Market Value

ETFs and futures


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


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.

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.

Liquidity coverage ratio constraints

Tier 1 core capital ratio requirements

Restricts banks’ ability to warehouse

risk on balance sheets

Volcker Rule limiting proprietary activity

Restricts banks’ ability to assume

proprietary positions

Basel IIIDodd Frank Consumer

Protection Act


Regulatory landscape: the cost of change

Natural Long Investors

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.

Synthetic Short Investors

In the absence of sufficient short

investors, banks tend to take a net

short position

Less Natural Short Investors

Bank Balance Sheets

Hedging the resulting short

position forces banks to

deploy balance sheet

The investor replaces use of its own balance sheet with that of the bank’s

The cost of bank balance sheet is passed back to the investor as roll richness


Conclusions

Rising trading volume and lower costs are making ETFs more efficient beta vehicles1

Conversely, over the last 2-3 years, futures contracts have become more expensive, as banks

grapple with a changing regulatory landscape2

We expect further changes ahead, and urge investors to go beyond standard assumptions and

carefully evaluate the relative cost of potential beta vehicles3

We can help provide the data and due diligence tools investors require to react to the changing

economic efficiency of index tracking vehicles4


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