the etf - invesco · 13 etf structure introduction to the creation/redemption process to understand...

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THE ETF TOOLKITThe Professional’s Guide to Exchange Traded Funds

THE ETF TOOLKITThe Professional’s Guide to Exchange Traded Funds

For Institutional Investor Use Only — Not For Use with the Public

Dear Valuable Clients:

Invesco PowerShares is leading the Intelligent ETF Revolution® and we are anchored on a vision of delivering innovative, value-added investment management strategies through the exchange-traded fund (ETF) structure. We believe that indexing can go beyond benchmarking and Invesco PowerShares seeks to empower financial professionals by providing them with the advanced building blocks for constructing precise investment portfolios.

To best utilize PowerShares ETFs, it is important to have a thorough understanding of the ETF structure and the best ways to transact in each product. This ETF Toolkit is designed to walk you through the key topics related to the ETF structure and trading. The topics build upon each other and this guide is intended to help you become a more proficient user of ETFs.

We hope that you find this guide useful as you explore the ETF landscape and we encourage you to use this in conjunction with the services offered by the PowerShares Global ETF Capital Markets team.

Sincerely,

John Hoffman Global Head of ETF Capital Markets

John Hoffman Global Head of ETF Capital Markets

Grayson Lipton Head of ETF Liquidity & Execution Services

Tim Urbanowicz ETF Capital Markets Strategist

3

Introduction to ETF Capital Markets

The PowerShares Global ETF Capital Markets team is an integrated group of professionals that serves as the hub to the ETF ecosystem for PowerShares funds. This group manages relationships with market makers, authorized participants (APs) and various sell-side firms to support primary market ETF activity. In addition, our Liquidity & Execution Services team is focused on helping you enter and exit ETF positions as efficiently as possible.

The PowerShares Global ETF Capital Markets Team provides three core functions globally:

Liquidity & Execution Services: The Liquidity & Execution Services team is in place to help financial advisors and institutional clients through the ETF trading process. The team helps clients assess the potential liquidity of PowerShares ETFs, developing a client-specific trading strategy and evaluating the potential impact of a trade.

Market Maker & Authorized Participant Relations: As ETFs trade in the secondary market and typically cannot be purchased directly through the ETF issuer, efficient trading is dependent on the ETF market making community. The PowerShares Global ETF Capital Markets team works with various market making firms, APs and other sell-side firms to ensure these parties effectively make markets in PowerShares products. In addition, the team continuously monitors secondary market activity, assessing and tracking market maker performance, evaluating spreads and monitoring trading activity.

Research & Content: The PowerShares Global ETF Capital Markets team provides actionable market commentary to our clients. This involves assimilating and distilling high quality buy side and sell-side research into ETF investment strategies and providing market perspectives.

If you are interested in utilizing any of the services described above, please contact the PowerShares Capital Markets team by phone or by email.

PowerShares ETF Capital Markets p: 877 983 0903 e: [email protected]

mailto:[email protected]

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Table of Contents

Overview of the ETF Landscape 9

ETF Structure 13

NAV & IOPV 21

ETF Pricing & Valuation 33

Components of ETF Liquidity 37

Secondary Markets 43

Alternative Methods of Execution 47

Shorting ETFs 55

Contact Information & Resources 59

Glossary & Important Information 63

Overview of the ETF Landscape

ETF Structure

NAV & IOPV

ETF Pricing & Valuation

Components of ETF Liquidity

Secondary Markets

Alternative Methods of Execution

Shorting ETFs

Contact Information & Resources

Glossary & Important Information

9


On Jan. 22, 1993, the SPDR S&P 500 ETF (SPY) became the first ETF to launch in the US marketplace. Today, SPY has $190 billion in assets under management (AUM) and trades an average of 120 million shares or approximately $23 billion notional per day.1

Since the launch of SPY more than 20 years ago, the ETF landscape has grown tremendously in terms of AUM and number of products. New products have expanded to provide investors exposure beyond the US domestic equity space and now ETFs span virtually every asset class.

Global ETF AUM have grown at a compound annual growth rate of 25% over the past decade as more investors have taken advantage of the low cost, liquid, transparent, and tax efficient nature of this benefit rich vehicle.2,3 As of Jan. 1, 2015, there were more than 1,660 US-listed exchange-traded products and total AUM was greater than $2 trillion.4

1 Source: Bloomberg L.P., as of March 23, 20152 Source: Bloomberg L.P., as of March 31, 20133 Transparency: ETFs disclose their holdings daily. Low Cost: Since ordinary brokerage commissions apply for each buy and sell transaction, frequent activity may increase the cost of ETFs.4 Source: PowerShares Product Strategy Research, as of Jan. 1, 2015

Exhibit 1: ETF Industry Growth

Source: Bloomberg L.P., as of Dec. 31, 2014

AU

M (

$B)

$2,500

$2,000

$1,500

$1,000

$500

$094% 28% 20% 47%

48%39%

39%

43%-13%

46%

27% 5%

26%

18%

27%

‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14

With the increased utilization of ETFs across all investor segments and channels, the trading volumes in ETFs have also increased.

In 2014, ETFs represented 27% of all equity volume in the US with total dollar average volume exceeding $70 billion daily.4

Exhibit 2: US Equity Volume4

27%

73%

• ETFs • Other


Despite this tremendous growth, ETFs are still a new investment vehicle for many investors and it is important to understand the ETF structure when evaluating and selecting positions for your client’s portfolios. On the surface, ETFs are similar in many ways to mutual funds, separately managed accounts (SMAs), collective investment trusts (CITs) and other investment vehicles; however, there are a number of key differences which are critical to understand when comparing these investment wrappers. Most ETFs are established under the 1940 Act with exemptive relief. ETFs are also nuanced in their tradability and ultimately in the creation and redemption process.

One of the key differences between traditional mutual funds, SMAs and collective investment trusts (CITs) when compared to ETFs is centered around how investors fund positions. ETFs are listed securities that trade on national exchanges, such as NYSE ARCA, NASDAQ and BATS. Investors buy and sell ETF shares through their brokerage accounts and trades are printed to the consolidated tape. Institutional traders make markets in ETFs by quoting bids and offers and managing ETF inventory positions. These institutional traders can then bundle up smaller ETF orders into larger positions and create or redeem shares of the ETF by dealing directly with the ETF manager and the custodial bank. ETF shares are created (issued) and redeemed (retired) in large, predefined block sizes by these institutional traders.

Conversely, mutual funds, SMAs and CITs allow investors to deal directly with the fund manager, who accepts cash from the investor in exchange for new units issued by the fund at net asset value.

Given the exchange-traded nature of ETFs, it is critical for investors to understand how to efficiently trade, as they must interact directly with the capital markets when buying and selling ETF shares. In the following chapters, the focus of this guide is to lay the educational foundation to help you become a more efficient and effective ETF user.

Separately Managed Account (SMA): a pool of assets that is managed by an investment management firm for the benefit of an investor.

1940 Act: Act of Congress passed in 1940 which represents the primary source of regulation for mutual funds, closed-end funds and ETFs.

Exemptive Relief: regulatory order granted to ETF fund complexes to provide exemption from certain provisions of the 1940 Act necessary to operate within the ETF structure.


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



13

ETF Structure

Introduction to the Creation/Redemption ProcessTo understand the ETF structure, we must first explore the creation/redemption mechanism, which is central to the ETF. ETFs trade on securities exchanges similar to individual equities. Unlike stocks, ETFs have the unique capability of expanding or contracting shares outstanding on a daily basis, comparable to other open-ended investment vehicles, such as mutual funds. However, the creation/redemption process for the ETF is vastly different from other open-ended funds.

When new money flows into a mutual fund (subscription), the fund manager either uses the cash to purchase securities in the open market or maintains this cash position.

Exhibit 3: Mutual Fund Flow Subscription

Investor Market

Mutual Fund

Cash

$Cash

$

Units Stock

Creation/Redemption: creation is the process by which new ETF shares are issued to the market. Redemption is the process of retiring existing shares of the ETF.

When mutual funds experience redemptions, the fund manager must deliver cash back to the investor at Net Asset Value (NAV). As a result, the mutual fund manager may be required to sell securities in the open market to raise cash or maintain a cash balance in order to deliver cash back to the investor.

For illustrative purposes only.

Exhibit 4: Mutual Fund Flow Redemption

Investor Market

Mutual Fund

Cash

$Cash

$

Units StockInvestor Market

Mutual Fund

Cash

$Cash

$

SellSell


Exhibit 5: Behind the Scenes In-Kind Creation


In certain ETFs, where it may be difficult to transfer securities in-kind, creation and redemption may be effected in cash. In cash creations, the AP will exchange cash to the custodial bank for a block of ETF shares equal to the creation unit. Similarly, in cash redemptions, the AP will receive cash equal to the redemption unit and the custodial bank will retire the ETF shares.

While cash creations and redemptions are an alternative for certain ETFs, the majority of creations and redemptions in US-listed ETFs are affected in-kind. This in-kind creation and redemption mechanism is one of the sources of the tax efficiency provided by many ETFs.3 The delivery of securities out of the ETFs as part of this in-kind redemption transaction is not considered a taxable event for the ETF, meaning that the ETF does not recognize any gain or loss for tax purposes from the securities removed from the portfolio. The primary source of the tax efficiency provided by many ETFs comes from that fact that majority of buy and sell activity of an ETF takes place on the exchange and away from the ETF, meaning the ETF does not need to buy or sell any securities in response to these trades.

Basket of Securities

ETF Units

APsCustodial Bank


ETF Units

APsCustodial Bank

Exhibit 6: Behind the Scenes In-Kind Redemption

ETF shares are created and redeemed in block sizes by large institutional traders called Authorized Participants (APs). The number of ETF shares that represent the block size that APs create/redeem is referred to as the creation unit and is defined in the prospectus of each ETF. Most ETFs in the United States create and redeem in predefined sizes ranging from 50,000 to 200,000 share blocks.

The ETF structure, while still open-ended, can handle the creation/redemption in one of two ways: through an in-kind process (in-specie) or via a cash process. (See Exhibits 5 and 6 below) With the in-kind process, APs will exchange a predefined basket of securities to the ETF issuer’s custodial bank and receive a block of ETF shares. In the case of an in-kind redemption, APs will receive back a predefined basket of securities in exchange for ETF shares. In both the creation and redemption, the basket shares are exchanged in-kind between the custodial bank and the AP.

Authorized Participants (APs): Market participants who have a legal contract (AP agreement) in place with an ETF trust and the custodial bank which permits them to create and redeem shares of the ETF.

In-Kind Creation and Redemption: refers to the process which allows for shares to be created and redeemed by swapping ETF shares for the underlying constituents of the ETF.

Custodial Bank: ETF issuers utilize custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer.

12

3 4

43

2 1

Cash Creation or Redemption/Cash-in-Lieu (CIL): when an AP delivers cash to an ETF issuer to create new ETF shares, or receives cash back from the ETF issuer when redeeming shares. Cash-in- lieu may be done as part of an in-kind exchange in a basket with restricted securities or ID markets.

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Mechanics of Creation/Redemption To meet the listing standards for Investment Company Units, ETF issuers must publicly disseminate a daily basket file for each ETF which discloses the securities and cash held for one creation unit. This basket file allows APs and market makers to be informed of the securities and/or cash that needs to be delivered to the custodial bank to establish one new creation unit. Conversely, this basket also represents the securities and/or cash the AP would receive when redeeming ETF shares.

Exhibit 7: Sample Basket — PowerShares BuyBack Achievers™ Portfolio


Ticker PKW

Component Count 168

CU Estimated Cash $1,005.2598

Projected NAV $47.23407

Shares Outstanding 57,200,000

CU 50,000

CUSIP 73935X286

Standard CUSIP 0000S3889

Securities

CUSIP Name Basket Shares Price

00507V109 ACTIVISION BLIZZARD 1,008 $20.75

00101J106 ADT CORP/THE 246 $34.79

00738A106 ADTRAN INC 77 $22.59

00766T100 AECOM 217 $25.95

009363102 AIRGAS INC 105 $113.08

012653101 ALBEMARLE CORP 110 $47.77

01881G106 ALLIANCEBERNSTEIN HOLDING LP 137 $24.82

Basket File: a file published daily by the ETF issuer, disclosing the securities and cash required for one creation unit.

Market Maker: a dealer who undertakes to buy or sell in a security at specified prices by quoting bids and offers.

Creation Unit: the specified number of ETF shares that represent one unit of the fund. This is the block share quantity that APs must deal in when interacting with the trust for creation or redemption. This is typically 50,000, 75,000, 100,000 or 200,000 ETF shares and is specified in the prospectus of each ETF.


When an ETF experiences buying pressure, liquidity providers may be able to meet demand by selling inventory positions. However, if the liquidity providers do not have inventory in the ETF, they may sell ETF shares short, while simultaneously buying the underlying basket of securities as a hedge. These offsetting trades allow the liquidity provider to reduce directional market exposure. Often the goal of the liquidity provider is to profit from the bid/ask spread while minimizing risk.

Once APs have accumulated the requirements for a creation unit, they will exchange the underlying basket of securities for ETF shares with the custodial bank. The opposite process is true for redemptions. APs will buy shares of the ETF from investors while simultaneously shorting the underlying basket (or a correlated hedge). At the end of the day, they may redeem the ETF shares to the custodial bank and receive back the underlying basket, thereby flattening their position.

Exhibit 8: Provide Liquidity. Lock in Spread. Hedge Exposure.

For illustrative purposes only.*These shares can be sold from inventory or sold short.

Liquidity Provider

Buyer

Sell ETF*

Buy ETF

Creates ETF

Liquidity Provider (LP): a firm that is compensated through arbitrage or commission for the process of sourcing ETF shares for an investor. A liquidity provider may be a market maker or AP.

Buy Basket of Securities

17

ETF issuers utilize custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer. APs in the US are typically large financial institutions that must be self-clearing broker dealers, US-based and Depository Trust Company (DTC) members.

An AP is charged a pre-defined fixed and/or variable fee by the ETF issuer’s custodian to create or redeem shares of an ETF. This fee is paid by the AP and is called the creation/redemption ticket charge. The creation/redemption processes and fees are unique to each ETF.

As mentioned earlier, there are circumstances where creations/redemptions are handled via a cash create/redeem or, at times, a CIL process. With cash creations, APs are required to deliver cash equal to the NAV of the securities in the underlying basket in order to create new shares of an ETF. For cash redemptions, APs receive cash back for their ETF shares based on the NAV of the fund.

The standard creation/redemption process of an ETF, whether in-kind or cash, is defined in the ETF prospectus. However, in certain circumstances, the ETF issuer may allow APs to use “custom baskets.” This may be done to help APs avoid restrictions they may face when transacting in a particular security. For example, if the AP is restricted in dealing in a particular component, they may seek to deliver the cash value for this security and use a custom basket which excludes the restricted security.

Creation/Redemption Ticket Charge: the fee charged by the custodial bank to authorized participants creating and redeeming units of the ETF.

DTC is an electronic bookkeeping system for the transfer of securities.


Fixed Income ETF Structure The fixed income market is generally an over the counter (OTC) market where trades are often negotiated privately between parties, and trade data may not be as readily available as it is for equities. Parties can have different viewpoints on pricing based on inventory, and the same instrument may trade at multiple prices in a short period of time. The fixed income market is more opaque and many bonds, such as corporate or municipal bonds, trade less frequently than their equity counterparts. Some corporate bonds may sometimes go days without trading, making them more difficult to price.

ETFs holding fixed income instruments bring a new dynamic to the landscape, as the ETF is an instrument with full visibility as it trades on an exchange. Larger fixed income ETFs can trade millions of shares per day. With this type of volume, liquidity providers need to have an idea of what the portfolio of bonds is worth, regardless of how frequently the underlying bonds have traded. The ETF may act as a price discovery vehicle for the underlying basket of bonds, as the liquidity providing community determines fair value for the basket.

Fixed Income Creation and Redemption The fixed income creation/redemption process is different from the equity creation/redemption process due to the OTC nature of the bond markets, and the disparate increments in which the bonds are transacted. With an in-kind fixed income ETF creation, it is rare that an AP would deliver all of the underlying securities in the basket, as fixed income securities typically trade by appointment. PHB, the PowerShares Fundamental High Yield Corporate Bond Portfolio, holds approximately 282 different bonds. For an AP to purchase all 282 bonds in the basket would be inefficient and difficult to facilitate due to the relative scarcity of certain bonds. Instead, the ETF portfolio manager will be in contact with the APs and market makers to request certain bonds in order to weight the ETF as close to its underlying index as possible. The AP would then deliver the requested bond(s) in-kind plus or minus cash to arrive at the NAV of the Fund for their creation.

It may also be a practice with fixed income ETFs for an issuer to request the creation/redemption to be done via cash creation or cash redemption instead of in-kind. As an example, BKLN, the PowerShares Senior Loan Portfolio, is typically created and redeemed via cash. Instead of delivering the underlying securities for a creation, the AP delivers cash to PowerShares, the Fund provider, who will then purchase the underlying senior loans required for the Fund.

For ETF liquidity purposes, it is important to note that the trading hours of most fixed income securities is between the hours of 8 a.m. and 3 p.m. EST. ETFs, on the other hand, will continue to trade until 4 p.m. EST. This difference in closing times can affect a liquidity provider’s ability to hedge an ETF trade, as they no longer have access to the underlying bonds that comprise the ETF. For the last hour of ETF trading, liquidity providers may use futures and other highly correlated instruments to hedge their ETF trades.5

5 Depending on circumstances, it may be possible to trade bonds after the close

Over the Counter (OTC): instruments that are traded off the exchange.


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



21

ETF Net Asset Value (NAV) and Indicative Optimized Portfolio Value (IOPV)

In the US, there are additional requirements for meeting the listing standards for Investment Company Units beyond publicly disseminating the basket of securities. ETF issuers are also required to publish the value of the underlying basket using two different methods, a NAV and an Intraday Indicative Value (IIV) or Indicative Optimized Portfolio Value (IOPV).

NAV For each ETF, the NAV must be publically disseminated on a daily basis as calculated by valuing the underlying securities in the fund, typically by their closing price. The NAV is calculated by taking all fund assets, subtracting any liabilities and dividing by total shares outstanding. This provides a daily snapshot of the value of the portfolio to the marketplace. Providing a NAV for the ETF based on the value of the underlying holdings is particularly useful for evaluating an ETF’s value over a specific time period (i.e. day/month/year).

While the NAV calculation may be useful in providing a snapshot for end of day valuation purposes, it is not a trading tool for intraday valuation. As the underlying basket of an ETF fluctuates during the trading day, the value of the portfolio may deviate from the previous night’s published NAV and appear to be trading at a discount or premium to NAV based on the basket’s market movement. This should not be perceived as a discount or premium to the ETF’s current fair value. Rather, it is the change in valuation based on the market movement of the underlying basket.

For ETFs that have underlying basket components that close at times different from US equity market close (i.e., international equity, fixed income, futures based), the closing price of the ETF and the underlying basket value may deviate based on the market movement between when the basket closes and when the ETF closes.

Net Asset Value (NAV): is the value of all assets in the ETF minus any liabilities divided by total shares outstanding. NAV is calculated by the custodial bank and is disseminated once daily.


ETF Net Asset Value Example: PowerShares S&P 500 Low Volatility (SPLV) As an example, Exhibit 9 shows the NAV for SPLV on Thursday March 19th 2015 at $38.04. The order book for SPLV on March 20th at 2:22 pm, as shown in Exhibit 10, shows a bid/ask spread of $38.42/$38.43 and thus SPLV appears to be trading at a $.38-$.39 premium to NAV. Despite the appearance of a premium, SPLV was actually trading in line with the value of the underlying holdings; March 20, 2015 was simply a day when the underlying stocks in SPLV had appreciated, leaving the prior day’s NAV stale intraday.

Exhibit 9: SPLV NAV

Source: Bloomberg L.P., as of March 19, 2015. For illustrative purposes only.

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Exhibit 10: SPLV Orderbook

Source: Bloomberg L.P., as of March 20, 2015. For illustrative purposes only.


Exhibit 11: Equity Market Schedules

Fair Value: the theoretical price at which the ETF is neither over priced nor underpriced.

Intraday Indicative Value (IIV) or Indicative Optimized Portfolio Value (IOPV): the statistical value of the underlying holdings of an ETF published every 15 seconds and disseminated to the consolidated tape based on the last traded price of all the underlying constituents. This metric can be found on Bloomberg, as well as other financial sources.

Domestic9:30AM-4:00PM EST

Asia5:00PM-1:00AM EST

Europe2:00AM-10:00AM EST

Japan 7:00PM-3:00AM EST

London3:00AM-11:00AM EST

Mexico 8:30AM-3:00PM EST

IOPV/IIV To help determine fair value of an ETF intraday, the Indicative Optimized Portfolio Value (IOPV), also known as Intraday Indicative Value (IIV) may be a helpful tool. The IOPV metric calculates a value of the ETF, based on the last print of each security contained in the ETF’s basket and is mandated by the SEC to be published every 15 seconds. For ETFs comprised of US domestic equities, with constituents that trade frequently, the IOPV may be a reliable indication of ETF valuation. For ETFs comprised of international constituents, fixed income components or futures, the current market price of an ETF may deviate from the IOPV as the IOPV often utilizes last price which may be stale. For example, if an ETF that trades in the US holds constituents that trade in Japan, the constituents have ceased trading at the close of the Japanese market which is 3 a.m. EST, and will not trade again until 7 p.m. EST. Any implied market movement which has occurred since the last trade of the underlying basket will not be reflected in the IOPV calculation, as that IOPV is based on the securities’ last trade.

Due to the potential disconnect of trading times between certain international equity, fixed income, or futures-based ETFs, the IOPV may create the appearance of an ETF trading out of line with IOPV. In this case, the ETF’s pricing in the secondary market may be a better indication of fair value than the IOPV. As many liquidity providers are often simultaneously posting markets in a particular ETF, a mispricing by one liquidity provider would lead to an arbitrage opportunity by another liquidity provider. ETF pricing and the arbitrage mechanism will be discussed in detail in the next section.

As with the NAV, the IOPV is a useful tool as long as the IOPV calculation methodology and the limitations of the calculation are fully understood.

25

IIV/IOPV Domestic Equity Exhibit 12 shows the IIV/IOPV for SPLV at $38.07 on January 12, 2015, at 11:28:08. As you can see, this IIV/IOPV is in line with the bid/ask of SPLV on January 12, 2015 at 11:28:08 of $38.07/$38.08 as shown in Exhibit 13.

Exhibit 12: SPLV IIV/IOPV

Source: Bloomberg L.P., as of Jan. 12, 2015. For illustrative purposes only.

Exhibit 13: SPLV Bid/Ask



IOPV and NAV for International Equity ETFs The IOPV for an international equity-based ETF often deviates from the bid/ask spread of the ETF in the secondary market due to the differences in trading times. Exhibits 14 and 15 show the IOPV and the bid/ask spread for PXH of $18.56 and $18.48/$18.51, respectively. PXH is the PowerShares FTSE RAFI Emerging Markets Portfolio and is comprised of stocks listed in various emerging markets. Both screen shots were captured on Jan. 12, 2015 at 11:34:31 EST, a day where emerging markets were down roughly 1%.1 The IOPV, in this example, is reflective of the last print of each of the securities in the basket. Despite the fact that the securities may have been closed for some time, the close price of that security is still used for IOPV calculation purposes. The IOPV price will not reflect any market movement that may have occurred after the corresponding component closings.

The bid/ask spread of PXH in the secondary market, despite its appearance of being offered at a discount to IOPV, actually represents the most accurate fair valuation for the ETF. In this example, the ETF is acting as a price discovery vehicle for the basket given the various correlated instruments that are available to the liquidity providing community. Should one liquidity provider misprice the ETF, another liquidity provider may capitalize on this mispricing, trading the ETF until no additional arbitrage profit exists.

Although the IOPV is often a reliable indication of fair value for ETFs comprised of domestic equities, it is important to understand the limitations of the IOPV for ETFs comprised of international components. We encourage you to contact the ETF capital markets desk to gauge fair value in these circumstances.

Exhibit 14: PXH IIV/IOPV


27

Exhibit 15: PXH Bid/Ask



Fixed Income IOPV and NAV Unlike equity ETFs, with fixed income ETFs, the IOPV calculation may not be derived from the last price of all the underlying bonds in the basket. The IOPV calculation may use different swap or futures curves or bond valuation methods to determine an intraday value, which may cause the IOPV price to deviate from the ETF’s trading price. As with equity-based ETFs, if a fixed income ETF is mispriced according to a liquidity provider’s pricing model because of the arbitrage mechanism, that liquidity provider will trade the mispricing until the ETF falls back in line with fair value.

With PowerShares fixed income ETFs, it is important to bear in mind that the calculation of the NAV is based on the midpoint between the bid and the offer of the bonds that comprise the ETF based on the bond close (typically 3 p.m. EST). If sentiment after bond close but before the ETF close (4 p.m. EST) is positive for bond prices, the ETF will appear to close at a premium to NAV on its 4 p.m. close; while with negative sentiment, the ETF will appear to close at a discount.

Balance of flows in and out of a fixed income ETF is a major factor in determining where the ETF will trade relative to its underlying basket of fixed income securities. If there is skewed demand to purchase (i.e., more buying than selling), most likely, liquidity providers will have to create shares of the ETF which will involve them transacting in the underlying securities by purchasing the bonds OTC at the bond dealers’ offer. This would cause the ETF to trade at a perceived premium to the mid-marked value of the underlying bonds. If demand is skewed to sell the ETF, liquidity providers may have to redeem the ETF, selling out of underlying bonds OTC at the dealers bid. This would cause the ETF to trade at a perceived discount to the mid-marked value of the underlying bonds. If however, inflows and outflows are balanced with activity both on the bid and offer, liquidity providers will be able to match up customer flow and avoid the need to transact in the underlying bonds and thus potentially reduce investor transaction costs. This balanced flow may also help reduce any premium or discount the ETF may experience to the mid-marked value of the underlying bonds.

It is important to understand the marking methodology for each fixed income ETF. For example, some fixed income ETFs utilize bid side marking for striking NAV while others may utilize mid marks.

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As shown in Exhibit 16 below, during the first quarter of 2014, BKLN traded at an average premium to NAV of 12 basis points. Over the period, BKLN, was in a consistent series of creations, with shares outstanding increasing 15%. As new shares were created, the underlying loans were sourced on or near the offer and thus the Fund was priced at a premium to NAV.

Exhibit 16: BKLN Average Premium to NAV

Series of Creations: when an ETF experiences skewed buyer demand and thus the need to create new shares. An ETF in a series of creates may trade near the offer of the ETFs underlying holdings.

BKLN Case Study: Fixed Income Premium

Date: Jan. 2, 2014 – March 28, 2014

Average Premium to NAV: 12 bps

BKLN US EquityFund Percent Premium 0.121Fund Percent Premium Avg. 0.125



During the second quarter of 2014, as BKLN began to experience selling pressure, the fund entered a series of redemptions as shares outstanding dropped 3.4%. As shown in Exhibit 17, throughout this time period BKLN traded at an average discount to NAV of 9bps. Evaluating the first quarter premium to NAV of 12bps and the second quarter NAV of 9bps exemplifies the potentially cost efficient structure of the ETF.

Exhibit 17: BKLN Average Discount to NAV


BKLN Case Study: Fixed Income Discount

Date: April 1, 2014 – June 30, 2014

Average Discount to NAV: 9 bps

BKLN US EquityFund Percent Premium -0.099


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



33

ETF Pricing

The Arbitrage Mechanism Arbitrage is the practice of simultaneously buying and selling similar or identical instruments for a riskless profit. Arbitrage is an integral facet to the ETF structure in that liquidity providers set their pricing around the cost to buy or sell an ETF’s underlying basket plus carry costs, transaction costs and other frictions. In a US equity-based ETF, the liquidity provider may set their bid price lower than the price derived from the bids of all the constituents in the basket and set their offer price higher than the derived ETF price based on all of the offers of the constituents in the basket. If an investor sells at the liquidity providers bid price or buys at their offer price, the liquidity provider may simultaneously hedge their ETF trade with a trade in the underlying basket.

Arbitrage: the process of buying or selling similar or identical instruments to realize a riskless profit.

Exhibit 18: The Arbitrage Mechanism


Market Neutral

TheClient

ETF Shares

Short Sell ETF


Liquidity Provider

Potential Creation of ETF Shares


This arbitrage process may continue until the ETF price is driven back in line with the value of the underlying securities. It is important to note that the ETF price is not set based on supply and demand, as is the case for an individual security. Rather, due to this inherent arbitrage between the ETF and the underlying holdings, the ETF should trade close to the value of its underlying basket plus fees. For ETFs with underlying baskets with limited liquidity or ETFs with underlying baskets that trade during different hours than the ETF, liquidity providers often hedge ETF positions with instruments other than the entire underlying basket which will be discussed more detail in the next section: Components of ETF Liquidity.

Exhibit 19: Arbitrage — Basket vs. ETF


Long ETF Basket

(lower cost)

Short ETF(higher cost)

If a liquidity provider’s displayed offer is too high, other market participants will sell the ETF and simultaneously purchase the underlying basket, capturing an arbitrage profit from the mispricing. If a liquidity provider’s displayed bid is too low, other market participants may purchase the ETF and short the underlying constituents.


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



37


When examining the potential liquidity of an ETF, it is important to once again look at the situation from the point of view of a liquidity provider, as they may be the party providing liquidity. From the liquidity provider’s perspective, many times an ideal situation is to have traded ETF shares, lock in a spread and to finish the day with a flat or market neutral position. In order to do so, the liquidity provider may use one of three different hedges:

• The underlying basket constituents (as mentioned in ETF Pricing and the Arbitrage Mechanism),

• Related derivatives, and/or

• Other highly correlated instruments.

If a highly correlated hedge can be constructed, liquidity providers can be active in providing tight, liquid markets in an ETF. The average daily volume (ADV) of the ETF itself can aid in liquidity helping natural buyers and sellers find one another in the secondary market and avoiding the need to create or redeem shares. However, ADV only begins to tell the story of the true liquidity that can be sourced for a particular ETF.

Average Daily Volume (ADV): the average number of shares traded over a specified amount of time. ADV= total shares traded divided by number of days.

The Underlying Basket and Implied LiquidityOne hedge the liquidity provider can obtain is the underlying ETF basket, allowing arbitrage profit to instantaneously be captured. With this in mind, when determining the liquidity of a particular ETF, it is important to examine the liquidity of the underlying constituents of the ETF to gauge the number of ETF shares that may be traded without significantly impacting the price of the underlying components. Liquidity providers will likely hold their long/short position until they are able to either zero out the position with a creation/redemption to the issuer (primary market liquidity), or flatten their position in the secondary market (secondary liquidity).

To assess how liquid the underlying basket is, an investor may look at the implied liquidity of the ETF as a general indication. Implied liquidity is a statistical measurement that provides investors an indication of how many shares of the ETF can potentially be traded based on the liquidity of the underlying constituents. It is derived by calculating a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks. The implied liquidity figure allows an investor to determine the quantity of ETF shares that may be traded, while still remaining under 25% of the ADV in all underlying constituents of the basket.1 The greater the trading volume of the underlying basket, the less the potential impact a sizable ETF trade may have.

Implied Liquidity(30 day ADV x 25%)

shares per creation unitCreation Size= x

Implied Liquidity: a daily measure of how many shares of the ETF can potentially be traded based on the underlying basket constituents. This measure is derived by taking a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks.

The implied liquidity function on a Bloomberg terminal uses 25% as a default

(Least Liquid Constituent)


ETF Liquidity Beyond the BasketIn the instance that a very large position is being established which may represent a high percentage of volume in the underlying constituents and thus be impactful, a liquidity provider may utilize a completion basket as a hedge. Completion baskets use many, but not all, of the constituents of the ETF basket and thus typically exhibit a high correlation to the ETF. The liquidity provider may then work into the more impactful trades over time seeking to minimize the impact.

Related DerivativesRelated derivatives, such as options, futures and swaps are common instruments used by liquidity providers to hedge their market risk and add another layer of liquidity to the ETF. These derivatives may often provide a quick, highly correlated hedge for an ETF trade. The liquidity provider may choose to implement a derivative hedge when the corresponding basket is closed or when it is more time efficient to trade one derivative as opposed to the entire basket. Unlike using the ETF’s underlying basket, related derivatives may not be a perfect hedge and therefore may involve more risk for the liquidity provider. This increased risk may result in a potentially wider, less efficient market. To help reduce this risk, liquidity providers may seek derivatives with the highest correlation and then work out of the derivative hedge and into the basket over time.

Other Highly Correlated Instruments Products, such as other ETFs, CEFs and UITs that have a high correlation with one another, allow liquidity providers to effectively hedge by trading one instrument against another. This is a very common practice when trading in US-listed ETFs with international constituents, where the ETF basket is closed while the ETF is actively trading. For example, if the liquidity provider sells an emerging market ETF and cannot source the basket at the time of the trade, they may use another highly correlated emerging market ETF to remain as close to market neutral as possible.

Market Neutral: a hedged position that should not introduce positive or negative P&L or change in value due to market movement.

39

Secondary Market Activity in the ETF In addition to the liquidity that can be derived from the underlying holdings, the ETF’s average daily volume in the secondary market can add an additional layer of liquidity. As natural buyers and natural sellers enter the market for the ETF, order flow can cross in the secondary market, providing an additional layer of liquidity. For an ETF, such as the PowerShares QQQ, which trades approximately 50 million shares per day,1 it is very common that large share quantities can be traded without the need to utilize the methods previously described (i.e., primary market liquidity).

Together, all of the components discussed contribute to the ETF’s liquidity. A firm knowledge of the components of ETF liquidity may help alleviate fears of trading lower volume ETFs that do not appear to have significant depth in the secondary market.

For help assessing the liquidity of an ETF, please contact the PowerShares Global ETF Capital Markets team at:p: 877 983 0903 e: [email protected]

Exhibit 20: Components of Liquidity


ETF Liquidity

Underlying Basket & Implied Liquidity

Other Highly Correlated Instruments

Secondary Market Liquidity Related Derivatives



Exhibit 21: Components of ETF Liquidity (SPLV)


6 Source: Bloomberg L.P. as of Jan. 12, 2015

Components of ETF Liquidity — Example SPLVLooking at SPLV, which is comprised of a subset of S&P 500 Index’s securities, we can see an example of how this liquidity is sourced. As shown in Exhibit 21 below, on July 21, 2014, a 7,096,476 share block was printed near the screen offer of $35.09. Just prior to this time, the secondary market showed available liquidity of only 3,800 shares. The trade happened at 10:48:22 EST when both the ETF and the underlying basket could be sourced during US market hours. With 30 ADV of 1,780,000 shares, a print of almost four times that amount underscores that additional ETF liquidity may be derived from the underlying basket. While a trade of this size may appear large relative to SPLV’s ADV, it is only a small portion of the liquidity that can be derived based on the underlying holding. SPLV shows an implied liquidity of over 16.9 million shares.6

SPLV Case Study: Components of ETF Liquidity

Date: July 21, 2014

SPLV: 7,096,476 Share Block

30 ADV: 1,7800,000 shares

Day Range: 37.93–38.28


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



43

Secondary Markets

The process by which ETF trades are executed on US exchanges has changed significantly since the adoption of Regulation National Market System (Reg NMS) on Aug. 29, 2005. Reg NMS was established by the SEC in 2005 seeking to improve trading on the exchange. Since the implementation of Reg NMS, ETF (and equity) execution has become a more automated process where orders are electronically routed to the exchange at the National Best Bid or Offer (NBBO).

This post-Reg NMS environment makes it crucial for investors to understand the advantages and disadvantages of using market orders and limit orders. While a market order may be useful for a high urgency trade, it may leave an investor exposed to an unfavorable execution price. Particularly for thinly traded ETFs it may be beneficial to avoid using a market order, and to use a limit order. If a market order exceeds the size of the posted liquidity across all exchanges, the order will continue to be filled with any available posted liquidity on the screen until the order is completely filled.

As an example, let’s assume an investor wants to execute a market order to buy 25,000 shares of ETF ABC, which is thinly traded. For simplicity, let’s assume the order book for ABC (see Exhibit 22) at the time of trade displayed 6,000 shares on the bid/ ask with a quote of $25.21/$25.55 and another 20,000 shares on the bid/ask with a quote of $24.90/$26.01. If the market order to buy 25,000 shares is routed to the exchange, the order will give priority to the speed of execution and will be filled at the best prices available. In this situation, the investor will receive the first 6,000 shares at a price of $25.55, and if no other liquidity is displayed, the remaining 19,000 shares may be filled at $26.01, for an average execution price of $25.90. Depending on the investor’s goals for the trade, this may not have been the desired outcome. However, routing a market order to the exchange places priority on the speed to which the order is executed.

It is important to note given the inherit risk, market makers rarely post on exchange the full depth of liquidity they are willing to provide in an ETF. Instead, they may post a limited number of shares in the secondary market with a tight spread around fair value.

Exhibit 22: Order Book — Security ABC

Bid Ask

Shares Price Price Shares

6,000 $25.21 $25.55 6,000

20,000 $24.90 $26.01 20,000

National Best Bid/Best Offer (NBBO): the best (lowest) available ask price and the best (highest) available bid price posted on exchanges.

Market Order: a buy or sell order placed for a particular security which will be executed immediately at the best available price. A market order prioritizes speed of execution over the price at which the order is executed.


Using limit orders instead of market orders can help avoid a deviation from the current bid/ask spread in the secondary market. A limit order puts the execution priority on price and will ensure that if the order is filled, it will be filled at the specified price or better. Depending on the objectives of the investor, entering a buy order at a cent or two above the current offer, or entering a sell order at or a cent or two below the current bid (often referred to as a marketable limit order), may be a viable alternative to entering a market order. In our previous example, with ETF ABC, had the client used a limit order, they would have protected the order from the deviation in the fill price by allowing the liquidity providers time to refresh their quote and offer up additional shares in the secondary market.1 The technology used by liquidity providers allow quotes to refresh multiple times per second and may allow a limit order to be to be filled seamlessly at the specified price. Depending on the size of the order relative to the ADV of the ETF and the trading methodologies available, it may be advantageous to trade by using one of four alternative sources for ETF execution, discussed in the next section.

For questions on ETF trading, please contact the PowerShares Global ETF Capital Markets team at:p: 877 983 0903 e: [email protected]

Limit Order: an order to buy or sell shares at a set price or better. Limit orders do not guarantee an order will be filled.

Marketable Limit Order: a limit order entered at or above the best offer (to purchase) or at or below the best bid (to sell) for a security. There may be a higher probability of execution than traditional limit order placed inside the NBBO.

This is not a recommended trading strategy. However, using a limit order particularly for more thinly traded ETFs may help mitigate the risk of an undesirable fill price.



ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



47


As mentioned in the section, Secondary Markets, liquidity providers rarely post the full depth of ETF liquidity in the secondary market. However, this does not mean an ETF cannot be traded in size greater than the ADV or posted liquidity. There are often single ETF prints that are much larger than the ADV of an ETF. If these prints are not executed directly on secondary exchanges via market or limit order, there are typically four additional ways the order is handled:

• Risk market

• Average price trade

• Derivatively priced trade

• Direct creation/redemption through an AP

Risk MarketWhen an ETF order is larger than the liquidity posted in the secondary market, a client may seek a “risk market.” While typically used for larger orders, this can be done for any size trade. A risk market is a quote sized up to the specifications of the client. Risk trades are principal transactions, as the liquidity provider commits internal capital to trade on behalf of the firm against the client. With this process, a liquidity provider provides the customer with a bid and offer based on its own pricing model. (See Exhibit 23.) The quote is often two-sided, meaning it has the best bid and offer that the liquidity provider is willing to trade at, so that the client does not need to give up the direction of their order before trading. If the liquidity provider’s quote is higher than the current offer or lower than the current bid in the secondary market, the liquidity provider must first sweep the order book up to the quoted price which can improve client execution.

Exhibit 23: Obtaining a Risk Market

For illustrative purposes only. Client trades at best price.

Liquidity Provider

A

Liquidity Provider

B

Liquidity Provider

C

Client

2 Sided Quote

Call

2 Sided Quote

Call

2 Sided Quote

CallSlippage: refers to the risk of market movements from the time a trade in initiated to when it is actually executed.

Risk Premium: an indirect cost paid by an investor to a liquidity provider as compensation for taking on risk. Risk premiums are expressed in the ETFs quoted price.

A risk market may allow the client to know the exact price for the full block before executing. However, because the potential risk of slippage while implementing a hedge rests on the liquidity provider, a risk premium may be built into the quote provided. Initially, a risk trade is not directly posted on the exchange, but rather done over- the-counter (OTC) and is then printed to the consolidated tape.


Agency Risk Market/Liquidity AggregatorIn addition to obtaining a risk market from a liquidity provider in a principal capacity, a client may also use a liquidity aggregator. Unlike a liquidity provider, a liquidity aggregator will not provide a quote based on their internal pricing model, but rather reach out to several liquidity providers to obtain a price for the trade. By contacting different liquidity providers, the liquidity aggregator is able to get multiple viewpoints on the ETF and have the liquidity provider network compete for the business. Based on the quotes received, the client can execute their order at the best price offered. It is important to note the aggregator model may add an additional fee.

Exhibit 24: Utilizing a Liquidity Aggregator


Liquidity Aggregator: a party acting in an agency capacity to facilitate order flow between buyers and sellers which often includes aggregating bids and offers from multiple principal traders.

An individual liquidity provider may use a different pricing model that implements a highly correlated completion basket or may have inventory in a particular ETF and thus be willing to provide a better bid/offer than the rest of the network.

Liquidity Provider A

Liquidity Provider B

Liquidity Provider C

Client AggregatorBest Quote

Call

2 Sided Quote

Call

2 Sided Quote

Call

2 Sided Quote

Call

49

Exhibit 25 shows an example of a trade that was placed in the PowerShares Variable Rate Preferred Portfolio, VRP, and may have been executed using a risk market. The displayed print shows a 338,261 share block order to purchase VRP. At the time of the trade, there were only 10,000 shares offered at $25.28 (5,700 shares on the bid at $25.23) and yet the full 338,261 share block was printed inside the best offer at 25.2797.* This print illustrates that sizable liquidity may be accessed beyond and potentially more efficiently than what is posted in the secondary market.

Exhibit 25: Block Execution — VRP Risk Market


*Before this block print, the liquidity provider swept the order book on behalf on the client purchasing 12,000 shares of VRP.


Average Price TradeIn addition to sourcing ETF shares in the secondary market, the underlying basket for the ETF can be sourced over a period of time and printed as an average price trade. It is important to note that with an average price trade, the client bears the risk of any market movement while the underlying basket constituents are being sourced on their behalf. In this case, the client pays the average execution price and a potential commission to the liquidity provider.

One common way to accomplish this is to use a simple participation strategy, such as a time-weighted average price (TWAP) or volume-weighted average price (VWAP) of the underlying constituents of the basket. When a TWAP of the underlying securities is performed, a predetermined amount of the ETF’s constituents are purchased over a given time frame. For example, if an investor wanted to purchase 10 million shares of a given ETF using a TWAP over a period of five hours, they would systematically buy two million shares of the basket equivalent every hour until the entire 10 million share order was completed.

A VWAP of the underlying securities is similar to a TWAP; however, with a VWAP, a set percentage of the underlying securities average volume over the period will be purchased until the entire order is completed.

Average Price Trade: typically, a liquidity provider will trade the underlying constituents of an ETF basket over a specified time period for the client transaction. Once a representative number of ETF baskets have been traded the client will receive the average ETF price based on that execution (additional brokerage commission may apply).

Time Weighted Average Price (TWAP): Buy 100,000

Volume Weighted Average Price (VWAP): ADV=1,000,000 Shares, Buy 100,000

Time# Shares Bought

Percent of Order Bought

9:00 AM 20,000 20%

11:00 AM 20,000 40%

1:00 PM 20,000 60%

3:00 PM 20,000 80%

4:00 PM 20,000 100%

Total Volume

# Shares Bought

Volume Participation

Rates

250,000 25,000 10%

500,000 25,000 10%

750,000 25,000 10%

1,000,000 25,000 10%


Exhibit 26

Again, the client will pay actual execution costs along with a commission. In ETFs with lower ADV where the underlying constituents are more easily accessed than shares of the ETF, this method can be used to obtain a price that is close to the fair value of the ETF over the time the underlying basket is sourced. The drawback is that an average-price trade takes time, and thus reflects market movement during the execution period. If a buy order is executed in a rising market, the order may have been executed at a better price using a risk market (actual fill prices are executed at a higher price). On the other hand, if the market were to decline while sourcing, the buy order may be filled at a more favorable price then if a risk market were utilized.

Average price trade may not be available for all clients.

51

NAV OrderFinally, in cases where the block ETF execution is through an AP desk, straight NAV trades may be available. The way creation/redemption works differs based on whether the ETF is created in-kind or by cash at NAV. With an in-kind creation/redemption, the AP would source the underlying securities in the basket — most likely leading up to the close in each security’s market. The AP would then pass along the actual cost of the transaction to the client plus any brokerage commissions and create or redeem the ETF to the ETF issuer on behalf of the client. When deciding whether straight NAV trades via in-kind makes sense, a client must make sure that the size of their order will not have sizable affect in the individual components of the basket during their closing rotations. An order that is too large may impact the price received.

With straight NAV trades via cash, the AP must deliver cash in accordance with the same day NAV or next day NAV of the ETF. Often times, the NAV is not calculated until the evening of the day the order is placed, or in the case of international cash baskets, the AP’s price would be based on the next day’s NAV. Given these factors, when a client trades via straight creation/redemption, it may take a day or two to arrive at the actual execution price. For clients that need a price the same day the order is placed, this may not be a viable option.

Exhibit 27: Average Price Trade


Liquidity Provider

ClientSources Securities

Sell ETF at Average Price of Sourced Basket

Exhibit 28: Cash Creation


Cash

$

ETF Shares

AP ETF Issuer’s Custodial Bank

For help evaluating ETF trading strategies please contact the PowerShares Global ETF Capital Markets team at:p: 877 983 0903 e: [email protected]



ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs




Exhibit 29: Shorting ETFs


Open Interest Short Interest

1,000,000 Shares 0

1,000,000 Shares 0

1,000,000 Shares 1,000,000 Shares

1,000,000 Shares 1,000,000 Shares

1,000,000 Shares 2,000,000 Shares

Buyer1,000,000 shares

Loan

ETF Share Holder1,000,000 shares

Borrower1,000,000 shares

Borrower1,000,000 shares

Buyer1,000,000 shares

Short Sell

Loan

Short Sell

55

Shorting ETFs

In this section, we will explore the process and regulatory safeguards of the stock loan side of the ETF landscape. In 2005, the SEC adopted Regulation SHO to address naked short selling and extended periods of time with failures to deliver for sellers of securities.7 Naked short selling exists when a seller of a security does not locate or have the reasonable expectation of locating a security prior to a short sale. A failure to deliver exists when a trade does not clear because the shares are not available to the seller for delivery. Reg. SHO also created a threshold list of securities that have had a substantial number of failures to deliver. If a security has been on the threshold list for 13 days, the seller may be forced to cover the short position. ETFs may show up on the threshold list as a result of short positions sold by liquidity providers and not covered.8

In order to establish a short position in a security, an individual must first have access to the shares to sell or believe they will be able to borrow them. This is where the securities lending or borrowing market may come into play. A client will post collateral, often worth up to 105% of the securities that they borrow. They are then free to sell the borrowed security on the open market. On a daily basis, the borrowed position is marked to market or priced at the day’s closing value to ensure the borrower still has enough collateral to purchase the shares back at their market value. The borrower must pay the lender a rate, known as a borrow rate, for the right to borrow the shares. Should the lender want the shares back (often for the purpose of selling the shares in the open market), the borrower must buy the shares back thereby canceling their short position.

Short interest is the number of shares of a particular security that are sold short and are not covered. It is possible for more shares of an ETF to be short than are available in total shares outstanding. For example, in a scenario where there are one million shares outstanding which are owned by one holder, the holder of the ETF loans one million shares to a borrower who sells those shares short to a second buyer (Please see Exhibit 29). Suppose the second buyer loans the one million shares out to another borrower. In this scenario, we have one million shares outstanding and two million shares short. If this was an individual stock instead of an ETF, and the individual who loaned his stock called the shares back, the borrowers would be forced to cover by buying in the secondary market. This process is known as a short squeeze, which often causes the stock to rally. With ETFs, because of the creation/redemption mechanism, instead of buying shares in the secondary market, new shares could be created by the borrower instead of bidding up the price of the ETF. As several components make up an ETF’s basket, buying will be spread among all of the securities, thereby minimizing the effect of the forced cover.

7 Source: U.S. Securities and Exchange Commission, 20058 Per NASDAQ a Threshold List- A “threshold security” is any equity security of any issuer that is registered under Section 12 of the Exchange Act, or that is required to file reports under Section 15(d) of the Exchange Act (commonly referred to as reporting securities), where, for five consecutive settlement days there are aggregate fails to deliver at a registered clearing agency of 10,000 shares or more per security; the level of fails is equal to at least one-half of one percent of the issuer’s total shares outstanding; and the security is included on a list published by a self-regulatory organization (SRO). A security ceases to be a threshold security if it does not exceed the specified level of fails for five consecutive settlement days.

Mark to Market: when a position is marked to its current market value.

Short Squeeze: a situation when a security price starts to move up and investors with short positions are forced to cover (purchase) their shares. This often drives up the price of the security.


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs



59


For additional ETF resources please visit the institutional section of PowerShares.com and click on the “Capital Markets” tab. If you have specific questions on trading or liquidity of PowerShares ETFs, please contact the PowerShares Global ETF Capital Markets Desk at 877 983 0903 or email [email protected].

In addition to the resources provided in this ETF Toolkit, the global capital markets team offers:

1. Pre-Trade Analytics: provides the tools necessary to assess the potential liquidity of an ETF. The Pre-Trade Analytics tool is designed to give a holistic view of shares that can potentially be traded based on the various layers of ETF liquidity.

2. Weekly Trading Report: tracks ETF industry trends and flows including large trades, earnings, PowerShares inflows and outflows, volume and short interest.

3. Weekly Options Report: provides a snapshot of the entire ETF options industry, including metrics on ETF options volume, ETF open interest and ETF implied volatility.

4. Monthly Spread and Impact Report: will help assess the potential impact a large trade may have on an ETF by looking at various ETFs and hypothetical share quantities.

5. ETF Implementation Strategies and Trade Ideas: provides timely market commentary and actionable trade ideas given the current market environment.

For general questions on ETFs or to meet with an Invesco PowerShares Sales Reprehensive contact [email protected] or call 800 983 0903.




Factor DrivenSPHB S&P 500 High Beta Portfolio

EEHB S&P Emerging Markets High Beta Portfolio

IDHB S&P Developed Markets High Beta Portfolio

SPLV S&P 500 Low Volatility Portfolio

EELV S&P Emerging Markets Low Volatility Portfolio

IDLV S&P Developed Markets Low Volatility Portfolio

XMLV S&P MidCap Low Volatility Portfolio

XSLV S&P SmallCap Low Volatility Portfolio

FXEU Europe Currency Hedged Low Volatility Portfolio

IDHQ S&P International Developed High Quality Portfolio

SPHQ S&P 500 High Quality Portfolio

DWAQ* DWA NASDAQ Momentum Portfolio

DWAS DWA SmallCap Momentum Portfolio

PDP DWA Momentum Portfolio

PIE DWA Emerging Markets Momentum Portfolio

PIZ DWA Developed Markets Momentum Portfolio

PYZ* DWA Basic Materials Momentum Portfolio

PEZ* DWA Consumer Cyclicals Momentum Portfolio

PSL* DWA Consumer Staples Momentum Portfolio

PXI* DWA Energy Momentum Portfolio

PFI* DWA Financial Momentum Portfolio

PTH* DWA Healthcare Momentum Portfolio

PRN* DWA Industrials Momentum Portfolio

PTF* DWA Technology Momentum Portfolio

PUI* DWA Utilities Momentum Portfolio

CNTR PowerShares Contrarian Opportunities Portfolio

PXLG PowerShares Russell Top 200 Pure Growth Portfolio

PXLV PowerShares Russell Top 200 Pure Value Portfolio

PXMG PowerShares Russell Midcap Pure Growth Portfolio

PXMV PowerShares Russell Midcap Pure Value Portfolio

PXSG PowerShares Russell 2000 Pure Growth Portfolio

PXSV PowerShares Russell 2000 Pure Value Portfolio

AccessCHNA China A-Share Portfolio

PDBC DB Optimum Yield Diversified Commodity Strategy

PSR Active U.S. Real Estate Fund

PHDG S&P 500 Downside Hedged Portfolio

LALT Multi-Strategy Alternative Portfolio

PNQI NASDAQ Internet Portfolio

PPA Aerospace & Defense Portfolio

QQQ PowerShares QQQ

PGJ Golden Dragon China Portfolio

PIN India Portfolio

PSP Global Listed Private Equity Portfolio

PXR Emerging Markets Infrastructure Portfolio

ADRA BLDRS Asia 50 ADR Index Fund

ADRD BLDRS Developed Markets 100 ADR Index Fund

ADRE BLDRS Emerging Markets 50 ADR Index Fund

ADRU BLDRS Europe Select ADR Index Fund

KBWB KBW Bank Portfolio

KBWC KBW Capital Markets Portfolio

KBWI KBW Insurance Portfolio

KBWP KBW Property & Casualty Insurance Portfolio

KBWR KBW Regional Banking Portfolio

PBP S&P 500 BuyWrite Portfolio

PKW Buyback Achievers Portfolio

PZI Zacks Micro Cap Portfolio

IPKW International Buyback Achievers Portfolio

PSCC S&P SmallCap Consumer Staples Portfolio

PSCD S&P SmallCap Consumer Discretionary

PSCE S&P SmallCap Energy Portfolio

PSCF S&P SmallCap Financials Portfolio

PSCH S&P SmallCap Health Care Portfolio

PSCI S&P SmallCap Industrials Portfolio

PSCM S&P SmallCap Materials Portfolio

PSCT S&P SmallCap Information Technology Portfolio

PSCU S&P SmallCap Utilities Portfolio

PowerShares Product Line Up

*Within the past 12 months, changes to the Funds’ name and investment objective have occurred. For more information about these changes, please see the Funds’ prospectus.

61

Alternatively WeightedEQAL Russell 1000 Equal Weight

PDN FTSE RAFI Developed Markets ex-US Small-Mid

PRF FTSE RAFI US 1000 Portfolio

PRFZ FTSE RAFI US 1500 Small-Mid Portfolio

PXF FTSE RAFI Developed Markets ex-US

PXH FTSE RAFI Emerging Markets Portfolio

EQWL PowerShares Russell Top 200 Equal Weight Portfolio

EQWM PowerShares Russell Midcap Equal Weight Portfolio

EQWS PowerShares Russell 2000 Equal Weight Portfolio

PAF FTSE RAFI Asia Pacific ex-Japan Portfolio

PFIG Fundamental Investment Grade Corporate Bond Portfolio

PHB Fundamental High Yield Corporate Bond

PFEM Fundamental Emerging Markets Local Debt Portfolio

QuantitativePWB Dynamic Large Cap Growth Portfolio

PWC Dynamic Market Portfolio

PWV Dynamic Large Cap Value Portfolio

PMR Dynamic Retail Portfolio

PSI Dynamic Semiconductors Portfolio

PSJ Dynamic Software Portfolio

PXE Dynamic Energy Exploration & Production Portfolio

PXQ Dynamic Networking Portfolio

PBE Dynamic Biotechnology & Genome Portfolio

PBJ Dynamic Food & Beverage Portfolio

PEJ Dynamic Leisure and Entertainment Portfolio

PJP Dynamic Pharmaceuticals Portfolio

PKB Dynamic Building & Construction Portfolio

PBS Dynamic Media Portfolio

PXJ Dynamic Oil & Gas Services Portfolio

Equity-Based ResourcesPBD Global Clean Energy Portfolio

PBW WilderHill Clean Energy Portfolio

PUW WilderHill Progressive Energy Portfolio

PZD Cleantech Portfolio

PAGG Global Agriculture Portfolio

PSAU Global Gold and Precious Metals Portfolio

PHO Water Resources Portfolio

PIO Global Water Portfolio

IncomeKBWD KBW High Dividend Yield Financial Portfolio

KBWY KBW Premium Yield Equity REIT Portfolio

PEY High Yield Equity Dividend Achievers Portfolio

PFM Dividend Achievers Portfolio

BAB Build America Bond Portfolio

BKLN Senior Loan Portfolio

DSUM Chinese Yuan Dim Sum Bond Portfolio

PCY Emerging Markets Sovereign Debt Portfolio

PGHY Global Short Term High Yield Bond Portfolio

PICB International Corporate Bond Portfolio

LDRI LadderRite 0-5 Corporate Bond Portfolio

PLW 1-30 Laddered Treasury Portfolio

PVI VRDO Tax-Free Weekly Portfolio

PWZ* Insured California Municipal Bond Portfolio

PZA* Insured National Municipal Bond Portfolio

PZT* Insured New York Municipal Bond Portfolio

PCEF CEF Income Composite Portfolio

PGF Financial Preferred Portfolio

PGX Preferred Portfolio

PID International Dividend Achievers Portfolio

SPHD S&P 500 High Dividend Portfolio

VRP Variable Rate Preferred Portfolio


ETF Structure

NAV & IOPV



Secondary Markets


Shorting ETFs




Glossary

1940 Act: Act of Congress passed in 1940 which represents the primary source of regulation for mutual funds, closed-end funds and ETFs.

Arbitrage: The process of buying or selling similar or identical instruments realize a riskless profit.

Authorized Participants (APs): Market participants who have a legal contract (AP agreement) in place with an ETF trust and the custodial bank which permits them to create and redeem shares of the ETF.

Average Daily Volume (ADV): the average volume traded over a specified amount of time. ADV= total shares traded divided by number of days.

Average Price Trade: typically, a liquidity provider will trade the underlying constituents of an ETF basket over a specified time period for the client transaction. Once a representative number of ETF baskets have been traded the client will receive the average ETF price based on that execution (additional brokerage commission may apply).

Basket File: a file published daily by the ETF issuer, disclosing the securities and cash required for one creation unit.

Cash Creation or Redemption/Cash-in-Lieu (CIL): When an AP delivers cash to an ETF issuer to create new ETF shares, or receives cash back from the ETF issuer when redeeming shares. Cash-in lieu may be done as part of an in-kind exchange in a basket with restricted securities or ID markets.

Creation/Redemption: Creation is the process by which new ETF shares are issued to the market. Redemption is the process of retiring existing shares of the ETF.

Creation/Redemption Ticket Charge: the fee charged by the custodial bank to authorized participants creating and redeeming units of the ETF

Creation Unit: The specified number of ETF shares that represent one unit of the fund. This is the block share quantity that APs must deal in when interacting with the trust for creation or redemption. This is typically 50,000, 75,000, 100,000 or 200,000 ETF shares and is specified in the prospectus of each ETF.

Custodial Bank: ETF issuers utilize custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer.

Derivatively Priced Trade: Typically, a liquidity provider will trade the underlying constituents of an ETF basket over a specified time period for the client transaction. Once a representative number of ETF baskets have been traded, the client will receive the average ETF price based on that execution (additional broker commission may apply).

Exemptive Relief: regulatory order granted to ETF fund complexes to provide exemption from certain provisions of the 1940 Act necessary to operate within the ETF structure.

Fair Value: the theoretical price at which the ETF is neither over priced nor underpriced.

Implied Liquidity: A daily measure of how many shares of the ETF can potentially be traded based on the underlying basket constituents. This measure is derived by taking a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks.

Intraday Indicative Value (IIV) or Indicative Optimized Portfolio Value (IOPV): The statistical value of the underlying holdings of an ETF published every 15 seconds and disseminated to the consolidated tape based on the last traded price of all the underlying constituents. This metric can be found on Bloomberg, as well as other financial sources.

In-Kind Creation and Redemption: Refers to the process which allows for shares to be created and redeemed by swapping ETF shares for the underlying constituents of the ETF.

Lead Market Maker: A market maker who has an agreement in place with the exchange and is required to provide different levels of liquidity in return for rebates.

Limit Order: An order to buy or sell shares at a set price or better. Limit orders do not guarantee an order will be filled.

Liquidity Aggregator: A party acting in an agency capacity to facilitate order flow between buyers and sellers which often includes aggregating bids and offers from multiple principal traders.

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Liquidity Provider (LP): A firm that is compensated through arbitrage or commission for the process of sourcing ETF shares for an investor. A liquidity provider may be a market maker or AP.

Mark to Market: When a position is marked to its current market value.

Market Maker: A dealer who undertakes to buy or sell in a security at specified prices by quoting bids and offers.

Market Neutral: A hedged position that should not introduce positive or negative P&L or change in value due to market movement.

Market Order: A buy or sell order placed for a particular security which will be executed immediately at the best available price. A market order prioritizes speed of execution over the price at which the order is executed.

Marketable Limit Order: a limit order entered at or above the best offer (to purchase) or at or below the best bid (to sell) for a security. There may be a higher probability of execution than traditional limit order placed inside the NBBO.

National Best Bid/Best Offer (NBBO): The best (lowest) available ask price and the best (highest) available bid price posted on exchanges.

Net Asset Value (NAV): Is the value of all assets in the ETF minus any liabilities divided by total shares outstanding. NAV is calculated by the custodial bank and is disseminated once daily.

Over the Counter (OTC): instruments that are traded off the exchange.

Risk Market: A two sided quote by a liquidity provider, sized up to the specifications of the client. Risk markets can be beneficial to investors in that they allow an entire block to be filled at a specific price, and any risk associated with hedging the trade is born by the liquidity provider.

Risk Premium: an indirect cost paid by an investor to a liquidity provider as compensation for taking on risk. Risk premiums are expressed in the ETFs quoted price.

Separately Managed Account (SMA): a pool of assets that is managed by an investment management firm for the benefit of an investor.

Series of Creations: when an ETF experiences skewed buyer demand and thus the need to create new shares. An ETF in a series of creates may trade near the offer of the ETFs underlying holdings.

Short Interest: The number of shares of a particular security that are sold short and are not covered.

Short Squeeze: A situation when a security price starts to move up and investors with short positions are forced to cover (purchase) their shares. This often drives up the price of the security.

Slippage: refers to the risk of market movements from the time a trade in initiated to when it is actually executed.

Street Name: Assets held in the name of the brokerage firm as opposed to the name of the investor.

Important Risk Information There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply.

When we say that our ETFs are intelligent, we mean that in several different ways.

Our largest family of ETFs is based on IntellidexesTM — dynamic indexes that use rules-based quantitative analysis to choose stocks for their capital appreciation potential. We believe this is an intelligent way for an index to select stocks.

Our second-largest family of ETFs is based on FTSE RAFI indexes), which weight stocks according to fundamental economic factors. We believe this is a more intelligent weighting method than market-cap-weighting. Furthermore, our Fundamental Index® ETFs are based on four factors — sales, cash flow, book value and dividends — which we believe is a more balanced, intelligent approach than weighting stocks according to just one fundamental measure.

We also have a wide range of ETFs that target narrow slices of the market— from niche industries to specific world regions. For investors who are interested in these niches, we believe ETFs — which invest in multiple companies within a market sector — may offer a more intelligent investment approach than stock picking.

Overall, no matter what the focus, all ETFs offer investors tax efficiency and trading flexibility, which make them an intelligent investment tool for investors to consider. Whether you’re looking for broad market exposure, specialized investment strategies or access to niche markets, we believe PowerShares ETFs represent an intelligent option for your portfolio.

No option strategy can eliminate risk, including the possible loss of principal.

Option strategies, in particular, may result in the total loss of principal in a short period of time. Please note that options are not suitable for all investors and they may carry substantial risk.

Investment in securities in emerging market countries involves risks not associated with investments in securities in developed countries.

Investments in fixed-income securities, such as notes and bonds, carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health.

Short selling may require investors to meet margin requirements and potential losses may be accelerated.

The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.

VRP Preferred securities may be less liquid than many other securities, and in certain circumstances, an issuer of preferred securities may redeem the securities prior to a specified date.

Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.

Convertible securities are subject to the risks associated with both debt and equity securities. As with equity securities, declining common stock values may cause the value of the Fund’s investments to decline. A debt security tends to decrease in value when interest rates rise. Many convertible securities are subject to the same risks as lower rated debt securities.

Hybrid securities are potentially more volatile than traditional equity securities and may carry credit and liquidity risks.

Perpetual subordinated debt typically has lower credit ratings and lower priority than other obligations of an issuer during bankruptcy, presenting greater risk of nonpayment and increasing as the priority of the obligation becomes lower.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The Fund is non-diversified and may experience greater volatility than a more diversified investment.

PKW The fund may engage in frequent trading of its portfolio securities in connection with the rebalancing or adjustment of the Underlying Index.

SPLV In general, equity values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

There is no assurance that the Fund will provide low volatility.

PXH The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Stocks of medium-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Investing in securities of Chinese companies involves additional risks, including, but not limited to: the economy of China differs, often unfavorably, from the U.S. economy in such respects as structure, general development, government involvement, wealth distribution, rate of inflation, growth rate, allocation of resources and capital reinvestment, among others; the central government has historically exercised substantial control over virtually every sector of the Chinese economy through administrative regulation and/or state ownership; and actions of the Chinese central and local government authorities continue to have a substantial effect on economic conditions in China.

ADRs and GDRs may be subject to certain of the risks associated with direct investments in the securities of foreign companies, such as currency, political, economic and market risks, because their values depend on the performance of the non-dollar denominated underlying foreign securities.

BKLN Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.

Shares of closed-end funds frequently trade at a discount to their net asset value in the secondary market and the net asset value of closed-end fund shares may decrease.

Under a participation in senior loans, the fund generally will have rights that are more limited than those of lenders or of persons who acquire a senior loan by assignment. In a participation, the fund assumes the credit risk of the lender selling the participation in addition to the credit risk of the borrower. In the event of the insolvency of the lender selling the participation, the fund may be treated as a general creditor of the lender and may not have a senior claim to the lender’s interest in the senior loan. Certain participations in senior loans are illiquid and difficult to value.

The Fund currently intends to effect creations and redemptions principally for cash, rather than principally in-kind because of the nature of the Fund’s investments. As such, investments in the Fund may be less tax efficient than investments in ETFs that create and redeem in-kind.

PKW, SPLV, PXH Investments focused in a particular sector, such as consumer discretionary, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

PKW, SPLV, BKLN The Fund is non-diversified and may experience greater volatility than a more diversified investment.

VRP, PHB, BKLN The Fund may hold illiquid securities that it may be unable to sell at the preferred time or price and could lose its entire investment in such securities.

Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

VRP and PKW Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

PXH, PHB, VRP and BKLN The Fund’s use of a representative sampling approach will result in its holding a smaller number of bonds than are in the underlying Index, and may be subject to greater volatility. The Fund’s use of a representative sampling approach will result in its holding a smaller number of bonds than are in the underlying Index, and may be subject to greater volatility.

PHB and BKLN Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Due to anticipated Federal Reserve Board policy changes, there is a risk that interest rates will rise in the near future.

Shares are not individually redeemable and owners of the shares may acquire those shares from the Fund and tender those shares for redemption to the Fund in Creation Unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 Shares.

Invesco Distributors, Inc. is the distributor of the PowerShares Exchange-Traded Fund Trust, the PowerShares Exchange- Traded Fund Trust II, the PowerShares India Exchange-Traded Fund Trust, the PowerShares Actively Managed Exchange-Traded Fund Trust and the PowerShares Actively Managed Exchange-Traded Commodity Fund Trust.

ALPS Distributors, Inc. is the distributor of PowerShares QQQ, BLDRS Funds and PowerShares DB Funds. PowerShares QQQ and BLDRS Funds are unit investment trusts. Invesco PowerShares and Invesco Distributors, Inc. are not affiliated with ALPS Distributors, Inc

PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC. Invesco PowerShares Capital Management LLC (Invesco PowerShares) and Invesco Distributors, Inc. are indirect, wholly owned subsidiaries of Invesco Ltd.

Note: Not all products available through all firms.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Fund call 800 983 0903 or visit invescopowershares.com for prospectus/summary prospectus.

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