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Managing Active ETFs Everything You Need to Know About Guest Speaker: Darlene DeRemer (Grail Partners) K&L Gates Hosts: Boston (3/26/08) Stacy Fuller (DC),

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Presentation on theme: "Managing Active ETFs Everything You Need to Know About Guest Speaker: Darlene DeRemer (Grail Partners) K&L Gates Hosts: Boston (3/26/08) Stacy Fuller (DC),"— Presentation transcript:

1 Managing Active ETFs Everything You Need to Know About Guest Speaker: Darlene DeRemer (Grail Partners) K&L Gates Hosts: Boston (3/26/08) Stacy Fuller (DC), Francine Rosenberger (DC) and George Zornada (BO) New York (4/10/08): Stacy Fuller (DC), Beth Kramer (NY) and Francine Rosenberger (DC) San Francisco (4/15/08): Stacy Fuller (DC), Mark Perlow (SF) and Richard Phillips (SF)

2 Everything You Need to Know About Managing Active ETFs ETF Basics  2007 Growth: 42% increase to $580 billion  Key Concepts  Arbitrage mechanism  Exchange Listing  Transparency  Development  Index-based ETFs  Actively managed ETFs  Quant techniques/Large-cap securities  Transparency – changing requirements

3 Everything You Need to Know About Managing Active ETFs Overview  Background: The ETF Business  SEC’s Proposed ETF Rules  Launch Basics  ETF Distribution  Looking Ahead  Q&A

4 Everything You Need to Know About Managing Active ETFs ETF Background: ETF Growth to Outpace that of Other Product Segments  FRC projects that US ETFs will grow faster than six other mainstream investment products including mutual funds, hedge funds and 529 Plans  US ETF assets will exceed $1.5 trillion as of 2011 WITHOUT significant ETF presence in the 401(k) market or actively managed ETFs  In 2007, flows to active Domestic Equity mutual funds were -$62B, whereas domestic equity ETFs saw $46B of inflows—evidence that investor demand is already migrating to ETFs Financial Product Segment Growth Projections – 2007 to 2012E 1 Note: Mutual fund assets exclude money market funds Source: FRC Monitor, Grail Partners Research

5 Everything You Need to Know About Managing Active ETFs ETF Market Mechanics: Basic Operations Secondary Market: NYSE Arca / NASDAQ Broker/ Dealers XYZ ETF Sponsor/ Manager Market Maker (Specialist or Authorized Participant) Basket of Securities (creation/ redemption units) …in kind exchange for… ETF Shares (50k or 100k ETF shares) Broker/ Dealers Retail Investor Hedge Fund/ Institutional Investor Index XYZ Rule Set for ETF Portfolio cash ETF Shares cash ETF Shares Primary Offering of Fund Shares Fund ShareholdersSecondary Market ParticipantsETF Share Creation/ Redemption  Investors can buy and sell ETF shares with the help of broker/ dealers throughout the day  Can be shorted and bought on margin  Brokerages hold shares in Street name, like individual stocks Source: Grail Partners Market Makers facilitate ETF trading:  Create initial ETF shares and hold in inventory to allow trading to commence  Maintain trading at NAV, by increasing or decreasing liquidity on the market in equilibrium with demand  Full transparency of index-based portfolio allows market participants to exploit arbitrage opportunities when shares trade away from NAV  ETF shares are created and redeemed through in-kind trading between the fund and market makers  The ETF portfolio itself rarely needs to trade securities directly because of this in-kind exchange mechanism Financial Advisor

6 Everything You Need to Know About Managing Active ETFs Active ETFs – Why are they more attractive than mutual funds?  ETFs have advantages vs. mutual funds:  Tax efficiency: in-kind trading of fund shares allows capital gains to be realized outside of the fund, at the participant level avoiding gains distribution from the fund  Low cost: an ETF trades like an individual stock, so transfer agency and other recordkeeping costs are minimal – somewhat offset by new costs in the dealer system, and commissions  Investor protection/ enhanced return:  Exchange trading eliminates the possibility of market timing  No cash held for redemption requests – better performance through full investment  Trading costs are absorbed by transacting investor, not the fund shareholders  Portfolio flexibility: ETFs are traded as individual equities, allowing investors to short and buy on margin as they build their portfolios Source: Grail Partners

7 Everything You Need to Know About Managing Active ETFs ETF Comparative Fee Analysis  Given their passive nature and lower operating costs, ETFs generally have lower expenses as compared to both active and indexed mutual funds  However, newer ETF market entrants are pricing products above the historical market averages  ProShares funds, for example, are all priced at 95 bps for their enhanced bull and bear market index strategies 1 Mutual Funds include share classes targeted to broker/ dealer intermediaries, i.e. A-shares Some higher-fee funds are not yet included in the Simfund database, including new Rydex and ProFunds which are priced at 95 bps. Source: Simfund; Grail Partners

8 Everything You Need to Know About Managing Active ETFs Source: Bloomberg as of 3/24/08; Grail Partners Note: This table includes non-ETF exchange traded products like HOLDRS, BLDRS and ETNs. 1 ELEMENTS is a partnership between Nuveen Investments, Merrill Lynch, Swedish Export Credit Corporation and BNP Paribas 2 MacroShares ETFs were launched through a JV with Claymore in 2006; MacroShares bought out Claymore’s 50% stake in 8/07 3 SPA ETFs is an affiliate of London & Capital US ETF Assets by Sponsor

9 Everything You Need to Know About Managing Active ETFs Industry Competitors Described FirmProductPricing 1 Distribution Traditional Indexed Traditional indexing transitioned from mutual fund to ETF BGI  Wide range of traditional index offerings  170 ETFs; $306.2 B  36 bps  BGI was first to aggressively target broad retail and institutional audiences State Street  Wide range of traditional index offerings  67 ETFs; $158.0 B  19 bps  Mix of retail/ institutional Vanguard  Breadth of traditional, low-cost indexes  37 ETFs; $44.3 B  15 bps  Vanguard targets its traditional no-load investors and other brokerage clients Enhanced Indexed – Select Firms Unique indexing, in both construction and strategies/ industries covered Power- Shares 2  US and international rules-based quant ETFs  Leverage Rob Arnott fundamental indexes  100 ETFs; $30.3 B  39 bps  Mix of retail/ institutional  Leverages AIM wholesaler coverage given IVZ ownership ProFunds  Unique exposure (shorting, double exposure) to range of US equity indexes  58 ETFs; $15.6 B  95 bps  ProShares has launched ETFs with an established base of clients (RIAs) in its mutual fund offerings Rydex  Offering similar to that of ProShares  31 ETFs; $6.1 B  39 bps  Rydex has launched ETFs with an established base of clients (RIAs) in its mutual fund offerings Wisdom-Tree  US and international equity ETFs weighted by fundamental metrics: div. income, rev.  40 ETFs; $4.3 B  51 bps  Targets a mix of retail/ institutional investors XShares  Custom indexes focused on sector “verticals”; third party indexes  31 ETFs; $0.2 B  69 bps  Sales force targets retail and institutional investors  Proprietary and partnership ETFs 1 Reflects AUM-weighted average of all ETFs offered by the company 2 Nasdaq transferred its QQQQ fund and 4 BLDRS to PowerShares 3/07, reducing PowerShares’ average pricing Source: Bloomberg, Grail Partners Research as of 3/24/08

10 Everything You Need to Know About Managing Active ETFs Rule 6c-11  “exchange-traded fund” - a registered open-end fund that either (1) discloses the identities and weights of its portfolio securities; or, (2) (a) seeks returns that correspond to an index, and (b) the index provider discloses the identities and weights of its securities  shares listed/traded on exchange  marketed as ETF with limited redeemability  transacts in creation unit aggregations (CUAs)  exchange regularly disseminates per share value of CUAs  has website with price info: NAV, market and any premium/discount

11 Everything You Need to Know About Managing Active ETFs Disclosure Amendments  Section 24(d)  Product Descriptions  Not used  Summary prospectus  Rescission of Past Exemptions  Form N-1A: Tailor for retail investors  Replace disclosure re how to transact, and cost of transacting, in CUAs with same re transactions on exchange  Require disclosure of ETF’s total return based on NAV and market price  Require discount disclosure on web, in pro and annual report

12 Everything You Need to Know About Managing Active ETFs Liberalization of Orders  Sampling  Affiliated index-based ETFs  Section 48(a)  Asset basket requirements

13 Everything You Need to Know About Managing Active ETFs Rule 12d1-4  Investments by registered and private funds  4 Conditions  Limitation on control of underlying fund by investing fund  ETF is not a “fund of funds”  Fees comply with NASD Conduct Rule 2830  No redemptions by investing fund with more than 3% of ETF  Compare traditional funds of funds  Investments by registered funds only  12 Conditions

14 Everything You Need to Know About Managing Active ETFs Conditions for Traditional Funds of Funds  Limitation on control of underlying fund by investing fund  Underlying fund is not a “fund of funds”  Fees comply with NASD Conduct Rule 2830  Waiver by investing fund of certain fees based on other fees received from underlying fund  Limitation on investing fund’s influence over underlying fund  Limitation on investments by underlying fund in underwritings involving affiliate of investing fund (“affiliated underwriting”)  Finding by underlying fund board re any investment by underlying fund in affiliated underwriting  Finding by underlying fund board that any payments to investing fund were reasonable for services received in return  Finding by investing fund board that consideration received by investing fund from underlying fund did not influence investment  Finding by investing fund board that no duplicative advisory fees  Requirement of Participation Agreement (to provide notice of conditions involving board findings)

15 Everything You Need to Know About Managing Active ETFs Launch Basics  Choose Asset Class  ETN / Grantor Trust – Corp Fin  ETF – IM  Exemptive Application  Rule 6c-11  Market Maker / Specialist  Prepare Timeline: Precedented v. Novel Relief  Register Product  ETN / Grantor Trust – S-1 and 8-A  ETF – N-8A, N-1A and 8-A  Prospectus / PD v. Disclosure Amendments & Summary Prospectus  Approach T&M / Exchange  No action relief  Listing

16 Everything You Need to Know About Managing Active ETFs Seed Capital: Tempering the Pace of Proliferation  To support the secondary market, launching an ETF requires a minimum market inventory be established to facilitate trading and market liquidity  Exchanges typically require at least two ETF “creation units” be issued (generally 200,000 shares) prior to fund launch. If a fund’s NAV starts at $25, this equals $5 million in AUM  This initial seed capital is typically provided by market specialists—often using borrowed securities in their effort to support a product that will yield secondary trading activity  But for those market makers, seeding ETFs is becoming a much less attractive proposition  The drag or costs of providing seed capital are real:  Cost of borrowing (up to 200 bps or more) to fund and hedge  ETF expense ratio (~50 bps and higher); ETF fees are increasing as more niche and quasi-active ETFs are launched  The proposition of acting as an ETF specialist itself has become less attractive:  Spreads in ETF trading have tightened  Given the merger of NYSE and AmEx, electronic trading will become the dominant method for ETF specialists, in turn diffusing the share of volume that the specialist can capture  Therefore, the lack of seed capital in the ETF market is expected to be a major industry “choke point” and inhibitor of product proliferation, particularly among smaller ETF sponsors Source: Grail Partners

17 Everything You Need to Know About Managing Active ETFs ETF Distribution  Distribution  Specialists  Other institutional investors  Rule 12b-1 Plans  IPOs  Rule 12d1-4 Funds

18 Everything You Need to Know About Managing Active ETFs Distribution: Mutual Funds vs. ETFs Growth Areas Mutual Funds - 2007 Fee-Based Intermediaries 30% Proprietary Sales Force 5% Direct to Investor 10% Fund Supermarkets 10% Retirement Plans 25% Transaction Based Brokers 20% ETFs - Anecdotal  Institutional investors (hedge funds, portfolio managers) play a larger proportional role in ETFs than is typical in mutual funds  ETFs’ offer of sector exposure and cash equitization are contributors  However, retail sources (RIAs, brokers, wealth advisors) have become a more significant force in ETF distribution in recent years  Fee-based programs help make advisors indifferent to product packages, and ETFs are benefiting from this phenomenon  Tracking sales by source in ETFs is more difficult than in mutual funds Source: FRC, Grail Partners Research

19 Everything You Need to Know About Managing Active ETFs Looking Ahead  Trends  Next-generation ETFs  Semi-transparent ETFs  Tracking Baskets  Value Transparency  Black Box  “‘Is it critical that arbitrage be tight and strong?’ We think that’s an important question that the Commission will need to consider going forward as we face applications for non- transparent ETFs.”  Timing


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