Presentation on theme: "NAVIGATING THE ETF LANDSCAPE"— Presentation transcript:
1 NAVIGATING THE ETF LANDSCAPE FOR FINANCIAL PROFESSIONAL USE ONLY – NOT FOR PUBLIC DISTRIBUTIONDraft1
2 The exchange traded landscape CurrencyCommodityFixed IncomeInt’l/Global EquityDomestic EquityLet's talk about growth in terms of assets. We've seen assets increase to 789 billion. We're looking at a compounded 5-year annual growth rate of about 20 percent per year. In 2000 alone, ETFs took in $150 billion in net new cash. Now, this is an important statistic in the context of mutual funds, because ETFs still represent just about 10 percent of all combined assets with exchange-traded funds and mutual funds. What's really notable, though, is over the trailing 12-month period, ended in 2009, 25 percent of all net new cash flows have gone into exchange-traded funds, so we've certainly seen significant uptake in terms of investor interest.The second trend related to growth is related to volume. Volume is increased dramatically, as well. Currently over 25% of all equity trades on U.S. exchanges are comprised of exchange-traded funds. Something that's not as well known is that 5 out of the 10 most liquid stocks on U.S. exchanges are actually exchange-traded funds. So, to us this is really showing that we've seen an increase in interest of using exchange-traded funds as a vehicle of choice for equity, as well as other exposure to other asset classes.Now what the slide is showing you here, is perhaps the most encouraging trend that we've seen, and that is the increase in breadth of products and markets that ETFs offer exposure to. If you go back to the end of last decade, there were only about 32 exchange-traded funds, and these offered exposure to pretty straight forward asset classes, mostly in the U.S. equity market, large cap, some sectors, growth and value, and then some select individual countries.The exchange traded marketplace will look significantly different in five years.Source: BlackRock, as of 12/31/09.*Does not include Target Date and Alternative funds. There are a total of 912 Exchange Traded Products (ETPs) as of 12/31/09.
3 Key criteria for selecting the right ETF Know what you ownTotal costs matterLiquidityStructureProviderRead slide.
4 What you should know about indexes Market coverage offeredDefinition of value/growth, small cap, mid cap and large capIndex transparency“Resets” after adds and deletesModularity of index families and degree of constituent overlapRebalance frequencyBy understanding the differences in index methodology you can understand why index returns vary……and this creates opportunities. Let’s use the small cap indexes, S&P 600 and Russell 2000 during 1997 and During those periods, the S&P index may have an advantage. Remember what drove markets in 1999? The construction methodology differences between Russell and S&P meant that Russell had a larger weighting toward technology. Did you think that tech was overblown in 1999 or early 2000? If so, you may have decided that shifting to a lower tech weighting would be good. If you had anticipated that S&P would have had a lower tech weighting then, you might have also anticipated that it would have performed better in that year. Again, understanding the indexes means being better prepared and possibly seeing opportunities - or at least avoiding swings which is also valuable.Do the characteristics of the index align with client objectives?
5 Indexes represent the market Annual Return (%)200420052006200720082009Let’s take a look at the most widely followed market segment, US large cap. Representing about 90% of the total US, as the large caps go so can the overall market. There are two primary indexes representing this market, the S&P 500 and the Russell 1000.This chart shows the annual return differences for the Russell 1000 index and the S&P 500 index during 2004, 2005, 2006, 2007 and The differences are calculated as the return of the Russell index during that year less the return of the corresponding S&P index during the same year. Positive returns mean that the Russell 1000 index outperformed the S&P 500 index during each of these years. If you were an investor, and you had a choice of which index you would invest in, you would have preferred to have invested in the Russell index. Why? You would have received higher total performance than if you had invested in the S&P index. If you were an investment manager, on the other hand, you would have preferred to be measured against the S&P Why? Because it would have been easier for you to outperform the (lower returning) S&P500 than to outperform the (better performing) Russell As you can see, there are return differences between the Russell 1000 and S&P500, but we don’t have to stop there.Animate:How about growth and value? The differences become much larger.So which one is right? (animation of answer) Both.Note that on December 16, 2005, S&P transitioned their official style index series from the S&P/Barra to the S&P/Citigroup methodology. The data in this slide represents the index series that was “official” during the years shown (the S&P/Barra index series).Russell minus S&P 500®Russell 1000 Growth minus S&P 500 GrowthRussell 1000 Value minus S&P 500 ValueWhich one is right?Both.Sources: BlackRock, Russell, S&P, as of 12/31/09.Index returns are for illustrative purposes only and do not represent actual iShares ETF performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares ETF performance, please visit or request a prospectus by calling iShares ( ).
6 Style index comparison: Value, growth and core Russell 1000 Two factors: P/B and forecasted earnings growthP/E: 17.0679P/E: 19.6623ValueGrowthS&P 500®/Citigroup Three Growth factors Three Value factorsP/E: 16.7P/E: 20.4347306ValueP/E: 14.2Our next slide really just goes through the implications of differences in methodologies, and what we did was we looked at three different index providers--Russell, S&P, and Morningstar, and looked at the way in which they define growth and value, and looked at the ramifications of the underlying indexes from both the holdings perspective, as well as a fundamental perspective. Now Russell defines growth and value using two factors--really just price the book, and forecasted earnings growth--and from that, Russell puts stocks into one of really three categories--growth, value, or a little bit of both. And for the stocks that are a little bit of both, they are broken up proportionately, depending on their degree of growthy-ness and value-ness, in one index or the other. Say IBM, for example, could be allocated 70 percent in gross, and 30 percent in value. So, additively, they equal the parent index, a broader index, but certainly they can be counted as both in the middle, and that's what the dark green bar is--is showing.S&P uses a very similar approach, but uses 6 factors, 3 for growth, and 3 for value, so arguably a little bit more sophisticated in terms of more inputs being used to define growth and to define value; but similarly, stocks are put in either growth, value, or proportionately, a little bit of growth and a little bit of value.Morningstar, on the other hand, actually puts stocks into one of three mutually exclusive buckets: growth, value, or what they call core, which I think is not the most appropriately named, because core really means neither growth nor value. Really, what we're trying to show here is not to be exhaustive in terms of discussing style index methodology, but rather to show the ramifications of different methodologies.Take large-cap growth, for example. S&P’s large-cap growth index contains 306 stocks, and has a PE ratio of Morningstar large-cap growth has 89 stocks, but a PE of That multiple difference in PE is really significant. So, for investors that are looking for, you know, say on the value side, stocks with very low PEs, they may gravitate a little bit more towards Morningstar's methodology, if they're really trying to take more of a tactical bet. For those that are trying to use ETFs in terms of holistic building blocks, and are looking for, you now, more simplistic, or straight forward way of defining growth and value, Russell may resonate more with them. Bottom line is the different methodologies result in different characteristics of the underlying indices, which can be looked at very similarly to the way that individuals look at a PE ratio for individual stocks, as well.Morningstar Large Cap Five Growth factors Five Value factorsP/E: 14.8747889P/E: 23.6ValueCoreGrowthSources: BlackRock, FactSet, as of 12/09.
7 Mid cap index comparison: Distribution of market capitalization Russell Midcap 800 smallest companies in Russell 1000 Index$74.6M$15.5B$3.2BS&P MidCap 400 Names picked by committee$258.6M$8.3B$2.1BMedian market capMorningstar Mid Cap 70th to 90th percentile of US market capNow the next slide goes through three index providers in their exposure in the mid-cap market segment--Russell, S&P, and Morningstar--so just straight forward mid-cap exposure, mid-cap blend (or “core” in the case of Morningstar). And this slide is just to drive home again that three index providers designed to cover seemingly the same market segment can differ pretty significantly. So, the stats we want to draw you to are the numbers underneath the arrow. The median market cap for S&P is 2.1 billion, whereas for Morningstar, it's actually as high as 3.6 billion. We also show the size of the bar chart, which is showing the range--the smallest market cap, and then the largest on the right. As you can see, the market coverage is very different--Russell holding 800 companies, or the 800 smallest companies in the broader Russell 1000 index--has a much broader range of market cap exposure, whereas the S&P mid-cap 400 is much narrower and much more targeted. So, again, just to show that very different methodologies can result in very different exposure, and there are a lot of choices out there.Now, one of the topics that's getting a lot of attention over the last few years, is alternatively weighted indexes, and alternatively weighted exchange-traded funds based upon those indexes…$486.0M$10.1B$3.6BSource: BlackRock investment analysis, as of 12/09.
8 Alternative weighting schemes Fundamental-weighted: Stocks are ranked and weighted by fundamental measuresEqual-weighted: All stocks receive the same weightingKey considerationsTurnoverTransaction costsUnintended bias within the indexTransparencyRead slide.
9 Dimensions of total cost Explicit costsExpense ratioCommissionImplicit costsTrading spreadsRebalancingTracking errorExpense ratios are only one part of the cost picture. Total cost is way to think about the underlying costs of an ETF position, including explicit costs – like the expense ratio and commissions – and implicit costs – such as the cost of establishing the position, the cost of maintaining it during rebalancing, and impact of any tracking error.Most investors understand explicit costs, however few look at implicit costs when evaluating ETFs, especially when presented with two ETFs that - on the surface – appear similar, but have different expense ratios. While explicit costs are the easiest to explain to clients, implicit costs can frequently be more significant in the total cost equationThe expense ratio is the most frequently looked at measurement of “cost” for ETFsAll investors incur trading costs when purchasing an EXCHANGE TRADED fundRebalancing costs are important for those investors who rebalance their portfolios at some interval be it quarterly or annuallyTracking error refers to the under/over performance of an ETF after accounting for expense ratio. Differences in the fund’s underlying composition and management style as well as the skill and experience of the fund management team can both contribute to differences in tracking error between two similar products.
10 Total cost COMPARISON Explicit Costs Implicit Costs Total Cost ETF 1 Expense Ratio0.20%0.13%Commission0.01%Trading Costs0.03%0.16%Rebalancing0.01%0.03%Tracking Error0.51%0.58%0.76%0.91%Taking a look at this example, we can see how two ETFs with expense ratios of 20 basis points and 10 basis points compare when they are evaluated from a total cost perspective. Trading costs are one-way costs and include estimated average spread and market impact costs over a 3 month period. Tracking error is a one-year annualized estimate.Source: BlackRock.Trading costs are defined as one-way costs that include estimated average spread and market impact costs, as of 12/31/09. Tracking error is a one-year annualized estimate ending 12/31/09.
11 Total cost Full replication Optimization BENCHMARK TRACKING Fund holds all index names at benchmark weightOptimizationFund holds a representative sample of index namesRead SlideWe employ two different strategies for managing index funds: Full Replication and OptimizationFully replicating funds hold all index securities at benchmark weight. Tracking error is substantially reduced.Optimized funds hold a representative sample of the index securities. The sample approximates the index industry weights, as well as risk and style characteristics.Reasons for OptimizationIRS and SEC diversification requirementsLower turnover – lower transaction costsTax efficiencyLiquidity constraintsMarket access
12 iShares ETF liquidity offers price improvement iShares MSCI Emerging Markets (EEM)iShares Russell 2000 (IWM)Current bid/ask spread in underlying = 7.5 cents.Current bid/ask spread in underlying = 6.0 cents.Evidence of this improved liquidity is clear when looking at 2 products whose underlying securities would, at first glance, appear illiquidAs the emerging market iShares fund has grown, spreads in the ETF have tightened well below the cost to trade the underlying securitiesIWM presents a similar paradigm where the ETF trades at a spread well inside the cost to transact in the underlying stocks2) This pricing efficiency can be significant in ETFs that afford investors access to markets they would otherwise have difficulty securing, or where the costs would simply be prohibitive vs. the potential returnsEEM VolumeIWM VolumeETF Spread ($)ETF Spread ($)Sources: NYSE Arca, Bloomberg, as of 12/31/09.
13 Product structure 1940 Act 1933 Act Open-End FundUnit Investment TrustGrantor TrustExchangeTraded NotesLimited PartnershipInnovations in product structure have allowed exchange traded products (ETPs) to expand beyond the traditional, open-end fund structure associated with ETFs. Each structure has unique exposure, risk, and tax implications. These nuances may make some structures – and products – more appropriate for some investors than others.There are currently 5 main structures of funds.Unit Investment Trust (UIT). Of all the ETFs currently trading, only 4 of them are structured as UIT. These are the SPY, DIA, QQQQ and MDY.Open-End 40 Act Fund - Vast majority of ETFs are structured as open end investment companies and operate under the 40 act regulations.Rules of diversification make it challenging to manage a concentrated portfolio – such as a commodity fund like goldGrantor Trust – a trust for which someone other than the trust bears some or all of the income tax liability.Exchange Traded Notes – medium term notes that are uncollateralized debt securities - linked to the performance of a specified index.Limited Partnerships – Tax reporting requires a K-1.What is the principal source of risk?What is the potential for tracking error?What are the tax implications of the structure?
14 Attributes of ETFs and ETNs ExchangeTraded FundsExchangeTraded NotesLiquidityDaily on exchangeRegistrationInvestment Company Act of 19401Securities Act of 1933RecoursePortfolio of securitiesIssuer creditPrincipal RiskMarket riskMarket and issuer riskInstitutional-Size RedemptionDaily via custodianDaily to the issuerShort SalesYes, on an uptick or a downtickMain differences are (1) the recourse (more to come on this in next slide on creation process) and (2) principal risk.1 ETFs may be structured as 1933 Act Grantor Trusts.Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. There may be significant differences between the investments that are not discussed here.
15 Evaluating a provider Size and scale History Expertise Commitment to the industryResourcesAs with any investment you are evaluating for your clients portfolio, it is important to understand the firm providing the exposure. This would include understanding their history, reputation and commitment to the industry. How easy is it to access not only the information you require on their funds but also to reach their people. Lastly, are they dedicated to supporting the business of the financial intermediary or do they compete with the advisor? Do they have the size and scale to support product transparency and improved liquidity?
16 iShares.com: Essential resources for financial professionals iShares.com: Essential resources for financial professionalsLive and on-demand e-learningClient materialsResearch – white papersFund dataPortfolio construction toolsTrading strategy reportRead slide.
17 iShares resources Index Comparison Tool Compare how over 170 indexes differ by market capitalization, return, risk, holdings, sector and correlationOne of the resources offered on iShares.com is the Index Comparison Tool. This tool can be used to compare how over 130 indexes differ by market capitalization, return, risk, holdings, sector and correlation.Sample screenshots from the iShares.com website are for illustrative purposes only.
18 Carefully consider the iShares Funds’ investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which may be obtained by calling iShares ( ) or by visiting Read the prospectuses carefully before investing.Investing involves risk, including possible loss of principal.
19 The information provided is not intended to be a complete analysis of every material fact respecting any strategy and has been presented for educational purposes only.Asset allocation models and diversification do not promise any level of performance or guarantee against loss of principal.Shares of iShares Funds are bought and sold at market price (not NAV) and are not individually redeemed from the Fund.Mutual funds and iShares Funds are obliged to distribute portfolio gains to shareholders by year-end. These gains may be generated due to index rebalancing or to meet diversification requirements. Trading shares of the iShares Funds will also generate tax consequences and transaction expenses. Certain traditional mutual funds can be tax efficient as well.When comparing stocks or bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds. The annual management fees of iShares Funds may be substantially less than those of most mutual funds. Buying and selling shares of iShares Funds will result in brokerage commissions, but the savings from lower annual fees can help offset these costs.Neither BlackRock Institutional Trust Company, N.A., and its affiliates nor SEI and its affiliates provide tax advice. Please note that (i) any discussion of US tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.