ETFs: Past, Present, and Future

Bradley Kay
Associate Director, European ETF Research
Conference ID: 60202943
Ben Johnson UK Free Call: 0808 238 0673
ETF Strategist, European ETF Research UK Int’l Call: +44 1452 569 335

© 2010, Morningstar, Inc. All rights reserved.

<#>
 Overview

× A Very Brief History

× The ETF Marketplace Today

× What Is An ETF?

× What Advantages Do ETFs Offer?

× Trends For The Future

2
 Whence We Came: ETF Market Evolution

3
 A Very Brief History
× 1990 – The SEC issued the Investment Company Act Release No. 17809. This would ultimately facilitate
the creation of mutual funds that were able to create and redeem shares intraday.

× 1993 – SPDRs S&P 500 begins trading on the AMEX in January.

× 1999 – The Tracker Fund of Hong Kong (TraHK) was launched in November, becoming the first ETF in
Asia.

× 2000 – In April, the European Exchange Traded Fund Company launched a pair of listed diversified return
securities (LDRS) on the Deutsche Borse. The funds, which tracked the EURO STOXX 50 and STOXX 50
indices were co-managed by Merrill Lynch. Later in the same month, iShares launched the first ETF in the
UK, the iFTSE 100.

× 2003 – In February the first ETF on a fixed-income index in Europe was launched. The ETF eb.rexx
Government Germany was issued by Indexchange and tracked the Eurex Bonds Government Germany
index (eb.rexx).

× 2003 – ETF Securities launches the world’s first exchange-traded commodity Gold Bullion Securities in
Australia and London.

4
 European ETF Asset Growth by Broad Asset Category

£175

£150

£125
ETF Assets (GBP Billion)

£100

£75

£50

£25

£0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Jan-10

Equity Assets Fixed Income Assets Commodity Assets

Source: Blackrock, Bloomberg

5
 Where We Are Now

6
 Proliferation of Asset Classes

Category/Asset Class # of ETFs Total Net Assets As a % of Total Industry Assets

Europe Equity 424 60,526,666,986 42.47

International Equity 243 32,723,777,179 22.96
Fixed Income 153 30,582,153,845 21.46
Traditional Asset Classes 820 £123,832,598,010 84.68

Commodity 291 16,982,675,211 11.92

Other 18 1,476,473,085 1.04
Currency 22 208,379,461 0.15
European ETF Industry Total 1151 £142,500,125,766 100.00

Morningstar Data as of Feb. 2010

7
 Proliferation of Asset Classes
× Inthe beginning, ETFs only offered broad index and equity sector
exposure

× Now, ETFs offer access to nearly every asset category imaginable

× Fixed Income
× Fundamental Indexes
× Commodities
× Currencies
× Leveraged Equity
× Hedge Fund Strategies
× Niche Sector Slicing

8
 What Is An ETF?
× An umbrella term, covering a broad array of legal structures with a
proliferation of abbreviations
× ETFs × ETNs
× ETCs × ETPs

× Defining attributes
× Tracks a specific index or a strictly-defined portfolio of securities
× Almost exclusively passive investments
× Traded on a stock exchange
× A retail investment vehicle by nature
× Short-term arbitrage opportunity via daily or weekly share
creations/redemptions

9
 What Is An ETF?
× Typically UCITS III compliant
× Diversified portfolios of securities: stocks, bonds, derivatives

× Physical-replication ETFs
× Match their index by holding the actual securities in a unique
trust
× Full or Sampled replication

× Synthetic-replication (or swap-based) ETFs

× Obtain their index exposure through OTC swap contracts
× Hold securities in their own trust and/or have collateral pledged
to mitigate counterparty risk

10
 What Is An ETC?

× Formerly “Exchange-Traded Commodity”, now also currency funds

× Typically does not meet diversification standards for UCITS III

× Single commodity funds
× Single currency funds

× Debt instruments issued by Special Purpose Vehicles (SPVs)

× Degree of counterparty risk varies widely

× European Union Prospectus Directive allows broad distribution

11
 What Is An ETC?
× Physically-backed
× Only precious metals
× Virtually zero counterparty risk

× Synthetic-replication
× SPV sometimes keeps the ETC’s capital, but usually given to total
return swap (TRS) counterparty
× Collateral may be allocated through a third-party custodian or
simply pledged by the TRS counterparty
× Acceptable securities for collateral can vary widely from provider
to provider
× Read Those Prospectuses!

12
 What Is An ETN?
× Exchange-Traded Note

× Debt instrument issued by a backing bank

× Senior, unsecured debt of that bank
× Substantial counterparty risk!

× Nota very popular vehicle in Europe, with only two issuers

× Lyxor pledges collateral for their ETNs
× Barclays Capital issues uncollateralized ETNs

× Much more popular in the U.S., where they have substantial tax
advantages for futures-dependent indices such as commodities

13
 Innovation, You Say?

14
 What’s So Great About ETFs?

× Incredibly low costs

× Intra-day liquidity and real-time trading

× Access to new asset classes and strategies

ETFs bring the institutional to the individual

15
 Low Costs
× Passive investments
× No expensive analysts
× Typically low turnover

× Numerous back-office and mid-office efficiencies for providers

× Only need to issue and redeem shares with a limited number of
market makers
× Shifts portfolio trading costs to ultra-efficient market makers or
swap counterparties

× Custodial costs have economies of scale due to cross-listings and

broad distribution pulling in assets from across Europe

16
 Intra-Day Liquidity and Real-Time Trading
× Real-time execution means that you know the price you are paying

× Canprovide more liquid exposure to illiquid asset classes

× When corporate bond markets froze in 2008/2009, credit bond
ETFs kept trading

× Market makers arbitrage away premiums and discounts, keeping

prices close to fair value

× Warning: This shifts the onus of ensuring fair execution onto the final
buyer rather than the provider
× Liquidity differs from fund to fund

17
 Access to New Asset Classes & Strategies

× Funds for in-house use with sophisticated clients are now easily
offered to retail investors as well
× Physical precious metals
× Asset allocation strategies
× “Alternative betas”

× ETFsserve as a wrapper for futures contracts that would otherwise

have too high of a minimum size for retail investors

18
 Where Do We Go From Here

19
 Expansion of the Retail Market

× Everyone in the industry is waiting for the retail market to appear, but
it will be harder than expected

× Four major preconditions to a robust retail ETF market in Europe

× Increased retail investor demand
× Greater trading volume / visible liquidity
× Greater transparency
× Simple cross-border transactions within EU

20
 Expansion of the Retail Market: Investor Demand

× Need to make the case to individual investors for low cost and
passive investment
× Who will be the UK’s Jack Bogle?

×A critical mass of advisers and other financial professionals looking for

low cost vehicles
× Organic movement toward fee-based financial advice took
decades in the US
× Regulatory pushes in Europe may accelerate the process
(UK’s Retail Distribution Review)

21
 Expansion of the Retail Market: Greater Trading Volume

× OTC trading volume does not do much for retail investors

× Need to recruit a new sort of institutional investor, as heavy exchange

traders and retail investors have a natural symbiosis in ETFs
× Make shorting ETFs easier
× Movement toward ETFs as cheaper, easier, and more flexible
than other forms of beta exposure (futures, swaps, etc.)

× Moving trade volume onto the exchanges is a self-perpetuating

process once it starts, as greater liquidity makes larger on-exchange
trades easier, which in turn generates more liquidity

22
 Expansion of the Retail Market: Greater Transparency
× Apply MiFID to exchange-traded funds
× Reveal all liquidity to all market participants
× Help retail investors feel comfortable that the playing field is level

× Retail investors want to know what they are holding

× Full portfolios published frequently and with little delay

× Synthetic replication ETF providers will have to win not just on cost
and on tracking, but also have to match the openness
× Make collateral rules easier to find
× Disclose collateral portfolios as well as index portfolios
× This information is already available to institutional investors

23
 Expansion of the Retail Market: Cross-Border Transactions

× Liquidity makes ETFs a winner-takes-all competition

× Institutions will trade across borders for the best execution
× Retail investors need to be able to do the same
× This trend is already coming to fruition, as several retail
brokerages offer fairly inexpensive trading throughout the EU

24
 Consolidation in the European ETF Marketplace

× This winner-takes-all competition for liquidity will drive consolidation

in the ETF marketplace
× One or two “winners” will take the vast bulk of assets and
trading volume for any given index to track
× Despite having lower assets and not much growth, many smaller
funds will remain alive on assets from in-house customers

× Off-exchange distribution channels can not drive this consolidation

× Liquidity and low trading costs are the draw of the top funds, and
they do not carry over to off-exchange distribution

25
 Product Innovation Will Continue

× New entrants in a more mature market can only compete on low

costs or product innovation

× Plenty of new areas ripe for expansion

× Fundamentally-weighted indices
× Screened indices
× Active ETFs
× Funds of hedge funds
× “Alternative beta”

26
27