The Rise of Active Indexing – How Etfs Have Disrupted Investing, Trading and Asset Management

The Rise of Active Indexing – How ETFs Have Disrupted Investing, Trading and Asset Management

Joanne M Hill, Ph.D. CBOE Vest, Chief Advisor for Research and Strategy Chair, Research Committee, CFA Institute Research Foundation

CFA Institute 71st Annual Conference, May 2018 CFA Society, Dayton, December 11, 2018

16-04074, 2016-5725 Agenda

The Rise of Active Indexing – How ETFs Have Disrupted Investing, Trading and Asset Management

A. Fit of ETFs into the Evolution of Investment Strategies and Markets in the 21st Century B. ETF Mechanics, Features and Why They Appeal to Investors C. The ETF Landscape in 2018 -Assets, Flows, Trading, and ETF Managers D. The New Active – Factor (Smart Beta) Strategies in ETFs. E. Takeaways and A Forward Look at the ETF Industry

Content of this presentation is for CFA members and financial professional use only and not for further distribution without permission. It solely reflects the views of the author and can be quoted with permission. Contact information [email protected]. Many thanks to Elisabeth Kashner of FactSet, Victor Lin of Credit Suisse, Ben Johnson and Jackie Choy of Morningstar, and Eric Balchunas of Bloomberg for their insights and data assistance. 2 ETFs in Context: Historical Evolution of Index Strategies and Products

Early 1970’s Mid-to-Late 1970’s 1980’s 1990- 2000’s

Factor- Based Transaction Costs Strategies Investment Management Sensitivity Synthetic Index Funds Alpha/Beta Quantitative Equity Separation Individual Management Tactical Asset Stock Index Funds Allocation Absolute Selection Global Asset Return Allocation Portfolio Risk Parity and Insurance Risk Target Risk Management Downside Risk Equity Trading Tools Strategies ETFs

Portfolio Index Futures International Restructuring Futures Block Growth Index Options Trading Accelerates OTC Options/ Stock Options Basket Trading Structured Notes

Equity Swaps

For illustrative purposes only. 3 Breaking Out of Asset Allocation Buckets and the Active-Passive Divide After two deep bear equity markets in the last two decades the seeds of change came to investing and trading.

OUT: Discretionary active, hedge funds, OTC Index & ETF products Investing Grows IN: Transparent index strategies, lower fees, ETFs, quantitative investment approaches Rules-based active strategies become available, Risk Factors – Key especially in ETFs. Active management shifts Part of Process toward a more top-down focus on risk factors and investment themes.

Multi-Asset Class Expanded role for multi-asset class, inverse, and Tactical and variable equity risk strategies with tactical opportunities and changes in market risk.

ETFs have thrived in periods where investors have responded to the need for managing index exposure dynamically. In asset classes like fixed income and commodities, ETFs have transformed the way investors access exposure. 4 Greater Focus on Top-Down Investment Strategies Investment decision-making is changing: Active management used to mean stock or bond portfolio selection. Now there is more attention to top-down and risk factor-based investing.

The Old

Top-Down (macro) Top-Down (macro)

Bottom-Up Risk Bottom-Up Factor (micro) The New (micro)

The New

More focus on: • total portfolio and downside risk management • contributions to return vs. risk. 5 ETFs as a Disruptive Innovation The success of ETFs is related to the application of technology to investment management as well as to how investors access to investment products. ETFs are central to the application of technology to market microstructure, strategy and portfolio construction, and access to investment products. Multi- dimensional . Impact Trading & Exchanges Investment Distribution Investment Management Pensions High Net and Large Worth and Asset Family Owners Office Security Portfolio Research & Screening Construction

Insurance Retail

For financial professional use only. Not for public distribution. 6 ETFs appeal to broad categories of investors & across a range of investment horizons

Range of Horizons

Days/ Months Year Multi-Year Weeks

Broad Categories of Investors

Hedge Asset Asset Financial Funds & Individual Managers Owners Advisors Traders

ETFs uniquely have attracted investors across all channels of . investing – most democratic and transparent form of investment product. For financial professional use only. Not for public distribution. 7 ETFs are valued differently by different investors

Smart Beta and Risk Risk Factor Management Exposure Tactical Views- Trading Features Core Asset Class Exposure

Hedge Financial Asset Asset Individual Funds & Owners Advisors Traders Managers

Liquidity Management & Rebalancing For financial professional use only. Not for public distribution. 8 B. ETF Mechanics, Features and Why They Appeal to Investors

9 Basics of Exchange-Traded Funds – Combine features of stocks and fund products

Exchange-traded single shares that represent ownership in an underlying index, portfolio of securities, or bank note linked to the payoff of an index. ETF sponsor or manager lists fund on an exchange the same way a company would list its stock.

• Exchanges –Intra-day ETFs trade real-time, can be margined, lent and shorted like stocks. Dollar volume traded in ETFs is much larger than Shares flows seen by fund managers. • Market makers engage in arbitrage to keep ETF prices in line with fund holdings during the trading day. Many of the largest ETFs have Index/ continuous buyers and sellers and tight spreads. Fund • Fund managers see assets grow or fall daily based on net demand or supply by the end of the trading day. Shares creation and redemptions occur at the closing prices of the underlying securities through an authorized dealer (participant) – do not know end investor as in a typical fund product.

• Cost - fund management fee that is withheld from dividends or reduces fund value along with any commissions paid to purchase and sell ETF shares.

10 The ETF Food Chain § Investors large and small access ETF strategies through brokers and exchanges. § ETF managers license benchmarks from index providers and contract for custodian and distribution services. § Portfolio holdings are transparent and updated daily by ETF managers. § Authorized participants invest or divest in the ETF at the end of the trading day through the creation and redemption process at the closing prices of holdings. § ETF exchange trading provides intra-day price discovery, facilitated by market- makers and other off-exchange liquidity providers such as high frequency trading firms.

Index ETF Investors: Authorized Provider • Asset Owners Participant • Asset/Fund Managers • Hedge Funds Brokers / • Insurance Companies Exchanges Investment ETF Manager/ • Investment/Financial Banks Sponsor Advisors ETF • ETF Managers Distributor • Robo-Advisors • Self-Directed Investors Lead and other Market Makers. Custodian

For illustrative purposes only. 11 ETFs Asset Growth Driven by Share Issuance and Redemption - A fraction of daily trading activity

• ETF Issuance (Creation) and Redemption occurs at the closing value of underlying securities at the end of each trading day as Authorized Participants create or redeem ETFs with the ETF manager. • Shares created or redeemed reflect the expected net imbalance at the end of trading day by ETF liquidity providers, based on intra-day ETF trading.

ETF Creation and Trading Process

Primary Market ETF Manager/Sponsor

Cash or Price Based on Value of Securities Underlying Securities ETF Shares Market Maker/Authorized Participant Secondary Market ETF Market Price

Buyer Exchange Seller

For illustrative purposes only. Investors trading through brokers.

For financial professional use only. Not for public distribution. 12 Trading and Price Discovery

ETF are accessed like stocks - Facilitate use as tactical tools; but also means investors must understand how to trade effectively.

• Traditional Fund Products - Provide valuation and accept flows once a day or at longer intervals. - Trading costs of portfolio management (commission and market impact of managing fund inflows and outflows) are allocated to all current investors. - No visibility of intraday volatility, buying and selling pressure from flow or holdings except for once a quarter.

• Capital markets staff at ETF sponsors and ETF specialists at brokerage firms can assist in developing trading strategies. - Assist in setting up contacts with ETF liquidity providers and sharing information on trading costs and strategies based on ETF liquidity features.

• ETFs Trading Costs – Length of holding period is key to how important trading costs are in performance assessment. - Commission - ETF Bid/ask spread - driven by bid/ask spread of underlying securities, ease of arbitrage, market volatility - Varies by asset class - Ease of hedging and arbitrage with underlying securities; bid/ask spread of underlying securities is . the outer bound but many ETFs with regular two-way flow have tighter bid/ask spreads.

For financial professional use only. Not for public distribution. 13 Why the appeal of ETFs?

Benefit Features Access, Liquidity, On exchange via brokerage account - Can be bought, sold, & & Price Discovery shorted like a stock, so simple to initiate and manage exposure over time. Creation/redemption process keeps prices in line with underlying holdings. NAV vs. ETF price available through trading day. Capital commitment from broker/dealers adds to product viability and breadth of offerings. Lower Cost > Low cost comes from index structure. Management fee and Performance turnover is lower than most fund products. Lower embedded sales Advantage fees. Visibility of strategies and fees fosters competition. Do need to pay commissions to brokers and exchanges.

Transparency Daily disclosure of holdings by ETF managers facilitates performance attribution, due diligence, understanding of investment objectives and risks. Index providers supply performance and investment information on strategies

For financial professional use only. Not for public distribution. 14 Why the appeal of ETFs?

Benefit Features Used by All Classes “Democratized” investing for the largest pension funds, of Investors RIAs, and individual investors. Provide needed tools for asset or sector allocation, factor-tilt strategies, smart beta, thematic and now active investing

Variety of Product Asset Class, Sector, Thematic, and Factor Strategies. Choices Wide range of choices with easy access to analysis to compare features from sponsors, exchanges, and ETF websites (ETF.com, Morningstar, FactSet.)

Investor Protection Meet regulatory guidelines for stocks, fund products, notes in the country where they trade.

Tax Efficiency Lower turnover and capital gains distributions than most mutual funds from in-kind redemption feature

For financial professional use only. Not for public distribution. 15 Click the Strategy Road Map for ETFs – icon to add Applications Vary Across Investment Horizons an image. The photo will be Both Strategic cropped to Tactical / Strategic – fit the And Tactical placeholder. Horizon: < 1 Year Multi-Year Horizon Horizons Invest cash inflows Achieve Target Weight or Core or Enhanced Index easily Rebalance Exposure as part of Strategic Investment Policy Active or tactical view Over or Underweight Multi-Asset / Asset index exposure: Allocation Strategy

Completion Strategies Risk Factor Management Strategy Index as Active/ Hedge Fund Manager Alternative Portfolio Transitions Factor, Thematic or Style ETF Allocaon to Improve tilt investing Liquidity of Overall Porolio

16 Click the icon to add Strategy Road Map for ETFs: Short or Long-term an image. The photo will be cropped to Both Strategic And Tactical Horizons fit the placeholder. • Achieve Target Weight or Rebalance to Asset/Factor Weights

• Over or Underweight index exposure: Based on investment view, risk objective, or as hedge for active stock or fixed income strategies

• Risk Factor Management – modify risk of equity or fixed income (beta or duration). • Thematic or style tilt investing • Tilt to high dividend or dividend growth stocks • Country exposure with currency hedge • Fixed income exposure with interest rate hedge • Capture premium in option or volatility pricing 17 Click the icon to add Strategy Road Map for ETFs: Long-term an image. The photo will be cropped to Strategic – Multi-Year Horizon fit the • Core Index or Enhanced Index Exposure - Use ETFs to placeholder. implement components of strategic investment mix; liquidity allows for efficient implementation

• Multi-Asset / Asset Allocation Strategy – Use stand-alone ETF strategy to allocate to mix of best performing top-down investment opportunities relative to risk target

• Strategy Index as Active/Hedge Fund Manager Alternative - ETF- based strategy within an asset class or category, considering its investment return/risk profile, fees, transparency, or liquidity as the best choice versus a mutual fund or institutional manager

• ETF Allocation to Improve Liquidity of Overall Portfolio – Keep a portion of asset allocation in ETFs to provide for ease in meeting cash obligations, funding new managers, investing cash in anticipation of capital calls for private equity.

18 Institutional Uses of ETFs: A Global Perspective

A combination of tactical strategies and efficiently managing portfolio exposure Institutional Investor ETF Strategies

Tactical Adjustments Core Allocation International Diversification Rebalancing Portfolio Completion Liquidity Management Risk/Overlay Transitions Cash Equitization Interim Beta

0% 10% 20% 30% 40% 50% 60% 70% U.S. Europe Asia

Greenwich Survey of RIAs, asset managers, institutional funds, insurers, and consultants.

*Source: ETFs: Active Tools for institutional Portfolios, Greenwich Associates, 2017 and ETFs: Valuable Versatility in a Newly Volatile Market, 2018 (U.S. data). 19 C. The ETF Landscape in 2018 Assets, Flows, Trading, and ETF Managers

20 The ETF Industry Has Been Global from the Start

Growth rate ~25% since 2003 $6,000 Largest issuers are global asset Growth of Global ETP Assets (U.S.$Bil) managers and global investors $5,000 regularly invest in both home country and cross-border ETFs. $4,000

First ETF listed in Canada in $3,000 1990 on TSX 35 Index – SPY launched in1993. $2,000

Assets US $bn (Stacked) Morgan Stanley WEBs (World $1,000 Equity Benchmarks -launched in

1996 on international and $0 country stock indexes); core of iShares entry into the business in 2000. Americas assets Europe assets Asia assets Other Assets

ETFs in Europe and Asia started in early 2000s and asset WEBs à breakthrough for ETF industry growth: growth rate as North America • Organized as mutual funds vs. UITs (Unit Investment Trusts) ETFs, but more fragmented • Revealed power of ETFs for international investing and markets. price discovery while underlying security markets closed. Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018

For financial professional use only. Not for public distribution. 21 Exchange-Traded Products - U.S. Flows by Asset class

• Use of ETFs for fixed income exposure has been a key trend. • 2017 had significant flows with non-U.S. Equity representing the big shift.

Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018

For financial professional use only. Not for public distribution. 22 Most U.S. ETFs are Equity but Fixed Income is Growing

U.S. ETF Assets: $3.59Trillion Leveraged & Inverse Alternatives & (% Breakdown as of 11/29/2018) Asset Allocation Fixed Income ex-U.S. Commodities & Currencies Compares to $15.54 Trillion Fixed Income U.S. <5%> in Mutual Funds. 16%

ETF Assets are ~18% of Equity (Non-U.S. 21% Combined Mutual Fund & Global) and ETF Assets. 58% (ETFs are held by both mutual fund and institutional investors). Equity U.S. % of 2018 ETF Flows (through Nov.) $Mil Total Alternatives & Asset Allocation 1,285 0.5% Commodities & Currencies (592) -0.2% Equity U.S. 120,361 45.5% Equity (Non-U.S. & Global) 53,007 20.0% Fixed Income U.S. 69,820 26.4% Fixed Income ex-U.S. 11,603 4.4% Source: FactSet, as of 11/29/18 Leveraged & Inverse 9,186 3.5% Total 264,670 For financial professional use only. Not for public distribution. 23 Largest 25 U.S. ETFs by Assets (as of 11/29/18)

Assets Ticker Name Category ($Bil) Fees Cum Weight SPY SPDR S&P 500 ETF Trust Equity: U.S. - Large Cap $265.05 9.45 7.4% IVV iShares Core S&P 500 ETF Equity: U.S. - Large Cap $162.02 4 11.9% VTI Vanguard Total Stock Market ETF Equity: U.S. - Total Market $101.86 4 14.7% VOO Vanguard S&P 500 ETF Equity: U.S. - Large Cap $101.59 4 17.6% VWO Vanguard FTSE Emerging Markets ETF Equity: Emerging Markets $69.20 14 19.5% VEA Vanguard FTSE Developed Markets ETF Equity: Developed Markets Ex-U.S. $67.75 7 21.4% QQQ PowerShares QQQ Trust Equity: U.S. - Large Cap $66.09 20 23.2% EFA iShares MSCI EAFE ETF Equity: Developed Markets Ex-U.S. $64.35 31 25.0% 8 ETFs- 25% of 8ETFs- Assets IEFA iShares Core MSCI EAFE ETF Equity: Developed Markets Ex-U.S. $54.66 8 26.5% AGG iShares Core U.S. Aggregate Bond ETF Fixed Income: U.S. - Investment Grade $53.53 5 28.0% IEMG iShares Core MSCI Emerging Markets ETF Equity: Emerging Markets $49.77 14 29.4% IJH iShares Core S&P Mid-Cap ETF Equity: U.S. - Mid Cap $47.35 7 30.7% IWM iShares Russell 2000 ETF Equity: U.S. - Small Cap $45.72 20 32.0% VTV Vanguard Value ETF Equity: U.S. - Large Cap Value $44.53 6 33.2% IJR iShares Core S&P Small Cap ETF Equity: U.S. - Small Cap $42.88 7 34.4% IWF iShares Russell 1000 Growth ETF Equity: U.S. - Large Cap Growth $41.34 20 35.6% IWD iShares Russell 1000 Value ETF Equity: U.S. - Large Cap Value $38.88 20 36.7% BND Vanguard Total Bond Market ETF Fixed Income: U.S. - Investment Grade $35.70 5 37.7% VUG Vanguard Growth ETF Equity: U.S. - Large Cap Growth $35.02 6 38.6% VIG Vanguard Dividend Appreciation ETF Equity: U.S. - Total Market $30.93 8 39.5% VNQ Vanguard Real Estate ETF Equity: U.S. Real Estate $30.92 12 40.4% LQD iShares iBoxx $ Investment Grade Corporate Bond ETFFixed Income: U.S. - Investment Grade $29.87 15 41.2% GLD SPDR Gold Trust Commodities: Precious Metals Gold $29.70 40 42.0% EEM iShares MSCI Emerging Markets ETF Equity: Emerging Markets $29.57 69 42.8% XLF Financial Select Sector SPDR Fund Equity: U.S. Financials $29.50 13 43.7% 8 U.S. Equity, 3 Developed Non-U.S. Equity, 3 Emerging Market, 5 U.S. Factor, 2 Fixed Income, 2 Sector, 1 Precious Metals. Average Fee 0.15% (EQW), 0.12% (AW)

Source: FactSet, as of 11/29/2018 Source: ETF.com 24 ETFs valued as trading tools for over a decade.

• 25% of value traded in U.S. markets since 2007.

• Value traded has been steady in the last decade despite asset growth.

• Components of trading have shifted : • Broad U.S. equity now just 50% of activity. • Growth in international and fixed income ETF trading evidence of how ETFs have changed market structure.

Source: Credit Suisse, 2017 ETF. Outlook, January 11, 2018

25 Large ETFs Most Valued for Tactical Trading Features

Highest Turnover* U.S. ETFs Top Trading ETFs QQQ (Turnover < 30 Days). Average 12 days SPY HYG IWM EEM Turnover Ticker Trading (Turnover < 30 days) XLI DIA 9.67 QQQ PowerShares QQQ Trust XLE XLF 10.05 SPY SPDR S&P 500 ETF Trust XLV 11.15 HYG iShares iBoxx $ High Yield Bond ETF XLK XLY 12.90 IWM iShares Russell 2000 ETF EWJ LQD 13.12 EEM iShares MSCI Emerging Markets ETF EMB EZU 13.35 XLI IndustrialSector SPDR Fund GLD 14.88 DIA SPDR Dow Jones Industrial Average ETF EFA VNQ 17.63 XLE Energy Select Sector SPDR Fund MDY IEMG 19.63 XLF Financial Sector SPDR Fund VGK IAU 20.58 XLV Health Care Sector SPDR Fund 0 20 40 60 80 22.90 XLK TechnologySector SPDR Fund Turnover in Days ($Assets, 3/28/18 /Ave $Volm 45 days) 23.03 XLY Consumer Discretionary Sector SPDR

Source: FactSet, March 28, 2018 26 ETFs- The New Stocks: Popularity of Thematic ETFs reflects role as active tools

Examples of U.S. thematic ETFs with large recent flows include themes such as focused technology (robotics and China internet), regional banks, natural resources, infrastructure, aerospace. Assets 2018 12-Mth Ticker Thematic ETF ($Mil) Flows* Flows* 1 BOTZ Global X Robotics & Artificial Intelligence ETF 2,501 1,046 2,387 2 GDX VanEck Vectors Gold Miners ETF 8,268 985 (3,135) 3 FDN First Trust Dow Jones Internet Index Fund 6,933 985 1,563 4 KRE SPDR S&P Regional Banking ETF 5,177 895 1,347 5 XBI SPDR S&P BIOTECH ETF 4,834 609 890 6 XT iShares Exponential Technologies ETF 2,174 574 951 7 ITA iShares U.S. Aerospace & Defense ETF 5,701 546 2,027 8 IGF iShares Global Infrastructure ETF 2,497 417 1,050 9 ROBO ROBO Global Robotics and Automation Index ETF 2,333 371 1,681 10 KWEB KraneShares CSI China Internet ETF 1,646 357 1,130

11 KBE SPDR S&P Bank ETF 4,104 336 530 12 ARKK ARK Innovation ETF 706 322 644 13 GUNR FlexShares Morningstar Global Natural Resources 5,327 288 681 14 SMH VanEck Vectors Semiconductor ETF 1,287 223 356 15 PICK iShares MSCI Global Metals & Mining Producers ETF 629 204 267 * Source: FactSet, $ Millions as of 3/28/2018 27 ETFs as an Asset Management Product – More joining the ETF party, but how large of a commitment?

U.S. Managers of ETFs include not only the original large institutional index asset managers but also ETF specialty firms.

Asset managers that have focused on discretionary active fund products are now entering the ETF space.

For financial professional use only. Not for public distribution. 28 Market Share of Largest U. S. ETF Issuers

U.S. ETF Issuer AUM ($,M) % of Total Cum % Three largest U.S. ETF managers 1 BlackRock 1,395.63 38.87% 38.87% control 82% of assets and have 2 Vanguard 904.95 25.21% 64.08% long history in index investing with 3 State Street Global 620.31 17.28% 81.36% other fund products. 4 Invesco 182.25 5.08% 86.44% 5 Charles Schwab 121.92 3.40% 89.83% 6 First Trust 66.98 1.87% 91.70% Some ETF specialty managers have 7 WisdomTree 38.53 1.07% 92.77% had success. May be candidates for 8 VanEck 33.63 0.94% 93.71% consolidation or takeover. (Wisdom 9 ProShares 30.12 0.84% 94.55% Tree, Van Eck, ProShares, Direxion, 10 PIMCO 18.52 0.52% 95.06% 11 JPMorgan 18.27 0.51% 95.57% ALPS, Guggenheim now part of 12 Northern Trust 15.51 0.43% 96.01% Invesco, Global X acquired by 13 ALPS 12.79 0.36% 96.36% Mirae) 14 Fidelity 12.45 0.35% 96.71% 15 Rafferty Asset Management 12.23 0.34% 97.05% Six traditional U.S. large active 16 Deutsche Bank 12.10 0.34% 97.39% managers have had limited success 17 Goldman Sachs 10.41 0.29% 97.68% in the ETF business – but small 18 Mirae Asset Global 9.20 0.26% 97.93% relative to largest providers and their 19 UBS 6.76 0.19% 98.12% other product lines. 20 Barclays Bank PLC 5.27 0.15% 98.27% 21 Exchange Traded Concepts 4.57 0.13% 98.39% 22 Credit Suisse 4.31 0.12% 98.51% 23 New York Life 4.06 0.11% 98.63% 24 OppenheimerFunds 3.50 0.10% 98.73% Source: ETF.com and FactSet, as of 11/29/18 25 Victory Capital Management 3.32 0.09% 98.82% Other 42.45 1.18% 100.00% For financial professional use only. Not for public distribution. 29 D. The New Active – Factor (Smart Beta) Strategies in ETFs.

30 How Active Management is changing

Ben Johnson (Senior ETF Analyst, Morningstar) in the 10th Anniversary Issue of Morningstar Magazine, June/July 2017: “The Death of Active Management Has Been Greatly Exaggerated” Active investing will never die, but it’s being forced to evolve. § Investors are getting more active with passive. – Multi-asset /asset allocation funds/opportunistic allocations – Broker model portfolios – Robo advisors – Active managers using passive tools § Passive is getting more active – Smart beta – Thematic strategies – Multi-factor and dynamic factor allocation

For financial professional use only. Not for public distribution. 31 Strategic (Smart) Beta: What is the Concept?

• Investment strategies seeking to outperform risk-equivalent, cap- weighted indexes, modify risk, upside/downside capture, or portion of return from income. • Combine elements of indexing and active management – Uses rules-based strategies for stock selection and portfolio construction with regular rebalancing—Systematic active investing • May include single or multiple factors – Value, dividend yield, earnings or dividend growth, quality, volatility, momentum, etc. – Some factors have academic support for long-term outperformance (Fama-French factors) • Provides varying levels of active risk, mostly driven by weighting and number of stocks • Single factor approaches have periods of out- and underperformance relative to cap-weighted benchmarks; can be linked to a market view or used in a multi-factor approach to diversify.

For financial professional use only. Not for public distribution. 32 Investors face a wide variety of choices in factor/ smart beta strategies.

Factor-selection criteria à Ability to generate risk-adjusted alpha or modify risk: • Over a range of market conditions • Over a specific market environment based on an investment view. Factor Return Risk Alternative Access Modification Weighting

Dividend Growth Minimum Equal-Weighted Volatility High Dividend Dividend-Weighted Low/High Beta Value Growth Revenue-Weighted Downside Risk Earnings-Weighted Quality Reduction Income – Fundamental- Momentum Covered Weighted Option Multi-Factor Strategies Risk-Weighted

For financial professional use only. Not for public distribution. 33 Why Are Factor/Smart Beta Strategies in Focus Now?

• Continued challenges faced by discretionary active managers to deliver after-fee performance that beats benchmarks. • Recognition of returns for risk-premiums and systematic strategies beyond cap-weighting are a large component of traditional active management. • Risk factor allocation is next evolution of quantitatively-based strategies and aligned with more top-down investing. • Transparency and ability to do due diligence across historical market conditions with index return history. • Rules-based indexes have less vulnerability to behavior biases with very limited discretion in portfolio management process.

For financial professional use only. Not for public distribution. 34 Smart Beta ETF Flows by Category

Average Smart Beta ETF Fees* Assets > $1Billion 38 Largest 25 ETFs 21 Asset Weighted 26 Slource: Credit Suisse Equity Trading Strategy, February 2018 For financial professional use only. Not for public distribution. 35 Largest 25 Smart Beta U.S. ETFs ( ~ 55% of Assets)

Assets Volume Turnover Ticker Name Strategy ($Mil) ($Mil) (Days) Fees IWF iShares Russell 1000 Growth ETF Growth $39,365 $245 161 20 IWD iShares Russell 1000 Value ETF Value $35,775 $201 178 20 VTV Vanguard Value ETF Value $35,347 $182 194 6 VUG Vanguard Growth ETF Growth $31,953 $147 218 6 VIG Vanguard Dividend Appreciation ETF Dividends $26,738 $87 309 8 VYM Vanguard High Dividend Yield ETF Dividends $20,011 $73 273 8 IVW iShares S&P 500 Growth ETF Growth $19,902 $130 153 18 DVY iShares Select Dividend ETF Dividends $16,537 $80 205 39 SDY SPDR S&P Dividend ETF Dividends $15,137 $53 285 35 IVE iShares S&P 500 Value ETF Value $14,440 $115 126 18 USMV iShares Edge MSCI Min Vol USA ETF Low Volatility $14,048 $91 154 15 VBR Vanguard Small-Cap Value ETF Value $12,574 $33 376 7 IWS iShares Russell Mid-Cap Value ETF Value $10,434 $32 321 25 IWO iShares Russell 2000 Growth ETF Growth $9,077 $81 112 24 EFAV iShares Edge MSCI Min Vol EAFE ETF Low Volatility $8,748 $40 218 20 IWN iShares Russell 2000 Value ETF Value $8,722 $99 88 24 AMLP Alerian MLP ETF Dividends $8,241 $157 53 85 IWP iShares Russell Mid-Cap Growth ETF Growth $8,504 $35 245 25 VOE Vanguard Mid-Cap Value ETF Value $8,296 $31 265 7 MTUM iShares Edge MSCI USA Momentum Factor ETF Momentum $8,108 $98 83 15 IJK iShares S&P Mid-Cap 400 Growth ETF Growth $7,785 $19 420 25 SCHD Schwab U.S. Dividend Equity ETF Fundamental $7,108 $48 147 7 VBK Vanguard Small-Cap Growth ETF Growth $7,260 $20 370 7 SPLV Powershares S&P 500 Low Volatility Portfolio Low Volatility $6,860 $95 72 25 DXJ WisdomTree Japan Hedged Equity Fund Currency Hedged Fundamental$6,583 $215 31 48

Source: FactSet, March 28, 2018 For financial professional use only. Not for public distribution. 36 The Takeaway – ETFs Lead to Major Shifts in the Structure of Investment Management Business

Where We Came From Where We Are Going To

• Differentiated products, fees, • ETFs are accessible by all classes regulation, & distribution by investor of investors at same cost through category. (Asset Owners, Insurance, electronic trading at brokers. Retail)

• Distribution and discretionary • ETF revenue accrues to issuers, portfolio management viewed as index providers, exchanges, and key to revenues. brokers – all involved in distribution.

• Fundamental investing primary, • Quantitative analysis key for both quantitative investing more a niche index providers and ETF sponsors. business.

• Portfolio managers and investment • Performance history is basis for process is the focus of marketing and investment decisions; portfolio sales. manager secondary.

37 The Takeaway – ETFs Lead to Major Shifts in the Structure of Investment Management Business

Where We Came From Where We Are Going To

• Distribution directly connected with • More parties involved in distribution. investors, organized by channel. ETF managers sales force, but also Able to manage and reward success. brokers, index providers, and marketing.

• Asset manager manages trading of • Investor must have some knowledge strategy and flows. of trading to effectively use ETFs. Can receive assistance from broker or ETF manager’s capital markets staff.

• Performance record easily • Investor depends primarily on asset accessible by investor. Risk of relying manager for performance too heavily on real-time moves and very measurement and strategy dynamics. recent track record and assigning less weight to risk analysis. 38 What Can We Expect Going Forward – ETFs Staying at the Forefront of Investment Innovation

• Investors globally expand use of ETFs for global equity and fixed income diversification (beyond their local market) • Continued growth in access to fixed-income, commodity, and alternative market segments. • European and Asian ETP market growth continues with more factor and thematic products in all regions as more traditional active managers enter and expand their ETF presence. • Expanded use by Institutional investors, RIAs and financial advisors, and multi-asset and active fund strategies. More customized and advanced tools than the hammers and saws of the early ETF days. • Active management ETFs - more products – especially in fixed income, but not a transforming event. • Multi-asset, rules-based strategy ETFs gain institutional assets and become focus for new product offerings by ETF managers.

39 What Can We Expect Going Forward – ETFs Staying at the Forefront of Investment Innovation

• Continued interest in tactical strategies and high levels of trading activity – Thematic investing makes inroad relative to stock selection. • Smart beta factor and multi-asset investing – increasing component of ETF assets and institutional strategies, with lower fees. • Incorporation of ETFs into U.S. retirement saving strategies – Requires overcoming record keeper infrastructure impediments. • Market microstructure and regulatory frameworks adapt to ETFs as mainstream investment products. • Growth in services – o Index providers to ETF managers for product innovation o ETF analysis, data, and research to evaluate investment options more complex ETF strategies.

40 Thank you and look forward to questions and comments.

Contact information: [email protected], [email protected]

41 ETFs Serve as Both Investment and Trading Products

U.S. ETFs with Assets > $10Bil Number 72 Total Assets ($Bil) $2,264 65% of Total ETF Assets Equities $1,892 84% of ETFs > $10Bil Fixed Income $324 14% Gold $49 3% Concentration: 2,162 U.S. ETFs $ Assets/$Daily Volume Days 8 ETFs = 25% of Assets Daily Turnover 121 35 ETFs = 50% of Assets Equities 117 70 ETFs = 65% of Assets Fixed income 150 Turnover by Asset Size Top 10 > $50B 104 Average Fees Bps $25-$50 B 126 Equal Weighted 16.6 $10-$25 162 Asset Weighted 14.4 Source: FactSet, March 28, 2018 42 Largest 25 U.S. ETFs by Assets (as of 3/28/18)

Assets Assets/ Ticker Name Category ($Bil) Fees Volume Cum Weight SPY SPDR S&P 500 ETF Trust Equity: U.S. - Large Cap $255.01 9.45 10 7.4% IVV iShares Core S&P 500 ETF Equity: U.S. - Large Cap $140.98 4 110 11.4% VTI Vanguard Total Stock Market ETF Equity: U.S. - Total Market $92.80 4 236 14.1% VOO Vanguard S&P 500 ETF Equity: U.S. - Large Cap $87.28 4 119 16.7% EFA iShares MSCI EAFE ETF Equity: Developed Markets Ex-U.S. $76.86 32 44 18.9% VEA Vanguard FTSE Developed Markets ETF Equity: Developed Markets Ex-U.S. $70.00 7 156 20.9% VWO Vanguard FTSE Emerging Markets ETF Equity: Emerging Markets $69.20 14 94 22.9%

8 ETFs -25%of 8ETFs Assets QQQ PowerShares QQQ Trust Equity: U.S. - Large Cap $62.32 20 10 24.7% IEFA iShares Core MSCI EAFE ETF Equity: Developed Markets Ex-U.S. $55.26 8 123 26.3% AGG iShares Core U.S. Aggregate Bond ETF Fixed Income: U.S. - Investment Grade $54.41 5 140 27.9% IEMG iShares Core MSCI Emerging Markets ETF Equity: Emerging Markets $49.65 14 63 29.3% IJH iShares Core S&P Mid-Cap ETF Equity: U.S. - Mid Cap $44.18 7 191 30.6% IWM iShares Russell 2000 ETF Equity: U.S. - Small Cap $43.29 20 13 31.8% EEM iShares MSCI Emerging Markets ETF Equity: Emerging Markets $42.78 69 13 33.1% IWF iShares Russell 1000 Growth ETF Equity: U.S. - Large Cap Growth $40.24 20 164 34.2% IJR iShares Core S&P Small Cap ETF Equity: U.S. - Small Cap $36.71 7 160 35.3% BND Vanguard Total Bond Market ETF Fixed Income: U.S. - Investment Grade $36.63 5 202 36.4% GLD SPDR Gold Trust Commodities: Precious Metals Gold $36.78 40 43 37.4% IWD iShares Russell 1000 Value ETF Equity: U.S. - Large Cap Value $36.16 20 180 38.5% VTV Vanguard Value ETF Equity: U.S. - Large Cap Value $35.76 6 199 39.5% VUG Vanguard Growth ETF Equity: U.S. - Large Cap Growth $32.69 6 224 40.4% LQD iShares iBoxx $ Investment Grade Corporate Bond ETFFixed Income: U.S. - Investment Grade $31.55 15 37 41.4% XLF Financial Select Sector SPDR Fund Equity: U.S. Financials $31.65 13 20 42.3% VNQ Vanguard Real Estate ETF Equity: U.S. Real Estate $28.60 12 56 43.1% VIG Vanguard Dividend Appreciation ETF Equity: U.S. - Total Market $27.18 8 313 43.9% 8 U.S. Equity, 3 Developed Non-U.S. Equity, 3 Emerging Market, 5 U.S. Factor, 3 Fixed Income, 2 Sector, 1 Precious Metals. Average Fee 0.17% (EQW), 0.14% (AW)

Source: FactSet, as of 3/28/2018 Source: ETF.com 43