NICSA Midwest Regional Meeting | Managing Innovation and the Changing Competitive Landscape

Midwest Regional Meeting

July 22, 2014Northern Trust

Chicago, IL

Midwest Committee Co-Chairs

• Rajan Chari – Deloitte

• Nicole Best – Heartland Advisors

NICSA’s Mission

Connecting investment industry professionals to best

practices.

Today’s Agenda

9:30 – 10:00 am Registration10:00 – 10:05 am Welcome10:05 – 11:05 am Keynote Address11:05 – 11:15 am Break11:15 – 12:15 pm ETFs – Is There a Limit to

Innovation12:15 – 1:30 pm Luncheon Roundtables1:30 – 2:30 pm Regulatory/Compliance – A

Discussion of Current and Evolving Issues

2:45 pm Closing Remarks

Nicole Best Brenda Bittermann

William Canny Rajan Chari

Victoria Fitch Curtis Holloway

Mary HoppaCarolyn Jayne Tiffani JanssenKristine Lyons

Ian Martin

Sandy Morris David Murray Julie Nelson

Kimberly O'Connor Scott Schulenburg

Lisa Shea Steven Spiegel

Lindsay Whetton Ty Winters

Kim Zavislak

Special Thanks to the Midwest Regional Committee

Thank You to Our Sponsors

NICSA’s Global Leader Members

Upcoming Events

August 21NICSA NextGen: Investing in Tomorrow’s LeadersToday (Denver, CO)

September 11-12General Membership Meeting (Boston, MA)

February 8-112015 NICSA Strategic Leadership Forum

(Hollywood, FL)

Find NICSA On…

Transfer Agent Compliance Guide

The Fund Industry – Second Edition

The NICSA Knowledge Center

Keynote Address

The Evolution of ETFs

Jeremy Held, Director of Investment Strategy and Research, ALPS

For Investment Professional Use Only

The Evolution of ETFs

For Investment Professional Use Only

Are Not FDIC Insured May Lose Value

Agenda

Source: Blackrock – FUSE Research

1.History and Evolution of ETFs

2.Drivers of ETF Growth

3.Challenges to ETF Growth

4.ETF Impact on Mutual Fund Industry

5.Q & A

History of ETFs


History of ETFs – SPY ETF launched in 1993


88%

12%

ETF Assets – Year End 1998

SPY Assets All Others

First ETF (SPY) is launched in 1993

Subsequent ETFs are based on well-known, broad-based indices with liquid futures markets

ETF market is dominated by SPY and is primarily held by institutional investors

Are Not FDIC Insured

History of ETFs – Retail Phase 1999-2000

On March 10, 1999 NASDAQ launches QQQ (Cubes) based on the NASDAQ 100 Index.

QQQ raises $10 billion in 6 months,

At the end of 2000 the market share of SPY has been cut in half and ETF industry has grown to $59 billion in AUM

QQQ

43%

40%

17%


SPY Assets QQQ Assets62 Remaining ETFs



History of ETFs – Intermediary Phase 2000-2006


24%

76%


SPY & QQQ All Others

iShares and Vanguard enter the market

By 2006 ETFs have expanded from 64 to 328 and AUM has grown from $59 billion to $433 billion

SPY and QQQ now only make up a quarter of all ETF assets

http://www.ishares.com/us/index


History of ETFs – Expansion Phase 2006-Present


Expansion phase has seen rapid proliferation in products and product providers

Expansion beyond traditional market benchmarks with increased complexity (leveraged, inverse, currency, alternative, option-writing etc.)

Nearly 1,600 ETFs as of June 2014

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 -

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

200

328

542

701 811

991

1,189

1,354

1,512 1,565

ETF Product Growth – 2005 to 2014

Drivers of ETF Growth

Current State of the ETF market

ETFs continue to be one of the fastest growing products in the Mutual Fund market

ETF assets are currently at $1.9 Trillion

There are now 54 ETF providers

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 -

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

314 433

621 542

794

1,012 1,062

1,350

1,701

1,861

Assets ($bn)ETF Asset Growth – 2005 to 2014

Source: Blackrock – FUSE Research. Data as of June 2014


Current State of the ETF Market – Wide variety of choices


38%

16% 15%

11%

7%

5%4%

4%

ETF Assets – June 2014

Broad US Equity Bonds Sector EquityBroad International Equity Smart Beta / Fundamental Country FundsCommodities Other

In recent years ETFs have experienced rapid proliferation in products, asset classes and providers

Increased product complexity (leveraged, inverse, currency, alternative, etc.)

Narrow, thematic based products continue to gain traction

Are Not FDIC Insured

ETF Advantages

97% of ETF assets are in 1940 Act Mutual Funds – as a result most ETFs offer the benefit of DIVERSIFICATION

Compared to traditional open-end Funds, ETFs also offer the following benefits:

Expenses

Tax EfficiencyTransparency

LiquidityETF structure lends itself to taking advantage of investor trends

Source: Deutsche Bank, FUSE Research

ETF Advantages – Passive Investing is on the Rise

Passive investing has doubled its market share in the past decade

ETFs are a both a beneficiary and a catalyst for this shift

2005 2006 2007 2008 2009 2010 2011 2012 20130%

5%

10%

15%

20%

25%

30%

35%

14%16%

17%18%

21%22%

23%25%

26%28%

Passive Funds Assets – Mutual Funds and ETFs

2014

Source: FUSE Research. Data as of June 2014


ETFs as a Tool for Asset Allocation


ETF structure lends itself to asset allocation

Advisors are able to add value through asset allocation in addition to manager selection

ETFs can now be used to assemble entire portfolios, potentially with better precision, liquidity and transparency than Mutual Funds

38%

16% 15%

11%

7%

5%4%

4%


Broad US Equity Bonds Sector EquityBroad International Equity Smart Beta / Fundamental Country FundsCommodities Other



ETFs as a Stock Substitute

Source: Blackrock – FUSE Research . Data as of June 2014

15%

5%3%

77%

ETF Assets

Sector Country Commodity All Other

Sector, Commodity and Country Funds represent a much higher allocation of ETF assets than Mutual Fund assets

ETF investors may be using these narrower asset categories as stock substitutes

2%1%1%

96%

Mutual Fund Assets

Sector Country Commodity All Other

ETF Investors are Willing to Take on More Risk

ETF investors tend have higher investable assets and tolerance for risk

As a result, ETF investors may be using ETFs as a substitute for individual stocks

Series1 $-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$500,000 $450,000

$200,000

ETF InvestorMutual Fund Investor

Average Investable Assets

Above Average Risk Below Average Risk 0%

10%

20%

30%

40%

50%

60%

70%

45%

9%

30%

22%

ETF InvestorMutual Fund InvestorWillingness to

Take Risk

Source: Blackrock – FUSE Research, ICI. Data as of December 2013

ETF Flows are Consistent and Growing

ETF flows are consistent

ETF flows are strong despite negligible impact from Defined Contribution market

If ETFs are able to impact the DC market, ETF flows may overtake Mutual Funds

ETF Net Flows vs. Mutual Funds – 2005 to 2014

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-100

0

100

200

300

400

500

350 352390

-55

450

357

168

368 378

148

53 64

145162

119 120 116

190 187

12

Mutual Funds ETFs

Assets ($mn)



Investor Adoption suggests ETFs will continue to grow

Source: Blackrock – FUSE Research, Cerulli

72%

28%

ETF Use – Institutional Consultants

Recommended Not Recommended

ETFs are recommended by the majority of financial advisors and institutional investors

The transparency, liquidity, precision and lower costs of ETFs may continue to be a catalyst for growth in the future

79%

21%

Institutional Use – Financial Advisors

Recommended Not Recommended

39%

61%

Future Use of ETFs among Advisors

Plan to Increase Do not plan to increase

Challenges of ETF Growth

ETF Obstacles to Growth

ConcentrationSaturationConsolidation Barriers to Entry

Despite success of overall industry, the ETF industry has some significant challenges ahead


ETF Market is Dominated by the Big Three Firms

Source: Blackrock – FUSE Research, Financial Times

39%

22%

21%

6%2%

10%

ETF Market Share – June 2014

Blackrock State Street Vanguard Invesco Wisdom Tree 49 Others

Top three firms comprise 82% of all ETF Assets

Top three ETF firms are all ranked in the Top Four asset managers globally

Smaller players are starting to gain traction

ETF Industry is very bifurcated

ETFs are characterized by a small number of large, successful ETFs and a large number of smaller, less profitable ETFs

Almost half of all ETFs have less than $50 million in AUM

The median ETF asset raise is close to break-even from a profitability perspective

Top 2 ETFs

Top 5 ETFs

Top 10 ETFs

2007 2008 2009 2010 2011 20120%

10%

20%

30%

40%

50%

60%

70%

25%

35%

45%

55%

Market Share of Largest ETFs

Average ETF$0.00

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

$1.60

$1.80

$1.30

$0.10

Average and Median ETF Size

Median ETF

Top 25 ETFs

Source: FUSE Research – June 30, 2014

ETF saturation may be impacting newer fund launches

Despite overall success of ETFs, it is becoming increasingly harder to launch successful ETFs

Lack of new investment opportunities in the space may make future product development more difficult

2004 2005 2006 2007 2008 2009 2010 2011 2012$0.0

$50.0

$100.0

$150.0

$200.0 $198.0

$34.4

$49.3

$34.0

$20.1$7.2

$18.5 $16.8$7.4 $7.6

$21.5

Median Asset Raise in an ETF’s first year


Assets ($mn)

Increased competition has increased ETF failure rate

As more ETFs come to market, existing ETFs with lower asset levels are increasingly being liquidated

Lower profitability and reduced likelihood for asset growth are primary drivers for ETF liquidations

Almost 300 ETFs have been liquidated since 2008

Ratio of ETF launch to liquidation

Pre-2008 Since 20080

10

20

30

40

50

6053

3


ETF Impact on Mutual Funds

Mutual Funds still dominate the investment landscape

Mutual Funds are still and for the for-seeable future will be the dominant investment vehicle

Mutual Fund and ETF assets


2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Mutual Funds ETFs

5%

Assets ($mn)

16%

Impact of ETFs on Mutual Fund Industry is hard to ignore

Fee CompressionConsolidationNew Opportunities for Innovation

ETFs have created a new competitive landscape with the following potential impact:

ETF Impact – Fee Compression

Mutual Funds should continue to see fee compression due to low-cost competition from ETFs

ETF Expense Ratios

Average Expense Ratio Asset Weighted Expense Ratio0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%0.63%

0.20%

Source: Blackrock – FUSE Research. Data as of March 31. 2014

ETF Impact – Fund expenses are going down across all categories

Equity Funds

1999 20140.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%0.99%

0.74%

Bond Funds

1999 20140.00%0.10%0.20%0.30%0.40%0.50%0.60%0.70%0.80% 0.76%

0.61%

Hybrid Funds

1999 20140.74%0.76%0.78%0.80%0.82%0.84%0.86%0.88%0.90% 0.89%

0.80%


ETF Impact – Consolidation

Lower fees and increased competition has lead to a net reduction in Mutual Funds since 2002

Consolidation is not always bad – surviving Funds have benefitted with higher assets per Fund

Number of Mutual Funds

2002 2014 7,400 7,500 7,600 7,700 7,800 7,900 8,000 8,100 8,200 8,300 8,243

7,707

Average Mutual Fund Size

2002 2014 -

0.50

1.00

1.50

2.00

2.50

0.77

1.95


Assets ($bn)

Impact of ETFs – Active Management is Still Important

A large percentage of investors still prefer active management

To date, ETFs have failed to be successful with active solutions

PIMCO represents more than 90% of all actively managed ETF assets

93%

5%2%

1%


Passive Dividend Smart Beta Full Active



ETF Impact – Forced Innovation


Mutual Funds continue to dominate the actively managed landscape

Fund managers that can create active, innovative products should expect to be rewarded with inflows

Investors are rewarded with better funds by better managers and at a lower fee

AUM raised in active Mutual Fund Categories since 2008

World / Tactical Allocation

Non-Traditional Bond

Bank Loan Long / Short Equity

-

20

40

60

80

100

120

140

160

180

200 186

149

114

44

Assets ($bn)

Summary

ETFs are here to stay and will continue to have a lasting impact on the Fund Industry

ETFs have capitalized on investors desire for passive investing, asset allocation solutions and stock substitutes

Growth of ETFs is expected to continue but saturation, concentration and profitability remain concerns

Increased competition from ETFs should result in fee compression and continued consolidation of the Mutual Fund Industry

Active management is still in demand – managers who can deliver innovative products may stand to benefit more from emergence of ETFs

End result for investors is better funds from better managers at a lower cost

Break Sponsored By:

ETFs - Is There A Limit to Innovation

Moderator:Rajan Chari, Partner, Deloitte

Panelists:Peter Demarco, Deloitte

Chris Huemmer, Senior Investment Strategist, Northern Trust

Frank Koudelka, Senior Vice President, ETF Product Specialist, State Street Global Services

Katie Schoen, Vice President and Senior Analyst, Robert W. Baird, Co.

Exchange Traded FundsIs There a Limit to Innovation?

EXCHANGE TRADED FUND MECHANICS

Cash

ETF Shares

MarketMaker

ETFSponsor

BrokerDealer

/Financial Advisor

Investor

Physical Securitiesor Cash

ETF Shares

ETFShares

Cash

Most ETF activity occurring through daily buying and selling of ETF shares via the stock exchange

Create / Redeem occur when market maker requires more / less inventory based on trading activity

OR Authorized Participant acting on behalf of an

institutional client or their own proprietary trading (arbitrage)

AuthorizedParticipant

Primary Market Secondary Market

ExchangeTransfer Agent

/ Custodian

Crea

te (S

ubsc

riptio

n)

Rede

em (R

edem

ption

)

An Exchange Traded Fund is an investment company whose shares are traded intraday on stock exchanges at market determined prices. Investors buy and sell ETF shares through a broker just as they would shares of any publically traded company.

EXCHANGE TRADED FUND MARKETPLACE

U.S. ETP Flows and AssetsFlows and Assets as of June 30, 2014

$0$25$50$75

$100$125$150$175$200

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

$0$200$400$600$800$1,000$1,200$1,400$1,600$1,800$2,000

Net Flow Net Assets

-$400

-$200

$0

$200

$400

$600

$800

$1,000

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

$0$2,000

$4,000$6,000$8,000

$10,000$12,000

$14,000$16,000

Net Flow Net Assets

U.S. Mutual Fund Flows and AssetsFlows and Assets as of May 31, 2014

EXCHANGE TRADED FUND FILINGS

TransparentActive - Approved

TransparentActive - Not Approved

Non-Transparent Active - Approved

Non-TransparentActive - Not Approved

None

Radiance Asset Management

Syntax Analytics

Empowered Fund

EXCHANGE TRADED FUND ECO-SYSTEM

SERVICE PROVIDER MUTUAL FUND / ETF SIMILARITIES EXCHANGE-TRADED FUND

Advisor / Sponsor • Retained by the board to manage assets and operations

• Responsible for contracting with 3rd parties

• Many use in-house compliance resources; some smaller funds outsource compliance

• Determines ETF basket composition

• Monitors tracking and correlation of ETF

• Counterparty credit checking of Authorized Participants (APs)

Distributor • Underwrites and distributes mutual fund shares

• Purchases mutual fund shares directly from the fund and re-sells them

• Class drives end share purchaser• Often an affiliated broker/dealer of

the Advisor• Responsible for sales and

marketing

• Some sponsors use internal distributors, but most use third part “medallion” distributors

• Responsible for maintaining relationships with APs

• Approve “creation” orders• Aggregate and communicate AP

orders to sponsor (can facilitate orders or interact with TA)



ETF Operations • N/A • Leverages ETF platform for basket creation / dissemination of daily trading basket to NSCC and ETF Advisor: o Cash equivalent file (PLF A)o Value of portfolio basket (PLF B)

• Receive orders from transfer agent for “bursting” (generating underlying trades)

Fund Accounting • Book of record for the fund• Calculates daily NAV per share• Records trade activity• Records all non-trade fund inputs

and outputs• Uses a general ledger based record-

keeping system

• Leverages fund accounting general ledger system, with integration to ETF platform for in-kind trade activity



Transfer Agent • Process shareholder transactions and updates account information

• Send account statements• Facilitate distributions• Links to NSCC Fund/SERV, but not

DTCC

• Acts as record-keeper and stock transfer agent (can also be order-taker for AP create / redeem): o Accounts for AP activity and

maintains capital stock shareso DTCC FAST membership to

facilitate issuance, delivery and settlement of ETF shares (DWAC)

Custodian • Holds and maintains fund assets to protect shareholder interests

• Responsible for overseeing trade settlement, asset servicing, disbursements and inflows

• Connectivity to DTCC & NSCC for settlement and asset servicing

• Uses connectivity to DTCC and NSCC for: o ETF portfolio basket processing

and communication of basket componentso Monitoring “burst” ETF

transactions and underlying settlementso Continuous net settlement

(CNS) processing



Fund Administrator • Regulatory filings• Financial reporting• Fund budgets and expenses

• Financial statements: NAV and market value returns, premium / discount table, exclusion of in-kind activity from PTO calculation

• N-1A: creation / redemption process

• Compliance: testing adjusted for exemptive relief permission; 80% holder limitation managed through AP application process

• Performance / Returns: NAV versus market returns, daily reporting using data from exchanges

• Expenses: categories of expenses differ, unitary fees common



Fund Administration (continued)

• Tax expertise• Comprehensive Board services

• Distributions: work with exchanges to establish dates, communicate rate information. reconcile payments and record date shares with depository

• Tax services: consultative services related to tax efficiency (equalization, wash sales, cost methodology, bond amortization)

• Legal administration: assistance with stock exchange and other filings, AP agreements, specialized board reporting

Authorized Participant

• N/A • Acquires securities that make up the ETF basket

• Deliver securities to ETF custodian to form a creation unit

Luncheon Sponsored By:

Regulatory/Compliance – A Discussion of Current and Evolving Issues

Moderator:Rajan Chari, Partner, Deloitte

Panelists:Angela Palmer, Senior Vice President, Chief Compliance Officer, Robert W. Baird, Co.

Michael Mabry, Partner, Stradley Ronon Stevens & Young, LLP

Closing Remarks

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NICSA Midwest Regional Meeting | Managing Innovation and the Changing Competitive Landscape

Presentations & Public Speaking