evolution of etfs - vanguard...for institutional use only. not for distribution to retail investors....

For institutional investors only. Not for public distribution.

Evolution of ETFs Tim Huver European ETF Product Manager 14 November 2012

2 For institutional use only. Not for distribution to retail investors.

Agenda

The global ETP marketplace

Indexing adoption accelerates

Fee and regulatory (r)evolution

European ETF usage trends Trading evolution


Global ETP marketplace

0

500

1,000

1,500

2,000

2,500

3,000

3,500

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

1990 1993 1996 1999 2002 2005 2008 2011

Asse

ts (U

S$ b

illion

s)

Num

ber of ETPs

Source: Illustration by The Vanguard Group, Inc. using data from Bloomberg LP.

US-listed AUM = $1.06 trillion

Global ex-US AUM = $471 billion

Global AUM = $1.53 trillion

2011

Left axis US-listed ETP assets Worldwide ETP assets ex-US

Right axis Number of US-listed ETPs Number of Worldwide ETPs ex-US


ETPs and indexing, moving in tandem (flows)

Active and passive fund flows

-400

-200

0

200

400

600

800

Fund

cas

h flo

ws

(US

$ bi

llions

)

US active fund flows US passive fund flows

Global ex-US active fund flows Global ex-US passive fund flows

Source: Illustration by The Vanguard Group, Inc. using data as at 30 June 2012 from Morningstar, Inc.

ETFs as percentage of passive

Europe active fund flows Europe passive fund flows

74% 74% 80% 61% 72% 70% 62% 92% 78% 62% 100% 95% 66% 77% 46%

2008 2009 2010 2011 30 June 2012


ETPs and indexing, moving in tandem (AUM)

Total fund assets under management

2008 2009 2010 2011 30 June 2012

US active 86.9% 84.6% 82.0% 80.8% 79.9%

US passive 13.1% 15.4% 18.0% 19.2% 20.1%

Source: Illustration by The Vanguard Group, Inc. using data from Morningstar, Inc

Global ex-US active 94.2% 93.1% 92.9% 92.7% 91.3%

Global ex-US passive 5.8% 6.9% 7.1% 7.3% 8.7%

European assets under management

Europe active 93.5% 92.3% 91.6% 91.5% 91.3%

Europe passive 6.5% 7.7% 8.4% 8.5% 8.7%


European ETP marketplace continues to fuel growth globally

0

1,000

2,000

3,000

4,000

5,000

6,000

$0

$50

$100

$150

$200

$250

$300

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Left axis Assets (US$ billions)

Right axis Number of ETPs Number of listings

Source: Illustration by The Vanguard Group, Inc. using data as at 30 June 2012 from Morningstar, Inc and Bloomberg LP.


However, this growth also means many European ETFs are at risk of closing

Products in ‘at-risk’ range

$1

$10

$100

$1,000

$10,000

US$100,000

Ass

ets

(US

$ m

illion

s)

1 3 9 12 15 6 18

Open

Closed

Tenure (years)

Source: Illustration by The Vanguard Group, Inc. using data as at 30 June 2012 from Morningstar, Inc. *Total of 152 closed; assets not available for 30 ETFs. **Total of 1,935 OPEN; assets not available for 234 ETFs.

ETFs that failed to capture US$30 million AUM in 3 years

50.0% closed ETFs (61/122*)

36.3% open ETFs (617/1,701**)


Synthetic products dominate the European landscape but are far less adopted elsewhere

Proportion synthetic

Europe

Global ex-Europe

Source: Illustration by The Vanguard Group, Inc. using data from Morningstar, Inc.

0%

10%

20%

30%

40%

50%

60%

70%

80%

2007 2008 2009 2010 2011 2012 30 June 2012


While both synthetic and physical backed ETFs continue to capture cashflow…

European cash flow by structure

Physical

Synthetic

Source: Illustration by The Vanguard Group, Inc. using data from Morningstar, Inc.

-$20

$0

$20

$40

$60

$80

2007 2008 2009 2010 2011 2012 30 June 2012


Source: Analysis by The Vanguard Group, Inc. using data as at 31 December 2011 from EDHEC-Risk Institute.

0%

20%

40%

60%

80%

100%

2008 2009 2010 2011

Physical

Synthetic

0%

20%

40%

60%

80%

100%

2008 2009 2010 2011

Replication

Synthetic

Optimisation

European investors have a strong preference toward physical ETFs over synthetic

Investor preferences


A fee and regulatory (r)evolution

European fund industry gears up for raft of new rules

Source: Illustration by The Vanguard Group, Inc.


Where the revolution started

Percentage of fee-based compensation in the US

10%

18% 20% 26% 28%

31% 33%

39% 44%

50% 55% 54%

57% 55%

<1999 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Illustration by The Vanguard Group, Inc. using data as at 31 December 2011 from Financial Research Corporation, Securities Industry and Financial Markets Association, and Cerulli.


Where the revolution started

55%

25%

16%

10%

US Australia Canada UK

Percentage of fee-based compensation around the world

Source: Illustration by The Vanguard Group, Inc. using data as at 31 December 2011 from The Vanguard Group, Inc. and Cerulli.

’s going?


Pattern of channel uptake

It starts with institutions

Europe and Asia

Global ex-US market today

US and Canadian market today

Time

ETF

mar

ket p

enet

ratio

n (b

y ch

anne

l)

Direct

Adviser

Institutional

Illustrative (not drawn to scale). Source: Analysis by The Vanguard Group, Inc. using data as at 31 December 2011 from The Vanguard Group, Inc., Bain & Co. and Investor Economics.

Less sophisticated individual investors as final adopters.

Education and institutional adoption lead to recognition of ETFs’ benefits as low-cost diversification tool.

More sophisticated early adopters create liquidity, reduce spreads, make ETFs more broadly attractive.


Pattern of channel uptake

From institutions to advisers

Source: Analysis by The Vanguard Group, Inc. using data as at 31 December 2011 from The Vanguard Group, Inc., Bain & Co. and Investor Economics.

Institutional Adviser Direct

US 50% 45% 5%

Canada 37% 34% 28%

UK 90% 9% 1%

Continental Europe 85% 10% 5%

Asia 90% 9% 1%

Australia 10% 30% 60%


European institutional product preferences

Source: Analysis by The Vanguard Group, Inc. using 2011 data from EDHEC-Risk Institute

ETFs Futures TRS Index funds Liquidity 2.37 95.2% 2.77 98.6% 1.69 61.1% 2.23 91.3%

Cost of liquidity 2.14 88.6% 2.73 97.8% 1.66 60.9% 2.04 83.0%

Other cost 2.28 87.3% 2.69 97.8% 1.80 69.4% 1.97 72.8%

Tracking error 2.33 95.8% 2.59 97.0% 2.50 92.8% 2.26 94.0%

Product range 2.66 99.4% 2.02 78.3% 2.06 79.6% 1.91 76.7%

Transparency 2.06 81.6% 2.68 96.1% 1.77 63.9% 2.31 93.7%

Minimum subscription 2.76 98.7% 2.12 80.7% 1.47 41.3% 2.24 88.9%

Operational constraints 2.53 97.5% 2.18 84.7% 1.51 44.4% 2.30 91.3%

Regulatory regime 2.26 90.6% 2.47 93.8% 1.56 50.9% 2.42 97.6%

Tax regime 2.09 89.5% 2.23 89.9% 2.00 81.0% 2.13 95.8%

Control of counterparty risk 1.88 74.4% 2.59 91.4% 1.52 44.4% 2.38 92.9%

Average 2.31 90.8% 2.47 91.5% 1.78 62.7% 2.20 88.9%

Rating Familiarity


Investor preferences determine the implementation strategy

• Cost – What are all the associated acquisition and maintenance costs of the position, including expense ratios, bid/ask spreads, brokerage commissions, borrowing costs? How do these costs impact excess returns?

• Tracking error – What unique factors could cause tracking error? Funds and ETFs depend mostly on level of replication/optimisation, futures have basis risk and contango/backwardation, swaps can have changing terms/costs of the swap.

• Liquidity – How important is the level of liquidity? Funds have great end of day liquidity, futures and ETFs have varying intraday liquidity (can be very good or not very good), swaps are dependent on relationships and dealer capacity.

• Counterparty risk – To what extent does it exist? On-exchange futures are guaranteed by clearinghouse, swaps can be collateralised, physical ETFs and funds are largely settlement-based (sec lending can be collateralized).

• Capital requirements – What level of capital is required to establish and maintain the position? For example, ETFs and funds require 100% capital (unless a margin position), futures require less than 100% capital (but have initial margin and maintenance margin), swaps could have some level of required collateral up front and/or ongoing to reset exposures.

Product usage questions and considerations


0% 50% 100%

Decrease

0% 50% 100%

European institutions use of ETFs expected to continue increasing

ETFs

Futures

TRSs

Index funds

2011

2009 2010

2008

2006

Increase Stay the same

0% 50% 100%

Source: Illustration by The Vanguard Group, Inc. using data from EDHEC-Risk Institute.


0% 20% 40% 60% 80% 100% Frequently

Rarely

European usage trends

Investment purpose

Broad market exposure

Long-term/buy-and-hold investment

Short-term/dynamic investment

Specific sub-segment exposure (sector, style)

Tactical bets

Management of cash flows (e.g., cash equitisation)

Dynamic portfolio insurance strategies (e.g., CPPI)

Neutralisation of factor exposures of other investments

Access to tax advantage Arbitrage transactions to benefit from mispricing

of other assets relative to the ETF

Source: Illustration by The Vanguard Group, Inc. using 2011 data from EDHEC-Risk Institute.


European usage trends

Market access

12.7% 19.7%

22.2% 24.6%

26.3% 28.2% 28.3%

32.1% 32.2%

33.5% 44.6%

47.1%

0% 10% 20% 30% 40% 50%

SRI Hedge funds

Currencies Money market funds

Government bonds Equities

Volatilities Corporate bonds

Infrastructure Sectors

Real estate Commodities

Source: Illustration by The Vanguard Group, Inc. using 2011 data from EDHEC-Risk Institute.


0% 10% 20% 30% 40% 50% 60% 70% 80%

US ETF usage trends

Institutional funds vs. Asset managers

Note: Based on responses from 62 institutional funds and 18 asset managers in 2012. Source: Illustration by The Vanguard Group, Inc. using data from 2012 U.S. Exchange-Traded Funds Study by Greenwich Associates, LLC.

Transitions

Rebalancing

Tactical adjustments

Cash equitisation/interim beta

Portfolio completion

ETF overlay/liquidity sleeve

Core/satellite

Hedging

Other

Institutional funds

Asset Managers


Institutional funds

0% 10% 20% 30% 40% 50% 60% 70% 80%

Note: Based on responses from 62 institutional funds in 2012. Source: Illustration by The Vanguard Group, Inc. using data from 2012 U.S. Exchange-Traded Funds Study by Greenwich Associates, LLC.

Transitions

Rebalancing

Tactical adjustments

Cash equitization/interim beta

Portfolio completion

ETF overlay/liquidity sleeve

Core/satellite

Hedging

Other

2012

2010

2011

US ETF usage trends


Typical ETF Holding Period for US Institutions

Note: May not total 100% due to rounding. Based on responses from 62 institutional funds and 18 asset managers in 2012. Source: Illustration by The Vanguard Group, Inc. using data from 2012 U.S. Exchange-Traded Funds Study by Greenwich Associates, LLC.

12%

6%

0%

41%

41%

22%

11%

17%

22%

28%

0% 25% 50%

Less than 1 month

1 to 6 months

7 to 12 months

Less than 1 to 2 years

More than 2 years

Asset managers Institutional funds

2012

2011

21%

26%

12%

36%

15%

19%

24%

7%

0% 25% 50%


Flash Crash 6 May 2010 • ETFs blamed as 60% of securities with cancelled trades were ETFs

Rogue trading scandals at Société Generale and UBS • ETF Delta One desks involved, raising questions about ETFs

• Manipulated the custom settlement structure in Europe

• Falsified backdated settlement

• ETF trades booked against exposed futures bets

Other ways ETPs have been pulled into debates: • Counterparty risk with swap-based and physical ETFs

• Market volatility blamed on ETFs – End-of-day rebalancing on leveraged ETFs – Large ETF trades impacting trade in underlying baskets

• Questions about whether an ETF can collapse due to short interest and failure to deliver

• Premium/discounts on some ETFs owing to creation limitations

ETPs get the blame


To centralise markets, improve trade execution • Reg NMS

• MiFID and MiFID II

On market making compensation • Direct payment

• Indirect payment

To strengthen investor confidence • Regulation SHO short-selling rules

• Circuit breakers, limit up/down after 2010 Flash Crash

• High-frequency traders under scrutiny

An ever-changing regulatory environment


2005 • Larger banks and brokers

• Floor specialist

• Managed flow into specific ETFs

• ETF arbitrage

2012 • Boutique proprietary trading and hedge funds

• Upstairs traders with strong quantitative and programming skills

• High-frequency trading

• Complex portfolio risk management of a trading book of ETFs and hedges

The changing face of market making


Exchanges innovate globally • Ability for continuous trading around the globe (passing the book)

• Exchanges grow global footprint through consolidation

• Will new players emerge? (Singapore goal to be lead market in Pan-Asia)

Regulatory changes • Volcker Rule impact on proprietary bank trading and liquidity

• MiFID II ability to consolidate liquidity and push volume to lit markets

• New regulations to strengthen financial markets

• ESMA guidelines on ETFs

• AIFMD impact on distribution of US ETFs in Europe

Market makers • Demand for compensation to continue trading certain ETFs

• Potential impact on high-frequency trading

• Potential to see more boutique trading firms as regulatory changes impact traders at large brokers

What lies ahead?


The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information presented does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. The opinions expressed in this presentation are those of individual speakers and may not be representative of Vanguard Investments Switzerland GmbH. Issued by Vanguard Investments Switzerland GmbH, which is authorised and regulated in the UK by the Financial Services Authority. © 2012 Vanguard Investments Switzerland GmbH. All rights reserved.

Disclosures

evolution of etfs - vanguard...for institutional use only. not for distribution to retail investors....

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