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Debunking Three Common Misconceptions about ETFs Legends of the Fund

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Page 1: Legends of the Fund

Debunking Three Common Misconceptions about ETFs

Legends of the Fund

Page 2: Legends of the Fund

In a market where major ups and downs seem to be the norm, investors are acutely mindful of volatility when placing their investments. For more than a quarter century, investors have turned to exchange-traded funds (ETFs) for their dependable transparency, liquidity and low fees. As a result, ETF assets have risen to nearly $6 trillion in 2019 and show no signs of slowing down.

Yet despite this rapid adoption, ETFs still represent only 16 percent of total net assets of registered investment companies in the United States, the largest ETF marketplace in the world.1 So what is keeping some investors on the sidelines?

With so much room for growth, we dispel three common ETF-related misconceptions.

Myth: ETFs cause contagion or volatility in the market.

Fact: ETFs were designed to withstand volatility and have proven their resilience in all kinds of markets.

To address concerns about contagion and volatility in the ETF market, it’s helpful to first take a look back at the stock market crash of October 19, 1987, or Black Monday.

The Dow Jones Industrial Average (DJIA) plunged 22 percent, which to this day remains the largest one-day percentage decline in the index. As markets began to recover, the US Securities and Exchange Commission (SEC) took a hard look at what caused the crash. Over the next several months, the SEC put forth recommendations to quell future market volatility, calling on market participants to examine the potential for market makers to trade a single product in a basket of shares.

Taking up the challenge, a group of industry experts refined the use of in-kind transactions of underlying securities for fund shares that had typically been used by traditional mutual funds. Engineering a product that allowed investors to trade and sell fund shares without driving up costs, these pioneers ultimately conceived the ETF investment wrapper. What started as a single product grew into an entire industry, giving investors a new, innovative way to express their investment views. ETFs are created in the primary market and traded in the secondary market, a structural feature that can help to shield the investments from sudden volatility.

The resilience of ETFs was highlighted during the market volatility of 2001 and 2008 as they endured market shocks and still continued to increase assets. The impact of sudden market volatility was also seen in two flash crashes that occurred in 2010 and 2015. The key lesson from these events was for the industry to continue to educate investors and to harmonize

1 Investment Company Institute, 2019 Investment Company Fact Book.

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Page 3: Legends of the Fund

A well-designed, diverse strategy gives managers the benefit of offering a mix of products to investors

trading rules across ETFs, futures, options and equity securities. It’s imperative that investors consider the risk of any investment vehicle, including the underlying holdings, sector exposures and investment approach.

Myth: ETFs and mutual funds cannot co-exist in the market.

Fact: These products can be complementary, as investors have diverse objectives.

A well-designed, diverse strategy gives managers the benefit of offering a mix of products to investors and not putting all of their proverbial eggs into one (ETF) basket.In fact, 82 percent of issuers report that their distribution teams sell ETFs alongside other products, such as mutual funds.2 Firms with the most successful distribution strategies are taking a consultative approach to educate wholesalers and other partners about the nuances of each product. There are plenty of issues to consider for managers who offer both types of products, including appropriate sales incentives for differently priced funds.

Looking at the defined contribution market in the US, the benefits of the mutual fund investment wrapper, as well as other unregistered products like collective investment trusts, have historically surpassed those of ETFs. Generally, mutual funds have a share class with fees that are competitive relative to those of ETFs. Additionally, mutual funds can

be offered in fractional shares, ensuring the smaller investment amounts in these plans stay fully invested. Mutual funds also trade at an end-of-day NAV, which is consistent with how defined contribution platforms were designed.

Conversely, in the taxable account space there are certain features that are more favorable to the ETF investment wrapper. Most ETFs leverage the in-kind transfer mechanism for the creation and redemption of units for the marketplace. This reduces the cost of portfolio construction and cash drag. The use of in-kind transfers also enhances tax efficiency, reducing capital gains distributions. Additionally, the ability to externalize the costs of the creation and redemption activity to the market minimizes the impact to existing shareholders.

ETF specialists are increasingly being brought into sales conversations for their advice and, most importantly, to gain a better understanding of diverse client needs. As innovation in the ETF market continues to flourish, managers have a compelling reason to explore how these two product types can complement each other.

2 Cerulli Associates, US Exchange-Traded Fund Markets, 2018.

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Page 4: Legends of the Fund

The regulatory approval of a new class of semi-transparent active ETFs is helping to bridge the gap between passive and active investing

Myth: ETFs are exclusively for passive investing.

Fact: New doors are opening for active managers to launch ETFs.

The highly anticipated regulatory approval of a new class of semi-transparent active ETFs is helping to bridge the gap between passive and active investing. This significant industry development, first approved in May 2019, opens the door to a range of active managers who previously may not have been comfortable disclosing their best ideas to the market. Actively managed ETFs were first launched in 2008 by Bear Stearns. ETF sponsors were required to fully disclose holdings daily, which some could argue constrained its growth. Since then, firms continued to refine the concept of actively managed ETF filings, and have continued to capture the interest of the market and regulators.

For investors considering actively managed ETFs, there are a few things to keep in mind. Semi-transparent ETFs trade in the same way as a traditional ETF, but have greater confidentiality because holdings are published within the same guidelines as mutual funds. With the first semi-transparent active ETF structure gaining approval, other active managers have additional filings in the

queue with the regulator. Each structure employs different mechanisms for market makers to keep the price of the ETF in line with its underlying holdings.

How we can help

At State Street, we’re dedicated to creating better outcomes for the worlds’ investors and the people they serve. To help our clients adapt at speed to change, access best practices, connect across the industry, and achieve global consistency and efficiency, our experts work closely with clients to equip them for success. Our continuous investment in innovation, deep bench of professionals and globally integrated proprietary platforms mean we’re able to help clients at whatever stage they are in building their ETF portfolio — whether launching their first fund or adding to a portfolio of existing products.

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Page 5: Legends of the Fund

For more information, please contact:

FRANK KOUDELKA

Senior Vice President

+1 617 662 4749

[email protected]

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