INVESTOR SERVICES

The Next Stage in the

Growth of ETFs

They are the sine qua non for investment managers

today. In the last decade, the growth of U.S.-based exchangetraded funds (ETFs) has significantly exceeded every other asset
management category.
Global ETF assets stand at a record US$2.2 trillion
(as of Q3 2013), with more than 70 percent, or $1.56 trillion,
invested in U.S.-listed products. Furthermore, momentum does
not seem to be slowing; by third quarter 2013, ETFs experienced
$130 billion of inflows year-to-date.1
In the more than 20 years since the products inception,
ETFs have been used by most managers as a purely passive
tool, designed to provide broad market exposure. Though ETFs
continue to garner significant flows for this use, continuous
product innovation and a steady progression toward
value-added strategies have helped fuel recent expansion.

ETF sponsors are aware that,

while there has been healthy advisor
usage of ETFs in the last few years,
opportunity still exists to grow the market.

J.P. Morgan | Q1 2014

Todayactively managed ETFs with

full disclosure
Some market observers now point to
actively-managed products as the next
source for new inflows into ETFs. Today,
actively-managed ETFs comprise a small
sliver of the overall ETF pie; to date, a
mere 62 actively-managed ETFs have
been launched with roughly $14.5 billion
in assets and represent less than one
percent of total ETF assets in the U.S. as
of third quarter 2013.2
We believe that as actively managed
ETFs accumulate more assets they
will begin to compete with traditional
mutual funds for market share. The most
significant driver would be the expansion
of active ETFs into new channels and
new customers for investment advisors.

J.P. Morgan | Q1 2014

The case for an actively-managed product

in an ETF wrapper is both simple and
attractive: it proves more tax-efficient
and cheaper with intraday liquidity. Until
now, however, alpha-generating mutual
fund shops have been hesitant to enter
the space, a fact many attribute to the
requirement to provide daily portfolio
transparency. Undoubtedly, traditional
active managers who attract assets based
on their stock-picking capabilities would
be averse to unveiling their proprietary
research. In any event, it is true that
fixed-income strategies have so far
been the most successful in an activelymanaged ETF wrapper. The frontrunning of bond trading strategies is not
practical and does not expose managers
or the funds to such practices.

On the tablenew proposals

for the SEC
There are a few proposals from asset
managers currently before the SEC that,
if adopted, would limit the disclosures
that ETF sponsors would be required
to make. Some propose that ETF
sponsors be permitted to disclose their
portfolios on a less than daily basis.
Others look to limit disclosure to a subset
of the overall investment holdings.
Each proposal attempts to solve
the same challenge of trying to protect
portfolio management security selection
while providing enough transparency
so that market makers can make
efficient markets.

One such proposal is Precidian

Investments patented ActiveShares
concept. This proposal utilizes a blind
trust between the ETF and the authorized
participant seeking to redeem shares.
When the redemption is transacted, the
ETF would deliver in-kind, high cost
basis, tax lots of portfolio securities
out of the fund to the blind trust. The
blind trust would then liquidate these
securities and deliver the cash to the
redeeming authorized participant.
Precidians process allows an ETF to
maintain a discretionary veil over their
portfolio holdingsan attractive option
for alpha-generating managerswhile
realizing the tax benefits associated
with in-kind redemptions. In addition to
the use of blind trusts for redemptions,
Precidians proposal only allows creations
for cash similar to a mutual fund. An
actual intraday net asset value would be
disseminated every 15 seconds, which
Precidian believes will enable market
participants to hedge trading exposures
and permit the efficient trading of the
ETF shares closely tracking NAV within
a range similar to that experienced by
existing ETFs. The proposal also provides
a small allotment redemption option
to allow shareholders to redeem shares
at NAV directly with the fund. Unlike
existing ETFs that disclose the identity
and amount of a funds securities, which
form the basis for the NAV calculation
each business day, ActiveShares would
only disclose portfolio investments once
per quarter. This would be consistent
with the current disclosure requirement
for 40 Act-registered mutual funds.

Additional SEC filings

Both T. Rowe Price and Vanguard
have filed exemptive applications with
the SEC to offer ETFs with partial
transparency. Vanguard has proposed to
release a representative sample of the
fund holdings that will track the return
of the ETF share class. Vanguards

J.P. Morgan | Q1 2014

application provides statistical evidence

that the tracking error between the daily
return of the representative sample
basket and that of the ETF shares is
within the range of tracking error seen
in existing index-based ETFs.4

Some market observers point

to the fact that ETFs are
positioned to enter the wider
retirement funds market.

T. Rowe Prices filing suggests that

their proposed ETF will disclose a daily
hedge portfolio in which each fund will
consistently invest at least 80 percent of
its total assets. Additional data points
detailing the difference between the
performance of the funds NAV and its
hedge portfolio over a rolling, one-year
period would be made available to
provide traders with additional tools.
Creations and redemptions would
generally be transacted in-kind via the
delivery of the hedge portfolio.5

Mutual funds have long maintained a

stranglehold on the 401(k) market. This is
due in part to technological investments;
sponsor record-keeping platforms were
built and designed with the mutual
fund structure in mind decades ago.
Nevertheless, the benefits of having an
ETF offering in the stable of a retirement
plan are becoming quite clear. Generally
speaking, ETFs are a cheaper alternative
to mutual funds.

Finally, Eaton Vance has filed an

exemptive relief application with the
SEC to launch its patented exchangetraded managed funds (ETMFs). As
their name suggests, ETMFs would
trade on an exchange like existing ETFs;
however, those trade prices would be
linked to the funds end-of-day net
asset value. The final settlement value
of on-exchange executions would not
be known until the end of the business
day, after the net asset value has
been calculated.6 This hybrid mutual
fund/exchange-traded fund approach
would allow managers to maintain a
discretionary veil over the portfolio
investments following the mutual fund
quarterly disclosure requirement.

ETFs in 401(k) plans

Some market observers point to the fact
that ETFs are positioned to enter the
wider retirement funds market. Today,
mutual fund assets make up more than
half of the roughly $5 trillion in 401(k)
market assets (as of year-end 2012).7
Retail investors own approximately
55 percent of all ETF assets in the U.S.
Yet, defined contribution 401(k) plans
comprise barely one percent of
ETF assets.

The primary hurdle preventing more

widespread adoption is the fractional
share conundrum. ETFs trade intraday at
quoted prices in whole share increments,
unlike mutual funds that trade in batch
orders at the end of the day and can
allocate fractional shares.
TD Ameritrade feels they have a solution
that has solved the fractional share
challenge. When a plan participant
purchases an ETF, TD Ameritrade
funds the fractional share amounts by
rounding up to the necessary dollar
amount to purchase a whole share.
When a participant sells their position,
TD Ameritrade sells the position and
receives the proceeds of their stake in the
fractional share.8
While the timing of its rollout is pending,
Charles Schwab has announced the
intention to launch an ETF-only 401(k)
plan for providers.9 The plan would offer
commission-free trades for a host of
ETFs, allaying any potential concern over
high transactional costs. If successful,
other plan sponsors could follow suit as
investors demand greater flexibility with
retirement options.

Q1 2014 | J.P. Morgan

Understanding todays
advisor market
ETF sponsors are aware that, while
there has been healthy advisor usage of
ETFs in the last few years, opportunity
still exists to grow the market. There
is definitely room for an increase in
new advisors using ETFs as a core asset
allocation tool, as well as for current
advisors increasing their allocations
to ETFs.
The overall trend in the advisor market
has been toward an uptick in feebased relationships. If that continues,
late-adopting advisors should no
longer have the same affinity toward
mutual funds they once had in the old
commission-based advisory relationship.
Furthermore, a great benefit of ETFs
is that advisors are able to use them as
a core asset allocation tool in order to

diversify client investments to build

an active portfolio. They can do this
either through direct investment or
by utilizing ETF strategies that perform
the allocations.
Sponsors are capitalizing on this
opportunity in the advisor market by
offering tools to educate advisors on the
mechanics of ETFs and how to effectively
measure the true cost of ownership.
Understanding the factors beyond the
management fee that drives an ETFs
cost basissuch as the bid-ask spread
and liquidity associated with the
producthelps advisors better compare
similar funds.
Building a greater awareness of ETF
features and benefits will only help
future widespread adoption within the
advisor community.

1 BlackRock, ETP Landscape: Industry

Highlights, September 30, 2013,
www.blackrock.com.
2 Tom Lydon, New Wave of Active ETFs
Could Come from Mutual Fund Providers,
September 29, 2013, www.etftrends.com.
3 U.S. Securities and Exchange Commission, In
the matter of the Application of Precidian ETFs
Trust; Precidian Funds LLC; and Foreside Fund
Services, LLC, January 25, 2013,
www.sec.gov.
4 Matthew F. Cohen, ETF Confidential:
A Survey of Non-Transparent Actively Managed
ETFs, The Investment Lawyer,
June 2012, www.klgates.com.
5 U.S. Securities and Exchange Commission, In
the Matter of T. Rowe Price Associates, Inc. and
T. Rowe Price Equity Series, Inc., September
23, 2013, www.sec.gov.
6 U.S. Securities and Exchange Commission,
In the Matter of Eaton Vance Management
and Eaton Vance ETMF Trust,
September 12, 2013, www.sec.gov.
7 Cory Banks, Has Schwab Cracked 401k Code
For ETFs?, June 24, 2013,
www.indexuniverse.com.
8 Hung Tran, TD Ameritrade:
ETFs In 401(k)s Now Live, October 31, 2013,
www.indexuniverse.com.
9 Darla Mercado, Schwab ETF
platform for 401(k)s hits regulatory
speed bump, October 7, 2013,
www.investmentnews.com.

J.P. Morgan | Q1 2014

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