ETF Mechanics Matthew Tucker, CFA · ETF Mechanics Matthew Tucker, CFA . Managing Director, ... with the added layer of exchange-traded ... even if none of them took any action.\爀屲All

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ETF Mechanics Matthew Tucker, CFA Managing Director, Head of iShares Fixed Income Strategy

The Changing Fixed Income Market

As the corporate bond market grows, trading volume declines

Since 2005, the size of the corporate bond market has grown 1.2x, but trading volume has declined from about 0.7% of the market value to around 0.3%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

-

1,000

2,000

3,000

4,000

5,000

6,000

2005 2006 2007 2008 2009 2010 2011 2012 2013

TRAC

E Vo

lum

e as

% o

f Mar

ket V

alue

Mar

ket V

alue

($bn

)

Total Market Value in $bn (LHS) Volume as % of MV (RHS)

Size of Corporate Bond Market vs. Trading Volume as % of Market Value

Source: Barclays, Bloomberg, TRACE as of August 2013. The size of the corporate bond market is the sum of the market value of the Barclays US Corporate Index and Barclays US High Yield Index. TRACE volume of the corporate market is the 20-day average of the sum of the IG and HY market volumes as reported by TRACE.

FOR INSTITUTIONAL USE ONLY – NOT FOR PUBLIC DISTRIBUTION

The changing sources of corporate credit exposure

Constructing broad beta portfolios from bonds available at dealers can be challenging given low inventory levels and market fragmentation

Corporate bond ETFs represent a significant pool of single-trade beta assets with the added layer of exchange-traded liquidity

Source: BlackRock, Bloomberg as of August 2013.. Primary dealer inventory is measured by the primary dealer positions outright level of corporate securities due greater than 1 year. Credit ETF assets include US listed corporate bond ETFs, excluding leveraged or inverse funds.

-

50,000

100,000

150,000

200,000

250,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Valu

e ($

M)

Primary Dealer PositionsCredit ETF Assets

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What is an ETF? Two great investment ideas brought together

Diversified Tradable during the

day

Diversified funds that trade

like stocks

ETFs

Stock Like a Mutual Fund

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Fixed Income markets

Customer B

Broker A

Broker B

Customer A

Equity markets

FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION iS-10419

Fixed Income ETFs allow investors to trade bonds like stocks

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Presenter

Presentation Notes

The traditional fixed income OTC market is disjointed, there is not central source of liquidity and as a result different investors can have very different levels of access to inventory and pricing. Like equity ETFs, fixed income ETFs are listed and traded on public exchanges, bringing a new level of transparency and liquidity to the fixed income markets. Fixed income ETFs provide access to specific market segments including Treasuries, Mortgages, Corporates and Emerging Market Debt to name a few. This provides trading flexibility and improved access to liquidity. With FI ETFs you get the benefits of equity markets with fewer challenges than the traditional FI market The fixed income market is an Over The Counter (OTC) market Transactions are done directly between participants No exchange to ensure best execution Lack of transparency into what transaction costs are paid Potential for large disparities in transaction costs paid by investors Equities and ETFs are exchange traded Central execution Two-sided markets supported by a market maker Observable bid/offer spreads Direct measurement of transaction costs Transaction costs in FI are significant, and usually are not transparent to investors This is the value of efficiency provided by exchange transparency of cost ability to obtain best execution

Liquidity—iShares ETFs help address challenges with bond trading

Most bonds do not trade daily iShares bond ETFs can trade millions every day

The underlying bond market can be very illiquid and individual bonds can trade very infrequently

Most investment grade and high yield corporate bonds have historically traded fewer than half the days each month (see below)

LQD (iShares iBoxx $ Investment Grade Corp) and HYG (iShares $ High Yield Corp) traded $270 mm and $347 mm in February 2013 alone (see below)

Because ETFs trade on an exchange, investors can access bonds as easily as they can access stocks

Source: BlackRock, Markit iBoxx, TRACE. Data from 1/1/2012 to 12/31/2012 for the Markit iBoxx $ Liquid High Yield Index (“high yield”) and Markit iBoxx $ Liquid Investment Grade Index (“investment grade”). There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

2%

11%

25%

36%

26% 27%

16%

25% 23%

9%

1-5 6-10 11-15 16-19 20+

Per

cent

of I

ndex

Con

stitu

ents

Number of Trading Days

Investment GradeHigh Yield

Average number of days bonds in the indexes traded each month

$0

$50

$100

$150

$200

$250

$300

$350

$400

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

LQD HYG

30-Day Average Volume ($MM)

Source: Bloomberg as of 8/31/2013.

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FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION


*Market Bid/Offer spread refers to the underlying securities of the respective index **30-day average as of 9/30/2013 For illustrative purposes only. Source: BlackRock, Bloomberg, Barclays, NYSE Arca, as of 9/30/2013.

Barclays 20+ Year Treasury

iBoxx $ High Yield Corporate

iBoxx $ Investment Grade Corporate

Barclays 1-3 Year Treasury

Barclays TIPS Core Total U.S. Bond Market ETF

J.P. Morgan USD Emerging Markets

iShares ADV($M)** 997 435 275 100 82 92 86

iShares AUM ($M) 3,086 15,211 17,190 8,351 14,109 14,449 3,970

iShares ETFs generally offer price improvement, making the ETF less expensive to trade than the underlying securities of the respective index

iShares ETFs offer low-cost market access

1 1 2 1 3 2 4 5

50

35

2

15 15

150

0

20

40

60

80

100

120

140

160

TLT HYG LQD SHY TIP AGG EMB

Bid

/Offe

r Spr

ead

(bps

)

iShares Bid/Offer Basket Bid/Offer* (est.)


HYG Secondary to Primary Market Ratio

0

5

10

15

20

25

30

1/2/13 1/23/13 2/13/13 3/6/13 3/27/13 4/17/13 5/8/13 5/29/13 6/19/13 7/10/13 7/31/13

Seco

ndar

y to

Prim

ary

Ratio

(2

0-Da

y Ro

lling

)

Secondary to Primary Ratio (20-Day Rolling)

Date Redemptions ($MM) Exchange Volume ($MM) Secondary to Primary Ratio Amount Crossed on Exchange ($MM)

5/29/2013 -$180.06 $1,028.63 5.71 $848.57

6/3/2013 -$216.15 $1,320.47 6.11 $1,104.32

6/6/2013 -$64.57 $1,088.42 16.86 $1,023.85

6/20/2013 $0.00 $1,009.32 N/A $1,009.32

6/24/2013 -$18.17 $1,079.23 59.39 $1,061.05

Sources: BlackRock and Bloomberg, as of 7/31/13.

Sources: BlackRock and Bloomberg.

The majority of ETF trading occurs on the exchange

HYG Secondary to Primary Market Ratio on Large Volume Days

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Brok

erag

e Ac

coun

t

Investor /

Buyer M

arke

t Mak

er /

Aut

horiz

ed P

artic

ipan

t iShares

On Exchange ETF

Liquidity

Underlying Portfolio Liquidity

In-kind delivery underlying

portfolio basket

Two

Sou

rces

of L

iqui

dity

Cash

Deliver ETF Shares

ETF

• The creation / redemption process distinguishes ETFs from mutual funds and closed-end funds and enables the unique benefits of ETFs

The creation / redemption process is the conductor of liquidity between ETFs and their underlying assets


1. Authorized Participants are typically large institutional organizations, such as market makers, who are responsible for sourcing the underlying assets needed when creating units of an ETF/receiving underlying assets when redeeming units of an ETF.

2. Must occur in creation/redemption unit standard sizes, generally in multiples of 50,000 shares. 3. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained

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The innovative mechanism of iShares ETFs

Presenter

Presentation Notes

First let’s review something we’re all familiar with….how a traditional mutual fund works. Mutual fund shareholders interact directly with the fund, exchanging shares for cash or vice versa. The fund may take cash and buy securities or conversely sell securities in order to raise cash. When buying shares, shareholders receive the net-asset value (NAV) priced at the end of the trading day. As you know mutual fund regulations state that all shareholders must be treated equally, so that additional costs (costs in addition to the expense ratio) – transaction costs or tax distributions – are passed on to all remaining shareholders. What does this mean? If a large redemption from a seller forces the mutual fund to liquidate part of the portfolio and realize a capital gain for the fund, other shareholders must bear those costs – even if none of them took any action. All Exchange Traded Funds work differently than mutual funds. When shareholders buy or sell, they are interacting with one another on the exchange just as they would when buying or selling a stock. This means that the transaction costs and tax consequences the investor may incur are confined to this transaction, just like when you buy and sell shares of any stock you own. That is, any costs or taxes an investor may incur when selling shares of ABC, Inc. do not affect any other shareholders of ABC, Inc. This is one of the primary differences between an ETF and a traditional mutual fund. So what happens if a buyer (or seller’s) needs cannot be met by current market supply? How do new shares get to the market? Like a fund, shares of ETFs are continuously offered. The creation (and redemption) of shares occurs between what is known as an Authorized Participant and the fund. An Authorized Participant is often an institutional broker/dealer, a market maker. In the case of iShares ETFs, the holdings and weights of each fund, its assembly recipe, are published daily. When investors want shares of, say, the iShares S&P 500, the AP assembles (buys or gets from own inventory) each security within the S&P 500 in its precise weight and gives them to the fund. Then, in exchange for the securities, the fund gives the AP the shares of the fund. This is known as an “In-kind” transfer, and according to current IRS regulations, is a tax free exchange. Note that some markets and ETFs require cash transactions to create shares (and even redeem shares). Where possible, iShares leverages in-kind transfers. In summary: 1) shareholders interact with each other on an exchange 2) Shares are created and redeemed by authorized participants and the fund 3) The process serves to insulate other shareholders from the actions of a particular shareholder Analogy: Flowers, bouquets and a flower shop.


$95

$96

$97

$98

$99

$100

$101

6/18/13 6/19/13 6/20/13 6/21/13 6/22/13 6/23/13 6/24/13 6/25/13 6/26/13 6/27/13 6/28/13

Dolla

r Val

ue S

cale

d to

$10

0

HYG NAV Frequently Traded Bonds

HYG Market Price, NAV and Frequently Traded Holdings (scaled to $100)

Sources: BlackRock and Bloomberg, from 6/18/13 – 6/28/13.

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ETFs trade with the bonds that are trading

HYG market price based on Bloomberg closing prices; NAV as reported by BlackRock and Bloomberg. Prices for frequently traded bonds consist of the last trade of the day (in order to better align timing with the closing market price and NAV of HYG) for a transaction (buy or sell) of $1MM face value or greater as reported by TRACE. Prices were then weighted and normalized by the security’s representative weight in HYG.

For illustrative purposes only. The performance quoted represents past performance and does not guarantee future results.


Market Value of Barclays HY Index, HYG, HYT and CDX.HY (scaled to $100)

$85

$90

$95

$100

$105

4/30/13 5/8/13 5/16/13 5/24/13 6/1/13 6/9/13 6/17/13 6/25/13 7/3/13

Dolla

r Val

ue S

cale

d to

$10

0

HYG Barclays HY Index CDX HY 5-Yr HYT

Source: Bloomberg, from 4/30/13 – 7/5/13.

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ETFs trade with other exposure vehicles

Fixed Income ETF Applications

ETF applications in institutional portfolios

A recent Greenwich Associates survey indicates that 40% of the pensions, foundations and endowments polled plan to increase their use of ETFs over the next year1

Institutions which were once using ETFs solely for transitions or rebalancing are now using them for increasingly strategic purposes with longer holding periods

3%

0%

28%

3%

24%

31%

45%

24%

38%

21%

11%

27%

31%

42%

44%

50%

52%

55%

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

Other

Hedging

Core / Satellite

ETF overlay /…

Portfolio completion

Cash equitization /…

Tactical adjustments

Rebalancing

Transitions

Greenwich survey highlights: How institutions are using ETFs today

2012 2010

21%

15%

26%

24%

12%

36%

15%

19%

24%

7%

0% 10% 20% 30% 40%

> 2 years

>1–2 years

7–12 months

1–6 months

<1 month

Typical ETF Holding Period

2012 2011

Liquidity overlay strategies have surged in popularity among institutional funds, where the % of institutions implementing these strategies has

increased from 3% in 2010 to 31% in 20121

Further demonstrating the shift from tactical to strategic is holding period, where 51% of institutions averaged ETF holding periods of one year or

longer, up from 36% in 20111

1. Source: 2012 Greenwich Associates – US ETF Research. Base: 62 pensions, foundations and endowments. Interviews conducted between February and April 2012.


0

10

20

30

40

50

60

70

1 2 3 4 5

Cum

ulat

ive

TE (b

ps)

Trading Days Elapsed

Potential Cumulative Tracking Error20% Allocation Per Day

75 bps Vol 100bps Vol 125 bps Vol

Global Capital Markets

iShares ETF

Cash Bonds

Cash

Phase 1: Get invested (T)

Phase 2: Transition to bonds (T+1-15)

Cash Bonds

iShares ETF

For illustrative purposes only. Source: BlackRock. Volatility levels shown in the chart are yield volatilities.

ETFs for quick beta

Put cash to work quickly…. Declining bond liquidity makes investing large cash

balances more challenging ETFs can provide quick beta exposure to minimize

execution risk This can be particularly useful in HY where volatility

is high and bond liquidity is low

….Then add bonds strategically With an ETF providing short-tem beta exposure, a

manager can patiently wait for opportunities to add bonds

This greater flexibility provides more control over the impact of flows on the portfolio


Exposure iShares Ticker ADV ($m)

High Yield HYG $435.0

Emerging Markets (USD) EMB $85.6

Commercial MBS CMBS $1.0

International Developed IGOV, ISHG $5.1, $1.8

Emerging Markets (Local Cur.) LEMB $2.9

Emerging Markets Corp. CEMB $0.4

Emerging Markets HY EMHY $1.4

For illustrative purposes only. ADV as of 9/30/13. Source: BlackRock, Bloomberg

ETF for targeted exposure

Access hard-to-reach markets ETFs open up new areas where PMs can invest US-listed funds provide diversified, one-trade

exposure to non-US corporates or sovereigns ETFs also provide exposure where PMs may not have

research coverage such as CMBS or global high yield

Manage smaller subsidiaries and separate accounts Bring scale to management of smaller accounts

through on-exchange trading simplicity ETFs offer single trade diversification, even at low

notional amounts ETFs often provide cost efficient exposure through

low bid-offer spreads and low management fees


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“Cash Port” assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in a money market fund, rebalanced monthly. No additional transaction costs are assumed.

“ETF Port” assumes allocation of 95% to BAML High Yield Master II Index and 5% invested in iShares iBoxx $ High Yield Bond ETF (HYG) using ETF market price total returns, rebalanced monthly, and includes 2bps of roundtrip transaction costs for the ETF investment per month.

Sources: Morningstar, BlackRock as of December 31, 2012. For illustrative purposes only. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Past performance does not guarantee future results. For standardized iShares Fund performance, please refer to the end of this document.


3-Year Alpha (bps)

Cash -58.7

ETF -8.2

Difference 50.5

Rolling average 1 year alpha w/ cash: -58 bps Rolling average 3-year alpha w/ cash: -64 bps

Rolling Annualized Alpha with 5% Liquidity

Utilizing HYG to manage cash could have improved 3-year performance by 51 bps vs. holding cash This includes ETF management fees and transaction costs

ETFs can provide liquidity and help protect alpha

iShares ETFs allow you to easily express your views across different asset classes

View Applied to stocks Applied to bonds Related Fixed Income iShares ETF

Economic recovery starting

• Consumer cyclicals • Growth stocks

• High yield bonds • Investment grade corporate

bonds • Commercial mortgage

backed securities

• HYG • LQD • CMBS

Economic growth declining • High quality stocks • Consumer staples • Dividend or value

• US Treasuries • Agency bonds • High quality corporate

bonds

• GOVT • MBB • QLTA

Reduce home country bias

• Developed markets • Emerging markets

• Developed market Treasuries

• Emerging market bonds

• IGOV, ISHG • EMB, LEMB


The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

Implement your macro views in fixed income

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Presenter

Presentation Notes

The challenge many investors face is that they have experience implementing market views with equities, but not in FI For many this is because they never had the tools, before the introduction of FI ETFs most investors couldn’t easily implement FI views Now investors are developing the framework for FI tactical asset allocation And what they are finding is that their existing market view has implications not only for equity markets, but for FI as well

Avoiding Pitfalls

Key Criteria for Selecting the Right ETF

FOR INSTITUTIONAL USE ONLY – NOT FOR PUBLIC DISTRIBUTION iS-10772

How well do you know your ETF manager? Manager

What’s inside your ETF? Exposure

What are the implications of structure? Structure

Can you trade when you need to? Liquidity

What does it really cost? Costs

Layers of Liquidity

As a result of the unique creation / redemption mechanism, liquidity in a fixed income ETF is not limited to the fund’s average daily volume

For illustrative purposes only. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

An ETF’s average daily volume (on screen liquidity) is not the extent of its liquidity

Liquidity can be sourced in the secondary market by using execution strategies, such as limit orders

New shares of the ETF can be created by accessing the underlying bond market

Secondary Market

ADV

ETF Market Depth

Market maker Indications of liquidity

Primary Market Creation / redemption liquidity

(underlying basket)


Understanding ETF Trading Behavior

Arbitrage activity anchors ETF pricing to underlying value If the ETF price moves too far above the offer side of the underlying portfolio, market

participants can short the ETF and purchase the underlying securities If the ETF price moves too far below the bid side of the underlying portfolio, market

participants can purchase the ETF and short the underlying securities

Arbi

trag

e R

egio

n

Arbi

trag

e R

egio

n

ETF Bid/Offer (Liquidity Layer)

Portfolio Bid (NAV)

Portfolio Offer

ETF Premium to NAV

ETF Creation Cost

Portfolio Mid-market

Sell Pressure Buy Pressure

Although market participants may generally take advantage of differences between the NAV and trading price of ETF shares, there is no guarantee that they will do so. With short sales, an investor faces the potential for unlimited losses as the security’s price rises.


Price Discovery in Action: S&P 500 ETF (IVV)

Source: BlackRock and Bloomberg as of July 31, 2013. For illustrative purposes only. There can be no assurance that an active trading market for ETF shares will develop or be maintained. Past performance does not guarantee future results.


Price Discovery in Action: Short-term US Treasuries (SHY)



Price Discovery in Action: High Yield (HYG)




Standardized Performance as of 9/30/2013

Fund Name

Fund Inception

Date

30-Day SEC Yield (as of 9/30/13)

YTD 1 Month 3 Months 6 Months 1 Year 3 Years 5 Years 10 Years Since Inception

iShares iBoxx $ High Yield Corporate Bond ETF (HYG) 4/4/2007 5.30%

Fund NAV Total Return 2.49% 1.09% 2.17% 0.26% 5.69% 8.34% 10.48% -- 6.38%

Fund Market Price Total Return 2.25% 0.72% 2.23% 0.08% 5.57% 7.99% 10.78% -- 6.31%

Index Total Return 2.50% 1.08% 2.28% 0.37% 5.86% 8.49% 11.20% -- 6.81%

The performance quoted represents past performance of specific funds and does not guarantee future results for such funds. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. Shares of iShares Funds are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. Market returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. eastern time (when NAV is normally determined for most iShares Funds), and do not represent the returns you would receive if you traded shares at other times. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

Carefully consider the iShares Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, and, if available, summary prospectuses, which may be obtained by calling 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Diversification may not protect against market risk or loss of principal. When comparing bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual bonds. Buying and selling shares of iShares Funds will result in brokerage commissions. Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy.


The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”). The iShares Funds are not sponsored, endorsed, issued, sold or promoted by FTSE International Limited (“FTSE”), JPMorgan Chase & Co., MSCI Inc., Markit Indices Limited, Morningstar, Inc., National Association of Real Estate Investment Trusts (“NAREIT”), Russell Investment Group or S&P Dow Jones Indices LLC, nor are they sponsored, endorsed or issued by Barclays Capital, Inc. None of these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with the companies listed above. Neither FTSE nor NAREIT makes any warranty regarding the FTSE NAREIT Residential Plus Capped Index or Industrial/Office Capped Index; all rights vest in NAREITAll rights in the FTSE Developed Small Cap ex-North America Index vest in FTSE. “FTSE®” is a trademark jointly owned by the London Stock Exchange plc and The Financial Times Limited and is used by FTSE under license. ©2013 BlackRock. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. iS-10909-1013


Not FDIC Insured • No Bank Guarantee • May Lose Value

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ETF Mechanics Matthew Tucker, CFA · ETF Mechanics Matthew Tucker, CFA . Managing Director, ... with the added layer of exchange-traded ... even if none of them took any action.\爀屲All