Myths and Realities of ETFs and Index Investing - Ananth Madhavan, Managing Director, Global Head of Research for ETF and Index Investing, BlackRock Presented at the AQR Asset Management Institute conference, Perspectives: Systemic Risk in Asset Management held on 26 April 2017 at London Business School.

1. Myths and Realities of ETFs and
Index Investing
Ananth Madhavan
Global Head of Research for ETFs and Index Investing
BlackRock
April 26th, 2017
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2. Similar trends across the world
Source: Simfund MF for US Domiciled Mutual Funds. Simfund Global for Non-US Domiciled Mutual Funds. iShares GBI for ETFs. Excludes Fund of Funds (except for Multi-Asset),
Money-Market and Closed-End Funds. As of 11/16. Cumulative flows for active EQ MFs and ETFs as of 1/9/2017.
(1.0)
(0.5)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Mutual fund cumulative flows ($tn)
US Non-US
Active
equity
-$1.0
(1.0)
(0.5)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
ETFs
$1.2
Alternative Investments
$0.2
Active
equity
-$0.3
ETFs $0.5
Factors
$0.1
Multi-asset
$0.0
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3. A security…
 Price transparency – real-time, public
 Secondary liquidity – non-intermediated
 Simplicity – trades on an exchange like a stock
…and an investment tool
 Most seek to track benchmark indexes
 Low cost
But unlike traditional mutual funds, creations/redemptions do not require the fund
to interact with the market
ETFs - Combine Elements of Stocks and Mutual Funds
Individual
corporate
bonds
High Yield
Corporate
Bond ETF
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4. Clients choosing among four financial
instruments
ETFs small relative to potential
Notes: ETFs as of Sept 2016, Global market as of Aug 2016, MFs as of Aug 2016, ETPs as of Aug 2016.
Source: Bank for International Settlements, Strategic Insight Simfund, BlackRock, Bloomberg.
The competitive set is large – there is a huge runway for adoption
$18
Stocks
$65
Bonds
$95
$3.8
$21
$49
$160
ETFs Global Mutual
Funds
Equity Index
Futures &
Swaps
Equity &
Fixed Income
Securities
$3
Index
Securities
ETFs
“Active” low value
funds: closet
index & factor
huggers
Index funds /
separate accounts
Single
security
holdings
Futures
and swaps
F: $25
S: $24
S: $24
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5. Fixed income market penetration is still very low
US equity
ETFs
US equity
mutual funds
US fixed income = $46T
Europe equity = $11T Europe fixed income = $14T
US market: All data as of 30/06/2016. Equity data sourced from BlackRock, Bloomberg, Simfund. Fixed Income data sourced from BlackRock, Bloomberg, Sifma, Morningstar.
European market: All data as of 30/12/16. Data sourced from BlackRock, Morningstar. Mutual funds sourced from Morningstar category “Europe OE & ETF & MM”. Europe equity market size = sum of market
capitalisation of MSCI Europe IMI Index. Europe fixed income market size = sum of market capitalisation Barclays Pan Euro Aggregate + Barclays Pan Euro High Yield indices..
 US bond ETF
penetration is only
one-tenth equity ETF
penetration
 European bond ETF
penetration is similarly
small
US equity market = $24T
US bond
mutual funds
0.8%
US bond ETFs
38.0
%
7.6%
6.7%
15.1%
Europe
domiciled
bond
ETFs,
0.6%
Europe
domiciled
bond mutual
funds
21.3%
Europe
domiciled
equity
ETFs,
1.5%
Europe
domiciled
equity mutual
funds
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6. Case study: US HY ETF in stressed markets
Fixed income ETFs have weathered many stressed markets including:
 Credit Crisis (2008)  European Sovereign
Debt Crisis (2010)
 U.S. Treasury
Downgrade (2011)
 Taper Tantrum
(2013)
 Oil Selloff
(2014)
 12/11/2015
During each of these stressed periods, many bond ETFs have displayed:
INCREASED VOLUMES DISCOUNTS TO NAV NO FORCED SELLING
Bond ETFs may trade more during a crisis
Source: BlackRock and Bloomberg as of 30 September 2016. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained
Fixed income ETFs in stressed markets
0%
5%
10%
15%
20%
25%
30%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
US HY ETF Create/Redeem as % of HY Cash US HY ETF Exchange Volume as % of HY Cash
Financial Crisis
European
Debt Crisis
US Treasury
Downgrade
Taper Tantrum
Oil Sell Off
(2014)
High Yield
Sell-Off
(2015)
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7. US HY ETF trading activity has limited impact on the underlying
bond market
Sources: BlackRock and Bloomberg, as of 30 September 2016. For illustrative purposes only. The performance quoted represents past performance and does not guarantee future results.
The dollar value of the ETF shares traded on the exchange divided by the gross dollar value of the
flows into and out of the ETF
Date
Creations / redemption
($m)
On-exchange volume
($m)
On-exchange to creation /
redemption ratio
Volume crossed on-
exchange ($m)
2015 high yield sell-off
11/12/2015 560.63 4,310.75 7.69 3,750.12
14/12/2015 395.40 3,033.06 7.67 2,637.66
15/12/2015 191.04 2,910.50 15.23 2,719.46
16/12/2015 104.09 2,460.44 23.64 2,356.35
18/12/2015 0.00 1,873.21 N/A 1,873.21
2013 Taper Tantrum
29/05/2013 178.99 1,028.63 6.56 849.63
03/06/2013 214.17 1,320.47 4.54 1,106.29
06/06/2013 64.401 1,088.41 17.84 1,024.01
 On-exchange to creation /
redemption ratio of bond ETFs
tends to increase over time
 A US HY ETF secondary to
primary ratio has tended to be
around 6:1 (i.e. for every 1 unit
of this US HY ETF that is
created/redeemed $6 trades on-
exchange
ETF secondary to primary ratio for a US HY ETF on large volume days
0
5
10
15
20
25
Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16
SecondarytoPrimaryRatio
(20-DayRolling)
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8. Considerations re: indexed markets
Reduce price discovery:
• Passive so large, price discovery impaired
• Reduced ability of active managers to generate alpha
1
2 Reduction in liquidity of underlying assets
(Fixed Income)
3 Additional Volatility induced by ETF trading
4 Reduced product market competition from
common owners
5 Insufficient monitoring by passive investors
• Information velocity of active managers much higher passive
• Premise: The ability to generate alpha is independent of the correlation
environment because longs and shorts (vs. benchmarks) cancel each other out
• Main drivers of increased correlations are central banks
• More passive flows by non-information motivated traders could provide more
alpha opportunities for active managers
• Traders are choosing ETFs because of declining underlying liquidity, not the
reverse
• Fixed Income ETFs add to overall market liquidity through direct un-
intermediated secondary trading
• Especially valuable in stress - acts as a safety valve
• Trading of ETFs is a source of price discovery
• In times of stress, people trade more ETFs
• No evidence of any communication or implicit collusion among large
shareholders
• Passive managers have clearly stated governance principles
• As long-term scale players, the large passive investors invest far more in
governance than do dispersed individual shareholders or smaller active managers
Governance
Market functioning
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