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ETFs:A BEGINNER’S GUIDENovember 2018

The purpose of this guide is to provide an introductory guide to exchange traded funds (“ETFs”) inEurope. We note that this guide has been made available to the public and is informational only andshould not be treated as legal advice.This guide does not constitute professional advice of any kind and should not be treated asprofessional advice of any kind. No person should act upon the information contained in this guidewithout obtaining specific professional advice. The Investment Association (the “IA”) accepts no duty ofcare to any person in relation to this guide and accepts no liability for your reliance on the guide.All the information contained in this guide was compiled with reasonable professional diligence,however, the information in this guide has not been audited or verified by any third party and is subjectto change at any time, without notice and may be updated from time to time without notice. The IAnor any of its respective directors, officers, employees, partners, shareholders, affiliates, associates,members or agents (“IA Party”) do not accept any responsibility or liability for the truth, accuracy orcompleteness of the information provided, and do not make any representation or warranty, express orimplied, as to the truth, accuracy or completeness of the information in this guide.No IA Party is responsible or liable for any consequences of you or anyone else acting, or refrainingto act, in reliance on this guide or for any decision based on it, including anyone who received theinformation in this guide from any source and at any time including any recipients of any onwardtransmissions of this guide. Certain information contained within this guide may be based on orobtained or derived from data published or prepared by third parties. While such sources are believedto be reliable, no IA Party assumes any responsibility or liability for the accuracy of any informationobtained or derived from data published or prepared by third parties.Should you need further assistance then please feel free to reach out to your usual InvestmentAssociation contact. We thank Dechert LLP for its assistance in the review of this guide.

THE ETF LANDSCAPEETFs were first introduced approximately 25 years ago in Canadaand the United States. Since then they have grown into a majorportion of global capital markets, representing 4.8 trillion inglobal Assets Under Management (AUM)1. This is up from just 417bn in 20052.The US remains the largest regional ETF market,with approximately 3.65 trillion in AUM as ofJanuary 2018. Europe is the second largest ETFmarket, with approximate AUM of 850bn, followedby the Japanese and Asia-Pacific markets. Canada,Latin America, South Africa and the Middle Eastalso offer investors a variety of ETF products.Equity-based ETFs make up a considerablemajority of ETF products. However Fixed Incomebased ETFs have grown significantly in recentyears and now form a very material part of themarket. 4.8trnin globalAUMEurope 850bnin AUMUS 3.6trnin AUM12 BlackRock Global Business Intelligence, as of 31 March 2018EY’s Global ETF Research 2017 reportTHEINVESTMENTASSOCIATION.ORG 3

WHAT IS AN ETF?An exchange-traded fund (“ETF”) is an investmentfund (commonly aiming to track an index) whereshares in the investment fund are traded on astock exchange(s) and can be bought or sold byinvestors at the current market price throughouttrading hours (i.e. it allows for “intra-day” trading).sell shares in the ETF. This differs from traditionalinvestment funds which may only provide for directsubscriptions and redemptions of their shares ona periodic basis based on their net asset value(“NAV”) and so do not normally provide for intraday trading.Typically, shares in an ETF itself may only bedirectly subscribed for or redeemed with theETF itself through an intermediary financialinstitution known as an Authorised Participant(“AP”). Subscriptions and redemptions of an ETFare usually effected in large blocks of sharesknown as “baskets” by APs. Alongside the officialmarket makers for an ETF, APs will make marketsin and distribute the ETF within the secondarymarket (i.e. the stock exchange), through whichinvestors (including retail investors) may buy andThough similarly named, ETFs should not beconfused with other forms of exchange tradedproducts (ETPs), such as exchange traded notes(“ETNs”) or exchange traded commodities (“ETCs”).ETPs, which are also traded on exchange, aresubject to different regulatory frameworkscompared to ETFs and often would carry differingstructural and risk characteristics to that of an ETF.an investment fundwhere shares in theinvestment fund are tradedon a stock exchange(s)and can be bought or soldby investors at the currentmarket price throughouttrading hours.4 ETFS: A BEGINNER’S GUIDE

HOW ARE ETFsREGULATED IN EUROPEETFs in Europe may be established either incompliance with the Undertakings for CollectiveInvestment in Transferable Securities (“UCITS”)directive, in which case they must then beidentified with the “UCITS ETFs” label in their name;or the alternative investment managers’ directive(“AIFMD). Very many of the ETFs established inEurope are UCITS ETFs; consequently they benefitfrom, and are subject to, the robust regulatoryenvironment and safeguards which comes fromthe UCITS directive.European ETFs are often subject to a widevariety of laws and regulation, ranging from rulesregarding their establishment and daily operationsto regulations relating to the use of benchmarksand finally laws setting out how ETFs may bemarketed, distributed and sold across Europe. R isk management and tolerancelevels for UCITS ETFs, includingguidance related to managingcounterparty risk and conflictsof interests Collateral management A bility to redeem UCITS ETF on the primarymarket at NAV if the secondary market is nolonger available (e.g. if an AP defaults) D isclosure and reporting requirements forUCITS ETFs and ETFs, including specificrequirements for active ETFs.European regulation allows UCITS ETFs to track anindex (as a passive strategy) or an active strategy.Nevertheless most of European ETFs follow anindex-based strategy and active ETFs are not sopopular.In addition, physical European ETFs will benefitfrom regulatory safeguards created by theSecurities Financial Transactions Regulation (SFTRegulation), which provides greater information onsecurities lending and OTC derivatives trades. Forsynthetic ETFs, the EMIR regulation limits the risklinked to OTC derivatives, with central clearing forsome derivatives and/or risk mitigation techniquesfor others.Together, these set out provisions relating tothe following for an ETF established and sold inEurope:Each individual ETF will also be subject to theappropriate exchange rules in each jurisdiction inwhich the ETF is listed. E ligibility requirements for inclusion in a UCITSETF portfolio, assets diversification rules andlimitations on illiquid assets D iversification rules for indices used by aUCITS ETFThere has also been scrutiny applied on ETFsmore generally at a global level, including thepublication of the International Organization ofSecurities Commissions (“IOSCO”) Principles forthe Regulation of Exchange Traded Funds in 2013. R egulations for ETFs using Benchmarks totrack an index3 his includes, as applicable, adherence to: the UCITS Directive, the Eligible Assets Directive, the Prospectus Directive, the Benchmark Regulation and MiFID II. In addition,Tspecific guidance has been provided for UCITS ETFs by ESMA’s Guidelines on ETFs and other UCITS Issues.THEINVESTMENTASSOCIATION.ORG 5

WHAT IS THE SOURCE OF PROFITAND THE RISK OF LOSS?THE PRINCIPAL WAY OF GENERATINGRETURNS – ETF INDEX REPLICATIONETFs will typically look to track an index. It is theperformance of that index which provides thebroad nature of the investors’ experiences of gainsor losses. There are three ways in which ETFs canlook to replicate an index. As with any investment,indices can go down as well as up and so trackingan index may lead to losses.Full physical replicationAll securities within an index are purchasedaccording to their weightings, in order to ensurea minimal tracking error. This method may not bepossible for illiquid indexes, and may be costlywhere an index consists of a large number ofsecurities. As a result physical replication is usedmostly for liquid and/or narrowly defined indexes.Physical ETFs may also carry out securitieslending, which generates incomes for the fund butcreates some counterparty risk. A strict securitieslending policy (with an appropriate counterpartiesand collateral management) is required at thoseETFs in order to appropriately manage such risk.6 ETFS: A BEGINNER’S GUIDEOptimised physical replicationThis replication is also called as “samplingreplication”. This is where a limited number ofsecurities are considered, in order to create anETF that broadly reflects, but does not fully track,a given index. There will be inevitable trackingerror using this method, but optimisation looksto ensure that these deviations are low andcontrolled while looking to eliminate economicallyunattractive securities. This method is used mostlyfor indexes with illiquid investments and broadbased indexes.So-called “optimised” physical ETFs may alsocarry out securities lending, which generatesincomes for the fund but creates somecounterparty risk. A strict securitieslending policy (with an appropriatecounterparties and collateralmanagement) is required atthose ETFs to appropriatelymanage such risk.

Synthetic replicationKnown also as “unfunded swap-based ETFs”,synthetic replication involves the use ofderivatives, such as total return swaps. Underthis structure the ETF uses the investor’s cash tobuy a “substitute basket” of securities. The fundsimultaneously enters into one or several swapagreements with one or several counterpartiesthat commit to deliver the reference index’sperformance (plus securities lending revenuesgained on the lending of the index components,less swap fees if any) in exchange for theperformance of the securities purchased andsubsequently held by the fund.Synthetic ETFs do not lend their assets butthey generate counterparty risk through theuse of the swaps (from their reliance on thebank counterparties remaining solvent andable to meet their obligations under the swapcontracts). Controls at these ETFs are designed toappropriately manage such counterparty risk.OTHER WAYS OF GENERATINGRETURNS – SECURITIES LENDINGETFs will sometimes engage in securities lending,wherein securities held by the ETF are loaned toanother investor or form. Securities are commonlylent temporarily to other market participants whomay need them for a variety of their own reasons.A market participant needing shares or othersecurities may approach an ETF to borrow themtemporarily. In return, the ETF will receive a fee,and a borrower must also post collateral. The ETFwill often receive payments equal to the dividendsreceived over the security during the time it is heldby the borrower.Securities lending can generate significantrevenue for an ETF. This income generated istypically used to offset the index replication costsand thus allows the fund to have a performanceas close as possible to the benchmark index.Nonetheless, ETF securities lending does bringwith it counterparty risk, in the event that aborrower defaults in returning the securities at theend of the loan period.ACTIVE ETFsWhilst historically ETFs tracked well-knownindices, there are some ETFs in which a portfoliomanager will exercise discretion over what to buyor sell, outside of following an index. These activelymanaged funds are presently a minority; currentregulatory debate is over the extent to which activeETFs should reveal their holdings on a daily basis(see below), many active ETFs do.THEINVESTMENTASSOCIATION.ORG 7