ETF Fundamentals

Chris McHaney, CFA

Vice President & Portfolio Manager

BMO Global Asset Management

PMAC

February 26, 2013

Industry Insight

“ ETFs have the potential to recast the traditional ways of building client portfolios and are

in the process of altering the competitive and economic landscape of the business” Investor Economics

Source: BMO Asset Management Inc.

Industry Insight - ETF growth has multiple drivers

• Cost efficiency. Low fees are the largest driver of ETF popularity

• Diversification. Reduce single stock or bond risk

• Transparency. All holdings outlined – (know your exposures)

• Hard to access exposures. eg: Gold or covered call strategies

• Scalable. Can be implemented for small and large plans

• Tax efficiency. More tax efficient than other types of investments

• Simplify investment decisions. A growing range of products allows

investors to use ETFs for very focused sector, asset or geographic coverage.

ETFs help create more diverse portfolios

250 ETFs in Canada and over 1000 in the US

New types of portfolios can be created given more:

• asset classes

• international options

• sectors

• factors

• strategies

Trading tips: • When entering a trade always use a limit order • Avoid trading ETFs immediately after market open or prior to market close • Throughout the day, ETFs closely track NAV except for at these times

ETF Liquidity

Trading volumes of the underlying = ETF liquidity

Average bid/offer spread

ETF Liquidity

Type of Weighting Schemes

• Market Capitalization Weighting

• Fundamental Weighting

– Revenue Weighting

– Dividend Weighting

– Beta Weighting

• Equal Weighting

– Sectors

– Broad Indices

• Price Weighting

Types of ETFs – Equal Weight

• Equal weighting – for mature sectors

Source: BMO ETFs, Bloomberg

The Lost Decade?

•Depends on how you look at it

•From a market cap perspective, sure. Equal weighting and fundamentally weighted indices however showed very solid returns

When Is Each Index Methodology Appropriate?

Market-Cap Weighted Methodology

Fundamentally Weighted Methodology

Equal Weighted Methodology

When To Use •When the market favours growth oriented companies

•When large caps outperform small caps

•When market favours companies trading at attractive valuations

•When market cap weighted indices heavily favour a certain country, sector or company

•When market cap weighted indices heavily favour a certain country, sector or company

•When market favours companies trading at attractive valuations

•When small caps outperform large caps

When To Avoid •When markets are overvalued

•When the index is heavily weighted towards a certain country, sector or company

•When small caps outperform large caps

•When the market favours growth oriented companies

•When a certain country, sector or stock is significantly outperforming

•When small cap companies are illiquid

•When market wants to avoid company specific risk

Index Selection

Keys to look for when selecting a benchmark:

• Investability

• Completeness

• Clear, Published Rules and Governance

• Accurate and Complete Data

• Acceptance by Investors

Understanding ETFs – Demographics

• Households that hold ETFs are on average wealthier - Investible assets are on average above $180k vs $102k

• ETF holders have a higher income (90k vs 67k)

• Average age is 53

Source: Investor Economics March 2010 & BMO Retirement Institute

74% of all investors will switch or consolidate to an advisor within 10 years of retirement

ETFs vs. Mutual Funds

• Mutual funds are conducive to smaller, more frequent transactions

• Long term investors may not require intraday liquidity

• The structure of ETFs helps investors control when they realize capital gains

How Are ETFs Being Used By Institutions?

Tactical asset allocation and transition management continue to be the main use of ETFs

We are also seeing a increasing number of Canadian institutional investors using ETFs

Transition Management

• During a manager search, unmanaged assets can significantly deviate from the plan benchmark and objectives, potentially creating a mismatch to liabilities

• ETFs can be used to maintain market exposure

Manager A ETF

Manager B

Use ETFs Minimize Trading Hour Differences

•Since some ETFs are listed on a number of different exchanges and a number of different time zones, investors can get international exposure in their own time zone

•Like futures, ETFs provide price discovery in markets when their underlying markets are closed

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Disclaimer