Harbour Asset Management New Zealand Equity Advanced Beta Fund FAQ S

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1 Harbour Asset Management New Zealand Equity Advanced Beta Fund FAQ S January 2015 ContactUs@harbourasset.co.nz What is Advanced Beta? The name Advanced Beta is often interchanged with terms such as Smart Beta, alternative beta or strategy indices. Traditional index or passive funds aim to replicate an index that weights stocks by market capitalisation. This makes a stock price the primary determinant of the stock's prominence in the index. This can lead to being overweight expensive stocks and underweight undervalued ones. In contrast, Advanced Beta strategies are designed to provide broad equity market exposure. They use other factors to weight stocks in the portfolio. Factors are often fundamental in nature, such as value and yield, but can also be market-based, with factors such as volatility or momentum. These factors can often have their own unique performance cycles. How do Advanced Beta Fund risks compare to Index Funds? There are many different types of Advanced Beta strategies ranging from a focus on low volatility to leverage. Depending on portfolio construction Advanced Beta strategies can give greater diversification than a market cap weighted strategy, and greater visibility into understanding where the risks and returns may lie. As an investor it is important to understand how the risk and return profiles of the underlying strategies are derived. A strategy may be empirically proven over the long term to provide investors with comfort and understanding regarding the likely success of the strategy. How do Advanced Beta Fund returns compare to Index Funds? Due to the different construction of Advanced Beta portfolios, return outcomes can deviate from traditional or published headline index returns. Investors need to be aware that Advanced Beta strategies may go through periods of relative underperformance when compared to a capitalised weighted index. The factors used in constructing Advanced Beta portfolios can often have their own unique performance cycles. Having an understanding of the sources of returns can provide investors with reasons for periods of under or outperformance. Investors in index ETF s or index passive funds will typically get the index return less associated costs. Cash holdings and fund expenses typically provide a return drag compared to the index return. Some funds try to account for this by securing other income from activities such as stock lending or using derivatives. How does Advanced Beta compare to Active and Passive Portfolio Management? Many active managers, including Harbour, use particular quantitative factors in the investment process to achieve above benchmark returns. Advanced Beta funds in some cases capture these sources of return while retaining the benefits of rules based investing, such as, transparency, diversification, investment strategy capacity and relatively low turnover and costs. Portfolio construction is generally rules based, transparent and prescriptive. Advanced Beta strategies can be used within broader investment portfolios to complement both traditional capweighted passive index strategies as well as actively managed strategies. Advanced Beta funds typically cost less than active management because the process is rules based, and does not require the same level of research or any stock selection decisions undertaken by a fundamental active manager. 1

2 Source: Morningstar. What is the Harbour Advanced Beta Fund? The Harbour Advanced Beta Fund is designed to provide investors with market exposure to the NZX Portfolio Index, with additional tilts towards value, yield and growth factors. The fund is rules based and quantitatively driven with monthly rebalancing of the factor portion of the portfolio, low portfolio turnover and an appropriate fee structure. Around 70% of the Fund will track the NZX Portfolio Index with a 30% exposure to three equally weighted portfolios targeting factor exposure to value, yield and growth. Harbour has extensive experience managing both active and passive funds for clients with strong skills in effective portfolio implementation. How is the portfolio constructed? The portfolio is constructed with a circa 70% weight to the NZX Portfolio Index constituents, and the remaining 30% in the quantitatively screened factors of valuation (10%), yield (10%) and growth (10%). The positions derived from the factor screens also pass liquidity and data sensibility screens before being included in the final portfolio. What is the factor allocation in the active portfolio? Why are equal weightings applied? The factor allocations are approximately equally weighted 10% value, 10% yield and 10% growth. The success factors have their own unique performance cycles. Although they have outperformed capitalisation and modifiedcapitalisation weight methodologies in simulations over the long term, the simulations show periods of relative underperformance. Rather than optimising for the highest returns, hence the riskiest/most volatile strategy (Growth), or minimising volatility and creating a larger weight in the most defensive strategy (Yield), Harbour uses an equally weighted approach for diversification of market exposure sources. Unless there is an empirical reason to weight the factors differently, we consider the equally weighted approach as the most transparent and robust approach across market cycles. This is in-line with many advanced beta methodologies rather than weights based on optimisation or qualitative measures. 2

3 Why did Harbour select only three success factors? Harbour selected success factors that are well known, proven and already included in existing Harbour equity investment processes. Out of ten possible factors we settled on three: Growth, Value and Yield. All three factors were largely uncorrelated, have unique risk and return characteristics and perform differently in market cycles. Further, all strategies performed to statistical and financial significance. Harbour has experience using all three factors, with the aim to diversify the Advanced Beta Fund s sources of return to provide an enhanced return to the NZX portfolio index over most market cycles. Who is the Advanced Beta Fund suitable for? Depending on investor needs and constraints, the Harbour Advanced Beta Fund may be suitable for different types of investors. Advanced Beta strategies can be used on their own or within broader investment portfolios to complement both traditional capitalisation-weighted passive index and actively managed strategies. From the passive perspective, the Fund invests in a modified cap weighted index with tilts to factors that drive investment returns. This may be a more efficient allocation of capital than investing the most in the largest stocks in the market in a traditional passive capitalisation weighted approach. The Advanced Beta Fund aims to capture these sources of return while retaining the benefits of rules based investing, such as, transparency, diversification and relatively low turnover and costs. For active strategies, the Advanced Beta Fund can be used as a core portfolio which could be combined with specific stocks or a concentrated portfolio. The Advanced Beta Fund allows active investors to have an anchored portfolio with an efficient allocation of capital to factors that may drive equity returns over the long term, implemented at a lower cost than traditional active management. It is important to speak to a financial advisor before making any investment decisions. What is the benchmark for the Fund? The Harbour Advanced Beta Fund is benchmarked against the NZX Portfolio Index including imputation credits. Why have you chosen the NZX Portfolio Index as a Benchmark? The NZX Portfolio Index is a modified capitalisation weighted index with a bias towards smaller cap companies. Studies have shown that over time small cap companies outperform large cap companies. Hence, a modified capitalisation weighted benchmark may provide a more efficient allocation of capital, than a capitalisation weighted benchmark which provides a higher index weighting to the largest stocks. What is the performance objective of the Fund? The Fund aims to track the NZX Portfolio Index with additional tilts to empirically proven success factors to provide an enhanced return to the NZX Portfolio Index over most market cycles. What is the tracking error target? The expected ex-ante tracking error is less than 200 basis points. Why Yield? Yield is a fundamental factor that Harbour has been using since inception of the Harbour Equity Income Fund process. Dividend yield is an important fundamental factor as it is tangible proof of excess free cash flow. It is independently verified by the investor and is not subject to potential management manipulation of accounting numbers. Why Growth? Growth is an important driver of equity returns. Harbour has used growth indicators in its equity growth process for over 10 years. 3

4 Why Value? Value has been part of the Harbour Equity Income Fund process since the Fund s inception. Value is a fundamental factor that performs well in many markets and many market cycles. This approach focuses on the intrinsic value of a stock, buying undervalued stocks. Why are the success factors only 30% of the portfolio? The Advanced Beta Fund may be seen as a substitute to investments tracking the NZX Portfolio Index. The Advanced Beta Fund includes extra proven and transparent sources of returns compared to the purely passive option. To keep similar risk and return characteristics to the NZX Portfolio Index, Harbour considers that a 30% success factors 70% passive is optimal. This strategy has a tracking error of between 1.5 to 2% per annum. What is the passive percentage of the portfolio? Approximately 70% of the Fund will passively track the NZX Portfolio Index. The remaining 30% of the Fund is invested in companies which are identified from the success factor screens. What is the beta of the Fund? The Fund aims to have a similar beta to the NZX Portfolio Index. Beta may vary between 0.9 and 1.1. What is the maximum weight of a stock in the active portfolio? The maximum weight of a stock may be meaningful if it screens positively in the growth, yield and value screens. Investment guidelines place constraints around position size relative to the company s market capitalization. What is the minimum weight of a stock in the active portfolio? For the active portion of the portfolio, to make the position meaningful we envisage a minimum of 35 basis points (0.35%). Do you have position size limits relative to liquidity or market cap for the active portfolio? Yes, the investment guidelines ensure we have limits on positions relative to market capitalisation. What is the average cash weight in the portfolio? What is the cash weight limit? The portfolio will typically be fully invested with minimal cash balances. The Fund has a cash limit of 5% of the portfolio. What sector tilts will the portfolio have? The Fund does not intentionally tilt towards certain sectors. However, sector tilts that differ from the benchmark are likely to exist. Are there stocks outside of the index that get included in the active portfolio? Yes, stocks with sufficient liquidity and size can be included in the Fund if they are candidates for index inclusion. These companies are generally confined to dual listed stocks not in the benchmark, or companies which have recently IPO d and we may have been uncertain about index inclusion at the initial bidding process. They may have sufficient liquidity characteristics and screen well on the success factors. What is the process for IPO stocks and inclusion? Where a company is likely to be included in the index due to its listing size, Harbour may make a bid into the IPO book build process. What are the fees? Fees are 0.52% management fee (includes investment management fee and fund administration) plus 0.02% other to cover legal and audit. There are no entry or exit fees. There is also no performance fee. 4

5 Does the Fund pay distributions? No. What is the estimated turnover for the portfolio? Advanced beta portfolios typically have less turnover than active funds. Turnover of the simulated portfolio has been between 0.3 and 0.6 times p.a. over the last 10 years. We would expect the turnover to be within this range. Does the Fund stock lend? If so does the Fund keep all of the income? Yes, the portfolio may prudently conduct stock lending up to a maximum of 20% of the portfolio. All proceeds (after transaction costs) from stock lending are paid to the Fund, not the manager. What are the risks? We consider that the principal risks you face when investing in the Fund are in the following four main areas: 1. Manager specific risk Manager specific risk relates to us as a company and the risks around how we manage and operate our business, including the making of investment decisions. These risks will differ from the risks of other fund managers. 2. Fund specific risk Fund specific risk relates to the Fund s investment style (i.e. how we manage the Fund) and the risks the Fund faces due to the underlying securities that the Fund invests in. As a result, Funds have different risk profiles. 3. General risks General risks relate to the investment fund industry as a whole and the risks associated with us offering managed funds to the public. 4. Security lending The Fund has the ability to implement a securities lending programme where securities held by the Fund may be loaned to a borrower. This introduces borrower credit risk and settlement risk. In managing your investment, we are aware of these risks and believe the following factors can help manage potential risks you face as unit holder in the Fund: A well-resourced and experienced investment team Sound investment philosophy Consistency of investment process Governance and controls. Further and more detailed information on these four risk categories and the factors that can Harbour believes can help mitigate risks can be found under What are my risks? on page 16 of the Investment Statement. Important to note: This information summary is provided for general information purposes only. Investment into the Advanced Beta Fund must only be made using the offer document, which is available on our website - click here. Simulated performance is not indicative of potential actual performance of the Fund. 5