ETFs Evolved: The Next Generation of ETFs

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1 ETFs Evolved: The Next Generation of ETFs February 2013 HorizonsETFs.com ETF solutions for every investor Member of Financial Group

2 Evolution: Cheaper, Faster and Better 2

3 ETFs Explained What is an ETF? An Exchange Traded Fund is a hybrid security that combines the best features and benefits of both stocks and mutual funds From stocks: Offers intraday liquidity through an equity exchange listing Marginable Can be sold short No minimum number of units at purchase Can use stop-loss orders From mutual funds: Instant portfolio diversification Ability to tailor the holdings to deliver a specific mandate Priced at end of the day at NAV (Net Asset Value) Specific to ETFs Market maker ensures liquidity at fair market value on intraday basis 3

4 How ETFs work Buyer Exchange Seller Secondary Market ETF Market Maker Sellers Cash or in-kind transfer of securities ETF Units Primary Market ETF Provider For Illustrative Purposes Only 4

5 Rapid Growth of ETFs Institutional growth of ETF usage still outpaces retail growth Source: Investor Economics as of September 30,

6 ETFs the Next Generation Equity Index ETFs Commodity/leveraged ETFs Active ETFs Fixed Income ETFs Synthetic/Swap Index ETFs Alternative Strategy Index ETFs 6

7 Fixed Income ETFs Versus Buying Bonds Diversification More industry diversification and credit curve positioning Transaction costs Institutional managers usually get better execution given their scale and understanding of market dynamics Active management Increases: Greater access to new issues at competitive prices Access to bonds or preferred shares in the secondary market Can participate and influence pricing of new issues (e.g. reverse inquiries) Can capture arbitrage opportunities between markets (Canada, US and Europe) 7

8 Fixed Income ETFs: Index Replication Certain types of corporate bonds or preferred shares are in thinly traded markets Fixed income traders can front-run indexing strategies, increasing the cost to rebalance the strategy Pricing on bonds is opaque Many bond indices have hundreds of bonds including illiquid issuers not suitable for ETF portfolio. ETF provider may pare back bond holdings. Fixed income ETFs engage in sampling, which is an index replication tactic that cherry picks liquid securities with a high beta to an index which may have a large allocation to less liquid securities For example: Only about 300, or half of the underlying bonds of the DEX All Corporate Bond Index have sufficient liquidity to be included in an ETF Result: A higher degree of tracking error can generally occur with ETFs that seek to replicate indices in thinly traded markets. An easy screen is to look at the historical performance of the ETF versus the index, a high deviation in performance beyond the management fee may suggest trading execution problems or index replication difficulties 8

9 Total Return Swap ETFs TRS: an agreement between two parties where one party makes a payment to the other, based on the return of a particular asset, in exchange for a payment from the other party based on the return of a different asset Obligation rests on the swap provider to deliver upon the agreed investment objective or returns. There is counterparty risk associated with swaps the swap provider must have the ability to deliver the returns - but investors end up with low cost, and usually precise delivery of returns Frequently used by large institutional investors, such as pension plans and large endowments Easy to use on large-cap equity indices where liquidity of the underlying stocks is abundant Swap provider makes money on the swap fee, if any, and potentially can find arbitrage opportunities to make additional returns with the investor money 9

10 Swap-Based ETFs: Growth Source: Morningstar 10

11 Canadian TRS Investment Structure Example assuming $100 investment = Total Cost = 7bps (or 5bps) Investor $100 $100 TRS ETF Custodian ($100 held In cash)** Units Equity Leg Index Return (Total Return) Floating Rate Leg Interest Interest (CDOR = 1.3%) Swap Counterparty Benefit Basket of Index Stocks 1. No Distributions for/tri 2. No Swap Fee *.Or equivalents 11

12 Total Return Swap ETFs: Impact of a Lower Negative Tracking Error Initial Investment ($) Annual return of benchmark index Annual tracking error Terminal value* ($) Difference vs. Fund A Terminal Value ($) Fund A 1,000,000 10% (0.07%) 2,701, Fund B 1,000,000 10% (0.15%) 2,679, (21,529) Fund C 1,000,000 10% (0.30%) 2,639, (61,435) Fund D 1,000,000 10% (0.45%) 2,600, (100,746) Difference of return over 10 years Compounded daily total return over 10 years. Source: Horizons Exchange Traded Funds 12

13 Tax Advantages All else being equal, in a rising market, a total return strategy ETF should generally be expected to deliver greater after-tax compounded performance versus a price index tracking ETF that distributes dividends on a quarterly or semi-annual basis HXT XIU Initial Investment $25, $25, NAV on Sept 14, 2010 $ $ Number of Units 2,500 1,400 Gross Income From Distributions $ - $ Tax Liability (26.57%) $ - $ Net Income From Distributions $ - $ Here s the proof. This table shows a comparison of the after-tax performance of HXT versus XIU, assuming each ETF had been bought and held since September 14, 2010, the date of HXT s inception NAV on Sept 14, 2012 $ $ Total Return (Price Return + Gross Distributions) 6.62% 6.17% After-Tax Total Return 6.62% 4.80% Difference Between After Tax Return and Total Return 0.00% -1.54% Ending Value of Investment $26, $26, Dollar Value of Return $1, $1, *Tax rate denotes highest marginal rate for an Ontario resident. Source: Bloomberg from September 14, 2010 to September 14, 2012 FOR ILLUSTRATIVE PURPOSES ONLY 13

14 What are Active ETFs? Similarities to passive ETFs Low Cost Intra-day trading Tax-efficient Eligible for registered accounts DRIP and PACC eligible Market makers ensure unit price reflects NAV Differences with passive ETFs Delivers actively managed investment strategy Managed by an investment professional Uniquely designed to meet a specific investment objective 14

15 Active ETFs: Growth Canadian Active ETFs represent $5 billion in AUM at the end of 2012, and US Active ETFs have surpassed $10 billion. 30+ Active ETFs at Horizons ETFs Huge asset growth potential as ETF industry is still small versus other pooled funds. McKinsey & Co forecasts U.S. active ETF market to reach between $500 million and $1 Trillion AUM within a decade PIMCO Total Return ETF (BOND:NYSE) Launched in March of 2012 BOND has raised more than $4 billion in AUM U.S. Active ETF market surpassed $10 billion in AUM in *As at December 31,

16 Growth of Canadian Active ETFs Active ETFs are appealing to a broader demographic than traditional mutual fund advisors 16

17 Active Management is Not Dead It just tends to be expensive. Using active management in certain categories with a low-management fee can result in better risk adjusted returns Average Canadian Equity Mutual Fund MER is about 2.1% MERs for Canadian Equity ETFs are less than 1% Actively managed ETFs can give investors exposure to strategies traditionally reserved to accredited investors, such as hedge funds, covered call strategies and managed futures 17

18 Explosive Growth In Income ETFs Source: Investor Economics 18

19 Trading ETFs: Real Life Example of ETF Liquidity Liquidity is only a concern with the underlying securities of an ETF. ETFs that track liquid asset classes, are themselves liquid Next slide is Bloomberg trading screen for Horizons S&P/TSX 60 Index ETF (HXT:TSX) Market Maker was able to fill a $50 million trade that represented more than ten times its average daily trading volume with minimal impact on bid/ask spread Source: Bloomberg 19

20 Example of a $50M Institutional Order In HXT Source: Bloomberg 20

21 Disclaimer Commissions, trailing commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by AlphaPro Management Inc. and BetaPro Management Inc. (the Horizons Exchange Traded Products ). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing. The Horizons Exchange Traded Products consist of the Horizons Index ETFs ( Index ETFs ), Bull Plus and Bear Plus ETFs ( Plus ETFs ), Spread ETFs ( Spread ETFs ), Inverse ETFs ( Inverse ETFs ), VIX ETFs (defined below) and active ETFs. The Plus ETFs, Spread ETFs and certain other Horizons Exchange Traded Products use leveraged investment techniques that magnify gains and losses and result in greater volatility in value. These Horizons Exchange Traded Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, which, where applicable, are described in their respective prospectuses. Each Plus ETF seeks a return, before fees and expenses, that is either 200% or -200% of the performance of a specified underlying index, commodity or benchmark (the Target ) for a single day. Each Spread ETF seeks a return, before fees and expenses, that is the sum of 100% of the performance of one Target plus -100% of the performance of a second Target for a single day. Each Index ETF or Inverse ETF seeks a return that is 100% or - 100%, respectively, of the performance of a Target. Due to the compounding of daily returns, a Plus ETF s, Spread ETF s or Inverse ETF s returns over periods other than one day will likely differ in amount and possibly direction from the performance of their respective Target(s) for the same period. The Horizons Exchange Traded Products whose Target is the S&P 500 VIX Short-Term Futures Index (the VIX ETFs ), one of which is a Plus ETF and one of which is an Index ETF, as described in their prospectus, are speculative investment tools that are not conventional investments. The VIX ETFs Target is highly volatile. As a result, the VIX ETFs are not generally viewed as stand-alone long-term investments. Historically, the VIX ETFs Target has tended to revert to a historical mean. As a result, the performance of the VIX ETFs Target is expected to be negative over the longer term and neither the VIX ETFs nor their Target are expected to have positive long term performance. Investors should monitor their holdings, as frequently as daily, to ensure that they remain consistent with their investment strategies. Standard & Poor s and S&P are registered trademarks of Standard and Poor s Financial Services LLC ( S&P ), TSX is a registered trademark of TSX Inc. ( TSX ) and GMP is a registered trademark of GMP Securities L.P. ( GMP ). These marks have been licensed for use by AlphaPro Management Inc. and BetaPro Management Inc. where applicable and by GMP in the case of the GMP Index. The Horizons Exchange Traded Products are not sponsored, endorsed, sold, or promoted by S&P, TSX or GMP and their affiliated companies and none of these parties make any representation, warranty or condition regarding the advisability of buying, selling and holding units/shares in the Horizons Exchange Traded Products. All trademarks/service marks are registered by their respective owners. None of the owners thereof or any of their affiliates sponsor, endorse, sell, promote or make any representation regarding the advisability of investing in the Horizons Exchange Traded Products. Complete trademark and service-mark information is available at 21

22 Biography Howard J. Atkinson, CFA, CIMA, ICD.D President, Horizons ETFs Management (Canada) Inc. Mr. Atkinson has 25 years of investment management industry experience focused on exchange traded funds. He joined Horizons ETFs Management (Canada) Inc. (formerly named BetaPro Management Inc.) as Executive Vice-President in October 2006 and has led the significant growth in assets under management from $100 million to more than $4 billion with 82 ETFs listed on the Toronto Stock Exchange. The Horizons ETFs family makes up one of the largest families of ETFs in Canada. Horizons ETFs is a member of the Mirae Asset Financial Group. Prior to joining Horizons ETFs, Mr. Atkinson was responsible for the Exchange Traded Products business at Barclays Global Investors Canada Limited and has held positions with a national investment dealer and major mutual fund companies. Mr. Atkinson serves on the board of directors of both Horizons ETFs and its subsidiary BetaShares Capital Ltd., an Australian firm providing exchange traded funds under the BetaShares ETFs brand. In addition, Mr. Atkinson is a past President of the Toronto CFA Society and is a member of the S&P/TSX Canada Index Advisory Panel. In 2009, he achieved the ICD.D designation from the Institute of Corporate Directors. Mr. Atkinson is the author of four books including The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, (Insomniac Press, 2005) and Les Fonds Négociés en Bourse: Un outil de placement novateur pour l'investisseur avisé (Transcontinental, 2003). Mr. Atkinson has been a contributing writer and frequent analyst referenced in many major Canadian newspapers, including The Globe & Mail, National Post, Toronto Star, Vancouver Sun, and Ottawa Citizen. He is also a co-author of Market Efficiency, a chapter in the CFA Institute Investment Series book entitled Investments: Principles of Portfolio and Equity Analysis (Wiley, 2011) and is currently used as Level 1 material within the Candidate Body of Knowledge. Mr. Atkinson is a regular guest on BNN (Canada s Business News Network) and has appeared several times on CNBC Europe and Global TV. In February 2010, he was recognized by ACTIF, Quebec's premier financial education co-operative, as the Top Educator for his efforts to foster financial literacy among Canadians. Mr. Atkinson is also the current chair of the Canadian ETF Association (CETFA), an independent national association that represents and promotes the Canadian ETF industry. CETFA was founded by three leading Canadian ETF firms in May 2011 and is the first organization of its kind in the world. 22