Ins and Outs of Exchange-Traded Funds

Ins and Outs of Exchange-Traded Funds June 25, 2012 Naveed Mohammed, CFA, Mutual Funds Analyst Dennis Fong, Mutual Funds Analyst Tyler Hosie, Associate Introduction Exchange-traded funds have become prevalent in the global and Canadian investment world. The global ETF industry grew in assets by a compound annual growth rate (CAGR) of 29% from 2001 2011. As of April 2012, this consisted of 3,204 funds with US$1,526.3 billion in assets under management (AUM). The Canadian market has seen similar growth, consisting of US$50.0 billion of AUM in 249 funds 1. TSX-listed ETFs cover a broad range of asset classes from Fixed Income to Equity, Commodities, and Currencies, with a range of geographic and sector flavours. Even ETF funds-of-funds are now available to purchase as one-ticket solutions. ishares continues to be the dominant provider in Canada with 79% of the market share of assets, followed by BMO Asset Management (the fastest growing provider) with a 12% presence 2. Vanguard recently entered the Canadian market and is positioned as the low-cost provider. As the investment choices continue to expand it is important to understand the advantages and disadvantages of ETFs along with the criteria used to evaluate them. Once this is understood, investors can benefit from a few rules of thumb to ensure optimal trading execution. Figure 1: Canadian ETFs Assets US$B 50 40 30 20 CAGR: 30% Number of ETFs 50 250 200 150 100 10 0 3 50 0 Source: ishares, ETP Landscape Industry Highlights, April 2012 The Basics # ETFs Assets An ETF is an open-ended fund consisting of a basket of securities that aim to track the performance of an underlying index. The index itself may be constructed in a manner that is more passive (i.e., market capitalization weighted, equally weighted) or active (i.e., fundamental) in nature. 1 ishares ETP Landscape Industry Highlights April 2012 2 ishares ETP Landscape Industry Highlights April 2012 Member-Canadian Investor Protection Fund

2 Advantages and Disadvantages ETFs offer many advantages compared to other types of investment vehicles. The most direct comparison is often mutual funds. Advantages Lower Cost: Many ETFs charge lower management fees than mutual funds, mainly due to their passive investment process. For example, the TD Canadian Index, the least expensive index mutual fund that aims to track the performance of the S&P/TSX Composite Index, has a Management Expense Ratio (MER) of 0.88%. This compares to the ishares S&P/TSX Capped Composite Index Fund (XIC) with an MER of 0.27% (excluding trading costs). Transparency: ETFs have notable price and holdings transparency. ETF prices can be observed at any point in time during market hours and holdings are provided on a daily basis, whereas mutual fund prices (NAVs [Net Asset Value]) are only observed after market close (i.e., not known at the time of purchase), and full portfolio holdings are only released twice a year in the financial statements. Diversification: Since ETFs usually aim to track the performance of an index, they are often well diversified within the particular asset class. ETFs provide tax efficiency in a number of ways: Fewer Capital Gains: Most of the tax efficiency of passive ETFs is due to the composition of the underlying index. ETFs that track a market capitalization weighted index will exhibit a great deal of tax efficiency due to infrequent trading, as opposed to an equal weighted index where the manager must continually rebalance. Redemption Process: When ETF units are redeemed, a market maker will transfer ETF units in-kind for a predefined basket of securities. Once this exchange is complete, the ETF units are destroyed. Since no cash is exchanged, capital gains are not realized. Also, the ETF manufacturer can choose to deliver the underlying securities with the lowest cost base, thus mitigating future capital gains that may result from selling underlying securities. This is much different than mutual fund redemptions where the manager must sell underlying securities, triggering a taxable event. Flexibility: Since ETFs trade similar to a stock, they can be short-sold, purchased on margin, etc. Liquidity: Trading similar to a stock also means ETFs can be bought and sold at any time the market is open. In addition, the creation and redemption process provides liquidity beyond existing units (discussed below). Disadvantages The disadvantages of investing in ETFs are mainly by-products from the advantages discussed above. Trading Commissions: Depending on the size of the order, the transaction costs to purchase an ETF on the stock exchange may be material. Bid-Ask Spread: The bid-ask spread implicitly assumes at the time of transaction that the investor is buying securities at a higher amount than they can be sold at in order to compensate market makers. This spread is largely driven by the bid-ask spread of the underlying securities and the competitiveness amongst market makers. Difficult to Beat the Index: ETFs are unlikely to beat the underlying index due to management fees, fund expenses, and trading costs.

3 ETF Creation and Redemption Process A basic understanding of the ETF creation and redemption process provides the foundation in understanding an ETFs liquidity and pricing. The creation of an ETF is as follows (Figure 2): 1. A designated broker (market maker) puts up seed capital and buys securities that the ETF sponsor wishes to hold. For example, if the ETF aims to track the S&P/TSX 60 Index, then the designated broker will purchase the constituents in the same weights as the index. 2. The securities are then delivered to the ETF sponsor in exchange for an equally valued amount of ETF shares. Both parties benefit from this transaction. The ETF sponsor receives the shares it needs to track the index and the designated broker now has ETF shares that it can sell for a profit via the bid-ask spread. The redemption process is the reverse. Figure 2: ETF Creation Designated Broker Buy securities Market ETF ETF Sponsor Exchange securities for ETF units Source: BMO Nesbitt Burns Pricing This creation and redemption process is also crucial to keeping the ETFs market price in line with its NAV. As shown in Figure 3 on the following page, when there is an over-supply in the market for a particular ETF, the price will become out of favour compared to the underlying securities. Designated brokers will take action by purchasing enough of the undervalued ETF in the market and redeeming it with the ETF sponsor at fair value in exchange for the underlying securities. The designated broker will then sell the securities in the market and lock in an arbitrage profit (vice-versa for over-demand). This process will occur until the ETF market price and NAV achieve equilibrium.

4 Figure 3: ETF Arbitrage 1. Over-Supply: ETF NAV > ETF Price 2. Equilibrium: ETF NAV = ETF Price Designated Broker Purchase undervalued ETF units Market Designated Broker Sell securities for arbitrage profit Market ETF $$ ETF $$ Redeem ETF units (at fair value) in exchange for securities ETF Sponsor ETF Sponsor Source: BMO Nesbitt Burns Liquidity The creation and redemption process also plays an important role in an ETFs liquidity. Liquidity of an ETF is not bound by the actual trading volume of the ETF itself or confined to existing ETF units. Designated brokers who are responsible for posting bid and ask offers can create and redeem ETF units as the supply/demand changes. As per Figure 4, the BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO) appears to have a small amount of liquidity based on its trading volume. However, the actual liquidity, as demonstrated by the bid-ask spread, is more represented by the liquidity of the underlying securities. This is an important point so it is worth repeating: ETF liquidity is better represented by the liquidity of the underlying securities rather than its own trading volume. Figure 4: ZEO and Underlying Securities Liquidity Shares (MM) Spread (C$) 8 6 4 2 0 0.02 ZEO 7.36 SU 6.40 TLM 5.22 CNQ 4.25 ECA 3.21 NXY 3.10 ENB 3.07 COS 2.88 CVE 2.48 TRP 1.96 PWT 1.52 HSE 1.35 ARX 1.08 IMO 1.01 ERF 0.05 0.04 0.03 0.02 0.01 0.00 Daily Bid-Ask Spread (Three-month average) Source: BMO Asset Management, Bloomberg Note: Underlying securities of ZEO as of April 30, 2012; Three-month average ending March 2012 Daily Volume MM (Three-month average) Evaluation Criteria We now turn our focus to the criteria that are important when evaluating ETFs. The criteria can be segmented into two groups: qualitative and quantitative.

5 Qualitative Evaluation Criteria Two important qualitative aspects that must be examined before purchasing an individual ETF are the underlying index and the replication method. Underlying Index: Understanding the underlying index is essential when purchasing an ETF. Indices can be created using a number of different methodologies (market capitalization weighted, equally weighted, fundamentally weighted, etc.) and can have very different underlying holdings (direct investment, American Depository Receipt, etc.). All of these factors impact the diversification of the index along with the risk/return profile in different market conditions. Figure 5 shows two ETFs that aim to provide exposure to the BRIC countries (Brazil, Russia, India, and China). These ETFs track different indices that have very different underlying holdings. As can be seen, the country weightings, number of holdings, and return profiles have meaningful differences. Figure 5: BRIC ETF Comparison ETF ishares: MSCI BRIC Index Fund (BKF-US) Guggenheim: Guggenheim BRIC Index Fund (EEB-US) Index Index Description MSCI BRIC Index Measures the combined equity market performance in Brazil, Russia, India and China BNY Mellon BRIC Select ADR Index Comprised of American and Global depositary receipts selected, based on liquidity from a universe of all listed depositary receipts of companies from Brazil, Russia, India and China currently trading on U.S. exchanges Index Weighting Market capitalization Expense Ratio 0.69% Holdings* Brazil: 27% Russia: 13% India: 14% Market capitalization China: 41% Other: 5% 0.60% Brazil: 49% Russia: 2% India: 11% China: 34% Other: 4% Annualized Returns (US$)** *As of June 5, 2012 ** As of June 12, 2012 Source: ETF db # of holdings: 327 1-Year: -22.84% 3-Year: -3.77% 5-Year: NA # of holdings: 84 1-Year: -20.75% 3-Year: 0.18% 5-Year: 0.57% Replication Method: There are a few common types of index replication methods that ETFs employ, which fall into two broad buckets Physical and Synthetic. Physical: Physical replication is when an ETF holds the actual underlying constituents of the index. These ETFs can use full replication or optimized sampling to provide this exposure. In theory, full replication should provide better exposure to the underlying index; however, full replication may not always be employable if the underlying securities are illiquid, or it may not always be cost effective if the index contains a very large amount of constituents. Synthetic: Synthetic replication is when an ETF utilizes a total return swap or derivative contract in order to provide exposure to the underlying index. Synthetic ETFs may track the index more closely because the swap return equals the index return. Rebalancing costs may also be less compared to Physical ETFs. Counterparty Risk: The discussion of Physical versus Synthetic ETFs cannot be complete without the mention of counterparty risk. Although Synthetic ETFs contain counterparty risk (the swap partner defaults or fails to honour its contractual obligations), Physical ETFs may also have counterparty risk due to an ETF sponsors use of security lending to earn revenue in hopes of decreasing the tracking error. Investors must examine each ETFs counterparty risk before investing.

6 Quantitative Evaluation Criteria Quantitative evaluation of ETFs includes cost, performance, and liquidity. Cost: The evaluation of ETF costs is twofold: Management Expense Ratio (MER): The MER is one of the most important cost considerations to evaluate before purchasing an ETF. The MER of an ETF is equal to the sum of its management fee, operating expenses, and taxes. MERs must be evaluated in the context of the fund s asset class. Bid-ask Spread: The smaller the bid-ask spread, the better. In essence, the smaller the spread, the less profit the market maker is taking from the investor. Performance: The following discussion of an ETFs performance is in the context of how well the ETF provides the underlying index return. Keep in mind that ETFs in similar asset classes may follow indices that employ different methodologies, leading to different returns. In a perfect world, an ETFs return should equal the index return less any applicable fees. However, this is not always the case. The excess return of an ETF (and its decomposition) should be as close to zero as possible and should have minimal volatility. Excess Return = ETF Market Price Return Index Return Excess Return = ETF Market Price Return ETF NAV Return Index Return Premium/Discount to NAV Return Tracking Return Premium/Discount to NAV Return: A well-functioning ETF should have this source of return minimized along with its volatility due to arbitrage in the creation and redemption process. However, a greater return when comparing the Market Price to its NAV indicates that the market price of the ETF appreciated relative to the sum of the underlying holdings. This is extra return that the investor has earned, but this should not be expected to continue in the future. In fact, it may reverse. Tracking Return: ETFs aim to track the performance of an index. Thus, the tracking return should be minimized along with its volatility (tracking error). Liquidity: The more the better. As discussed above, do not confuse the trading volume of an ETF with its actual liquidity. The actual liquidity of an ETF is a function of the liquidity of the underlying assets and the competitiveness of the market makers. Purchasing Considerations There are a few rules of thumb that should be followed when purchasing ETFs. These will help ensure the investor obtains the optimal pricing and liquidity. Use limit orders always: ETF market makers will typically post bid and ask offers in blocks of 5,000 or 10,000 units. If an investor places a market order and the market maker s offer gets filled before the investors entire order does, the investor s order will be filled deeper in the order book. Market makers will post new blocks once their previous ones are filled. As such, using limit orders will help ensure that the investor receives the best possible price. For example (see Figure 6 on following page), if an investor wants to purchase 6,000 shares and places this purchase with a market order, the investor will receive a partial fill at $10.01 (5,000 shares) and the remaining at $10.02. If the investor placed a limit order at a price of $10.01, the market maker would automatically offer more shares at $10.01 (assuming constant market conditions) once the first 5,000 shares were sold. For large orders (over 10,000 units) it is recommended that they be placed using a trading desk.

Avoid trading during the opening and closing of the market: Trades should be avoided near the market open (9:30 10:00 a.m.) and at the market close (3:30 4:00 p.m.). Securities, and subsequently the indices they belong too, are volatile during this period and thus the market price may change quickly. If orders must be placed, use limit orders. When possible, trade when the underlying securities are trading: Market makers will determine their bid and ask offers based on the prices of the underlying securities. If the securities are not trading (i.e., emerging markets securities, European securities, etc.) then they will have to price the ETF based on an approximation of the market price; e.g., the previous closing price. The most transparent price and liquidity occur when the underlying securities are trading themselves. Figure 6: Market Depth Order Book (Offer) Source: BMO Nesbitt Burns Conclusion Broker Shares Price X 5,000 $10.01 Y 2,000 $10.02 Z 800 $10.03 ETFs are now one of the most widely explored investment options, and the growth of these products is expected to continue. ETFs offer many advantages and may earn a spot in investor portfolios. In our opinion, the use of ETFs comes down to fit. The active versus passive debate is one that routinely plays out in the media; however, in our opinion, both of these investment philosophies have merit and both can co-exist in the same portfolio. Rather than focusing on these strategies in isolation, we believe that investors should focus on combining active and passive investments to help generate better risk-adjusted returns. When using ETFs to accomplish this, both qualitative and quantitative aspects must be evaluated in order to ensure that the investor is receiving the exposure and risk/return profile intended. Following the evaluation criteria and purchasing ETFs using the rules of thumb described above will help ensure proper liquidity and fair pricing. 7

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