Seeking higher returns or lower risk through ETFs

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Contents Seeking higher returns or lower risk through ETFs Factors and the rise of smart beta Reducing risk through smart beta strategies Enhancing return through smart beta strategies Smart beta ETFs The ishares Edge Minimum Volatility ETFs The ishares Edge Multifactor ETFs 03 06 06 08 09 10 11 2

Seeking higher returns or lower risk through ETFs Exchange-traded products (ETPs) continue to grow in popularity, among both retail and institutional investors. According to the September 2016 edition of the BlackRock Global ETP Landscape, 2016 could end up being the biggest year ever for ETPs. Global ETPs gathered US$30.5 billion in September, with year-to-date flows climbing to US$243.8 billion, ahead of 2015 s record-setting pace. There s now US$3.39 trillion invested in ETPs. One of the main reasons why ETPs and exchangetraded funds (ETFs) have been some of the most successful investment products ever launched is that they cover a very wide range of asset classes and investment exposures, accessible through one listed stock. Retail investors in particular use ETFs to obtain a range of precise exposures, to more effectively diversify a portfolio. One of the main reasons why ETPs and ETFs have been the most successful investment products ever launched is that they cover a very wide range of potential applications. The progression of ETF product development has offered Australian investors access to broad global mainstream market-cap share indices (for example the MSCI World and the S&P 500), single-country indices in both the developed world and emerging economies, equity sectors (such as healthcare and consumer staples), and other asset classes, such as fixed income, commodities and currencies. The newest generation of ETFs encapsulate exposure to fundamental factor-based or style based strategies. Factors These ETFs target particular factors, which are fundamental underlying drivers of long-term investment return. Factors can be macro-economic, such as the pace of economic growth and inflation, which can explain returns across asset classes like stocks and bonds: for example, strengthening economic growth can boost stock prices while rising inflation can drive bond prices lower. Alternatively, these factors can be style factors, which help to explain returns within asset classes. Most of the new generation of ETFs target equity style factors. For example, within equities, value stocks which have low prices relative to fundamental measurements (such as price/equity ratio, dividend yield or net asset value) have historically outperformed the broad equity market over the long term. The style factors this guide will focus on are: value, momentum, quality, smaller size (market capitalization) and minimum volatility. These factors cater for investors who want stock market exposure, but would like that exposure to be designed so as to harness factors to target particular outcomes. 3

Let s look at these factors more closely. Value Value stocks are considered cheap because they are out of favour with the market and are consequently priced low, relative to the company s earnings or assets. A value stock is usually considered to have a relatively low price/earnings (P/E) ratio and a low price to net tangible assets (NTA) value, but a high dividend yield (because its price has fallen). Value investors look for such value anomalies and buy the stock because they believe that the market will eventually recognise its true value and the stock will be re-evaluated (bid up in price). Inexpensive stocks relative to these fundamental measurements have tended to outperform. Price momentum Momentum refers to the rate of change of a price. A stock changing price quickly has momentum: there is an empirically observed tendency for stocks rising in price to keep rising, and for stocks with falling prices to keep falling. Momentum investing seeks to ride this trend, to buy stocks with strong past performance in a particular period because they are likely to outperform stocks that showed poor performance in the period, in the belief that the stocks with strong momentum will generate excess return in the next period. This is often a technicallydriven (price charts) strategy. Company quality Company quality is usually assessed on criteria such as balance sheet strength, low debt levels, a record of consistent earnings and dividend growth, high return on equity (ROE), profitability, management efficiency, consistently rising cash flow generation, high dividend payout ratios and sustainable competitive advantage. Some of these criteria are more subjective than others, but the term quality generally denotes companies that historically have weathered economic and market downturns better than other stocks. Quality stocks traditionally have their strongest relative performance during economic downturns. Quality can be considered a defensive attribute: it has tended to under-perform, on a relative basis, only during stronger economic times. 4

Size (capitalisation) Small caps or small market capitalisation companies generally tend to outperform their larger counterparts, for a range of reasons. They often have high growth rates, and there is often an exploitable information gap because they are poorly covered by analysts, and as this gap is filled, the small-cap stocks can appreciate in value quite quickly. Small, high-growth companies have tended to outperform their larger counterparts. (There is no universal definition for small capitalisation, which differs from market to market: in Australia, for example, small caps usually refers to stocks in the S&P/ASX Small Ordinaries Index, which have a market value of about $2 billion or lower.) Minimum volatility The stocks in a market index that show the lowest historical volatility that is, they fluctuate in price less than the overall index tend to be more mature companies that are less dependent on continued economic growth: such stocks also tend to have higher than average dividend yields. They tend to fall by less in market downturns, but they also tend not to rise as much in market rallies. 5

Factors and the rise of Smart Beta Investors have become conditioned to think of beta as the market return from an asset class. In equities, beta is usually sought through exposure to a broad market index based on market capitalisation weights. A newer approach is to target smart beta, through strategies that aim to outperform traditional benchmarks by targeting exposure to one or more of these factors. Like traditional beta strategies, smart beta strategies also use rules-based indexes; investing in factordriven indices through smart beta strategies can allow investors to seek improved returns, reduced risk or enhanced diversification. The factors that can be targeted for smart beta are clear and persistent drivers of investment returns that have been identified in the professional investment markets for many years, and which have given investors excess returns (that is, over the broad stock market index) over extended time frames. 1 Smart beta strategies are growing in popularity, with most strategies available today investing in stocks. Whether they use a multiple factor or a single factor approach, smart beta strategies give investors the potential to fine-tune their exposures and reduce unintended risks. As a result, using smart beta strategies can result in a more deliberate allocation to potential sources of risk and return, so as to enhance the possibility of extra returns while bearing a similar amount of risk as the market or to reduce risk. Smart beta strategies blend the characteristics of active and passive investment. They can be considered active in that they can potentially enhance returns and reduce risk through exposures to proven drivers of return. But they are passive in that they are index-driven, and their implementation is transparent, systematic and rules-based. This means that they tend to have lower fees and higher capacity than traditional active strategies. Reducing risk through smart beta strategies Some smart beta strategies are built with the goal of reducing risk. These minimum volatility strategies have historically delivered market-like returns with less risk, by targeting lower volatility stocks. Some minimum volatility strategies will also take into account the correlations among stocks and will have guardrails in place to limit sector and country concentrations. Minimum volatility funds have historically lost less during market declines but have still captured meaningful gains during market upswings. As shown below, using back-tested data, over the last ten years, the MSCI Australia IMI Select Minimum Volatility Index has captured 87.7% of the upside of the broader market but only 73% of the downside. 1. BlackRock publication Smart Beta: Capturing the Power of Factor Investing, Page 2. This publication does not define the excess returns, nor the extended time frames. Past performance is not a reliable indicator of future performance. 6

Over the same period, the MSCI World Minimum Volatility (A$) Index has captured 70.7% of the upside, but only 52.1% of the downside. (Upside and downside capture ratios measure the portion of broad market return captured by a given index in positive months and negative months respectively.) them over entire market cycles to realise their full potential benefits. There are minimum volatility strategies that are constructed to mirror the sector and country exposures of a broad market index, so investors can use them as long-term building blocks for their portfolios. 2 Because minimum volatility strategies are designed to work best during periods of market volatility and over the long term, you might consider holding 2.BlackRock, MSCI, as of 31 August 2016. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. 7

Enhancing return through smart beta strategies While minimum volatility strategies are designed to reduce risk relative to the overall market, investors have used smart beta strategies with exposures to factors like value, quality, momentum and smaller size (market cap) to seek enhanced returns with similar amount of risk as the market. Single-factor strategies Smart beta strategies capturing one factor can be used tactically or they can be used to help portfolio diversification. For example, during the late economic cycle when earnings are deteriorating and financially healthy stocks are in particular favour, investors might do better holding stocks with low debt levels and stable earnings. To implement this in their portfolio, investors could tactically use a quality exposure as a single-factor smart beta strategy. Alternatively, an investor could choose to balance a share portfolio skewed toward growth stocks by introducing a smart beta equity fund tilted toward value. With single-factor smart beta funds, investors can build custom portfolios that reflect their own investment views and needs. Having said that, there is evidence to suggest that it is difficult to pre-empt or time factors. That is where multifactor strategies can help. 8

Multifactor strategies Multifactor strategies are designed to provide diversified exposure to several factors. Depending on the market environment, individual style factors may be more or less relevant, so a portfolio using a multi-factor approach can potentially add value in a variety of market conditions. Over the long term, combining factor exposures may produce even more consistent results than factor exposures individually. Smart beta multifactor strategies help target key drivers of return while owning a portfolio with a similar profile and risk to the broad stock market: in effect, this means that multi-factor equity funds are diversified portfolios that can be used for long-term core allocations. The table below explains what factors these multifactor strategies incorporate and how they are calculated. 3 Quality Financially healthy firms with strong balance sheets typically outperform lower quality stocks over time Higher return on equity, earnings consistency, lower debt to equity Value Stocks that are inexpensive relative to their fundemental value generally outperform growth stocks. Lower P/E and P/B Size Smaller companies, often overlooked or mispriced, have tended to outperform larger cap stocks Lower market cap Momentum Trending stocks have historically continued to appreciate due to the herding effect of return-following investors Price appreciation Smart beta ETFs New-generation smart beta ETFs are designed to give investors effectively the ability to diversify within the return stream of equities, by capturing investment factors or market inefficiencies in a rules-based, transparent manner. Smart beta ETFs are built around a different index to the traditional market-capitalisation-based indices, with the index designed to harvest a different return allowing heightened diversification as well as the opportunity to earn enhanced risk-adjusted returns. The new ishares Edge range of Smart Beta ETFs consists of four minimum volatility and multifactor funds designed to provide Australian investors with a low-cost way to strengthen portfolios, by reducing risk or enhancing returns. In an environment with lower returns and increased volatility, being able to generate outperformance or reduce stock market risk at low cost is increasingly important to investors. 3. BlackRock publication Smart Beta: Capturing the Power of Factor Investing, Page 3. 9

ishares Edge Minimum Volatility ETFs The ishares Edge Minimum Volatility ETFs are available across Australian and global equities. They seek to deliver market-like returns with less risk. Importantly, their benchmark indices have lost less during downturns, when broad markets have suffered. 4 Fund Name: ishares Edge MSCI Australia Minimum Volatility ETF Ticker: MVOL Fee*: 0.30% Description: This ETF aims to give investors a diversified exposure to Australian stocks and achieve returns in line with the market, while incurring potentially less risk. The ETF is designed to allow investors to invest with confidence through market cycles, with a strategy that aims to reduce losses relative to the broader market during downturns. Using back-tested data, the ETF s benchmark index, the MSCI Australia IMI Select Minimum Volatility (A$) Index, has delivered similar return to the MSCI Australia IMI (A$) Index but with significantly less risk. 5 Fund name: ishares Edge MSCI World Minimum Volatility ETF Ticker: WVOL Fee*: 0.30% Description: This ETF aims to offer diversified exposure to a broadly diversified portfolio of global stocks, achieving returns in line with the MSCI World Index with potentially less risk. The ETF is designed to allow Australian investors to diversify into global stocks with confidence through market cycles, with a strategy that aims to reduce losses relative to the broader market during downturns. Using back-tested data, the ETF s benchmark index, the MSCI World Minimum Volatility (A$) Index, has delivered similar return to the MSCI World (A$) Index but with significantly less risk. 6 4. https://www.blackrock.com/au/individual/ishares/smart-beta 5. https://www.blackrock.com/au/individual/literature/brochure/ishares-edge-au-minimum-volatility-brochure.pdf 6. https://www.blackrock.com/au/individual/literature/brochure/ishares-edge-world-minimum-volatility-brochure.pdf Past performance is not a reliable indicator of future performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. 10

ishares Edge Multifactor ETFs The ishares Edge Multifactor ETFs are also available across Australian and global equities. These ETFs provide a cost effective way to seek outperformance by investing in either domestic or international companies that have the potential to deliver above market returns over the long term, with similar risk and exposure to the broad market, by focusing on the four main factors identified above. Fund name: ishares Edge MSCI Australia Multifactor ETF Ticker: AUMF Fee*: 0.30% Description: This ETF is designed to harvest factor-driven outperformance over the long term in a portfolio of Australian stocks with a similar profile and risk to the broad market. The ETF aims to target four proven drivers of return in Australian equities: quality (financially healthy firms), value (inexpensive stocks), size (smaller companies) and momentum (stocks in a rising price trend). Using back-tested data, the ETF s benchmark index, the MSCI Australia IMI Diversified Multiple-Factor (A$) Index, has outperformed the MSCI Australia IMI (A$) Index over the long-term, achieving improved returns while running a similar level of risk. 7 Fund name: ishares Edge MSCI World Multifactor ETF Ticker: WDMF Fee*: 0.35% Description: This ETF aims to generate factor-driven outperformance over the long term in a portfolio of global developed market stocks, while bearing a similar profile and risk level to the broad market. The ETF aims to target four proven drivers of return in a diversified international shares exposure: quality (financially healthy firms), value (inexpensive stocks), size (smaller companies) and momentum (stocks in a rising price trend). 7.https://www.blackrock.com/au/individual/literature/brochure/ishares-edge-au-multifactor-brochure.pdf Past performance is not a reliable indicator of future performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. 11

Why ishares for Smart Beta? BlackRock is a pioneer in factor-based investing, with decades of expertise in factor research and implementation. ishares Edge Smart Beta ETFs provide an easy, transparent and low-cost way to access factors, targeting outcomes such as reducing risk or enhancing returns. The most comprehensive range of smart beta ETFs listed on the Australian Securities Exchange (ASX).^ Over 30 years of experience and rigorous research in factor based investing and index based asset management. Backed by BlackRock, trusted to manage more money than any other investment manager in the world.* ^Source ASX, as at 14 October 2016. *Based on US$5.117 trillion in AUM as of 30 September 2016. * Management fee as a percentage of a fund s net asset value. Subject to change. DISCLAIMER This document has been issued by Switzer Financial Group Pty Ltd ABN 24 112 294 649 AFSL 286 531 (Switzer) and provides general information and advice only. It has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. Past performance is not a reliable indicator of future performance. Switzer, its officers, employees and agents believe that the information in this document and the sources on which the information is based (which may be sourced from third parties) are correct as at June 2016. While every care has been taken in the preparation of this document, no warranty of accuracy or reliability is given and no responsibility for this information is accepted by Switzer, its officers, employees or agents. Any investment is subject to investment risk, including delays on the payment of withdrawal proceeds and the loss of income or the principal invested. While any forecasts, estimates and opinions in this document are made on a reasonable basis, actual future results and operations may differ materially from the forecasts, estimates and opinions set out in this document. No part of this document may be reproduced or distributed in any manner without the prior written permission of Switzer. Switzer has commercial arrangements in place with BlackRock Investment Management (Australia) Limited ABN 13 006 165 975 AFSL 230 523 (BlackRock) in relation to the BlackRock ishares range of products. All views expressed in this document are those of Switzer. BlackRock does not accept any responsibility or liability for the views, opinion or content of this document unless otherwise specified. BlackRock does not pay any commissions or remuneration in relation to its ishares products. BlackRock is the responsible entity and issuer of the Australian domiciled managed investment scheme ishares funds quoted on ASX. BlackRock is the local agent and intermediary for ishares funds quoted on ASX and issued by ishares, Inc. ARBN 125632 279 formed in Maryland, USA; ishares Trust ARBN 125 632 411 organised in Delaware, USA. The liability of shareholders is limited. BlackRock Fund Advisors (BFA) serves as an advisor to the ishares funds that are registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940. BFA is a subsidiary of BlackRock Institutional Trust Company, N.A (BTC). BTC is a wholly-owned subsidiary of BlackRock. BlackRock does not guarantee the repayment of capital or the performance of any product or rate of return referred to in this document. Any potential investor should consider the latest disclosure document or PDS in deciding whether to acquire, or to continue to hold, an investment in any BlackRock ishares product. BlackRock s disclosure documents and financial services guide are available at HYPERLINK http://www.blackrock.com.au www.blackrock.com.au. BLACKROCK, ishares and the stylised i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. 12