Jose Garcia-Zarate Senior Fund Analyst, Morningstar

@MorningstarInc

©2015 Morningstar, Inc. All rights reserved.

Jose Garcia-Zarate

Senior Analyst

Passive Strategies Research - Europe

Exchange-Traded-Funds From Basics to Strategic Beta

Agenda

▶ The Basics

▶ Key Market Statistics

▶ Strategic Beta

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The Basics

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▶ An Exchange-Traded Fund is an open-ended fund that replicates the performance of a specific index or strategy

▶ Defining attribute: ETFs trade on an exchange like common stock

What is an ETF?

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Exchange-Traded Products (ETPs)

An umbrella term referring to a broader set of vehicles.

Exchange-Traded Notes (ETNs)

Senior unsubordinated debt instrument. Not UCITS compliant.

Exchange-Traded Commodities and Currencies

(ETCs)

Track commodities and currencies. Not UCITS compliant.

Exchange-Traded Funds (ETFs)

Track a wide variety of predominantly equity and fixed

income indices. UCITS compliant.

The Creation and Redemption Process

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Replication Methodologies

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g Physical Replication

/Seek to mimic the index by holding the actual securities

/Full or sampled replication

gSynthetic Replication

/Obtain the index exposure through OTC swap contracts

/Hold securities (or have collateral posted) to mitigate counterparty risk

/Exchange the performance of the securities with the performance of the reference index

Key Features and Uses

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gKey Features

/Low costs

/ Intraday liquidity / Trading flexibility

/Access to all asset classes

gHow ETFs are used:

/For buy and hold investing

/For tactical investing

/For cash equitisation

/To gain instant, diversified exposure to a market, strategy or asset

TER is not the only cost to consider when buying an ETF

gHolding Costs

Physical ETFs

/TER (-)

/Rebalancing costs (-)

/Securities lending (+)

Synthetic ETFs

/TER (-)

/Swap spreads (-/+)

g Trading Costs

/Bid-offer spread (-)

/Brokerage commission (-)

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Holding Costs + Trading Costs = TOTAL COST OF OWNERSHIP

How to Measure Tracking Ability

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g Tracking error

/Volatility of a fund’s return differences over a period of time

/A low tracking error indicates the fund has consistently tracked its benchmark

g Tracking difference

/Difference in returns between a fund and its benchmark over a period of time

/Perfect tracking means the ETF’s return lags the index’s by an amount equal to the ETF’s fees

/Positive tracking difference indicates the fund has outperformed its benchmark

Key Market Statistics

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Global ETP Market – AUM Growth

▶ AUM closing in to USD 3trn worldwide

▶ USA accounts for 74% of global AUM; Europe follows with 17% and Asia with 6%

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Source: Morningstar. Data as of end March 2015.

Europe ETP Market – AUM Growth

▶ ETPs represent 6.5% of total investment fund market AUM in Europe

▶ Q1 2015 saw record high net inflows of EUR 31.2bn

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Source: Morningstar. Data as of end March 2015.

Europe ETP Market – Market Share by Asset Class

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Source: Morningstar

Europe ETP Market – Market Share by Replication Method

▶ Morningstar has a neutral view on replication

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Source: Morningstar

Strategic Beta

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Assets are flowing into passive investment vehicles that are increasingly active in their nature and implementation–the line between active and passive is now more blurred than ever before

▶ Strategic Beta—widely referred to as “smart beta”—refers broadly to a growing category of indices and the exchange-traded products and other funds and investment products that track them

▶ The majority of these indices seek to enhance returns or minimise risk relative to a traditional market capitalisation-weighted benchmark

▶ Others seek to address oft-cited drawbacks of standard benchmarks such as the negative effect of contango in long-only commodity futures indexes and the overweighting of the most indebted issuers in market capitalisation-weighted fixed-income benchmarks

▶ These benchmarks and the investable products that track them exploit many of the same sources of return (size, value, quality, momentum, etc.) or mitigate risk in a manner similar to active managers

▶ This category represents a middle ground on the active-to-passive spectrum—deviating from a traditional strictly passive market portfolio, but doing so in a rules-based, transparent, and relatively low-cost manner

Strategic Beta Defined

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▶ Many have defined the space in the negative, including products tracking any benchmark that is not market capitalisation-weighted

▶ Per our definition, while most of the indices that underlie investment products in this category are not market capitalisation-weighted, some are (e.g., those that have style “tilts”)

▶ We do not include sector indices, thematic indices, country indices, and other types of indices that screen constituents on the basis of sector membership, investment theme, or geography in this category

▶ We also exclude benchmarks that underlie those products that are included in our “trading” categories, such as leveraged and inverse funds

Strategic Beta Defined

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Is Strategic Beta Passive, Active, or Both?

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Strategic Beta

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Rules-Based (Passive)

Bet Against Market Portfolio (Active) Market-Cap

Weighted

Actively Managed

Strategic Beta

Taxonomy

Strategic Beta

Risk-Oriented

Minimum Volatility/Variance Low/High Beta Risk-Weighted

Return-Oriented

Dividend Screened/Weighted Value Growth Fundamentals Multi-Factor Size Momentum Buyback/Shareholder Yield Earnings Weighted Quality Expected Returns Revenue Weighted

Other

Non-Traditional Commodity Equal-Weighted Non-Traditional Fixed Income Multi-Asset

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Strategic Beta ETP Market Share – US v Europe

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Source: Morningstar. Data as of end March 2015.

Favoured Strategies - US v Europe

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Source: Morningstar. Data as of end March 2015.

What’s Driving this Trend?

▶ Investors cite multiple reasons for using strategic beta products

/ Managing risk

/ Enhancing returns

/ Tactically adjusting asset allocations

/ Portfolio completion

/ Reducing fees

/ A general disillusionment with active managers

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Morningstar’s Mission

▶ The goal of Morningstar’s research team is to play the role of referee in this space

/ By laying the ground rules

/ Highlighting the winners

/ Calling out the losers

/ All in the interest of helping investors navigate this increasingly complex landscape

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