Passive Equity Index ETF Performance Review: Full-Year 2013 FINANCIAL PRODUCTS RESEARCH January 19, 2014

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1 : Full-Year 2013 We conduct a performance review of key metrics for equity index-tracking ETFs in Canada and U.S. We analyze cap-weighted, purely passive ETFs for proprietary ranking of index tracking efficiency Metrics analyzed include NAV-based tracking and market-based premium/discount to NAVs We believe other styles or actively managed products are not suitable for this performance analysis Canadian Equity: Large Cap: HXT ranks highest with its synthetic structure while relative newcomer VCE tops the list of physical ETFs. HXT s extremely tight tracking is a direct consequence of its underlying swap structure, which delivers the total return of the index (with reinvested distributions) directly to the NAV of the fund, with the trade-off being derivative counterparty risk. In 2013 HXT lagged its index by 6 bps, with virtually no volatility around that figure (tracking error), because of its industry-low of 7 bps (5 bps after waiver). VCE from Vanguard follows close behind although it tracks a different index (FTSE Canada) with 77 constituents. Because it is relatively smaller, VCE has thinner trading than its peers which track the S&P/TSX 60. As a result, its premium/discount metrics were higher in terms of both average and variability, but they were still low enough to demonstrate excellent overall market making efficiency. Broad: ZCN from BMO continues to impress as it had the best full 2013 performance of the broad Canada ETFs, in keeping with its low of 17 bps. Although it had a very slight but measurably higher variability around its excess return figures than closest peer XIC from ishares, the fee differential overwhelmed the tracking error and ZCN outperformed by the expected 10 bps in Not shown in the table is VCN, Vanguard FTSE Canada All Cap Index ETF, which launched too recently for this analysis (August 2013), but which we will continue to monitor closely as an alternative for broad Canadian equity exposure. Table 1: Canada and U.S. Equity ETF Performance and Tracking Comparison s Tracking General Calendar 2013 s Prem/Disc to NAV ETF Metrics Canada Horizon S&P/TSX 60 HXT $ Large Cap Vanguard FTSE Canada VCE $ ishares S&P/TSX 60 XIU $12,544 7, Broad BMO S&P/TSX Capped Composite ZCN $1, ishares S&P/TSX Capped Composite XIC $1, U.S. Equity Broad & Hedged Vanguard US Total MarketCAD Hedged VUS $ Vanguard S&P 500 CAD-hedged VSP $ Large Cap, ishares S&P 500 CAD-Hedged XSP $2,012 1, CAD Hedged BMO S&P 500 Hedged to CAD ZUE $ BMO S&P 500 ZSP $ Unhedged Vanguard S&P 500 VFV $ Horizons S&P 500 HXS $ * *HXS' does not include 30 bps swap fee U.S. Equity: Broad and CAD Hedged: Thus far, VUS from Vanguard is the only ETF in Canada that offers full exposure to a broad swath of the investable equity market in the United States, including mid and small caps. (It is a CAD-hedged wrap of the U.S.-listed VTI). Its low drag vs. the index and tight tracking render it our preferred vehicle for this type of exposure, although it should be said that its metrics are influenced by its fund-of-fund structure (like most wrap ETFs, its end-of-day NAV is actually a reflection of the trading price of its underlying ETF). Its un-hedged version VUN is too new for us to analyze here. CAD Hedged: Vanguard s VSP was launched in November 2012 with an aggressively low undercutting similar hedged S&P 500 ETFs from BMO and ishares. As such its top ranking performance in 2013 is in line with expectations.

2 Unhedged (Continued from Table 1, Page 1): CAD fell more than 6% vs. the USD in 2013, so the unhedged S&P 500 ETFs were among the best performing U.S. equity ETFs because of the strengthening U.S. dollar. ZSP from BMO finished the rankings at the top, thanks to its extremely tight tracking as well as very low and stable premium/discounts to NAV. VFV, despite having a lower, suffered a greater drag of 12 bps relative to ZSP, but this is not cause for concern because its metrics were in line. The swap-based HXS from Horizons tracked a CAD-hedged version of the S&P 500 until April 2013, at which point it switched to unhedged; therefore, its 2013 performance was lower than its current peers but higher than the three S&P 500 ETFs that were CAD-hedged throughout all of International Equity CAD Hedged: ZDM from BMO switched to the well-recognized MSCI EAFE index in April 2013, but it had excellent tracking metrics throughout the year, lifting it to the top of the rankings. Emerging Market Equity Unhedged: ZEM from BMO also switched indices in 2013, so its benchmark for the purpose of calculating excess returns must be spliced depending on the period. With these adjustments in place, its metrics in 2013 edged out its peers. Table 2: International Equity ETF Performance and Tracking Comparison s Tracking General Calendar 2013 s Prem/Disc to NAV ETF Metrics International Equity BMO MSCI EAFE Hedged to CAD ZDM $ CAD Hedged Vanguard FTSE Dev. ex North Am. CAD VEF $ ishares MSCI EAFE CAD-Hedged XIN $1, Emerging Market Equity BMO MSCI Emerging Markets ZEM $ Unhedged ishares MSCI Emerging Markets XEM $ Vanguard FTSE Emerging Markets VEE $ U.S. Listed ETFs (Table 3, Page 3) S&P 500: It is an extremely tight horse-race among the S&P 500 ETFs, with all three of the big U.S. providers offering a very liquid and cost competitive product. VOO from Vanguard just barely beat its peers in 2013, and by only 2 basis points. While we wouldn t hesitate to recommend VOO for U.S.-listed S&P 500 exposure, the metrics are so close that it wouldn t necessarily be worth the cost to switch. Broad U.S. Equity: It was a banner year for U.S. markets with greater than 30% returns for most equity indices. VTI consists of more than 3,500 holdings and remains our preferred ETF for broad U.S. equity. Its excellent structural performance (1bp of weekly mean excess return and 4 bps of annualized weekly variability) means that it effectively delivered an index return directly into the hands of investors. Its performance in this regard is doubly impressive considering the size of the index and the fact VTI s metrics were even more efficient than large-cap industry heavyweights such as SPY. International Equity: IEFA from ishares tracks broad investable market version of MSCI s EAFE index, with over 2,000 holdings. Although it is optimized, its tracking metrics were excellent. Emerging Market Equity: IEMG tracks the MSCI Emerging Markets Investable Market Index, and although that region was hit hard in 2013, its performance was least negative with great tracking. Page 2

3 Table 3: U.S.-Listed Equity ETF Performance and Tracking Comparison s Tracking General Calendar 2013 s Prem/Disc to NAV ETF Metrics U.S.-Listed U.S. Equity Vanguard S&P 500 VOO $15,326 1, S&P 500 ishares Core S&P 500 IVV $53,254 4, SPDR S&P 500 Trust SPY $170,364 97, Broad Vanguard Total Stock Market VTI $39,662 3, ishares Core S&P Total US Stock Mkt ITOT $1, U.S.-Listed International Equity Broad ishares Core MSCI EAFE IEFA $1, Large Cap ishares MSCI EAFE EFA $52,873 16, Broad Vanguard FTSE Developed Markets VEA $19,525 2, U.S.-Listed Emerging Market Equity Broad ishares Core MSCI Emerging Markets IEMG $3,412 1, Large Cap ishares MSCI Emerging Markets EEM $37,029 62, Broad Vanguard FTSE Emerging Markets VWO $43,228 18, Page 3

4 Our performance review is centred on two key areas: 1. represents the difference between the benchmark index and ETF NAV return, and it is a function of the ETF structure. The returns generated by the fund s assets might differ from the target index, in both 1A) absolute amount and 1B) volatility. We measure these as the weekly average, annualized. 2. Premium/Discount to NAV represents the difference between the NAV of the ETF and its price, and it is a function of the ETF trading and market making. The market price of an ETF might differ slightly from the fund s NAV by a premium or discount. The 2A) magnitude and 2B) volatility of this premium/discount affects the return. We measure these as the daily average. By analyzing both the mean and volatility of these two metrics over a period, we believe we re able to effectively assess the overall performance of ETFs from an investor standpoint. Note: Analyzing the tracking and performance of international ETFs requires additional adjustments, especially when an ETF and its underlying index have different hours of operation. ETF and Index providers handle these timing differences in a variety of ways, sometimes adjusting the NAV of non-trading assets to reflect movements in other global market variables such as currency. Our rankings factor these adjustments, but the raw numbers in the above tables do not necessarily incorporate all the variables within the time period under observation. 1. Index to ETF NAV: The provider of an ETF attempts to deliver the index performance by managing fund assets that replicate the index. We measure the effectiveness of this management through 1A) mean excess return (NAV-based returns minus index returns), and 1B) the standard deviation of excess returns (tracking error). 1A) : For an ETF to effectively track its index, the total return of its assets should closely match the index. Over a period such as a year or a quarter, we d like to see the average of its weekly excess returns as close to zero as possible. 1B) Tracking Error: We d also like to see consistent excess returns from week-to-week, without wild swings. In Chart 2, a good ETF would have bar heights close to zero (low mean excess return), with little spread between them (low tracking error). return (bps) Chart 2: Example of ETF Weekly s over Benchmark Index Source: Bloomberg, National Bank Financial Weeks Premium/Discount to NAV 2. ETV NAV to Market Price: An investor who buys the ETF in the open market will pay a share price that may be slightly different from the actual NAV. Here we look at 2A) the average premium or discount to NAV, but more importantly we look at 2B) the volatility of this premium or discount. 2A) Premium (Discount) to NAV: The next step in accessing true index exposure is to ensure that the market price of an ETF is as close as possible to the NAV of its underlying assets. Typically, the in-kind creation and redemption process of an ETF forces this premium to zero through the arbitraging activity of market makers. 2B) of Premium (Discount): The metric that matters more to investors is how volatile the premium is, because this will cause further deviation from index performance when buying or selling. Chart 2 illustrates a sequence of daily premium/discounts to NAV. The bars should be as close to zero as possible, but more importantly, there should be little difference between the bars. Premium (Discount) Chart 1: From ETF Price to NAV to Index: Important Metrics Source: National Bank Financial Step 1 Step 2 Index 1A) 1B) Tracking Error 0.4% 0.3% 0.2% 0.1% 0.0% -0.1% -0.2% Net Asset Value Market Price 2A) Prem/Disc. To NAV 2B) of Prem/Disc. Chart 3: Premium/Discount to Net Asset Value of Sample ETF Source: Bloomberg, National Bank Financial -0.3% Days Definitions : Total return of an ETF or index with dividends reinvested over a period such as a week, quarter or year : return of ETF minus benchmark index total return. E.R. ( ): Average of weekly total ETF returns minus total benchmark index returns of : Standard deviation of weekly ETF NAV returns less benchmark index returns. Also called Tracking Error Prem/Disc. to NAV (Premium/Discount to NAV): Average end of day price premium divided by Net Asset Value Prem/Disc. to NAV : The standard deviation of the end of day price premium to Net Asset Value Page 4

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