Q Versatility Fuels Expansion: ETFs in Canadian Institutional Portfolios

Q1 2016 Versatility Fuels Expansion: ETFs in Canadian Institutional Portfolios

CONTENTS 3 Executive Summary 4 ETF Usage and Allocations on the Rise 4 Gaining Exposures through ETFs 5 Continued Growth Among Current Users 6 An Expanding List of ETF Applications 6 International Diversification and Core Exposures CANADIAN INSTITUTIONS RANK AS SOME OF THE MOST ACTIVE AND SOPHISTICATED ETF INVESTORS IN THE INSTITUTIONAL MARKETPLACE METHODOLOGY 63% OF CANADIAN INSTITUTIONAL ETF ASSETS ARE CATEGORIZED AS STRATEGIC 7 Evolution of Strategic Use of ETFs 8 Liquidity Needs Attract Institutions to Bond ETFs 8 ETF Liquidity on the Rise 9 Embracing ETF Innovation Greenwich Associates interviewed 50 Canada-based institutional investors, 37 of which are exchanged-traded fund users and 13 are non-users, in an effort to track and uncover usage trends. Respondents included 33 asset managers that actively manage money for institutional funds, 12 institutional funds, including corporate pensions, public pensions, foundations, and endowments, and five insurance companies. 9 ETFs Beyond Equities 10 Institutions Replacing Derivatives with ETFs 10 BlackRock s ishares is Canadian Institutions ETF Provider of Choice 11 Conclusion Insurers 10% Respondents 24% Institutional funds Consultant Andrew McCollum advises on the investment management market globally. Asset managers 66% Cover Photo: istockphoto/andrew_mayovskyy The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. 2016 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. 2 GREENWICH ASSOCIATES

Executive Summary The results of the Greenwich Associates 2015 Canadian Exchange-Traded Funds Study show that Canadian institutions rank as some of the most active and sophisticated ETF investors in the institutional marketplace. Among the trends placing Canadian institutions at the head of the global pack: 1. In addition to using ETFs for tactical portfolio functions, Canadian institutions are employing the funds to obtain long-term exposures central to their investment strategies. Sixty-three percent of Canadian institutional ETF assets today are categorized as strategic, with portfolio diversification and obtaining core investment exposures cited as the top two reasons for ETF use. 2. Canadian institutions are moving faster than their counterparts in other markets to adopt ETFs in fixed income and other asset classes beyond equities. Sixty-eight percent of Canadian institutional ETF users employ the funds in fixed income. That share is expected to increase as investors respond to the shifting interest-rate environment and move to address liquidity concerns. 3. Canadian institutions are early adopters of new ETF products. Forty-four percent of Canadian institutional ETF users employ non-market-cap weighted/smart-beta ETFs, with a sizable share of institutions using these innovative products in fixed income. Thirty-one percent of Canadian institutional ETF users invest in currency-hedged ETFs. 4. Canadian institutions have recognized ETFs ability to deliver cost-effective beta and are actively replacing derivatives positions in their portfolios with ETFs. Eighty percent of the institutional ETF users in the study expect to replace an existing equity futures position with ETFs in the next year. Based on these and other trends, nearly one-third of institutional ETF users in Canada plan to increase ETF allocations in the coming year. As they source new ETF investments, institutions are looking closely at ETF expense ratios and the alignment of individual funds with their own exposure needs. 3 GREENWICH ASSOCIATES

ETF Usage and Allocations on the Rise The results of the Greenwich Associates 2015 Canadian Institutional Exchange-Traded Funds Study reveal a market that is maturing and becoming more sophisticated as it grows. The institutional users of exchange-traded funds participating in the study have invested an average 21% of total assets in ETFs, while among Canadian asset managers that share rises to over 25%. The institutions in the study use ETFs for many reasons, but most cite the speed, flexibility and total cost advantages as important benefits: ETFs give us a simple way to get market exposure and diversification, and they are tax-efficient with extremely low cost. Canadian Asset Manager ETFs are a fast way to get into the market; they are cheaper and have capacity to take on large volume. Canadian Corporate Defined-Benefit Plan ETFs are fast, easy and let us be proactive. If we want exposure to emerging markets, ETFs can do it quickly. I could do some right now. Canadian Public Pension Fund Contributing to the widespread use of ETFs in Canada is the relatively large share of assets managed internally by Canadian institutions. While nearly 75% of American institutional funds outsource to external managers, just 42% of Canadian institutional funds do so. In addition, 87% of Canadian institutions overall and 82% of Canadian institutional funds describe themselves as active investors. Gaining Exposures through ETFs Canadian institutions use ETFs to gain exposures to a variety of asset classes, with U.S. and international equity being the focus for 86% and 84% of institutions, respectively. European (62%) and Asian (57%) equities are the focus for relatively fewer institutions. INSTITUTIONS ADOPTING ETFs IN NEW ASSET CLASSES Equity Portfolio 95% Fixed Income Portfolio 68% Other Allocations 57% U.S. equity 86% Domestic government bonds* 59% REITs 49% International equity 84% International government bonds 49% Commodities 35% Domestic equity* 76% Domestic credit* 49% Infrastructure/Real estate investments 5% European equity 62% International credit 32% Loans/Mortgage 5% Asian equity 57% Emerging market debt 3% Exchange-traded fund (ETF) 3% 0% 100% Note: *Respondent s country. Based on 37 responses. 0% 100% 0% 100% 4 GREENWICH ASSOCIATES

Sixty-eight percent of Canadian institutions use fixed-income ETFs a similar share to U.S. institutions (63%). Asset managers (76%) and insurance companies (75%) are more likely to invest in fixed-income ETFs than institutional funds. From 2014 to 2015, the share of Canadian institutional ETF investors using the funds in real estate nearly doubled from 27% to almost 50%, topping usage among their counterparts in the U.S. and other markets. In keeping with the heavy weighting to commodities in Canadian financial markets, 35% of institutional users employ ETFs in that asset class. Continued Growth Among Current Users Although only about 1 in 10 non-users in this year s study say they are considering adopting ETFs for the first time, one-third of current users plan to increase allocations to these funds in the year ahead. While most of those expect increases to be in the 5% 10% range, nearly a quarter anticipate expanding allocations by more than 10%. Only 6% are planning reductions. In fixed income, 29% of institutional users expect to increase their allocations to ETFs in the next year. Fully half of these institutions plan to boost allocations by more than 10%. By contrast, only 14% of users expect to reduce fixed-income ETF allocations. Adoption rates for fixed-income ETFs could also increase as current impediments to investment diminish. Among ETF non-users, for instance, about 30% say they do not invest because the funds are not supported by their trading or portfolio management platforms. Approximately 20% of institutional non-users say they are prevented from using ETFs by internal investment guidelines or restrictions. Technological constraints and internal prohibitions will give way as ETFs emerge as standard tools in institutional portfolios, opening the door for a new group of potential investors. INSTITUTIONS TO BOOST ETF ALLOCATIONS IN EQUITIES AND FIXED INCOME Fixed-Income ETFs 48% 10% 29% 14% 55% Equity ETFs 33% Note: May not total 100% due to rounding. Based on 21 responses for fixed-income ETF and 33 responses for equity ETF usage. 6% 6% Increase Decrease No change Don t know Tax gain/loss harvesting Manager transitions Ease of service More exposure to a specific area of the market Fixed-interest securities (bonds, emerging markets, etc.) Quick allocation Tactical exposure Low cost/cost-efficient Note: Based on 35 responses. Specific exposures/ asset allocation? How Do You Use ETFs? Other portfolio management mentions Helps gain diversification Capacity (active vs. passive) Stocks (dividends, sector specific, etc.) More exposure to international markets Volatility/risk reduction Passive exposure Liquidity/ cash management 5 GREENWICH ASSOCIATES

An Expanding List of ETF Applications The expanding role of ETFs in institutional portfolios can be attributed to several factors, including investors increasing familiarity with the potential benefits of the funds, the removal of barriers to entry and the continued evolution of the ETF market overall. As one Canadian insurance company explained, We ve probably been using ETFs for 15 years, from simple strategies to more complex. In the beginning there were much fewer types of ETFs available, and now there s hundreds of different narrow-spectrum ETFs that cover very narrow market sectors. We ve evolved from using broad-based funds to more specialized, narrow-sector funds. Canadian institutions are creatively applying ETFs to a long and growing list of portfolio functions, further increasing allocations. Canadian institutions in the study listed nearly 30 applications for ETFs, ranging from portfolio management and gaining exposures to specific securities, markets and sectors to reducing volatility/risk, lowering costs, and diversifying holdings. International Diversification and Core Exposures International diversification is the most common reason Canadian institutions use ETFs. Eighty-three percent of the users in the study cite diversification as one of their primary applications for ETFs. Institutions explained why they use ETFs to gain international exposure: MOST COMMON ETF APPLICATIONS International diversification Core allocation Rebalancing Portfolio completion Liquidity management Tactical adjustments Cash equitization Risk management/overlay management Transition management/did not select interim beta (net) Interim beta/transition management (net) Long and lend 25% 22% 17% 47% 44% 83% 78% 69% 69% 67% 64% 0% 100% Note: Based on 36 responses. The biggest reason we use ETFs is to gain access to international equities that we don t have the research capabilities in-house to pursue. Canadian Asset Manager We use ETFs when we are trying to get exposure to fixedincome markets in countries where we have no trading acumen or trading ability. For example, we have been able to get exposure to Japanese fixed-income markets or Columbian fixed-income markets using ETFs rather than building the capability that we wouldn t need three months later. Canadian Asset Manager We can go around the world very easily with ETFs where we can t do that with funds or fund managers. Canadian Investment Consultant ETFs provide inexpensive exposure to foreign markets, and we can hedge currency exposure with them too. Canadian Asset Manager ETFs are the easiest and quickest way to get exposure to emerging markets. Canadian Public Pension Fund 6 GREENWICH ASSOCIATES

The share of Canadian institutions using ETFs to achieve core exposures in their investment strategies increased from 67% last year to 78% this year. Nearly 70% use ETFs for rebalancing, portfolio completion, liquidity management, and/or to make tactical adjustments to their portfolios. Between 40% and 50% say they use ETFs for each of risk management/ overlay management and cash equitization. Evolution of Strategic Use of ETFs Over the five years Greenwich Associates has conducted its ETF research, the results have revealed several clear trends. Institutions in most markets begin using ETFs in relatively simple, short-term tactical tasks. As they become more familiar with the benefits and efficiency of ETFs, institutions start expanding the funds to more complex, long-term and strategic functions. We ve gotten more comfortable using ETFs to gain long-term exposure to various asset classes, said one Canadian insurance company. ETF USE: TACTICAL OR STRATEGIC? Institutions provided a long and diverse list of how they are using ETFs in strategic applications in their portfolios: Tactical 37% The challenge is easy exit, entrance and exposure to whole asset classes. ETFs solved that perfectly. They are liquid and inexpensive. They allow us to switch the exposure between asset classes to keep the risk of our portfolios constant. It s nice to get diversified exposure to emerging markets and non-north American-traded ETFs. It solves the hassle of trading on foreign exchanges. Canadian Asset Manager We use ETFs for momentum trading and managed beta. We have ETFs broken into time baskets, where we have them in a short-time view on the market, either all in the market or all out, with all cash or all Nasdaq. So instead of trimming the single name exposures when we want out of the market, we have one position we go in and out of to capture the upswing of the market and limit our downswing. Canadian Asset Manager Sixty-three percent of Canadian institutional ETF assets are categorized as strategic, as opposed to tactical, in nature. Perhaps even more indicative of ETFs changing role in these portfolios are average holding periods. In any portfolio, assets held for two years or more represent long-term strategic holdings. In 2015, 47% of Canadian institutions report average holding periods for ETFs of at least two years. That share is up from just 31% in 2014. 63% Strategic Note: Based on 35 responses. TYPICAL ETF HOLDING PERIODS >2 years 1 2 years 7 12 months 1 6 months <1 month 9% 9% 18% 18% 47% 0% 25% 50% Note: Based on 34 responses. 7 GREENWICH ASSOCIATES

Liquidity Needs Attract Institutions to Bond ETFs In institutional markets around the world, ETFs generally take hold first in equities and then gradually gain traction in fixed income and other asset classes. The study results suggest that Canadian institutions are ahead of their peers in other markets in terms of that process, and that bond ETFs are fast becoming staple vehicles in Canadian institutional portfolios. Nearly 70% of Canadian institutional ETF users in the study now employ fixed-income ETFs, with 95% using these funds for at least two years. Although that latter finding suggests that the institutional fixed-income ETF market has started to mature in Canada, Greenwich Associates expects to see continued increases in usage. In addition to the nearly 30% of users expecting to increase allocations to fixed-income ETFs, about 20% of non-users in the study say they are at least somewhat likely to start using fixed-income ETFs in the next year. Trends now playing out in global fixed-income markets could boost the adoption rate in coming months. TOP REASONS FOR USING FIXED-INCOME ETFs Easy to use Quick access Liquidity Single-trade diversification Lower trading costs vs. cash bonds Low management fees 95% 95% 95% 86% 71% 71% Many institutions say the current interest-rate environment is prompting their increase in bond ETF allocations. As they shorten duration in anticipation of rising rates, institutions are moving assets out of individual bond positions and into ETFs. Avoid need for singlesecurity analysis 62% 0% 100% Note: Based on 21 responses. Institutions using bond ETFs say they are attracted to the funds by a wide range of benefits. Ninety-five percent of bond ETF users cite the funds ease of use and quick access as reasons for investment. An equal number of users say they invest in fixed-income ETFs for liquidity. ETF Liquidity on the Rise While regulatory impacts are boosting institutional demand for ETFs in the U.S. and other markets, Canadian markets have been less affected by these developments. However, liquidity remains a primary concern for investors in what is already a relatively small and illiquid market. Since 2008, bond ETF liquidity has grown 5.1x, or at an annual growth rate of 31%. 1 Greenwich Associates expects institutions need for liquidity to boost future levels of ETF investment. Canadian institutions also will continue to invest in ETFs for the additional advantages they derive from the funds. Among bond ETF users, 86% cite the benefits of single-trade diversification, 71% mention both lower trading costs vs. cash bonds and lower management fees, and 62% cite the elimination of the need for single-security analysis. SINCE 2008, BOND ETF LIQUIDITY HAS GROWN 5.1 x 1 BlackRock, Bloomberg, based on the cumulative annual trading volume of all U.S.-listed fixed-income ETFs, as of 12/31/15. 8 GREENWICH ASSOCIATES

ASSET MANAGERS EMPLOY ETFs IN INSTI- TUTIONAL MANDATES, MULTI-ASSET FUNDS The results of the 2015 study confirm that Canadian asset managers increasingly view ETFs as appropriate vehicles for both their retail and institutional clients. Fifty-seven percent of the asset managers in the study use ETFs in retail managed accounts, separately managed accounts or unified managed accounts, and 52% use ETFs in institutional mandates. Almost half use ETFs in equity funds and 43% use them in fixed-income funds. Over half the asset managers use ETFs in multi-asset funds, which are emerging as an important source of ETF demand. In the typical multi-asset fund, 44% of assets are invested in individual securities. ETFs are not far behind at 40%. Approximately one-quarter of these asset managers employ a strategy made up predominately or exclusively of ETFs, and 36% say they are likely or very likely to offer such as strategy in the future. MULTI-ASSET OFFERINGS FUELING ETF DEMAND AMONG ASSET MANAGERS Retail managed accounts/ SMA/UMA Institutional mandates/ Institutional accounts Multi-asset funds Equity funds Fixed-income funds Commodity funds 13% 43% 52% 52% 48% 57% 0% 60% Note: Based on 23 responses from asset managers. Embracing ETF Innovation Institutions in Canada are adopting innovative ETF products at a much faster clip than their counterparts in other markets and this embrace of the new is helping drive the growth in ETF use and allocations. Fortyfour percent of Canadian institutional ETF users employ non-market-cap weighted/smart-beta ETFs, compared to 28% of U.S. institutional ETF users. Among Canadian asset managers, that share hits 48%. Canadian institutions are experimenting with a wide range of new fund types. Eighty-one percent of institutions that have invested in non-market-cap weighted/smart-beta ETFs use multi-factor ETFs, threequarters use equal-weighted ETFs, 69% employ minimum-volatility ETFs and 56% use single-factor ETFs. ETFs Beyond Equities 44 % OF CANADIAN INSTITUTIONAL ETF USERS EMPLOY NON- MARKET-CAP WEIGHTED/ SMART-BETA ETFs Even more dramatic has been Canadian institutions rapid adoption of new ETF types in asset classes outside equities. Forty-four percent of Canadian users of non-market-cap weighted/smart-beta ETFs now use smart-beta funds in fixed income. Among users in the U.S., only 5% have adopted these funds in fixed income. A quarter of Canadian users also employ smart-beta ETFs in commodities, while only 1 in 10 U.S. users do so. Thirty-one percent of Canadian institutional ETF users are employing currency-hedged ETFs, with a matching share using currency forwards or futures. Almost 40% of Canadian asset managers that use ETFs are employing currency-hedged ETFs, a share that exceeds the 25% using 9 GREENWICH ASSOCIATES

forwards or futures. Institutions using currency-hedged ETFs use them mainly for long-term risk management (cited by 64%) and to hedge short-term exposures (64%). Institutions Replacing Derivatives with ETFs Growing numbers of Canadian institutions are replacing other investment vehicles with ETFs a trend that Greenwich Associates believes will contribute to the continued expansion of ETFs in institutional portfolios in coming years. One Canadian asset manager said his firm is using ETFs to replace mutual funds and individual stocks and bonds. Whatever our client comes with, we usually transition them to core holdings and ETFs and keep individual positions only for tax or legacy reasons for doing so, said the firm s representative. Many institutions are replacing derivatives with ETFs. Half the Canadian institutions in the study use futures to access beta. Forty-six percent use futures for hedging, and 31% use them to take on fully funded long positions. Despite these high levels of futures usage, three-quarters of the institutions believe an S&P 500 ETF provides more cost-effective beta exposure than an S&P 500 future. Acting on those preferences, almost 60% of Canadian institutions that use futures to access beta say they swapped out of derivatives products into ETFs for operational simplicity over the past year, while 25% say they ve made that switch to reduce costs. Eighty percent of the institutional ETF users in the study expect to replace an existing equity futures position with ETFs in the next year, and about 1 in 10 expect to use bond ETFs to replace an existing fixedincome futures position. Institutions say they are motivated to make these changes primarily because ETFs are easier to use and implement than futures and provide better performance and diversification. MOST IMPORTANT FACTORS WHEN SELECTING AN ETF (Criteria cited as Very Important ) Expense ratio of fund Matches exposure needs Liquidity/trading volume Performance of fund (tracking error/tracking difference) 76% 76% 70% 62% BlackRock s ishares is Canadian Institutions ETF Provider of Choice When selecting a specific ETF for investment, Canadian institutions cite several factors as very important. Of equal importance are whether the fund s expense ratio makes it a good value and whether the fund Fund company and management behind the funds Assets Under Management of EFTs Benchmark used/benchmark provider Quality of service offered by fund provider Breadth of ETF offerings 27% 19% 16% 38% 35% 0% 80% Note: Based on 37 responses. 10 GREENWICH ASSOCIATES

matches their exposure needs a clearly strategic application. After these two factors, institutions selecting an ETF look at a fund s liquidity/ trading volume and performance, including tracking error. PROPORTION OF RESPONDENTS USING EACH ETF PROVIDER* ishares/blackrock 92% Institutions also take a close look at the companies providing the funds. Roughly half mention the overall reputation of the fund company behind the ETF, as well as the quality of service and breadth of offerings from the fund provider as somewhat important factors when selecting an ETF. Vanguard BMO State Street/SPDRs 44% 56% 64% Based on these criteria, ishares, the exchange-traded fund division of BlackRock, ranks as by far institutions preferred provider of ETFs. Ninety-two percent of institutional ETF users in the study use ishares as a provider, followed by Vanguard at 64%, BMO at 56%, and State Street/ SPDRs at 44%. While Vanguard is cited for providing the best value for the management fees, the institutions name ishares as best in class in ETF liquidity, range of product offerings, index tracking, innovation, product transparency, and service platform. Conclusion PowerShares Horizons First Asset First Trust 14% 14% 39% 33% 0% 100% Note: *Other mentions included WisdomTree, PIMCO, Schwab ETFs, Guggenheim, RBC Global Asset Management, Directions, and Market Vectors by Van Eck. Based on 36 responses. The results of the Greenwich Associates 2015 study point to continued growth in the Canadian institutional ETF market. Almost 30% of bond ETF users and one-third of equity ETF users expect to boost ETF allocations in the coming year, with half of fixed-income and almost a quarter of equity ETF users planning increases of more than 10%. As institutions become more familiar with ETFs, lift internal investment restrictions and adopt new technology platforms that support a wider range of investment vehicles, ETFs will continue to attract new institutional users and assets. Demand for fixed-income ETFs near-term will increase as institutions move to shorten portfolio duration and meet ongoing liquidity needs. Future growth will be driven by the versatility of ETFs and the creativity of Canadian institutions, which are applying the funds in a long and growing list of strategic and tactical portfolio functions. Canadian institutions are among the world s institutional leaders in their use of new ETF products and are adopting ETFs in fixed income and other asset classes beyond equities. Taken as a whole, this diverse list of applications and continued growth in usage rates and portfolio allocations make clear that, when it comes to ETFs, Canadian institutions rank among the world s most active and sophisticated investors. greenwich.com ContactUs@greenwich.com Ph +1 203.625.5038 Doc ID 16-2004

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