fall 2017 - global · water, up from 14.1 million in the previous year. source: bmo responsible...

1Title

Fall 2017

ESG: From Philosophy to Practice (pg. 1)

Automation: The Future is Now (pg. 7)

Can ETFs Replace Futures? (pg. 11)

This Issue

ESG: From Philosophy to Practice

As Environmental, Social and Governance (ESG) factors become more of a driving force behind the investment decisions of asset managers and institutions globally, Responsible Investing (RI) experts Vicki Bakhshi and Jamie Jenkins of BMO Global Asset Management (EMEA) discuss how to successfully deploy an ESG focus that’s entirely complementary to long-term performance goals, through an award-winning vehicle that’s now accessible to Canadian institutional investors.

Leading the ESG Train

In a world where macroeconomic trends have confronted us with unprecedented social, environmental and economic challenges, regulators and policymakers have increasingly moved to mandate ESG integration across investment portfolios. Now, more so than ever, it’s important for asset managers, investors and consultants to take their lead, and work together to create a sustainable financial system for the future.

From an expanding and ageing global population to the impacts and threats of climate change, biodiversity and urbanization, we need to harness the creativity and dynamism of companies and capital markets to focus on businesses that are proactively – and effectively – managing their ESG risks and opportunities.

But this doesn’t – and shouldn’t – exclude long-term performance. In fact, companies providing solutions to these global challenges position themselves to benefit from growth opportunities, resulting in the potential for alpha generation. While the historical perception would equate investing responsibly with the need to sacrifice returns, increasingly, a growing body of evidence suggests the opposite is true. Turning the historic theory on its head, recent academic studies have shown a positive link between robust sustainability practices and stronger company-level operational performance.1 As a result, there’s been a wide awakening of interest around global sustainability and RI.

As a leader in the evolution, BMO Global Asset Management has long taken sustainability seriously. Launching Europe’s first social and environmental screened strategy more than three decades ago, we’ve since worked to expand our dedicated suite of RI strategies, which now covers US$2.0 billion2 across a mix of asset classes, including bond and equity funds. All of the strategies offer a way to invest in companies that strictly adhere to certain ethical standards, and are managed to provide capital growth – underpinned by our belief that the prudent management of ESG issues can have a fundamental impact on the creation of long-term investor value.

A history of innovation in Responsible Investment...1984 1987 1997 2000 2006 2007 2010 2011 2014 2016

Launch of Stewardship Growth - first ethical strategy in UK

Launch of Stewardship Income & Stewardship North American strategies

Stewardship North America becomes Stewardship International strategy

Launch of Responsible Engagement Overlay (reo® )

Founding signatory to Principles for Responsible Investment (PRI)

Launch of Responsible UK Sterling Bond strategy

Launch of Emerging Markets ESG Strategy

Launch of ESG Risk Tool

Rebranded as Responsible Strategy Range

Launch of Green Bond Strategy

Source: BMO Global Asset Management, August 2017.

1

ESG: From Philosophy to PracticeVicki Bakhshi - Director in the Governance and Sustainable Investment team at BMO Global Asset Management (EMEA)

Jamie Jenkins - Director and Head of Responsible Global Equities

http://www.bmoiq.com/media/224513/IQ-Chart-October-2017-01-EN.jpg

http://www.bmoiq.com/newsletter/contributors/vicki-bakhshi/

http://www.bmoiq.com/newsletter/contributors/jamie-jenkins/


How to Turn Sustainability into Opportunity

Our approach to responsible investment within our Responsible Funds range is based on three pillars: Invest, Avoid and Improve – investing in companies meeting positive sustainability themes; avoiding those with damaging or unsustainable business practices; and improving by using our influence as an investor to encourage appropriate practice on ESG issues through engagement and voting rights.

While our process involves comprehensive screening and exclusion, it doesn’t stop there: we actively mine for companies that are ESG leaders and provide solutions to global sustainability challenges – in sectors like healthcare, clean technology, waste management or natural resources. Known as thematic-oriented investing, not only do these companies work in favour of the social good, but they also stand to benefit financially, as these trends develop further. And because of our belief in using our role – and our rights – as a shareholder to create positive change, we’re able to invest in businesses that are intrinsically high-quality, but have encountered short-term challenges that we can help overcome through our active ownership approach. Particularly relevant now is how we’ve put our three-pillar approach into practice to develop a detailed and comprehensive strategy addressing climate change across all of our RI strategies, engaging with both companies and policymakers.

Responsible investing is not just about managing risk – it’s also about finding opportunities.

Engaging with ESG

As a responsible investor, we now assess the progress of our investments against the framework of the Sustainable Development Goals (SDGs), a set of 17 ambitious goals developed by the United Nations and agreed by 193 governments. By doing this, we’re able to understand if our investee companies are strong or weak ESG performers in relation to a universal policy agenda, carefully determining the extent to which our strategies align with each goal, and our approach thereafter.

This forms part of BMO Global Asset Management’s extensive engagement efforts, and it’s how we distinguish ourselves in the marketplace. Crucially, ESG considerations are integrated throughout our investment process – from idea generation through to portfolio construction, and beyond. Because investment is never straightforward, there will always be ESG risks and opportunities that need to be continually addressed and monitored, on an ongoing basis, as part of every strategy.

Engagement is the cornerstone of our ESG philosophy, and as shareholders, we aim to play a constructive role in working with companies to achieve the best long-term results and enhance value for our investors. Engagement is not simply an initial discussion with management about operational issues; it’s the front and centre of our entire approach, with multiple touchpoints to make a difference. By engaging effectively, asset managers can encourage companies to harness the business opportunities presented by the SDGs, estimated at $12 trillion by 2030.3

The need for engagement is clear: with encouragement from regulators, pension plans in Canada – and globally – are seeking to actively pursue their shareholder rights to promote sustainable ESG practices in their investee companies, with the Canadian Coalition for Good Governance and the UN Principles for Responsible Investment providing valuable networks for Canadian plans to implement this into practice. The challenge, though, is that good-quality stewardship is resource-intensive and difficult to achieve across global portfolios.

Engagement is the cornerstone of our ESG philosophy – we believe that as shareholders we have a responsibility to take our ownership rights seriously.

As a solution to the problem, BMO offers the reo© (responsible engagement overlay) engagement and voting service to promote improved ESG disclosure and performance, and address global ESG risks. The service, established in 2000, provides in-depth engagement by BMO’s 13-strong Governance and Sustainable Investment (GSI) team for asset owners seeking to use their influence for positive change. reo© represents over US$130 billion in assets, engaging 768 companies across 52 countries in 2016, with 191 instances of change achieved.4

Our in-house GSI team is instrumental to our engagement initiatives – defining and continually evolving the standards by which

2

https://sustainabledevelopment.un.org/?menu=1300

https://sustainabledevelopment.un.org/?menu=1300


we measure our investments, and deciding whether companies meet the stringent criteria for our RI strategies. Working closely with our fund managers, the dedicated group of experts maintains the credibility of the ethical and ESG screening process, and levers its 17 years of experience with reo© to execute on all voting and engagement tactics surrounding shareholder ownership – understanding precisely at what level to intervene, and how to fit environmental and social policies into a business context.

Climate Change and Water Stress: How We Engage and Add Value

The integrated assessment of ESG opportunities and risks, twinned with our ongoing engagement, is what make our strategies truly differentiated, as we’re dedicated to increased transparency and investing in companies with improving ESG profiles. As a testament to this, our team just released the ESG Profile and Impact Report 2017 for our BMO Responsible Global Equity Strategy, which tracks the Fund’s connection to the SDG goals, including an assessment of its carbon and water exposure, ways to reduce its footprint, and mitigate risk. What follows are two examples of how we’ve addressed two growing issues of global importance: climate change and water stress.

1. After the 2015 United Nations Climate Change Conference in Paris, we asked U.S.-based industrial gas group Praxair, one of our investee companies, to provide information about its climate change management strategy, including scenario planning to understand how the COP21 carbon reduction commitments could impact its future profits, and shareholder value.

2. Given that the World Economic Forum listed the water crisis as a top-three societal risk in terms of impact for the third straight year, our strategy has been to increase exposure to companies actively addressing this critical challenge, such as Suez, an industrial services business at the forefront of the shift towards a circular economy. It returned 4.7 million tonnes of secondary raw materials to the market in 2015, and supplied 14.7 million people in developing countries with drinking water, up from 14.1 million in the previous year.

Source: BMO Responsible Global Equity Strategy: ESG Profile and Impact Report, 2017.

BMO Responsible Global Equity Strategy – Our Alignment with UN SDGs

Goal 9

33%

Goal 6

3%Goal 3

19%

Goal 7

3%Goal 8

10%

Goal 2

4%

Goal 12

5%

Goal 11

8%

Strategy’s connection with

the SDGs

Responsible Consumption

and Production

Industry, Innovation and Infrastructure

Good Health and Well-being

Clean Water and Sanitation

Decent Work and Economic

Growth

Affordable and Clean Energy

Sustainable Cities and

CommunitiesZero Hunger

Source: BMO Responsible Global Equity Strategy: ESG Profile and Impact Report, 2017.

3

https://bmogamhub.com/system/files/esg_profile_and_impact_report.pdf

https://bmogamhub.com/system/files/bmo_am_responsible_global_equity_esg_fund_jhi096_profile.pdf


http://www.bmoiq.com/media/224508/IQ-Chart-October-2017-02-EN.jpg


BMO Responsible Global Equity Strategy: Performance with Principles

At BMO Global Asset Management, our sophisticated and thorough investment process is supported by three layers of experience and insight, including the respective portfolio managers; the specialist GSI team; and the Responsible Investment Advisory Council, an external board of experts created in 2014 to enhance the standards on which our Responsible Fund range is based, and discuss any pertinent ESG issues, or borderline cases relating to our investments. While each team has its own responsibilities, all three work in concert to achieve our Invest, Avoid and Improve goals.

Within the BMO AM Responsible Global Equity ESG Fund, which launched in Canada in September, we lever this expertise to focus on growth companies that are demonstrating a clear commitment to sustainability and can prosper in spite of economic and policy-driven volatility. Risk management is at the core of our disciplined process, recognizing risks posed by ESG issues – such as natural resource constraints and climate change – to broader material threats. In keeping with our ESG philosophy, embedded in the DNA of our strategy is an increasing focus on positive sustainability themes and the wider societal responsibility of every company in which we invest. It’s not enough to meet the ethical screening standards of our GSI team, or MSCI Research- this is a mere starting point for our analysis, and requires skilled, in-depth interpretation, and often, further investigation. From here, we select – from a pool of approximately 1,000 stocks – companies that are demonstrably and proactively working towards the UN SDG framework, whether this means supporting gender equality and good governance within corporations, or managing energy-water linkages to curb water stress as we support the transition to a decarbonised economy.

Green Bonds: Another Example of Proactive ESG Investing

BMO Global Asset Management is also now managing specialist, segregated green bond mandates for our institutional clients, allowing them to channel their fixed income investments directly into green technologies, such as renewable energy projects or climate change solutions. The US$188 billion5 fast-growing green bonds market is continuing its meteoric expansion, and we see it as a powerful, and efficient way to allocate capital at scale towards environmental challenges, while investing in low-risk, investment-grade bonds. The development of robust, enforceable standards in this market still lags, so we rely heavily on our own due diligence to ensure bonds are genuinely green.

As part of our fundamental analysis, our Responsible Global Equities team intelligently utilize ESG data to feed reliably into our valuation processes, enhancing mainstream investment analysis. A prospective company’s ESG profile is integrated directly into our discounted cash flow (DCF) valuation models through a quality checklist, with ESG momentum representing one of the 10 factors used to calculate an overall quality score, or “Q-score”, which is then incorporated into the discount rate we use to value businesses. ESG momentum, which is often reflected in several of the other quality factors as well, can interestingly enough have a sudden and drastic impact on the term value.

Ultimately, as managers of BMO AM Responsible Global Equity ESG Fund, we are investing, through an ESG filter, in a portfolio of 50 to 70 diversified, high-quality businesses that should outperform over the long term, due to their robust cash flow; focus on growing franchise value; and sheer dedication to improving shareholder returns – all the markings of a sound investment proposition. It’s a win-win situation for Canadian institutions seeking a vehicle with a bottom-up, fundamental approach, which is philosophically aligned to their moral and ethical values, while meeting fiduciary objectives and delivering credible, attractive long-term performance. A mere glance at the Fund’s returns will confirm this: its 1-year and 3-year returns, on a gross basis, are both 14%, compared to MSCI World benchmark returns of 11.70% and 11.80%, respectively.6 Our commitment to consistently achieving these results is reflected in our policy to benchmark the strategy against the mainstream MSCI World Index, critical to demonstrating that we are an absolute bedrock option for investors, and competitive against every other global equity fund on the market.

Sustainable Success: Mettler Toledo International

Why it has performed: A multi-national manufacturer of scales and analytical instruments, the Company is a strong incremental market share expansion story that is supporting the transition to a culture of greater health and safety and precision in manufacturing. With a rarefied market position and a track record for value creation, there is a high client-retention rate. Mettler is also in a sweet spot in terms of its product and the value-add it provides China, as the country undergoes an industrial transition. While it’s not a household name, it is a business that has grown consistently in our portfolio over the last 20 years, with broad platform exposure that is valued by customers for its precision, reliability, value and low environmental impact.

4




GET STARTED

Detail Strategy Specifics

Strategy BMO Responsible Global Equity

Launch Year 1997

Fund Currency CAD and EUR

Universe Global Equities

AUM CA$953 million

Number of stocks range 50 to 70

Tracking error range No explicit limit

Turnover Internal target 30%

Benchmark MSCI World

Internal stock limits Max 5% per stock in large cap Max 3% per stock in small cap

Source: BMO Global Asset Management, as at August 31, 2017.

To learn more about BMO AM Responsible Global Equity ESG Fund, or our comprehensive RI fund range, and other ideas to enhance your portfolio, please contact your Regional BMO Asset Management Institutional Sales & Service Representative, click here, or access the materials below.

BMO Responsible Global Equity Strategy: ESG Profile and Impact Report 2017

1 University of Oxford and Arabesque Partners, 2015. Study reviewed 190 independent academic papers, found that 88% showed a positive link between robust sustainability practices and stronger company-level operational performance.

2 BMO Global Asset Management, as of March 31, 2017.

3 Business & Sustainable Development Commission, January 2017. Better Business World Report.

4 BMO Global Asset Management, as of December 31, 2016.

5 Natixis Research, February 2017.

6 BMO Global Asset Management, as of August 31, 2017. Annualized CAD gross returns for Responsible Global Equities Composite. Benchmark used is MSCI World TR, CAD gross of fees. Inception Date of Composite: December 12, 2005. For additional information regarding the firm’s policies for reporting of performance returns, please refer to the disclosure section below.

* The reo© engagement and voting service is not utilized by all legal entities of BMO Global Asset Management.

5


http://www.bmoiq.com/newsletter/sales-team/

http://www.bmoiq.com/newsletter/sales-team/

http://www.bmogam.com/corporate/about-us/responsible/



6ESG: From Philosophy to Practice

Not intended for distribution outside of Canada.

Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations.

The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Any statement that necessarily depends on future events may be a forward-looking statement. Past performance is no guarantee of future results. Investments should be evaluated according to the individual’s investment objectives. Professional advice should be obtained with respect to any circumstance. Prospective investors are advised to read the offering memorandum and to consult with an independent financial advisor prior to making any investment decision based on this document.

All Rights Reserved. The information contained herein: (1) is confidential and proprietary to BMO Asset Management Inc. (“BMO AM”); (2) may not be reproduced or distributed with-out the prior written consent of BMO AM; and (3) has been obtained from third party sources believed to be reliable but which have not been independently verified. BMO AM and its affiliates do not accept any responsibility for any loss or damage that results from this information.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp. and BMO’s specialized investment management firms.

Important information about the Fund is contained in the offering memorandum including, a detailed description of the Fund’s investment objectives, investment strategies and portfolio metrics. This document pertains to the offering of the funds described in this document and in the Information Memorandum only in those jurisdictions and to those persons where and to whom they may be lawfully offered for sale, and only by persons permitted to sell such Shares. Eligible purchasers will need to qualify as “accredited investors” and “permitted clients” under applicable Canadian securities laws.

This document has been prepared for information purposes only and should not be construed as a solicitation for, or offering of, an investment in securities in any jurisdiction where such offer or solicitation would be prohibited. While the information contained in this document is believed to be reliable, no guarantee is given that it is accurate or complete. This document is not, and under no circumstances is to be construed as an advertisement or a public offering of the Shares described in this document or the Canadian Offering Memo-randum or Information Memorandum in Canada. No securities commission or similar authority in Canada has reviewed or in any way passed upon this document or the merits of the Shares described in this document or the Canadian Offering Memorandum or Information Memorandum, and any representation to the contrary is an offence. Prospective investors are advised to read the offering memorandum and to consult with an independent financial advisor prior to making any investment decision based on this document.

Fund terms and conditions are indicative only and subject to change.

On 6 July 2015 BMO Global Asset Management became the trading name of the F&C group of companies and claims compliance with the Global Investment Performance Standards (GIPS®). Prior to 31 December 2015 F&C Asset Management claimed compliance with GIPS and was independently verified. GIPS Compliant Presentation reports are available upon request. BMO Global Asset Management has prepared and presented this report in compliance with the GIPS standards. BMO Global Asset Management has been independently verified for the periods 1995 through 2016. The verification report(s) is/are available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

The Responsible Global Equities Composite includes all discretionary portfolios managed according to F&Cs core Global ESG investment strategy. Portfolios within this composite are measured against the MSCI World index but are restricted to investing in companies that are considered to be making a positive contribution to society whilst avoiding those considered to be detrimental. The universe of acceptable companies available for investment is created by F&Cs Governance and Sustainable Investment team and approved by an independent Committee of Reference. The portfolios within this composite have a typical tracking error range of 0-8%.

Gross of fees performance is calculated gross of investment management fees and where available, administrative fees. Gross of fees performance is net of all trading expenses. Net of fees performance is presented net of all investment management, administrative fees and trading expenses. This composite uses actual fees. A full breakdown of fees for this composite is available on request.

Additional information regarding the firm’s policies and procedures for the preparation of compliant presentations, valuation, calculation and reporting of performance returns is available on request.

© 2017 BMO Global Asset Management. All rights reserved. ® “BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.

Automation: The Future is Now 7

Automation is no longer a figment of a very distant future; it’s a present-day, modern reality, and institutions worldwide need to adapt. The question is not which industry will be impacted, but rather, by how much. Sal Guatieri, Director and Senior Economist at BMO Capital Markets, shares the broader implications of automation and artificial intelligence (AI) technology on the labour force, the economy – and your investments.

A Widespread Impact

Automation is everywhere – from the check-out kiosks at grocery stores to the autopilot function on airplanes. It’s no longer reserved for elaborate Google demonstrations on creating a self-driving vehicle, or the IBM Watson supercomputer. And it’s not just a matter of which industry will be impacted, but rather the activities that will be automated within these industries, and how much work will be changed by new AI technology, potentially requiring the entire transformation of business processes.

While most analysts will agree that we’re not – and won’t be for at least two decades – at the point where computers will entirely be able to replicate human thought processes, we have certainly arrived at a major crossroads: algorithms are increasingly performing human tasks, and this isn’t exclusive to manual, routine jobs (many of which have already been displaced by automation).

Instead, a growing number of non-routine, cognitive tasks are at risk – from lawyers conducting research, to x-ray examinations by radiologists, and even a journalist writing an article. AI technology can recognize investment patterns to customize portfolios. The automation trend will only increase as processing and algorithms improve, and as companies collect more big data, and mine it for useful information. Indeed, 90% of the data in the world has been created in the past two years alone1 – with the data flood only expected to continue, while open-source frameworks have dramatically diminished barriers to entry allowing for large-scale data processing. As a result, workers – regardless of industry – will have to be mindful that more of their tasks will be at risk of displacement, with new automation working its way up and down the skills chain, and threatening a wider range of occupations than in the past.

42% of the tasks that Canadians are currently paid to do can be automated using existing technology.2

What will be the result?

While higher-skilled jobs are apt to benefit from this growing movement, it can have a long-lasting influence on worker anxieties and wages, particularly those with low-paying jobs. Many workers will be increasingly reluctant to ask for a wage increase, given the insecurity stemming from the proliferation of advanced automation. A study using U.S. job and wage data estimates that each new robot per 1,000 workers lowers wages by 0.25% to 0.5%.3 Due to the highly competitive environment, employers will feel compelled to cut wages or displace employees entirely to increase productivity and reduce costs.

Advances in robotics have already decreased the number of manufacturing jobs, while automated checkout machines and self-serve ordering kiosks are threatening more retail positions.

7

Automation: The Future is NowSal Guatieri - Director and Senior Economist, BMO Financial Group

http://www.bmoiq.com/newsletter/contributors/sal-guatieri/


Source: Creig Lamb, The Talented Mr. Robot: The impact of automation on Canada’s workforce, Brookfield Institute, June 2016.

According to a recent academic study, 47% of American jobs are at high risk of losing out to automation in the next decade or two, with positions in transportation, office support, administration, accounting, retail and manufacturing in the greatest danger.4 Global consulting firm McKinsey estimates that about 60% of jobs could have 30% or more of their tasks automated.5 The adverse impact on wages6 could increase as more tasks are automated, which could ultimately restrain inflation and interest rates.

The Flipside. For Some.

On the positive side, automation will actually complement certain occupations, such as mathematicians, statisticians and economists, allowing them to increase their bargaining power with employers as a result of greater productivity brought upon by AI technology, resulting in improved wages for these individuals. And many of these so-called “knowledge workers” are being hired by a growing number of retailers.

Amazon, for example, has already engaged hundreds of economists and statisticians who can effectively and insightfully mine reams of data collected on consumer behaviour. Ultimately, the online giant will be able to predict what consumers want, anticipating shifts in demand to better coordinate product supply, thereby gaining a competitive advantage over peers.

These highly skilled roles are the jobs of the future: people who can create, or benefit from, the algorithms that are driving the AI revolution, and who use creativity, flexibility, or judgment in their occupations. It is in these industries – in which automation can be leveraged to enhance value-add – where we will see rising wages and essentially unlimited demand for services, whether it’s an economist, a business manager, or a computer programmer.

http://www.bmoiq.com/media/224522/Automation-Chart-October-2017-03-Large.jpg

The Many Benefits of Automation:

• Increased productivity• Labour cost savings• Employment growth• More reliable, insightful information• Enhanced services• Performance of tasks at superhuman levels• New products and industries • Elimination of mundane, repetitive tasks• Enriched quality of life

The Aftermath

Inevitably, what this means is that developed economies (and highly skilled workers) stand to gain the most from the AI revolution, while emerging market (EM) countries, which are heavily reliant on low- and middle-skill positions for the health of their economy, could be left behind, because it is these low-paying jobs that are increasingly at risk of being automated.

It will be an enormous challenge for many EM nations – like India and Latin America – that have so far been able to capitalize on their low-wage costs for exports, to viably compete. In fact, we may actually witness production return to North America, but instead of humans filling these roles, robots will perform assembly line tasks, and at a lower cost. The U.S. and Canada will benefit from the increased income generated at home, while emerging markets could see their economies fall further behind.

As a result, developing countries will have to quickly adapt, and the way to achieve this is through education, and creating jobs that can help drive and sustain the technology revolution. Government and policymakers (in emerging markets and around the world) will increasingly have a role in planning for this paradigm shift, through new training and programs designed to help future-proof their populations.

Unfortunately, there will be a displacement period with the advancement of automation, where jobs will be disrupted, social fabrics will be strained, and people will have to re-train for higher skilled positions. But this is nothing new – it’s a consequence of every new technology or machine adopted in history since the cave-dwellers.

In the end, the benefits of automation outweigh the costs for society as a whole: even though jobs are lost initially, more products are created and at less of an expense, leading to increased purchasing power, which eventually generates a greater number of jobs in new industries and overall improved living standards.

Future-Proofing Your Investments

For institutional investors, a company’s ability to integrate automation and AI into its work process should be a fundamental consideration over the next decade, as we continue to see the convergence of fast computing, and the creation of new algorithms that can mine big data to predict the future. Businesses that are at the forefront of this revolution are expected to flourish, catapulting themselves forward as industry leaders and stalwart competitors. As such, investors should consider companies leading the technology revolution that are able to lever automation for their benefit, while avoiding dinosaur businesses that shun automation and will soon become extinct.

As part of the transition towards a greener global economy, the consideration of environmental and social governance (ESG) factors is also a growing trend for investors, and AI processes and automation will be crucial in the development of this movement – from improving the efficiency of windmills to solar-powered electricity, and self-driving vehicles. The companies developing these innovations stand to gain the most over the next decade, as businesses providing solutions to global challenges position themselves to benefit from growth opportunities, resulting in the potential for alpha generation. And while thousands of jobs will be lost as a result of these advances, thousands more will be created.

For example, with autonomous vehicles, individuals will still need to produce and program these cars, and entirely new industries will be dedicated to developing the necessary infrastructure, and for the customization of these vehicles. In all likelihood, when self-driving vehicles are finally marketed en masse, “drivers” will still exist, though their roles will change dramatically, much like bank tellers had to adjust and become more specialized and customer-focused with the advent of ATMs.


Embracing the New Reality

As prices of robotics systems fall and performance improves, the integration of automation and AI technology across all walks of life will only intensify. Though certain occupations are more vulnerable to automation than others, the reality is that even the highest-paid occupations have a significant amount of activity that can be automated, and few (if any) industries will be left untouched. While the implications will be enormous – from the major restructuring of entire business processes to job displacement, polarization, and wage reduction, the opportunities will extend far beyond labour savings.

As an investor during these advanced times, greater attention should be paid to companies that have made the efforts to staff, manage and lead increasingly automated organizations, harnessing the massive potential new technology affords, and using it as an important competitive differentiator to ultimately benefit your portfolio returns.

1 IBM, Big Data Analytics.

2 Creig Lamb, The Talented Mr. Robot: The impact of automation on Canada’s workforce, Brookfield Institute, June 2016.

3 Acemoglu, Daron and Pascual Restrepo, Robots and Jobs: Evidence from US Labour Markets. March 17, 2017.

4 Frey, Carl B. and Michael A. Osborne, The Future of Employment: How Susceptible are Jobs to Computization?, September 17, 2013.

5 McKinsey and Company, A Future That Works: Automation, Employment and Productivity, January 2017.

6 Chui, Michael, James Manyika and Mehdi Miremadi, Four Fundamentals of Workplace Automation, McKinsey and Company, November 2015.




All Rights Reserved. The information contained herein: (1) is confidential and proprietary to BMO Asset Management Inc. (“BMO AM”); (2) may not be reproduced or distributed without the prior written consent of BMO AM; and (3) has been obtained from third party sources believed to be reliable but which have not been independently verified. BMO AM and its affiliates do not accept any responsibility for any loss or damage that results from this information.




https://www.ibm.com/analytics/us/en/big-data/

http://brookfieldinstitute.ca/wp-content/uploads/2016/08/TalentedMrRobot_BIIE-1.pdf



https://economics.mit.edu/files/12763

http://www.oxfordmartin.ox.ac.uk/downloads/academic/The_Future_of_Employment.pdf

http://www.oxfordmartin.ox.ac.uk/downloads/academic/The_Future_of_Employment.pdf

http://www.mckinsey.com/global-themes/digital-disruption/harnessing-automation-for-a-future-that-works

11Can ETFs Replace Futures?

As ETFs are incorporated across an expanding number of institutional portfolios globally, is it possible that they will eventually unseat futures in conventional portfolio construction?

Chris McHaney, Vice President, Portfolio Manager, Global Structured Investments at BMO Global Asset Management, discusses the driving forces behind the widespread adoption of ETFs, the major differences between the two strategies and key determi-nants to understanding the optimal solution for an institutional investor.

Can ETFs Replace Futures?

Both futures and ETFs are exchange-traded vehicles with clear visibility and limited counterparty risk, offering sophisticated investors low-cost, diversified exposure where they might otherwise need to purchase and manage the underlying basket of securities. While futures have traditionally been the “go-to” option for institutional investors seeking to gain equities exposure and invest the cash in their portfolios, ETFs have increasingly become the new – and in many cases, better – alternative.

Globally, the proliferation of ETFs has been unprecedented, breaking past $4 trillion in assets under management earlier this year, as new product launches and investor inflows continue to swell: there are now almost 7,000 exchange-traded products managed by 313 providers globally.1 Indeed, according to a recent study by Greenwich Associates, 45% of institutions that use derivatives to access beta have replaced an existing derivatives position with an ETF in the past year, and 75% of U.S. insti-tutions would choose an S&P 500 ETF over S&P 500 futures for obtaining the most cost-effective beta exposure within a fully funded position.2

What’s driving this evolution toward ETFs?

The Components of…

ETFs

• Exchange-traded investment vehicles are managed by the ETF provider, with net asset value published on a daily basis, and audited periodically by independent entities

• Buying and selling is as easy as trading on the stock market• Pricing reflects entire cash outlay upfront, bid-offer spreads (resulting in real-time premiums and discounts to the fund’s

net asset value), explicit commissions, fund management fees and total expense ratios• Premiums and discounts can occur based on supply and demand, creation and redemption fees, and costs to replicate

the index• Cash flows derived from ETF position gains/losses; dividends; opportunity for lending income

Can ETFs Replace Futures?Chris McHaney - CFA, Vice President, Portfolio Manager, Global Structured Investments, BMO Global Asset Management

12

Futures

• Exchange-traded, standardized derivative contracts between two counterparties, where both parties agree to buy and sell a particular asset of specific quantity at a predetermined price, at a specified date in the future

• An initial amount is paid when the position opens, called an initial margin, which a buyer or seller must deposit at the exchange’s clearing house (typically a low, single-digit percentage of the notional value, which does not need to be paid in cash)

• Pricing reflects a component that represents interest charges on “borrowed” funds, since buyers do not need to pay a lump sum upfront for their notional amount, thereby deploying leverage (implicitly paying sellers to not only replicate index returns, but with sellers’ own funds)

• Roll costs, or the transaction cost of rolling a future month-to-month,3 is variable in nature, and is calculated by comparing the interest rate earned on unused cash to the implied interest rate paid

• Cash flow earned from a futures position gains/losses (including from roll activities and dividends of underlying stock); interest income on cash collateral, offset by the implicit financing cost embedded

Source: CME Group, Conversation with the Buy-Side: Futures and ETFs, May 2017.

Shifting Cost Dynamics

For institutions looking for a cost-effective way to invest the cash in their portfolios and eliminate cash drag, futures have gen-erally been viewed as the cheaper option, but economies of scale have driven ETF providers to trim total expense ratios, and the sheer trading volume of ETFs have boosted their liquidity, lowering the bid-ask spread, making them increasingly attractive to investors as a main investment tool. This is especially the case as equity index futures experience rising holding and roll costs due to a confluence of factors, including shifting supply-and-demand forces in the marketplace, as well as increased regulatory burden and higher capital requirements for financial institutions that have appeared since the 2008 crisis to help reshape the global financial system.

Previously, a billion-dollar book of business would have been leveraged up to 30 times by an investment bank (primarily through a futures position); however, with leverage limitations now in place, and higher balance sheet charges, market partici-pation has decreased, creating wider spreads, reduced capacity, and a more difficult environment in which to transact.

Understanding Costs

Transaction Costs – Can be broken into two parts: i) the trade’s commission, which is an explicit fee charged for opening/closing a position, and ii) the trade’s market impact, which measures adverse price movement caused by executing the trade order (based on trade size, combined product liquidity, and/or execution timing and methodology)

Carry Costs – The expected expenses as a consequence of maintaining exposure for a period of time:

• Futures – spread between futures implied financing rate and interest earned on cash; transaction costs of rolling futures from month-to-month (which change depending on when the roll is executed)

• ETFs – ETF management fee; total adjustment, or income generated from ETF securities lending and tax advantage; tracking error

Source: Bank of America Merrill Lynch, May 2017.

Still, many in the industry agree that the higher execution costs of futures may not have been as much of an issue if not for the supply and demand dynamics within the futures market. As stock prices have risen in recent years, investors have reduced their short positions, boosting demand on liquidity providers and increasing the implied financing of futures, which has contributed to higher roll costs that hit every time a contract is renewed for another month, or quarter.

Nevertheless, futures – with their inherent leverage – remain a low-cost option, especially at the outset, as investors do not need to pay a large sum upfront for the derivatives contract. The risk, or downside, is the assumptions based into the price – for example, the underlying yield that can be earned on any unfunded cash collateral, which can fluctuate based on interest rates. If that yield cannot be achieved, then said future’s performance would actually be worse than owning the underlying asset, which is especially relevant amid the current rising rate environment. Futures are also subject to dividend forecast errors; adding


13

to this the temporal nature of futures’ rolling costs, and price discovery in the market is subject to variabilities and greater devi-ations away from equilibrium prices.

Ultimately, cost will depend heavily on the underlying investment, and because of the assumptions embedded into the implied financing of a future, investors can’t be certain of the less-expensive route between futures and ETFs until after the fact. In the below figures, it is evident that the ETF is the more cost-effective option for a fully funded (i.e., no leverage) MSCI EAFE position for a period of one year – due primarily to the cost of borrowing, and the fact that it generates more securities lending income than in the case of a S&P 500 ETF position. While the cost differential between futures and ETFs has narrowed dramatically in recent years, the choice between the two will depend largely on an investor’s requirements, preferences (in terms of desired exposure) and constraints, as the approach to implementation is vastly different.

Comparing the Costs: Futures vs. ETFs

Table 1: Cost of holding fully funded (no leverage) MSCI EAFE futures (MFS) for the prior one year

MSCI EAFE futures (MFS) 3M median daily notional open interest and volume: 25.2bn and 1.2bn USD

MSCI EAFE Futures (MFS)

Futures 25mn USD 50mm USD 100mm USD 250mm USD

Total Transaction Costs 5.1 bps 8.1 bps 11.2 bps 38.6 bps

Commissions at Entry and Exit 0.5 bps 0.5 bps 0.5 bps 0.5 bps

Market Impact at Entry and Exit 4.6 bps 7.6 bps 10.7 bps 38.1 bps

Total Carry Costs 16.4 bps 16.4 bps 16.4 bps 16.4 bps

Adjustment of 4 Rolls Due to Richness/Cheapness 14.3 bps 14.3 bps 14.3 bps 14.3 bps

Transaction Costs for Futures Rolls 2.1 bps 2.1 bps 2.1 bps 2.1 bps

Total Yearly Cost 21.5 bps 24.5 bps 27.6 bps 55.0 bps Source: BofA Merrill Lynch Global Research, May 22, 2017.

Table 2: Cost of holding fully funded (no leverage) MSCI EAFE ETF (EFA) for the prior one year

MSCI EAFE futures (MFS) 3M median daily fund total assets 67.1bn USD and 3M median notional volume 1.0bn USD

MSCI EAFE Futures (EFA)

ETFs 25mn USD 50mm USD 100mm USD 250mm USD





Management Fee per Year 33.0 bps 33.0 bps 33.0 bps 33.0 bps

Total Adjustments from Securities Lending and Enhancements

-31.4 bps -31.4 bps -31.4 bps -31.4 bps



14

Table 3: Cost of holding fully funded (no leverage) S&P500 futures (ES) for the prior one year

S&P500 futures (ES) 3M median daily notional open interest and volume: 354.2bn and 173.4bn USD

S&P500 Futures (ES)

Futures 25mn USD 50mm USD 100mm USD 250mm USD




Total Carry Costs -3.0 bps -3.0 bps -3.0 bps -3.0 bps

Adjustment of 4 Rolls Due to Richness/Cheapness -4.7 bps -4.7 bps -4.7 bps -4.7 bps

Transaction Costs for Futures Rolls 1.7 bps 1.7 bps 1.7 bps 1.7 bps

Total Yearly Cost -2.1 bps -1.6 bps -0.5 bps 5.7 bps Source: BofA Merrill Lynch Global Research, May 22, 2017.

Table 4: Cost of holding fully funded (no leverage) S&P500 ETF (SPY) for the prior one year

S&P500 ETF (SPY) 3M median daily fund total assets 235.8bn USD and 3M median notional volume 15.0bn USD

S&P500 ETF (SPY)

ETFs 25mn USD 50mm USD 100mm USD 250mm USD





Management Fee Per Year 9.5 bps 9.5 bps 9.5 bps 9.5 bps


A Simplicity Story

Indeed, while cost is a primary focal point for investors, and a major driver of the shift toward ETFs, it is just one element. The biggest difference between the two vehicles essentially boils down to operational simplicity.

Ease and efficiency have become synonymous with the trading and settling of ETFs: the transaction is as simple to execute as buying plain-vanilla equities, and therefore seamless to incorporate into a portfolio, without all the “trading noise” associated with futures. This is important for smaller institutions that – if not already trading in futures – would have to spend significant time and resources developing and implementing operational infrastructure to monitor and manage these derivative products on a day-to-day basis.

When futures are used, the roll cost, and the risks and costs associated with it, fluctuate depending on market conditions – from supply and demand, to regulations. If the roll moves away from original targeted levels, then the roll needs to be re-evaluated, requiring the constant – and close – assessment of costs, benefits, and holding period of the position. Futures also require a re-lationship with a clearing broker to manage cash margins – whereas an ETF is a “set-and-forget-it,” open-ended type of invest-ment that can be held indefinitely, compared to futures’ quarterly maturity.

For this reason, if an investor is seeking long-term exposure, an ETF would likely be the better solution to avoid the ongoing oversight, and expertise required to navigate the fickle financing scenario of a futures position. Again, this decision would of course depend on the institutional investor’s vehicle, its regulations (whether its charter even permits the use of derivatives), and if it has the necessary back-office team to support the trading of futures.


15

The Right Tool for the Right Job: Investment Considerations

Features Futures ETFs

Investor Access Point Exchange Exchange

Product Classification Derivative Product Non-Derivative

Daily Investment Management Responsibility

High – Rolling and Daily Margin tracking

Low – done by ETF manager

Product Specifications Standardized Standardized

Leverage Margin requirement usually at 5% of notional

Zero leverage, with 100% of no-tional as upfront payment

Dividends Estimated in the price Reinvested or distributed based on type of ETF

Dividends Impact Unanticipated dividends will impact the futures price

Reinvestment ETF may have track-ing error Distributed ETF will distribute dividends at pre-decided frequen-cy, which may differ from actual dividend payout date

Dividend Taxation N/A ETF jurisdiction, investor domicile, and other reasons may lead to complicated taxation

Maturity Quarterly maturity – investments need to be rolled over

Open-ended

Tracking Error Yes – via calendar roll Yes – via replication efficiency

Risks Dividend Risk, Tracking Error, Interest Rate Risk

Tracking Error, Taxation, Cash Drag

Explicit Costs Commissions, Bid/Ask Spreads Management Fees, Bid/Ask Spreads, Commissions

Variable Cost, Revenue Roll Cost, Unanticipated Dividends Dividend tax treatment, dividend payout timing, cash drag, lending activity

Counterparty Risk Low – exchange acts as intermediary for all trades

Low – exchange acts as intermedi-ary for all trades

Other Advantage Low commissions, leverage Liquidity Source: BofA Merrill Lynch Global Research, May 2017.

Broad Access to Suit Investor Needs

The explosive growth of ETFs also means that investors have fewer capacity constraints, and can use the vehicle to access ef-ficient, liquid and large (or small) positions across a broad range of styles, sectors, geographies and asset classes, with institu-tions worldwide increasingly slotting ETFs into a widening range of portfolio functions.

Despite the incredible size and scale of the futures market, it is still relatively limited to a handful of indices. Meanwhile, ETFs cover every major index, sector, region, industry and market niche. Increasingly, ETFs are seen as a convenient way for institu-tional investors to build a diversified portfolio that meets any asset allocation model, with regular rebalancing, all within one simple purchase.


16

A Clear Winner?

Ultimately, ETFs and futures are similar in that they both serve as important buy-side tools to manage portfolio risks and expo-sures. While ETFs may be attracting increasingly more institutional investors as a result of shifting market dynamics, each in-strument has its own unique advantages and risks, and any preference towards either depends on any number of factors, from position size and holding period, to operational style and liquidity and leverage needs.

Perhaps the key discussion point to determine a winner is the expected holding period: for instance, for short-term exposure, futures may be the sensible choice given that the upfront savings won with this option will take time to erode, and the vari-ability of the implied financing – along with the rolling and daily margin tracking – are unlikely to be a major factor for short-term trades. However, for the long-term, the marginal savings afforded by futures would not necessarily merit the complexity, inherent leverage risk, and potential disadvantages associated with managing a derivatives position, especially if an institution doesn’t already have the proper infrastructure in place – and given ETFs’ compressing bid-offer spreads and increasing volumes.

If numbers are any indication, it seems like the simplicity, broad suitability, and convenience of transacting with ETFs is one of the fundamental, decisive factors for institutions. Case in point: in its latest study, Greenwich Associates projects that total insti-tutional investment in ETFs will see an additional $300 billion in flows annually by 2020.4

As one of the fastest-growing asset managers in the world and a recognized innovator in ETFs, we offer an expansive suite of global ETFs, including BMO S&P 500 Index ETF (ticker: ZSP) and BMO MSCI EAFE Index ETF (ticker: ZEA), to help clients reach their unique objectives, ultimately aligning our capabilities with investor needs.

To learn more about BMO Global Asset Management’s ETF products, please click here.

1 The Financial Times, Global ETF assets reach $4tn, May 2017.

2 Greenwich Associates, Active Strategies, Indexing and the Rise of ETFs, February 2016. For its 2016 Global ETF Study, Greenwich Associates interviewed 481 institutions in 21 countries around the world. That total includes 187 institutions in the United States, 132 in the United Kingdom and Continental Europe, 59 in Asia, and 53 Canadian institutions. This year, Greenwich Associates extended the study to Latin America for the first time, interviewing 50 institutions there.

3 A future roll involves closing out of an expiring futures position and initiating a position in the next month’s contract, usually done by trading a calendar spread that simultaneously executes both transactions.

4 Greenwich Associates. Active Strategies, Indexing and the Rise of ETFs. February 2016. For its 2016 Global ETF Study, Greenwich Associates interviewed 481 institutions in 21 countries around the world. That total includes 187 institutions in the United States, 132 in the United Kingdom and Continental Europe, 59 in Asia, and 53 Canadian institutions. This year Greenwich Associates extended the study to Latin America for the first time, interviewing 50 institutions there.




All Rights Reserved. The information contained herein: (1) is confidential and proprietary to BMO Asset Management Inc. (“BMO AM”); (2) may not be reproduced or distributed with-out the prior written consent of BMO AM; and (3) has been obtained from third party sources believed to be reliable but which have not been independently verified. BMO AM and its affiliates do not accept any responsibility for any loss or damage that results from this information.

S&P500® is a trademark of Standard & Poor’s Financial Services LLC (“S&P”). “TSX” is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with ZSP.. ZSP is not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such ETFs.


https://www.bmo.com/gam/ca/advisor/products/etfs

17

The exchange traded funds or securities referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities or any index on which such funds or securities are based. The prospectus contains a more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related funds.


BMO ETFs are managed and administered by BMO Asset Management Inc. an investment fund manager and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.



fall 2017 - global · water, up from 14.1 million in the previous year. source: bmo responsible...

Documents