Not all passives are alike Leigh Stephens Director of Investment Specialists November 2016 For Investment Professionals only

Important information & risks This material is for information purposes only. It is not intended to be relied upon to make any investment decision. Although the information herein has been obtained from sources believed to be reliable, neither Close Brothers Asset Management or any of its employees guarantee its accuracy, completeness or fairness. The most recent data has been used where possible. Except in so far as liability under any statute cannot be excluded, no member of Close Brothers Asset Management accepts liability (whether arising in contract, tort or negligence) for any error or omission in this document. The information contained in this presentation is believed to be correct but cannot be guaranteed where data is sourced from third parties. Opinions constitute our judgment as at the date shown & are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Past performance is not a reliable indicator of future returns. No investment, or investment strategy, is without risks. The value of investments will go up & down & clients may get back less than invested. Issued & approved by Close Asset Management Limited (Company No.1644127) which is registered in England & Wales, is authorised & regulated by the Financial Conduct Authority & is a subsidiary of Close Brothers Group plc. Close Asset Management Limited uses the trading name Close Brothers Asset Management. Registered office at 10 Crown Place, London EC2A 4FT. Unless otherwise stated, the source of all information or figures is Close Brothers Asset Management.

Learning outcomes Understand the basics of passive investments and how to use them. Why do some passives track differently to others? Due diligence and what you need to know.

Passive growth has been phenomenal Born in 1989, the AUM of passives has seen extraordinary growth. 25 years of history Over 100% growth in only 5 years Equity Fixed Income Commodities & others Source: iShares ETP Landscape Report August 2016 As at end of August 2016

Passives taking market share Size Flows Total Active Equity Passive Mutual Fund Flows Billions Trillions Active Mutual Fund Flows Total Passive Equity Source: Strategas Investment Research, Nov 2016

Costs matter, for both active and passive Average annual returns over the ten years to 31 December 2014 from both Active and Passive funds Average annualised return (%) Past performance is not a reliable indicator of future results. Source: Vanguard calculations, using data from calculations using Morningstar, Inc. Notes: All mutual funds in each Morningstar category were ranked by their expense ratios as of 31 December 2014. They were then divided into four equal groups, from the lowest-cost to the highest-cost funds. The chart shows the ten-year annualised returns for the median funds in the lowest cost and highest cost quartiles. Returns are in sterling terms with income reinvested, net of expenses, excluding loads and taxes. Both actively managed and indexed funds are included. For funds with both income and accumulation share classes, we use only accumulation share classes to avoid double counting.

Competition has forced fees lower Tracker funds engage in cut-throat price war. Index tracker fund price war heats up! The world’s largest money manager is cutting fees at more than a dozen exchange-traded funds… The move by BlackRock Inc. covers $216 billion in assets and will lower expenses below or on par with those offered by low-cost pioneer Vanguard Group. Does a price war loom for ETF providers? Some observers argue that the competitive nature of ETF fees means that more cuts beckon… After BlackRock's move to reduce expense fees for more than a dozen of its ETFs, The Charles Schwab Corporation is also treading the same path... It is one of the major investment firms that initiated this price competition. Source: Wall Street Journal, Financial Times and Nasdaq November 2016

How the market has changed 1 2 3 4 Cost Lower portfolio & transaction costs = Lower fees & costs Trading cost efficiencies Automatic rebalancing Cost Beta Beta Accurate market returns Avoids biases and reduces downside risks against benchmark e.g. S&P Indices vs Active Funds. When whole of market works. Managing risk and diversification Tilting Tilting Effective & efficient method of adopting directional views, through various styles Sector Market cap Theme Systematic Several techniques to capture systematic market tilts Optimisation = Risk model to build desired characteristics Low Beta Managed Volatility Value Growth Quality Smart Beta

Some Smart Beta examples Seek enhanced returns Quality Return on equity Earnings variability Debt to equity Value Forward earnings/price EV/Operating cash flow Price to book Momentum Momentum based on MSCI Barra Momentum Factor weighing relative strength and historical alpha. Low Size Market capitalisation based on MSCI Barra Size Factor Own companies with stable earnings and strong balance sheets Own companies that are cheap vs. fundamentals Own companies that have been steadily rising Seek to capture small cap performance premium While having low correlation among excess returns Quality Value Momentum 100% -34% 1% -16% Source: BlackRock, Seek Enhanced Returns, Nov 2016

No longer one or the other Investment management styles Passive asset allocation + Passive ‘pure’ beta security selections Active asset allocation + Passive ‘pure’ beta security selections Active asset allocation + Market ‘pure’ beta, index tilts and Smart Beta No longer one or the other

How to choose the right passive Universe of indices Index Selection >1000 ~500 Significant concentration here Index fund/ ETF providers >10 Instrument Analysis >100

But what to buy? Confusing terminology Investment vehicles ETFs ETNs Open ended funds Exchange traded products (ETP) ETPs Tracker funds Exchange traded funds (ETF) ETCs Exchange traded notes (ETN) Exchange traded commodity (ETC) Logos used for illustrative purposes only

Buying and selling … At NAV or daily traded Some are priced continuously throughout the day while others are priced once a day Open ended tracker funds can only be created or redeemed at NAV. Knowing the pricing time is crucial as dealing is forwarded to tomorrow’s price Creation/redemption process for ETPs accommodate liquidity and eradicates any premium or discount to NAV Investors can buy and sell ETPs like any other listed securities (e.g. stocks, bonds, REITs) KNOW YOUR SECURITY

Research process Index Selection Index fund/ETF Providers Not all the index investments are the same. We have a rigorous, robust and methodical process to analyse them. Quantitative, Qualitative, Index calculation agent, Methodology, Stress test, Rebalancing Index Selection Counterparty risk, Capitalization, Headcount, Legal structure, Expertise, Stock lending policy, Due Diligence, Business support etc. Index fund/ETF Providers Replication, Swap terms, Liquidity, Level of stock lending, Collateral, Bid/Ask, Tracking error, OCF, etc. Instrument Analysis Logos used for illustrative purposes only

Smart Beta can result in better performance Index Selection Broad Market indices Smart Beta indices 100 Biggest UK listed companies 500 Biggest US listed companies 50 Biggest EU listed companies Optimise the portfolio of companies to provide minimum volatility Only include companies that have 10/20 years of sustained dividend growth Smart Beta can result in better performance Source: Vanguard,Nov 2016.

Understand your index - they are not the same Different index providers would have different definitions For example what passes as a Value stock MSCI = Earnings to price Book to Price EV/CFO* S&P = Earnings to Price Book to Price Sales to Price FTSE = Earnings Yield Sales to Price Cash Flow Yield *Enterprise Value (EV) Cash from operations (CFO)

S&P 500 companies included in the most numbers of ETFs Beware of duplication S&P 500 companies included in the most numbers of ETFs Company Number of ETF’s 250 246 243 240 Company Number of ETF’s 239 238 233 232 230 Source: Strategas Investment Research, November 2016 Logos used for illustrative purposes only

Instrument providers Replication methodology (Physical/Synthetic) Many you will know Replication methodology (Physical/Synthetic) Securities lending policy Due Diligence Update and monitoring meetings v Some you may not v Logos used for illustrative purposes only

The hidden cost of passive Tracking difference = The returns of fund relative to the returns of the index Fund performance = 1.5% - Index performance 1% Tracking difference 0.5% INDEX FUND Tracking error = the standard deviation of Tracking difference The lower the tracking error, the more faithfully the fund is matching its index. Source: Monevator, November 2016

Have to look through multiple features Instrument analysis Have to look through multiple features Performance Tracking Error Average B/A Spread OCF AUM 1 Year (%) YTD (%) 1 Year (Weekly) 30 Days (% from mid) % USD (M) DB x trackers FTSE 100 UCITS ETF 16.02 13.05 0.03 0.26 0.09 84.8 Vanguard FTSE 100 UCITS ETF 15.54 12.38 0.05 3064.9 iShares Core FTSE 100 UCITS ETF 15.53 13.07 0.04 0.07 5429.3 HSBC FTSE 100 UCITS ETF 15.30 12.28 0.06 0.11 172.9 Lyxor FTSE 100 UCITS ETF 15.90 12.70 0.15 799.8 Source FTSE 100 UCITS ETF 15.47 12.43 0.00 0.20 90.3 Worst Best Source: Close Brothers Asset Management, as at 27/09/2016 Indexes used for illustration purposes only. Not a recommendation

Close Tactical Select Passive Funds 3 Multi-Asset, Risk-Rated Funds – mapped to Dynamic Planner Active Asset Allocation, Market Beta, Index Tilts and Smart Beta Comprehensive Due Diligence on providers and instruments 5 year track record Comprehensive adviser support

Learning outcomes Understand the basics of passive investments and how to use them. Why do some passives track differently to others? Due diligence and what you need to know.

Close Brothers Asset Management 10 Exchange Square Primrose Street EC2A 2BY Leigh.stephens@closebrothers.com www.closebrothersam.com