Summer 2021

Using BMO ETFs to Exert More Control

Exchange Traded Funds are effective market access tools, giving family offices greater control over several important elements in investing: currency exposure, taxation, investing costs, enhancing the portfolio construction and implementation process.

Daniel Stanley
Director, Institutional & Advisory
Jul. 2, 2021

Exchange Traded Funds are effective market access tools, giving family offices greater control over several important elements in investing: currency exposure, taxation, investing costs, enhancing the portfolio construction and implementation process.

The first thing to keep in mind is that an ETF is just like any other fund in Canada that owns a basket of securities like stocks or bonds. But what makes this basket unique is that, unlike a mutual fund or pooled fund, this fund trades on an exchange, like the TSX. As such, it is the only pooled investment which has a secondary market, an important consideration because this is where investors reap the benefits of tighter spreads, thereby minimizing execution costs.

There are several distinct advantages which ETFs bring to Family Offices: 

  • Manage U.S. estate tax liability with our .U ETFs;
  • Reduce the cost of bond portfolios by using bond ETFs;
  • Factor ETFs provide greater precision to desirable attributes which enhance performance;
  • ESG ETFs provide transparent rules-based strategies which can be integrated into asset allocation models;
  • Help ease capacity constraints and liquidity risks that are associated with traditional alternative investments. 


ETFs, Currency Exposure, and Estate Taxes

Typically, wealthy families have significant U.S. assets and, as a result, have embedded U.S. Estate Tax liabilities and exposure to changes in the USD/CAD exchange rate. ETFs can help you manage your currency exposures, minimize your exposure to U.S.-based assets, thereby minimizing your U.S. Estate Tax liabilities. 

It is cleaner to hold US assets in an ETF than it would be to hold them directly because a Canadian-listed ETF is a Canadian trust, so the investment is considered to be Canadian for US Estate tax purposes, even if all the holdings are in the US or elsewhere.

Our extensive selection of Canadian-listed, hedged and unhedged ETFs gives you the power to choose your exposure to the US markets with or without US dollar exposure. 

We also offer U.S.-dollar denominated ETFs that give you exposure to the U.S. markets in a Canadian Domiciled Trust structure that does not increase your U.S. Estate tax liability. For example, a $10 million USD investment in ZSP.U, the BMO S&P 500 Index ETF (USD Units) will give you exposure to large cap U.S. stocks without increasing your U.S. Estate Tax liability — there is no connection to the IRS.


Bond ETFs Can Be Lower Cost and Easier to Trade

Beyond giving you more control over your currency exposure and tax bill, ETFs can also be used to give you more control over the cost of investing. Using ETFs to access the bond markets often provides a substantial cost savings instead of investing in the underlying securities.

Why? Because bonds don’t trade on a stock exchange, they trade over the counter,” and, if you want to build a portfolio of bonds, you need access to a bond dealer, and that will cost you more money. 

But a bond ETF is a low-cost basket of diversified bonds that can be traded on an exchange and used to build a high-quality portfolio, quickly and efficiently. Looking at the BMO suite of bond ETFs, the cost advantage exists in the Aggregate Bond Index, Government Bonds, and Corporate Bonds. As an example, if you wanted to buy Long-Term Federal Bonds the spread (an important component of total cost) on those bonds is double the spread of the BMO FTSE Long Term Federal Bond Index ETF – ZFL. 

So, one of the main reasons for investing in ETFs is that it often has a lower total cost of investment, as is the case with the bond market examples above.

But ETFs also allow your family office to access unique investment strategies, giving you more control over the portfolio construction and implementation process.


Factor and ESG Investing

With ETFs, a family office can tilt their exposure to desirable factors in a structure that’s transparent, rules-based, and dispenses with the subjectivities of active managers. 

Academics have done a lot of research on how investors can generate returns in excess of the market. Their conclusion is that it’s not, in fact, talented stock pickers that generate the highest returns. 

Quite the contrary: according to S&P Dow Jones in the most recent SPIVA report, as of the end of December 2020, 75% of large cap fund managers underperformed the S&P 500 over a five-year basis and 60% underperformed over a one-year basis. 

Instead, research shows that excess returns come from owning stocks with identifiable, measurable, and repeatable factors, like:

  • Low volatility;
  • Dividend;
  • Quality;
  • Size (small cap);
  • Momentum;
  • Value.

These factors are the source of returns in a stock portfolio, just as nutrients are the source of energy in our food, and research has shown that, over long periods of time, factors explain almost all returns in all markets.

Importantly, these factors give a Family Office control over the portfolio implementation and construction process. Suppose the source of your family wealth is technology and you want to diversify your exposure. Then you can consider low volatility or dividend factors, factors where technology doesn’t feature prominently. Suppose the source of your family wealth is real estate and you want a liquidity sleeve for divestments or future investments, then you should consider our BMO Equal Weight REIT ETF – ZRE as a complement to your private holdings.

While we like to think of factors like quality”, dividends” and low volatility” as core holdings, you might use factors like momentum” and value” for more tactical purposes. For example, the value factor has been the best performer over the last six months because it screens for stocks that are cheap” but tend to experience improving earnings and higher valuations in the early stages of an economic recovery when growth and inflation pick up. 

The trend to incorporating ETFs that screen stock indices for desirable characteristics has broadened to include environmental, social, and governance characteristics (aka ESG). While ESG screening isn’t the same as screening for factors like the ones listed above, a transparent, measurable, and rules-based ESG ETFs are well suited to a Family Office because they’re easier to implement and cleanse capital.


Alternative Investing

Lastly, ETFs are a great vehicle to get exposure to the risk premia associated with alternative asset classes.

Alternatives are increasingly attractive in a low interest rate environment, but the investments themselves are two-tiered. The biggest pension funds having the first pick of assets, the ability and expertise to invest directly, as well as keep control over the liquidity and capacity risks of alternative investing. 

The rest of us typically invest in alternatives indirectly, having to hire someone to do due diligence and manage the portfolio, meaning we have little control over the key liquidity and capacity risks that are common to the alternative investment space.

Your family office can use an ETF as a proxy for an alternative asset class to capture the risk premiums from alternative investments without the capacity constraints or liquidity concerns that typically come with alternative investments and at a fraction of the cost.


BMO ETFs and Your Family Office

The ETF has levelled the playing field between the biggest investors in the world and the rest of us, providing investors like your Family Office control over several key elements in the investment process, such as currency exposure, taxation, investing costs, and the portfolio construction and implementation process. 

With BMO ETFs, you can better manage your U.S. estate tax liability with our .U ETFs, you can reduce the cost of bond portfolios by using bond ETFs, you can gain control over specific equity exposures with factor ETFs, you can increase consensus on thorny issues like responsible investing using ESG ETFs, and you can help ease capacity constraints and liquidity risks that are associated with traditional alternative investments.

Disclosure:

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

The viewpoints expressed by the authors represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. 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. Past performance is no guarantee of future results. The statistics in this update are based on information believed to be reliable but not guaranteed.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

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

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/​or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.