1Title

Spring 2018

Blockchain: A New Era of Transparency, Efficiency and Security (pg. 1)

Strategic Engagement: Reducing Risk, Driving Returns and Changing the World (pg. 4)

Global Small-Cap Allocation: A Catalyst to Portfolio Success (pg. 12)

This Issue

1Blockchain: A New Era of Transparency, Efficiency and Security

While the current volatility of virtual currencies like Bitcoin may prevent them from playing a significant role for asset allocators today, blockchain – the technology behind the cryptocurrency – should be on the radar for institutional investors. By simplifying and streamlining many business processes, blockchain is an important underlying technology that has the potential to transform the financial industry.

Though blockchain is still in the early days of exploration and implementation, and far from widescale adoption, Hugh McKee, Head of BMO Partners, shares his insights on the potential benefits of the revolutionary technology, prospective investment opportunities, and ways to participate in a growing trend that’s gaining collective momentum.

More to Blockchain than Bitcoin

While most in the financial sector have a grasp of Bitcoin and other virtual currencies, what they may not understand – or even distinguish between – is blockchain. Blockchain is more than a buzzword. Known by many simply as the technology that underpins Bitcoin, in fact, blockchain has significant potential to drive lower costs, faster processing, higher efficiency and increased transparency across industries from banks to governments, to pension funds.

As a digital, and cryptographically secure ledger, transactions are distributed across a network, with data recorded and validated through a consistent and verifiable peer-to-peer mechanism. Every member of the network has an identical copy of the ledger stored on their computer, and can review previous entries and record new ones. Transactions are grouped in “blocks,” and seamlessly recorded in a chain, with the links between these blocks and their content protected cryptographically. Previous transactions cannot be destroyed or forged, enabling a self-managed, decentralized network that operates without any coordination from an intermediary. Essentially, the ledger is immutable because it’s virtually impossible to change the ledger without effectively rewriting the entire chain. In the case of Bitcoin, the ledger is legitimized through a process called “mining,” which is used to incentivize members to validate the ledger and drive consensus on the book of record.  

Compare this to a traditional centralized environment, where there is one trusted authority (e.g., bank, government, credit card company) who maintains and is accountable for accurately updating the ledger, and as a result, is theoretically more vulnerable.  

Blockchain technology is also flexible.  You can have both public (such as Bitcoin, Ethereum, Ripple, etc.) and private blockchains depending on the use case.  Private blockchains have all the advantages of public networks, but only provide access to a smaller, more familiar subset of members.

Blockchain: A New Era of Transparency, Efficiency and SecurityHugh McKee - Head, BMO Partners

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The Blockchain Benefit:• Lower costs• Enhanced efficiencies• Increased transparency• Greater security and assurance• Wide-reaching scope across industries• Operates within a public or private network

A Disruptive Technology with Vast Possibilities

Blockchain is a potentially transformative technology that could have broad application beyond virtual currencies across many industries and use cases, from monitoring the providence of diamonds or fine art, to simplifying cross-border payments and enabling smart contracts for financial transactions.

In fact, the decentralized model could potentially have a significant impact on the financial services industry, and asset management in particular, both as a new way of doing business and by creating a new asset class.  For example, APG and PGGM (Stichting Pensioenfonds Zorg en Welzijn), managers of the two largest Dutch pension funds, announced late last year that they are testing a blockchain-based model to help administer pensions that would be shared by all stakeholders, including employers, pension funds and regulators.1 Meanwhile, JPMorgan Chase & Co recently launched a new payment processing network that will be powered by a proprietary blockchain technology called Quorum, which will allow payments to reach beneficiaries faster, with fewer steps and improved security.2

5 Illustrative Use Cases for Financial Services:

1. Cross-border payments or international money transfers – simplifying and hastening the transfer of value, which would also reduce costs significantly

2. Securities settlement/loan trading – allowing for greater trade accuracy and a shorter settlement process (can be applied to any exchange of physical or digital assets on a platform)

3. Smart contracts – executing commercial transactions and agreements automatically, while enforcing the obligations of all parties, without the added expense of a central authority, preventing fraud and enhancing efficiencies (e.g., insurance claims, trade finance)

4. Identity management – streamlining identification through a digital register for multiple services (e.g., voting, healthcare, banking)

5. Loyalty and rewards – increasing transparency and traceability of transactions will allow banks and insurers to create improved and more targeted loyalty programs

Both public and private blockchain applications provide a variety of new investment opportunities, from mining hardware, to exchanges, to virtual vaults and distributed applications. As a growing awareness builds around the technology, and regulators become increasingly involved to crystallize their position, we should expect to see the use of blockchain become more prevalent and mainstream – across industries, asset types and countries.

The Time is Now: Keep Blockchain on Your Radar

While blockchain has the potential to be completely transformative, it should be approached from the mindset that it will likely not be one solution that solves everything – similar to many technologies that came before it, including cloud computing and the Internet. While many financial institutions have invested millions in the technology in the hopes of adapting simplified, lower-cost processes, there are still some uncertainties around scalability, the underlying technology and regulatory stance that remain to be solved, and in many cases blockchain may not be the right solution.

Blockchain: A New Era of Transparency, Efficiency and Security

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The best way to think about adapting blockchain is to understand the drivers behind each potential use case, and to evaluate them against three essential criteria: value, friction and the importance of trust. First, is there material value in solving the problem, or is it simply an interesting science experiment? Second, is there an element of friction involved in the existing process including time, cost and complexity? Third, are there trust issues that need to be addressed? For example, the world of trade finance is fairly archaic, with long timelines, high costs, manual processes and potentially unknown counterparties that make it well suited to a blockchain solution.

Though the extent of how blockchain will alter the financial services industry remains to be seen, the fact is that its capabilities have allowed us to rethink how critical information can be sourced and exchanged, especially between global financial institutions.

This is an important time for institutional investors to evaluate how blockchain technology may impact their own business.  Exploring opportunities through network participation, experimentation, or even early implementation can help drive a better understanding of industry benefits and potential investment opportunities. Whether it is through active work with start-ups, peers, regulators or industry experts, it is vital to navigate the potential challenges – and benefits –to our sector, levering essential learnings as blockchain continues to mature, in an effort to shape the future of asset management.

As a global banking enterprise and a leader in innovation, BMO Financial Group joined the R3 consortium in 2015, a group of more than 100 banks, financial institutions, regulators, trade associations, professional service firms and technology companies collaborating to develop a robust blockchain platform designed specifically for financial services. We have also been involved in testing the technology for trade finance and digital verification purposes, but more broadly, our ongoing goal is to proactively assess emerging opportunities as the ecosystem evolves – fostering blockchain education, awareness and industry leadership through collaboration.

 

For more information on the Institutional Investors Blockchain Consortium, click here, or contact your Regional BMO Asset Management Institutional Sales & Service Representative.

 

1 Reuters, “Dutch pension fund managers APG, PGGM test out blockchain system,” October 16, 2017. 2 Reuters, “JPMorgan launches payments network using blockchain technology.” October 16, 2017.

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.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax, and 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.

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.

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

Blockchain: A New Era of Transparency, Efficiency and Security

Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

Just 15 years ago, simply requesting better disclosure on Environmental, Social and Governance (ESG) data was considered a challenge in North America. Now, focus and expectations have evolved to more substantive, and strategic engagement, raising the bar for companies – and investors – globally.

Vicki Bakhshi, Director in the Governance and Sustainable Investment (GSI) team at BMO Global Asset Management, discusses the drivers behind widespread engagement adoption, and how to access a unique, pooled service that provides institutional investors with ever-important responsible investment (RI) benefits – from expert insight, to effective stakeholder reporting and alignment across global portfolios.

Moving Towards Genuine, Global Engagement

The ESG movement has drawn incredible momentum over the last decade in the financial community, driven in large part by a growing body of evidence on the materiality to investors of ESG factors, and evidence of the link between strong sustainability practices and better long-term company performance. As a result, engagement – dialogue between investors and the companies in which they are invested – has become widespread in North America, Europe, and increasingly in Asia. As well as managing risks, engagement has been encouraged as part of the regulatory push towards active shareholder ownership, and the reality that asset managers have a trusted position as stewards of capital.

3 Key Driving Factors to Widespread Engagement Adoption:

1. Risk Management – identification and improved management of ESG risks and opportunities underpins long-term corporate outperformance

2. Stakeholder Expectations – for a responsible steward by beneficiaries and public stakeholders  

3. Compliance – from the United Nations Principles for Responsible Investment (UN PRI) to pension fund legislation in Ontario, and new stewardship codes in Japan, Taiwan and Hong Kong

Under these circumstances, engagement has evolved to a more global and collaborative state, and is now seen as a core responsibility of institutional investors, alongside proxy voting. Case in point: the five-year Climate Action 100+ initiative is one of the first genuinely global efforts to engage with companies on climate change, bringing together more than 250 investors worldwide committed to making a difference, and supported by US$28 trillion in assets under management. Meanwhile, pension plans in Canada – and globally – are seeking to actively pursue their shareholder rights to promote ESG practices in their investee companies with the Canadian Coalition for Good Governance and the UN PRI providing valuable networks for Canadian plans to implement this in practice.

4

Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

Vicki Bakhshi - Director in the Governance and Sustainable Investment team at BMO Global Asset Management (EMEA)

While involvement has certainly grown, the way in which investors engage has also become far more strategic compared when we at BMO started our engagement program almost twenty years ago – when sustainability disclosure was still in its infancy, and it was considered a struggle to persuade companies to implement basic policies and disclose ESG data. Today, our discussions increasingly focus on forward-thinking questions about how sustainability feeds into a company’s core business objectives. With oil and gas businesses, for instance, we would now focus on how they are positioning themselves  as the world transitions to a lower carbon economy, whereas in the past discussions may have been limited to collecting greenhouse gas emissions data.

The idea now is to encourage companies to address strategic ESG issues, with a view to reducing risk and supporting performance over the long-term – both through constructive dialogue aimed at moving towards best practice, and the active exercise of voting rights. And what we’re increasingly observing is a marked shift towards a less confrontational process, where companies are finally realizing that their owners are proposing changes meant to foster success, and improve their resilience to the future.

The challenge we face is how do institutional investors accomplish this substantive, resource-intensive engagement? Effective engagement requires not only a deep understanding of how ESG issues impact mainstream business strategy, but also significant time, resources and access to senior management. From recording to tracking and voting administration, to engaging in multiple touchpoints with companies, it is difficult for a pension fund to resource the ESG staff members with the knowledge and expertise required for good-quality stewardship across global portfolios.

Reo©: A Solution to a Global ESG Problem

A pooled engagement service, such as BMO Global Asset Management’s responsible engagement overlay (reo©), allows owners to add their assets to a large existing pool, benefiting from greater leverage, access to an expert analytics team, and internal data systems that enable institutional investors to track their progress and report back to stakeholders.

As one of the fastest growing global asset managers, not only do we have the ability to facilitate this type of client support, but we are equipped with the size and scale required to engage beyond domestic markets, and provide stakeholders with the information and international expertise they need to feel secure with their investments. In total, reo© covers US$163 billion1 in assets, representing 35 advisory-only clients, including pension funds, insurers, asset managers, charities and family offices in Europe, North America, and Australasia – this compares to US$98.8 billion2 in assets just a year earlier. It’s clear that institutional investors are increasingly realizing the wide gap that exists between what is expected from them in terms of RI and engagement, and what they can actually deliver on their own. Our service assures consistency in both voting and engagement across the entire portfolio, meaning if a pension plan has several holdings in the same company across different funds, it would benefit from aligned in-house standards, compared to the diverse corporate governance guidelines of individual managers. 

Looking forward, many pension plans are beginning to assess their efforts against the comprehensive framework of the Sustainable Development Goals (SDGs), a set of 17 ambitious targets to be achieved by 2030 that were developed by the UN and agreed upon by 193 governments. Recognising this, BMO’s reo© service is developing methodologies to identify how engagement can support these goals – with the outcomes of this work reported in our recent Responsible Investment Review.

Why Engage with Reo©?

✔ Greater influence on companies through a joint pool of assets ✔ Alignment of ownership practices with RI commitments and international standards ✔ Consistency and transparency across all holdings ✔ Access to in-depth insight, expertise and global coverage ✔ Comprehensive, confidential reporting and support

The reo© service, established in 2000, provides in-depth engagement and voting by BMO’s 15-strong GSI team – one of the largest specialist teams in Europe –  for asset owners seeking to use their influence for positive change. Leveraging our

5Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

dedicated group of sector and regional specialists and our long-standing history of RI innovation, we engage on ESG risks in our clients’ equity and corporate credit portfolios, applied as an overlay to holdings wherever they are managed.

Our team has a robust process for prioritizing risk, and an understanding of how to choose at what level to intervene, and how to fit environmental and social policies into a business context. Engagement is focused on companies where clients have the highest financial exposure, and those which we consider to be at the biggest risk in terms of ESG factors. The service, which is customized based on clients’ unique needs, delivers in-depth reporting on engagement, tailored to the client’s own portfolio; statistics and case studies for stakeholder and UN PRI reporting; real-time access to information through reo© Partner Portal; and the ability to discuss engagement with our expert team.

A Differentiated Process: More Proactive, than Reactive  

As a pioneer in the ESG evolution with the creation of Europe’s first ethical strategy more than three decades ago, and as a founding signatory to the UN PRI, BMO Global Asset Management has long taken sustainability seriously, and our reo© approach is no exception.

Our systematic methodology – composed of priority companies, thematic engagement projects and reactive engagement – leaves no stone unturned, with an emphasis on identifying risks before they materialize. Specifically, we identify, on a yearly basis, impactful ESG issues across different regions or sectors, carefully examining the long-term fundamental challenges, and the new, emerging risks presented. We then take these particular themes on as projects, with the intent of promoting best practice in these areas and improving the status quo. These projects sit alongside our priority companies, identified as companies with high ESG risks, but insufficient management systems.

Our clients also have the opportunity to share their input on our priorities through an annual consultation before final projects and companies are selected for the year, so that ultimately, our decisions are based on a unique combination of quantitative analysis, personal feedback, and an expert assessment by our GSI specialists, ensuring complete alignment with client objectives. 

To track our progress, and enable asset owners to share valuable data with their own stakeholders, we have been using the UN’s SDGs as a reference point in framing our engagement process since 2016, which we view as a critical step in driving significant change across the global asset management industry, and the companies in which our clients invest. This also speaks to a bigger current RI trend of achieving meaningful impact, beyond just assessing risk – with an increased focus on understanding how project and company engagement can actually help deliver on these goals.

5 of our Reo© Priority Projects for 2018:

Project ESG Issue SDGs Project Description

Climate Change (13) Climate Action Climate Action 100+ collaborative initiative: Targeting the world’s largest corporate greenhouse gas emitters, asking them to develop low-carbon business strategies and strengthen climate-related governance, as well as financial disclosures.

Labour Standards (8) Decent Work and Economic Growth

Modern slavery: According to the International Labour Organization, 21 million workers globally across supply chains of large businesses are subject to modern slavery. Focusing on companies in high-risk sectors, such as food, construction, textile and hotels/restaurants.

6Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

Waste and Recycling

(14) Life Below Water Ocean plastics: Engaging with relevant food and beverage companies to encourage the sale of drinks within bottles made of recycled materials, to phase out single serve plastic and find alternatives to plastic packaging.

Nutrition (3) Good health and well-being

Improving corporate strategies to nutrition: As obesity rates continue to rise, particularly among children, engaging food and beverage companies over the adequacy of their health and nutrition strategies.

Responsible marketing and sales: drug pricing

(3) Good health and well-being

Engaging with major global pharma to understand their views on keeping prices at acceptable levels, while identifying sustainable and transparent pricing practices and encouraging laggards in the industry to adopt these. 

Source: BMO Global Asset Management, Outlook – reo© 2018. Engagement Projects and Priority Companies.

As seen in the table above, our dedicated reo© engagement approach is distinguished by the breadth of scope across ESG issues. While much global engagement is driven by corporate governance issues, which is argued to have a more direct link to shareholder value, we also spend significant time and effort addressing labour standards, human rights, biodiversity management, and climate change. We believe – particularly on a longer-term horizon – that ESG issues are indeed material in terms of both risk and opportunity.

Our reactive engagement focuses on companies’ responses when things go wrong. Whether it be controversy over an executive pay package, an environmental disaster, a breach in business ethics or many other issues – our engagement aims to press companies not simply to act responsibly to resolve matters, but also to seek out the root causes. Following the Volkswagen emissions scandal, for instance, we met with the company’s Chairman of the Supervisory Boardto call for a more independent Board, in order to provide more robust management oversight in the future. 

Ultimately, all of our engagement work is linked back to some concrete materiality. As the UN SDGs gain momentum, our focus is shifting to opportunity as well as risk. By engaging effectively and promoting sustainable management, companies are encouraged to harness the business opportunities presented by the SDGs, estimated at $12 trillion by 2030.3 As an example, we are working to improve access to affordable medicines in emerging markets – home to the biggest expected increase in healthcare spending in the coming decade – which is promoting change that will help support the future growth efforts of pharmaceutical companies seeking to establish themselves in the region, while also relating directly to the SDG on Good Health and Well-being.

7Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

Mapping Our Engagement against UN SDGs:

Source: BMO Global Asset Management 2017 Responsible Investment Review.

3%

11%

24%

6%

4%

17%No SDG

Life on Land

Peace, Justice and Strong Institutions

11 Sustainable Cities and Communities

12 Responsible Consumption and Production

13 Climate Action

Sustainable Cities and Communities

Responsible Consumption and Production

Climate Action

 

Our Approach in Action: Mylan Case Study

Background: The Company was in the spotlight after increasing the price of its EpiPen product by five-fold in less than a decade, amid continued calls to regulate and limit drug prices industry-wide.

Action: BMO’s GSI team had an in-depth discussion with management. The company placed the blame on the complexities of the broader U.S. healthcare system – an assessment we dispute.

Outcome: We voted against the re-election of seven of the nine non-executive directors, including members of the compliance and remuneration committees. We also voted against the pay plan, which failed to pass at the AGM. Despite this public show of shareholder concern, we remain concerned about the implementation of sufficient reforms, and our efforts continue.

Source: BMO Global Asset Management 2017 Responsible Investment Review.

Our Public Policy Interactions:

While much of our approach is focused on one-on-one company dialogue, we also engage in collaborative work with policymakers – essential in raising standards for ESG management beyond what is possible through individual businesses. In 2017, we addressed significant governance, labour standards and climate change issues, including:

• Supporting the 30% Club Canadian Investor Group Statement of Intent, which calls for greater gender diversity on Canadian Boards

• Responding to the Bursa Malaysia consultation on the proposed corporate governance revamp• Supporting letters to G7 and G20 reiterating support for the Paris Agreement• Submitting to the Tokyo and Hong Kong stock exchanges on disclosure standards

8Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

9Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

 

Effective Engagement: A Table Stakes Tool

It’s more evident than ever before that the financial sector cannot be a passive bystander to the sustainability challenges of today. There is now a clear expectation of pension funds, and other institutional investors, to step up – both from a de-risking point of view, and simply because it’s the responsible act of a trusted steward.

According to a recent study by Bank of America Merrill Lynch, companies which ranked in the top fifth for their ESG scores in the years 2005 through 2010 experienced the lowest volatility in earnings per share (32%) in the subsequent five years, while those in the lowest fifth experienced the highest volatility (92%).4 Engagement – if used effectively – is one of the few tools investors can implement to actually address specific portfolio risks, especially if they are unable to divest from their position in the short term, which is a common issue as passive strategies continue to gain traction among global institutions.

To thrive in this “new reality” for the financial sector, there is greater need than ever for a comprehensive, streamlined service like reo© that can provide in-depth and strategic global engagement, supported by the resources, skill, information, and experience necessary to sustain positive progress and contribute as a responsible member of the investor community – ensuring ongoing client support in developing ESG strategies and compliance with international standards.

 

To learn more about BMO Global Asset Management’s proprietary reo© solution, comprehensive RI fund range, and ESG leadership initiatives, or other ideas to enhance your portfolio, please contact your Regional BMO Asset Management Institutional Sales & Service Representative, or access the materials below.

Classification: only to be shown if not public

reo®Responsible Engagement Overlay

For professional/ regulated qualified investors only

CM15755

March 2018

Three decades of expertise

Responsible Investment Solutions For professional investors/qualified investors only

2017 Responsible investment review

10Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

ESG Viewpoint November 2017

Performance with principles:How can ESG investing support financial returns?

Vicki BakhshiDirector Governance and Sustainable Investment

Responsible Investment Solutions For Institutional Investors only

Contact Us

bmo.com/institutional

Institutional business:

1.844.855.7034

bmoam.institutional@bmo.com

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Summary

• We believe that considering environmental, social and governance (ESG) issues in investments makes sound financial sense, as well as being the right thing to do: this view is increasingly backed up by research and evidence.

• Numerous studies find a link between company-level environmental, social and governance (ESG) performance and their financial and operational performance; in particular, there is evidence that taking ESG into account can help to protect against volatility and downside risk.

• Companies with strong ESG credentials can also present opportunities. We find that strong ESG performance can be a signal for quality, which can support stock selection.

• Looking at the track record of socially responsible investing (SRI) funds in practice, although some market conditions may see them deviate from mainstream benchmarks, the evidence shows that SRI portfolios have performed in line with mainstream peers over the long term, and may have superior risk characteristics.

• ESG momentum matters; and promising new research shows how investor engagement can lead to positive ESG momentum and financial outperformance.

Thomas HasslAnalyst Governance and Sustainable Investment

Continued

Responsible Investment Solutions For Institutional Investor use only

BMO Responsible Global Equity Strategy

ESG Profile and Impact Report 2017

1 BMO Global Asset Management, as of December 31, 2017. 2 BMO Global Asset Management, as of December 31, 2016. 3 Business & Sustainable Development Commission, Better Business World Report, January 2017. 4 ESG Part II, “A Deeper Dive,” Bank of America Merrill Lynch, 2017.

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.

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.

11Strategic Engagement: Reducing Risk, Driving Returns and Changing the World

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.

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.

© 2018 BMO Global Asset Management. All rights reserved. ® “BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.

Global Small-Cap Allocation: A Catalyst to Portfolio Success 12

While institutional investors worldwide have traditionally focused on larger-cap stocks, increasingly, more asset owners and managers are strategically allocating to small caps as part of their global equity portfolios. Catherine Stanley, Managing Director & Head of Global Small Cap at BMO Global Asset Management (EMEA), discusses what’s driving this growing trend, and the need to approach the sector with a long-term, quality-focused view that minimizes downside risk.

The Case for Global Small-Cap

While larger companies are traditionally associated with less risk and greater liquidity, it’s a well-established truth that smaller businesses are speedy, nimble and efficient allocators of capital. As a result of these qualities, and their initial size, small caps have historically generated superior earnings growth compared to their large-cap counterparts, which translates into better share price performance. And contrary to the claims of critics, small-cap outperformance isn’t exclusive to the U.S., the UK, or any developed market in particular – as shown below, it’s a global phenomenon that has captured increasingly more attention from international investors.

Indeed, the “small” in small cap leads to some mistaken preconceptions: the sector is actually a significant part of the market, representing 16.5% of the MSCI World benchmark index.1 Investing across all-cap segments, including the smaller end, provides exposure to the full equity risk premium, and allows asset managers to gain complete coverage of the global opportunity set.

In fact, a key benefit of small-cap investment is enhanced portfolio diversification, with more than 5,000 companies in our universe that can range up to approximately $10 billion in size, offering different sector composition and foreign exchange exposures than large-cap companies – an increasingly important benefit amid a volatile market environment. The largest individual stock in the MSCI World Small Cap Index represents only 0.3% of said benchmark, while the largest individual stock in the S&P/TSX Composite represents 6.7% of its index, highlighting the depth and breadth of options available in the global small-cap universe.2

The global small-cap market is also a prime breeding ground for value-add opportunities, where active managers can differentiate themselves through dedicated asset class expertise, by identifying companies whose share price does not fully reflect their intrinsic value and growth potential. As passive strategies continue to proliferate in the large-cap universe, small-cap investment has gained traction among risk-averse investors as a core, active complement designed to generate significant alpha. Even during market troughs, managers that implement careful, discerning, high-quality, small-cap stock selection can add enormous value.

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Global Small-Cap Allocation: A Catalyst to Portfolio SuccessCatherine Stanley - Director & Head of Global Small Cap, BMO Global Asset Management (EMEA)

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Small-Cap Outperformance: A Global Phenomenon (Large vs. Small-Cap Index)

Global Smallers Outperform – MSCI World Small Cap Compared to MSCI World

12-Month Absolute Performance

Source: Bloomberg and BMO Global Asset Management as at 31.12.2017. © 2018 MSCI ESG Research Inc. Reproduction by permission. Past performance should not be seen as an indication of future performance.

Source: BMO Global Asset Management as at 31.12.2017. © 2018 MSCI ESG Research Inc. Reproduction by permission. Figures are shown in USD.

Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

0

100

200

300

400

500

Nov 2002 Nov 2005 Nov 2008 Nov 2011 Nov 2014 Nov 2017

Rebased MSCI World Rebased MSCI World Small Cap

37.1

31.3 32.538.1

25.9

16.5

22.726.9

24.0 22.1

-9.9

25.920.9 22.4

-20%

-10%

0%

10%

20%

30%

40%

50%

Europe ex UK Japan UnitedKingdom

Other Pacific North America Total

MSCI World Small Cap MSCI World

6 compelling reasons to add global small caps to your portfolio:

• Faster inherent growth potential – smaller initial size means companies can grow at higher rates for longer periods of time, equating to more attractive share price performance

• Historic outperformance compared to large-cap companies – smaller companies tend to be speedy and efficient allocators of capital, with a more focused line of business and higher insider ownership, resulting in greater alignment of interests

• Exposure to niche sectors and opportunities – otherwise unavailable for large-cap universe• Sizeable part of the global market – represents 16.5% of the MSCI World Benchmark Index1

• Broad diversification – more than 5,000 companies in the small-cap universe, with different fundamental drivers and sector representation

• Active management benefit – market inefficiencies provide greater opportunity for disciplined, tactical managers

Global Small-Cap Allocation: A Catalyst to Portfolio Success

BMO Asset Management Global Small Cap Strategy: Disciplined Access to a Faster Growth Asset Class

As managers of BMO Asset Management Global Small Cap Strategy, we seek to maximize on these benefits and minimize asset class risk by selecting high-quality growth companies that can compound returns above the market rate and add value over time, focusing on a sweet spot of businesses ranging between $500 million to $10 billion in market capitalization – eliminating the higher-risk micro-cap end of the scale. Still, this sweet spot covers a wide range of companies and a multitude of sins, so we implement an active, bottom-up, long-term approach to facilitate success. Our high conviction portfolio of 75-95 holdings is supported by detailed scenario analysis, proprietary research and exhaustive due diligence, including hundreds of management meetings every year to gain first-hand knowledge from company leaders on their strategic business plans.

In the small-cap universe, choosing winning stocks is an art as well as a science. Investors are buying into the management team of these companies as much as anything else, and very often, they do not conform to what a pure spreadsheet analysis may suggest. We want to ensure they are not overly optimistic in their approach – and have a deliverable strategy and vision, with the right skills, track record and integrity to manage that delivery, and withstand any stresses that inevitably arise throughout the cycle.

Importantly, we are not momentum, or pure growth-orientated investors that jump on the short-term bandwagon. We distinguish our approach by focusing on the long-term fundamentals, removing as much risk as possible by assessing three critical criteria: quality, risk and value, which may involve assessing anything from sources of competitive advantage, free cash generation and debt structures, to corporate culture, board composition and product quality. Our beliefs and considerations are grounded in the predictability, repeatability and consistency of returns; markets change and businesses disappear, so it is important to ensure that shareholder interests are protected. This does not mean investing in the highest-return company in the sector, as that growth may not persist over the longer term. In fact, a potential target for us could be special situations with current lower returns, but where catalysts for change and new strategies leading to sustained business performance improvement have been identified. If the environment for a particular business turns negative, ultimately, our goal is to seek characteristics which still provide support for shareholder value, such as assets, intellectual property, cash flows or an offer that will lead to market share gains from weaker competitors.

What We Insist On:

Source: BMO Global Asset Management, January 2018.

• Capable operators

• Rational• Good capital

allocators• Aligned interests• Prudent• Transparent with

shareholders

• Trends in metrics important• Range of valuation

measures used • Sustainability of returns• Conviction in value

appreciation

• Well articulated model• Sustainable competitive

advantages• Free cash flow generative• Pricing power / scale• Favourable industry

structure / conditions• Financial strength• Diversified customer

/supplier/product set

14Global Small-Cap Allocation: A Catalyst to Portfolio Success

Risk-Aware: Covering All the Bases

Our enhanced risk focus is also evident in the diversification of our portfolio across sectors, providing us with inherent protection. We do not duplicate businesses; instead, we seek companies that play on different themes, and initially screen out any small caps that demonstrate a lack of growth, poor liquidity, excessive debt, or are located in a region with which we are not familiar.

Levering a track record of outperformance and a depth of asset class expertise with more than $2.4 billion invested in smaller companies,3 our ideas and convictions are informed by a team of five sector specialists, averaging 18 years of industry experience. This collaborative team approach is a true differentiator for BMO Asset Management Global Small Cap Strategy, as not only does it provide an abundance of resources, but also an efficient division of labour that fosters focused areas of specialization. It also further minimizes risk by allowing for the natural – and effective – competition of capital within the small-cap arena, again reflecting true diversification and the broad opportunity set available in the space.

Further, our portfolio decisions are supported by wider teams across our global enterprise, such as BMO’s Governance and Sustainable Investment (GSI) experts, which conduct research on material ESG concerns, such as governance, supply chain management and ethical behaviour, as well as provide post-investment analysis, monitoring and engagement.

Premium Growth, without Excessive Risk: Two Shining Examples

Dechra Pharmaceuticals – a UK-based veterinary pharmaceutical business with an international footprint developing and selling companion food, and animal medicines.

What we like: Dechra operates in an attractive, defensive growth market with limited cyclicality. With an aging population, the number of companion animals are on the rise, resulting in a long runway path of growth ahead. The Company also has strong positions in areas, such as dermatology, endocrinology and equine pharmaceuticals, with an established track record of organic and acquisitive growth and a robust product pipeline. It also benefits from a less costly and faster product development process than human pharmaceuticals, leading to higher rates of return on research and development investment. Dechra is typical of our long-term compounder criteria, complete with compelling intellectual property, balance sheet flexibility, exemplary management capabilities, high barriers to entry, and a diverse product range. Importantly, the Company has assets that carry value – regardless of market conditions.

Vail Resorts – an owner and operator of luxury ski resorts, including Perisher in Australia, Vail and Beaver Creek in the U.S. and Whistler in Canada.

What we like: Vail has a domestic and international customer base, and while it operates these premium ski resorts, it also owns the mountain and respective lodgings, which ensures strong asset backing to the business. While there is a weather factor, most of the Company’s revenues are derived from advanced season-pass sales, which reduces volatility and provides earnings visibility. With a long-term revenue stream and a resilient spend profile, Vail also benefits from a defined M&A strategy that is aiming to drive synergies in its pass systems and to diversify its locations.

History Repeats Itself: Small-Cap Strength to Persist

Looking ahead, the macroeconomic backdrop is generally supportive of smaller-cap companies as a whole, with stock selection remaining a main driver of performance. While rising rates present uncertainty across markets, over the long term, we believe that history will play out, and that small-cap outperformance (relative to large cap) will persist. Though certain pockets of our portfolio currently outshine in terms of performance, including the Real Estate, Consumer Staples and Industrials sectors, we are finding a wealth of opportunities with strong fundamentals and sensible balance sheets across our universe that are likely to hold premium ratings.

15Global Small-Cap Allocation: A Catalyst to Portfolio Success

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Certainly, while macro variables factor into our scenario analysis and portfolio construction, BMO Asset Management Global Small Cap Strategy is ultimately a reflection of our high-conviction stock picks: companies that we believe have successful business strategies and a management team capable of compounding shareholder capital over several years, generating superior risk-adjusted returns.

Amid this increasingly volatile and yield-oriented market environment, the need for growth, while being mindful and aware of overall portfolio risk, is now a main concern for institutional investors worldwide. By extending their global focus to small-cap equities – with an active team like ours distinguished by its specialized expertise, disciplined process and its strong emphasis on consistency and downside risk – asset managers stand to benefit from significant alpha generation, faster growth and enhanced diversification, while remaining protected today, and tomorrow.

 

For more information on BMO Asset Management Global Small Cap Strategy, or other innovative solutions designed to enhance your portfolio, contact your Regional BMO Asset Management Institutional Sales & Service Representative, or access the resources below.

 

1 BMO Global Asset Management, as of December 31, 2017. 2 “The Case for Global Small Cap Equities,” Connor, Clark & Lunn Financial Group’s Strategic Exchange. 3 BMO Global Asset Management, as of December 31, 2017. Represents assets under management in small-cap mandates, including segregated mandates managed by BMO Global Asset Management London small-cap managers.

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Global Small-Cap Allocation: A Catalyst to Portfolio Success

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Global Small-Cap Allocation: A Catalyst to Portfolio Success