Do ETFs Need an Index?

Given the popularity of investing for yield these days, it’s not surprising that BMO’s most recent product launch included the brand new BMO Canadian Dividend ETF (ZDV). But this fund does have at least one surprising trait—one that suggests the direction the ETF industry may be heading. What makes ZDV different from its competitors at iShares and Claymore is that it does not track an index.

In a previous post, I discussed the future of ETFs with Oliver McMahon, iShares Canada’s director of product management. “A lot of the products you’re going to see in the future will not track an index,” he predicted. “The holdings are still going to be fully transparent, and they’re going to be passive investments: the portfolio manager is not trying to derive alpha. But rather than paying a provider to produce an index, the methodology may just be determined in-house.”

That seems to be the case with the new BMO dividend ETF. According to the prospectus, ZDV and three others launched at the same time “are not index mutual funds and are managed in the discretion of the Manager in accordance with their investment strategies and, as such, are generally more active in nature than index mutual funds.”

Does “no index” mean “actively managed”?

Despite that declaration, I would stop well short of calling this an actively managed ETF. The prospectus goes on to state that “eligible securities will be selected using a rules-based methodology that considers dividend growth, yield and payout ratio and eligibility will be reviewed annually. Securities will also be subject to a screening process to ensure sufficient liquidity.”

Compare that with this description of the actively managed Horizons Dividend ETF (HAL): “HAL’s investment process is primarily based on fundamental research as well as quantitative and technical factors. Investment decisions are ultimately based on an understanding of the company, its business and its outlook.”

There’s a huge difference here. HAL’s managers have free rein to choose stocks for the fund, and to weight them in whatever manner they deem appropriate, so long as they fit the fund’s overall objective. The stocks in ZDV, by contrast, are selected according to a list of predetermined rules, and they are assigned weight in the fund based on yield. Assuming the manager adheres to these rules, it would be fair to call ZDV a passive fund, even if it doesn’t track an index.

Remember, a “rules-based methodology” is exactly what is used to construct an index. In the case of ZDV, however, BMO appears to have come up with the methodology themselves, rather than farming out that job to S&P or Dow Jones, like Claymore and iShares have done with their dividend ETFs.

The big question for investors is, does this make a difference? Does it really matter whether the ETF provider or a third party makes the rules? I’ll consider these questions in my next post.

10 Responses to Do ETFs Need an Index?

  1. Superior John November 17, 2011 at 2:22 pm #

    “Methodologies based in house” which we are not privy to, with fund A vs fund B approach to this way of determing which stocks to buy and sell leaves me feeling a little leary. I don’t want to say it would be like having a crap shoot, however, I would lean towards that side of the ‘in house’ approach.

  2. Canadian Couch Potato November 17, 2011 at 2:53 pm #

    @Superior John: I agree that transparency is important. However, there are many third-party indexes that are non-transparent. The Dow Jones Industrial Average is the most famous example. How do they choose the 30 companies? The same is also true of the S&P 500: there are decisions made about who gets in and who doesn’t, and they are not all rules-based.

  3. Peter November 17, 2011 at 8:09 pm #

    Hi Dan, I have been reading all your posts, and really enjoy them.

    I have been considering ZDV for a while now, since it came out. I think it would be a great one to complement something like the XIU, because it tends to give more weight to some of the mid caps and stocks outside of the TSX60. And also because it has total MER of 0.40%, which is alright.
    The one thing I am worried about is the spread, which seems to be quite large according to MorningStar, but I don’t know how reliable that is.

    Thanks.

  4. Chad Tennant November 18, 2011 at 10:33 am #

    Hey Dan,

    There are basically three approaches to ETFs: passive/market index, custom index, and quantitative/actively managed. Your post is focusing on custom indexing which is a hybrid between the two others. Claymore does not use a passive index approach rather they’ve partnered with RAFI, Aristocrats and other custom index manufactures for their funds. By the sound of it BMO is going the way of Claymore by focusing on custom indexing. Where custom indexing is transparent by disclosing which fundamentals are being used for inclusion, active management strategies are often not disclosed as to keep things under raps.

    For example, “The Claymore S&P/TSX Canadian Dividend ETF (TSX:CDZ) has been designed to replicate the performance of the S&P/TSX Canadian Dividend Aristocrats Index®.” The most definitive criteria is “The security has increased ordinary cash dividends every year for at least five consecutive years.”

    However, iShares approach has simply been to track established passive indexes for many of their ETFs.

    Thanks.

  5. Sean November 18, 2011 at 12:54 pm #

    It seem like ZDV will be very similar to XDV but you’re giving up transparency for a lower MER (The difference is probably what they’d pay a third party to use their index).

    Hey, with an “in-house index” the tracking error will always be zero!! Guess why?

  6. The Dividend Ninja November 18, 2011 at 1:47 pm #

    Hi Dan,

    Another excellent post! (Have you ever written a bad one?) The main issue I see with this ETF is the volatility it will endure over time. Yes it has a very nice current yield at 4.75%. But the stocks it is weighting are all quite volatile (in terms of share price fluctuation). These stocks are all paying a higher yield for a reason. For example: Veresen, Pembina, Northland Power, AGF, and Atlantic Power are top holdings. Obviously these are not your standard safe set-it-and-forget-it blue chips 😉

    So I don’t see a free lunch here, yes investors will get a great yield but at the expense of a significant fluctuation in share price. ZDV will perform very well in a rising market, but if we hit a bear patch I think this ETF will decline substantially – even more so than a TSX Index ETF. Also the ETF is weighted towards 31% financials, and 23% in energy. That also means more volatility – depending on those two sectors. On the other hand it might be a winner…

    Cheers

  7. Canadian Couch Potato November 18, 2011 at 1:57 pm #

    @Ninja: Thanks for the comment. How do you think ZDV compares with its competitors, XDV and CDZ, when it comes to market cap and sector concentration? I’m only asking because I’m interested in whether you think that ZDV’s “rules-based methodology” is clear. Would it help to have a transparent index so you could understand why these specific stocks were chosen?

  8. Steve in Oakville November 18, 2011 at 8:43 pm #

    Hey Dan,

    I think the key is that the screening decisions are laid out up front so there’s no descretion (or very little) on the part of the fund manager to include one stock over another. If the screening decision is based on a traditional index, or whether it follows a set of pre-determined rules, I’m not sure it matters much – to me at least.

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