A New Dividend ETF With Secret Sauce?

February 13, 2012

Last June, a new ETF provider appeared in Canada with little fanfare. I didn’t write anything about the launch of XTF Capital at the time, because their first lineup of products was a series of covered call ETFs and a convertible bond ETF that have little or no relevance to Couch Potato investors. However, last week XTF launched the first three ETFs in a new family that will track indexes provided by Morningstar. One of these, the XTF Morningstar Canada Dividend Target 30 (DXM), may be of interest to passive investors who use a dividend-focused strategy. So it’s worth a closer look.

Of course, the Canadian dividend ETF space is already a little crowded, with the iShares Dow Jones Canada Select Dividend (XDV) and Claymore S&P/TSX Canadian Dividend ETF (CDZ) currently holding almost $1.7 billion between them. Broken down by sector, this new XTF fund is about 25% financials (that’s half as much as XDV, but about 4% more than CDZ) and almost 30% energy, which is a far greater share than either of its competitors. It also holds 13% in utilities and almost 20% in telecoms.

The ETF’s fact sheet also breaks down the fund’s exposure to size and value factors using the Morningstar style boxes, which is an interesting feature. These style boxes tell you what percentage of the fund’s assets is in large, mid, and small cap stocks, and what percentage is in value, blend and growth stocks:

Of the 30 stocks in the new ETF, only five are also in both XDV and CDZ (Scotiabank, Fortis, IGM Financial, Shaw Communications and Telus), which is a bit surprising. Another 15 are in one or the other competitor, leaving 10 stocks that appear only in DXM.

What’s in the box?

Barry Gordon, president of XTF’s parent company, First Asset, was quoted in The Globe and Mail as saying that with these Morningstar indexes, “we are striving to deliver better returns with less risk than the broader market.” The ETF’s fact sheet includes hypothetical returns for the Morningstar Canada Dividend Target 30 Index, which would have outperformed the S&P/TSX Composite dramatically over the last three, five and 10 years, with a lower standard deviation to boot.

That’s quite a claim, but backtested returns of new indexes are almost worthless—it is always possible to identify a strategy that would have worked in the past, but this offers no guarantee that it will work going forward. The claim is especially dubious when it’s unclear exactly what strategy is being employed. That’s my biggest concern with this new ETF. The individual holdings are transparent, but the methodology is not: we’re told only that the Morningstar index is “based upon proprietary research” and that “it reflects the performance of 30 dividend-paying, Canada-based equities, screened for, among other things, above-average returns on equity and high cash flows relative to debt.” It seems to weight all of its holdings equally, rather than by market cap or yield, though even that is not made explicit.

While I fully understand the business reasons for creating products that keep their strategy under wraps, I’m not attracted to them as an investor. Black-box ETFs suggest there are magic formulas that can beat the market, and that investors should be paying for access to an exclusive club. But one of the pillars of passive investing is that returns come from exposure to known risk factors, not from secret sauce. This ETF provides a reasonably well diversified basket of Canadian dividend stocks and may be just fine for investors who want that in their portfolios. But whether it will provide superior risk-adjusted returns in the real world is an open question.

[Update: After this post went live, XTF Capital supplied a copy of the index methodology. See the comments section for an explanation and a link.]

{ 20 comments… read them below or add one }

Chad Tennant February 13, 2012 at 10:05 am

Did these Morningstar indexes pop out of thin air? Last time I checked S&P, Dow, MSCI and Russell were the leading third party index suppliers. Having done a quick search it appears MStar indexes are only associated with XTF. Given MStar’s clout, I’m not sure they made the right partnership/marketing deal with XTF, an ETF provider that receives little if any coverage and inflows.

Canadian Couch Potato February 13, 2012 at 10:33 am

@Chad: Yes, I think the Morningstar indexes were created specifically as benchmarks for these ETFs. That’s why I’m skeptical about the backtesting.

Ryan February 13, 2012 at 10:48 am

Would a covered call ETF portfolio be suitable for coach potato investors?

Canadian Couch Potato February 13, 2012 at 11:01 am

@Ryan: Personally, I do not think covered call ETFs are consistent with Couch Potato investing. These ETFs are extremely popular with income-oriented investors now, but you should be aware that they may end up being disappointing:
http://business.financialpost.com/2012/02/10/covered-call-etfs-good-for-income-not-return/

Eric February 13, 2012 at 12:37 pm

iShares has some ETFs based on Morningstar indexes.

Canadian Couch Potato February 13, 2012 at 1:31 pm

@Eric: Yes, iShares in the US does offer several ETFs based on Morningstar style indexes, screening for growth, value, and size factors. But I believe these Canadian indexes are unique to XTF Capital.

Chris February 13, 2012 at 1:38 pm

Any reason why these Canadian indexes won’t follow the rules set out here?
http://indexes.morningstar.com/Index/PDF/DividendRulebook.pdf

Pacific February 13, 2012 at 2:12 pm

Excellent review, I appreciate your detective work and clear explanations!

Barry Gordon February 13, 2012 at 6:19 pm

Hi. I’m the CEO of XTF Capital and parent First Asset. I would normally completely agree with your skepticism of backtested results. However, the equity indexes that we are replicating are based, at their core, on real track records of CPMS (www.cpms.com), which is a Canadian sub of Morningstar. To create the indexes, some changes were made to, among other things, ensure the indexes were investable and scalable. As you can see from the CPMS site, the actual track record (Cdn Income) is better than the index backtest. As for transparency, index construction and methodology is all set out in rulebooks, which (our fault) are not on our website http://www.xtf.ca yet. All available. Apologies. Very transparent. Happy to discuss.

Canadian Couch Potato February 13, 2012 at 6:31 pm

@Barry: Many thanks for stopping by and clarifying these points. I remain skeptical about backtested indexes, because real-world funds often have a lot of difficulty replicating those performance numbers after fees, trading expenses and taxes. (The RAFI indexes are a good example of this.) But I do appreciate you pointing readers to the CPMS site, where they can get more information.

Thanks also for pointing out that the methodologies are available to the public and for supplying me with a copy. Readers can get the PDF here.

I appreciate you reaching out like this and apologize if I jumped the gun. If I hadn’t written this post on the weekend I would have picked up the phone to ask. Cheers. :)

Barry Gordon February 13, 2012 at 7:12 pm

No apology necessary. It’s our fault we didn’t have the full information available to you. We’re really jazzed about these ETFs and think they will offer value add for Canadian investors. As you say – only time will tell – but we believe in Morningstar and CPMS. Thanks for taking the time to cover us. Cheers

Canadian Couch Potato February 13, 2012 at 7:18 pm

@Barry: Thanks for being gracious. I am definitely interested in learning more about the momentum ETF when its launch date is set. Let’s talk before then.

Barry Gordon February 13, 2012 at 7:27 pm

Both Canadian Momentum and Canadian Value launch on this Wed. (15th). I’ll make sure we speak tomorrow if you are available. Flip me an email with your availability. bgordon@firstasset.com

Maxwell C. February 13, 2012 at 8:23 pm

I will never ceased to be amazed how all the ETF/Index Mutual Fund big wigs all seem to watch this blog like hawks. It’s great when they add to the discussion with their clarifications. Keep up the good work everyone, you all help to make this an invaluable resource for the DIY investor!

Lake Superior John February 13, 2012 at 8:49 pm

@ Maxwell. These big wigs must follow this blog to find out how many of us are sensible enough to not get trapped into their expensive world(s). Time and time again note worthy authors of financial acumen have written about the virtues of self investment for those of us that are capable of doing so without loosing a third of future gains to investment ‘houses’.

Dan as always keep the great work coming!!

Canadian Couch Potato February 13, 2012 at 9:21 pm

@Maxwell and John: I’ve been grateful that ETF and fund providers have been generally very helpful in answering my questions and in straightening me out when I get something wrong. Better transparency and communication creates an atmosphere of trust and benefits everyone.

Lake Superior John February 13, 2012 at 9:42 pm

@ Dan: to quote you’ Better transparency and communication creates an atmosphere of trust and benefits everyone’. I’m sure this has been the goal of the industry year in , year out, however, countless examples exist when best intentions only favoured the house and not the investor.

Dan, keep them honest and open.

Thanks

Paul Arcand March 7, 2012 at 5:19 pm

Would you please have an article (or two) on convertible debentures. ( Please !)

Thank you in advance for your answer

Canadian Couch Potato March 7, 2012 at 9:04 pm

@Paul: Thanks for the suggestion. I have been thinking about tackling this now that there are a couple of ETFs tracking this asset class.

Barry Gordon March 8, 2012 at 8:49 am

@Paul. I wrote a fairly comprehensive piece on converts in January’s edition of Canadian ETF Watch. http://www.canadianetfwatch.com/reports/CanadianETFWatch-Volume3Issue1.pdf

Hope it’s helpful

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