Barry Gordon on Building an Index: Part 2

In Monday’s post I shared part one of my interview with Barry Gordon, CEO of First Asset, who explained how his firm worked with Morningstar to create new ETF indexes. In part two the interview, Gordon discusses his partnership with PC Bond Analytics, the firm that manages the DEX bond indexes, the most widely followed fixed-income benchmarks in Canada.

Let’s talk about how things worked with your barbell bond ETFs. With the Morningstar equity ETFs there was already an existing methodology. But although the barbell bond strategy is not new, as far as I know there has never been an index.

They know the concept well at DEX, so I went to them and said we want to create these ETFs that replicate a barbell index, do you think you can do that? The process was iterative in the sense that they would come to us with what they thought worked, and I would make suggestions and ask questions based on what we thought was better suited to an ETF. They had to make sure the index was really reflecting what I was trying to do. So there was this give-and-take, but there were not a whole lot of changes made to it. It was just about making sure that everything was boxed in properly based on what we wanted to achieve and what we were going to say about it.

Did they bring up any concerns that you had not anticipated?

Yes. For example, our portfolio manager wanted to include some floating-rate notes that are quite large in the market, and they said they didn’t have them in their universe, because they are not independently coded by three different dealers. So in that context, having the third-party index provider just adds another discipline to it.

Your barbell strategy calls for 25% floating-rate notes and 25% fixed-rate bonds on the short end. Was that your idea or theirs?

That was my idea. We said to DEX, “Is this scalable and replicable, and will it all hold together if we include floaters rather than just fixed-coupon bonds on the short end?” And they came back and said, yes, but how much? They said it wouldn’t work if it was all floaters, so they asked how much we had in mind. For simplicity, we said how about half? They went away and did their analysis and said, yes, that would work. So again, they impose a discipline that is useful.

You obviously have fund managers at your firm who could have easily drawn up their own rules-based methodology for your ETFs. Why didn’t you go that route?

There actually is a product in our lineup where we did do that: CXF, which is our Canadian Convertible Bond ETF. We talked with DEX about this, and they ended up doing an index for Claymore [now the iShares Advantaged Convertible Bond]. But we decided the convertible space in Canada needs a little bit of discretion at the margins. So we came up with a rules-based methodology that had liquidity filters and market-cap filters, but the portfolio manager can look at it and say, “No, such-and-such got through, but that’s a minefield—not just because it’s a bad company, but because there’s a problem with the specific issue,” or whatever.

I guess you could argue there are some asset classes that don’t lend themselves well to a purely passive investing strategy. Large-cap stocks, sure. Convertible bonds? Maybe not so much.

At least not in the Canadian space. In the US there is a very good convertible bond index that has been replicated, but the Canadian marketplace is a lot smaller. We believe in convertible bonds because of their risk-adjusted return profile, but our view is that it is not really well-suited for a fire-and-forget concept. So the manager has some discretion at the margins, but generally they follow the rules.

11 Responses to Barry Gordon on Building an Index: Part 2

  1. Nathan October 18, 2012 at 4:18 pm #

    So… what’s the logic behind a bond barbell? At least historically, the best-performing point on the yield curve has been around the middle. It’s theorized that this is because long-term bonds are often used to hedge against future risks, causing them to sell for a relative premium.

    It seems to me that in theory (in the best case) you would simply get performance given by the average (intermediate) duration of the fund. (In which case there isn’t much point.) In reality, you would likely do worse than a fund that held intermediate term bonds, due to their tendency to outperform.

  2. Canadian Couch Potato October 18, 2012 at 4:22 pm #

    @Nathan: Not sure if you saw the post I did about the First Asset barbell ETFs a while back. The strategy can outperform if the yield curve moves in specific ways:
    http://canadiancouchpotato.com/2012/07/12/the-long-and-short-of-barbell-bond-etfs/

  3. Nathan October 19, 2012 at 7:58 pm #

    Ah, no, I hadn’t seen that. Interesting stuff. If you accept that our best estimates at any given time of future interest rates are current interest rates, you could choose which strategy is best at any given time by just looking at YTMs and durations. Although I agree with RJ in the comments that right now for TFSAs you can’t beat 3% risk-free at People’s Trust or Canadian Direct.

  4. jamie October 19, 2012 at 11:31 pm #

    don’t want to burn any bridges here because I’m a big fan and reluctant convert to passive investing; but why all the emphasis on ‘First Asset’? How do they fit in? How is this passive index investing? And why, when I go to their link from your site don’t I see their MER’s clearly stated? So many of us are depending upon you!

  5. Canadian Couch Potato October 20, 2012 at 10:14 am #

    @Jamie: I think it’s important for index investors have some depth of knowledge about their strategy. With that in mind, I thought it would be interesting for index investors to learn how an ETF index is created, and the ideal person to explain that is someone who has been directly involved in the process. And as a small, independent ETF provider, First Asset offers an interesting perspective compared with the indexing giants like Vanguard and BlackRock (although just this month I wrote a similar post on Vanguard’s new indexes, too).

    First Asset’s MERs are listed prominently on each ETF’s web page. The Morningstar equity ETFs have management fees of 0.60%. The barbell bond ETFs are 0.20% to 0.25%.

    I’m not sure why an ETF with an index that screens for dividend or value stocks is not “passive index investing.” No one seems to level that criticism at iShares or Vanguard dividend ETFs. And why is a laddered bond ETF (like CLF or CBO) considered passive while a barbell bond ETF is not?

  6. jamie October 21, 2012 at 12:55 am #

    sorry about the chippy tone of my question and thanks for the response with all its nuances–lots to chew on.

  7. Canadian Couch Potato October 21, 2012 at 9:42 am #

    @Jamie: It was a fair question, and it’s something I have to balance all the time. At its core, the Couch Potato strategy is extremely simple: just by three or four index funds, rebalance once a year, and otherwise never think about it. But that makes for a pretty boring blog. More than that, I think all investors can benefit from understanding the strategy on a deeper level. The ones who never consider anything other than low MER, for example, are often the ones who bail out for the wrong reasons (see, for example, anything written by Gordon Pape on indexing).

    At the same time, there are a lot of ETF strategies that have nothing to do with passive investing, and I don’t want to get caught up in the hype. I favour a very plain-vanilla approach to indexing (and that is what I use with my own investments), while recognizing that many others use an overall passive strategy but with a few tweaks to suit their objectives and their personality.

  8. Smithson October 22, 2012 at 1:04 am #

    @CPP: Following up on the earlier discussion about bond barbell weighting – isn’t using a bond barbell simply making a bet on the direction of interest rates? In particular, aren’t you betting on a specific yield curve? Thus, if you wanted to be neutral on the direction of rates, wouldn’t the best bond ETF to hold be a bond ladder ETF? Wouldn’t that be preferable to even something like XBB (which is overweight short term)?

  9. Canadian Couch Potato October 22, 2012 at 9:39 am #

    @Smithson: Yes, choosing a barbell strategy is making a call that the shape of the yield curve will move in a certain way. But it’s a pretty small bet: in most scenarios, the barbell will not behave much differently from a more conventional bond strategy. It’s a “tilt,” but not a brazen forecast.

    XBB isn’t “overweight” short-term bonds: the index is designed to mirror the broad Canadian bond market, so it holds the market weight of short-term bonds. That said, yes, a ladder is an excellent way of structuring a bond portfolio if you are neutral on interest rates, but there is still the question of how long you want to go. If you keep your bond ladder to five years, then you really are overweight short bonds. If you go out 10 years or more you get closer to the duration of XBB.

  10. Barry Gordon October 22, 2012 at 3:59 pm #

    Nathan, Jamie, Smithson and others, in giving the interview to Dan, I was trying to shed some light on the construction process to provide a counterpoint to the less than vague allegation by Vanguard recently that “new” index construction that shows historical back tested results are just data mining. Every index is new at some point. Either the index provider is credible and worthy of your trust as an investor, or you should be skeptical of all indexes, period – even the composition and constituents of the S&P/TSX 60 is subject to periodic review and inclusion or exclusion is influenced by subjective factors such as “achieving sector balance”.

    On why barbells are good – we believe they provide an attractive, balanced way to invest in a portfolio of bonds, with a 50% defensive component and the offense provided by the longer term weighting – you end up with attractive current yield, lower duration than other broad market indexes, and as discussed elsewhere, it tends to outperform in a rising rate/curve flattening environment. At this stage of the rate cycle, we think it mitigates the need to make rate calls and is a good addition to fixed income portfolios – and very cost competitive. Hope all this helps.

  11. Canadian Couch Potato October 22, 2012 at 4:04 pm #

    Thanks, Barry. To follow up for other readers, the original context for my interview with Barry was the column I wrote in the October issue of MoneySense magazine entitled “Building a better benchmark.” Unfortunately, it is not available online.

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