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.