The BMO Canadian Dividend ETF (ZDV), launched last month, is unusual among dividend ETFs in that it does not track an index. Instead, it follows a “rules-based methodology” to screen stocks according to yield, dividend growth and payout ratio.

Last week, I asked whether ETFs really need an index in order to play a role in a passively managed, low-cost and low-turnover portfolio. Instead of tracking a traditional third-party index, can an ETF’s fund manager simply draw up its own set of quantitative rules and accomplish the same thing? If I had to make that argument in court, I’d build my case this way:

Many indexes are not transparent. Let’s all agree that transparency is paramount in a passively managed fund. But we should acknowledge that many well-known indexes are not particularly transparent.

Few people question whether funds tracking the S&P 500 or the Dow Jones Industrial Average are passive. And yet, although the major criteria are public knowledge, the companies in the S&P 500 are selected by a committee. The DJIA is even more of a black box—there’s nothing at all transparent about how this granddaddy of indexes is built. Just because your ETF tracks a third-party index doesn’t mean that you can understand exactly how the holdings are determined.

The fund provider may be determining the strategy. In the olden days, index funds all tracked well-known third-party benchmarks, many of which had been around for decades. But many new ETFs track indexes that were commissioned by ETF providers themselves.

Claymore’s bond ETFs are a good example, as are several of BMO’s equity funds, including the BMO Dow Jones Canada Titans 60 (ZCN). Dow Jones has long managed a family of Titans indexes that track the large-cap market in various countries, but I don’t think it’s a coincidence that the index for Canada has 60 stocks (the same number as the S&P/TSX 60), nor that it was launched in May 2009, three weeks before ZCN started trading.

The point is that even if a third party creates the index, the ETF provider may still be the one making the decisions about the overall strategy.

Index licensing is expensive. Any time an ETF or index fund uses a third-party benchmark, it pays a licensing fee. Fund companies are tight-lipped about how large this fee is, but according to a recent Reuters article, it is typically one-tenth to one-third of the overall management fee. In most cases, that would be somewhere between three and 18 basis points.

When the ETF’s investing strategy is straightforward, you have to wonder whether it really makes sense to pay an index licensing fee. The BMO S&P/TSX Equal Weight Banks (ZEB) is the most glaring example: it holds equal amounts of the big Canadian banks, and that’s it. Does one really need to hire Standard & Poor’s to divide by six? Couldn’t the fund save its investors several basis points by getting rid of the index?

For what it’s worth, the index-free BMO Canadian Dividend ETF (ZDV) is currently the cheapest dividend fund in Canada, with an MER of 0.40%, including HST.

Indexes still have value

I’ve laid out these arguments because I want investors to make sure they understand the subtleties. I do think it’s possible for a fund to be transparent, passively managed and maybe even cheaper without a third-party index. But I also believe that an investor considering an ETF with no index needs to ask some pointed questions:

Is the methodology fully explained? Indexes don’t guarantee full transparency, but they certainly help: many providers do publish thorough explanations of how their indexes are built. The description of the stock-picking criteria used by the BMO Canadian Dividend ETF (ZDV), by contrast, is extremely vague. All we’re told is that stocks are chosen based on “the three-year dividend growth rate, yield, and payout ratio” and that “securities will also be subject to a liquidity screen process.”

By comparison, the index-tracking Claymore and iShares dividend ETFs use methodologies that are explained in much greater detail by S&P and Dow Jones, respectively. If BMO were to provide a more meaningful description of its strategy, and they could ensure that the manager is not at liberty to stray from these rules, then I would consider ZDV a passive fund. But we’re not there yet.

Who’s benchmarking the fund’s performance? The most useful measure of an index fund’s performance is its tracking error, or the difference between the returns of the index and the actual return achieved by the fund. The iShares Dow Jones Canada Select Dividend (XDV) returned 12.82% in 2010, compared with the index’s return of 13.32%. As an investor, I know that the tracking error of –0.50% is identical to the ETF’s fee, which means the fund was managed almost perfectly.

How will investors measure the performance of ZDV? Even if the fund is transparent about its methodology, it will be impossible to know how well the managers executed that strategy. An index provider does more than just draw up a methodology: companies such as S&P and Dow Jones also compute and publish the returns of their indexes monthly and annually, which holds ETFs accountable. There’s a lot of value there—certainly it’s worth paying a few basis points for that benchmarking.

I’m not ready to jettison the idea of passively managed funds that don’t track an index. But it’s too early to accept them uncritically. For now, at least, I believe there’s just too much potential for things to go wrong when no one is looking.

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.

This week saw the launch of the Claymore S&P US Dividend Growers (CUD), an ETF that will have great appeal for income-oriented investors. The fund tracks the S&P High Yield Dividend Aristocrats Index, made up of the 60 highest-yielding US stocks that have increased their dividends every year for at least 25 years. (The stocks are then weighted by yield, not by market cap.)

These are companies with a very impressive record of paying their shareholders. By comparison, the S&P/TSX Canadian Dividend Aristocrats Index requires only five consecutive years of rising dividends. Of course, a fund of Canadian companies with a 25-year record of increasing payouts would have one holding: Fortis.

In my series of posts about dividend investing last January, I expressed some skepticism about the devotion to dividend growth strategies. It’s not that there’s anything wrong with the companies that have paid reliable dividends, of course. It’s just that some investors seem to take it for granted that these stocks will deliver above-market returns. They’re influenced by graphs like this:

The problem with this graph is that it’s entirely backward looking. If you knew in December 1986 which companies would be dividend growers over the next 24 years and which would cut their payouts, you would indeed have crushed the market. But of course, you couldn’t know that. You can only identify dividend growers after many years of increasing payouts. (This survivorship bias is brilliantly explained in this article on Seeking Alpha.)

Of course, by that time much of the advantage will be gone, because the company’s reputation will be priced into the stock. For what it’s worth, over the last five years, the Aristocrats index has performed almost identically to that of the broad US market (about 3.5% annualized), which should not be surprising if you believe that markets are at all efficient.

There’s value in low volatility

That said, mature businesses with a history of rising dividends are often less volatile. Indeed, have a look at the new PowerShares S&P 500 Low Volatility Portfolio (SPLV), which includes the 100 companies in the S&P 500 with the most moderate price swings over the previous 12 months. You’ll find many names that are also in CUD: stable, blue-chips like Exxon Mobil, Procter & Gamble, McDonald’s, Consolidated Edison, Johnson & Johnson, Kimberly-Clark, PepsiCo, Wal-Mart. It’s hard to go too far wrong with a lineup like that.

The new Claymore ETF isn’t wholly new in the marketplace: the SPDR S&P Dividend ETF (SDY) tracks the same index and has been around since 2005. The differences are that CUD trades in Canadian dollars and uses currency hedging. The Claymore ETF’s management fee is 0.60%, which should make its total MER about 0.68% when you include the taxes. That’s about double SDY’s expense ratio of 0.35%.

If you’d like to chew over the CUD, you can download the fact card here. Claymore has also produced a document outlining dividend growth strategies.

This past spring, a number of Canadian iShares ETFs celebrated their 10th birthday. The country’s largest ETF provider now has 10 funds with a history that goes back to at least 2001, and according to the research firm Fundata, six of them were first quartile performers for the decade ending June 30, 2011. (This means they outperformed at least 75% of their peers.) A pair of others were second quartile, with only two lagging the category average:

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Fundata also reports that 11 of the 16 iShares ETFs with a five-year track record were first quartile performers, too. That’s an impressive result for a family of funds that simply try to capture the returns of an asset class with no attempt to beat the market.

An ETF history lesson

Even before iShares, Canada was a pioneer in the ETF space: in 1990, the first successful exchange-traded index trackers appeared in Toronto. They were called Toronto Index Participation Shares (TIPS), and they tracked what was then called the TSE 35. In 1999, this product was purchased by Barclay’s Global Investors and later rebranded as the iUnits S&P/TSE 60. Today it’s called the iShares S&P/TSX 60 Index Fund (XIU), and it’s far and away the largest ETF in Canada, with about $10 billion in assets.

The ETF that is now the iShares DEX Universe Bond Index Fund (XBB) was also a trailblazer: it was one of the first fixed-income ETFs in the world when it was launched in November 2000. But it wasn’t an index fund: it simply held a single 10-year Government of Canada bond. (It used the ticker symbol XGX, with the G indicating “government” and the X a nod to the Roman numeral 10.) The predecessor of the iShares DEX Short Term Bond Index Fund (XSB), launched the same day, held one five-year bond. By December 2004, these ETFs had evolved into the index-tracking products they are today. They now hold hundreds of bonds each, and boast more than $3.5 billion in assets.

Another change in the iShares lineup came in 2005, when the federal government eliminated the foreign-content rules for RRSPs. Before that time, investors could hold only 10% to 30% of their RRSPs in non-Canadian assets. However, because XSP and XIN are domiciled in Canada, they offered a way to get U.S. and international exposure without qualifying as foreign content. After those restrictions were lifted, and investors could buy cheaper US-listed ETFs that tracked the same indexes, iShares added currency hedging to XSP and XIN to differentiate them.

The middle of the last decade was an interesting period for ETFs in Canada. iShares’ only competitor was TD Asset Management, whose four Canadian equity ETFs couldn’t compete on price. With incredibly bad timing, TD got out of the ETF business in late 2005. Just a couple of months later, Claymore launched its flagship Canadian Fundamental Index ETF (CRQ) and the popularity of ETFs began to snowball.

The future for ETFs

I recently spoke with Oliver McMahon, director of product management at iShares Canada, about the evolution of ETFs in this country, and where the industry may be heading.

“My prediction is, because most of the large and recognizable indexes are already covered by ETFs, a lot of the products you’re going to see in the future will not track an index,” McMahon says. “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.”

One example already in the iShares lineup is its Diversified Monthly Income Fund (XTR), which used to be the iShares S&P/TSX Income Trust Index Fund. When income trusts all but disappeared last year after the government changed the tax rules, this fund had to evolve. It now holds nine income-oriented ETFs with a breakdown of 50% equities and 50% fixed income, rebalanced quarterly. With such a simple mandate, it doesn’t make a lot of sense to pay an index provider.

Along the same lines, one has to ask why a fund like the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) needs to license an index. The ETF simply holds equal amounts the Big Six Canadian banks—presumably any fund manager with the ability to divide by six would be able to figure out the holdings. Yet part of the fund’s MER goes to S&P for performing this mathematical feat.

It will be interesting to watch the marketplace evolve in the coming years. I think there’s plenty of room for ETFs that don’t track a third-party index, though I hope it isn’t a slippery slope. Will the portfolio managers of these index-free funds be bound by strict rules, or given the leeway to use their own judgment? If it’s the latter, at what point does a supposedly passive fund become actively managed?

There is a lesson in iShares’ 10-year track record. All of those first quartile performers are plain-vanilla index funds, which means the old model works. It remains to be seen whether innovations can improve on it.

Joel Greenblatt has a sense of humour—I’ll grant him that. In The Big Secret for the Small Investor (Wiley, 2011), he pokes fun at the crass title of his previous book, You Can Be a Stock Market Genius, and goes so far as to renounce it: “It was meant to help the individual investor, too. It didn’t.” Now the author has new strategy to share with his readers.

Greenblatt spends the first few chapters building his case by explaining why identifying undervalued stocks is far more difficult than it sounds. Then he describes the challenges faced by active managers: if they are index huggers they almost never beat their benchmarks, and if they are more adventurous they risk periods of dramatic underperformance, which usually gets them fired. As a result, managers become so obsessed with short-term results that they can’t follow through with legitimate strategies—such as value investing—that might actually do well over the long term.

If you think you’re about to hear an argument for indexing, you’re right—sort of. Greenblatt doesn’t take the position of orthodox passive investors: that you should be content to achieve market returns at the lowest possible cost. Rather, he suggests that individual investors can beat the market—it’s just that they’re going about it the wrong way.

Greenblatt argues that traditional index funds are likely to beat most stock pickers, but you can do a lot better. He reviews the usual criticisms of cap-weighted indexes and touts fundamental weighting and equal weighting as superior alternatives. So far, nothing too surprising.

So what’s the big secret Greenblatt has been waiting to reveal? (Spoiler alert.) The secret is that investors can earn even better results with funds that track value-weighted indexes. Specifically, he recommends weighting stocks according to “cheapness,” as measured by trailing earnings yield, and “quality,” measured by trailing return on capital. He provides a table showing that the S&P 500 has returned 7.6% annually since 1990, while a value-weighted index would have returned 13.9%.

One secret remains

Getting to the end of Greenblatt’s book reminded me of the series finale of The Sopranos: you’re left wondering what just happened. After spending nine chapters making an argument for investing in value-weighted indexes, there’s no mention of how to actually do this. A brief appendix lists some fundamental and equal-weighted ETFs, as well as some value ETFs from Vanguard and iShares, but he’s quick to note these do not track the value-weighted indexes he’s been talking about. In fact, there don’t seem to be any products that follow Greenblatt’s strategy.

Then comes the last paragraph: “We have created a free website, valueweightedindex.com, to keep readers up to date on what I believe will be a growing area in the investment field.” Visit the site and you’ll eventually figure out that Greenblatt has created two mutual funds based on the ideas described in the book. In other words, the big secret for small investors is: “If you want to beat the market, buy my funds.”

I admit I felt duped—as though I had just read a 150-page marketing piece disguised as a book. I get that many financial authors have vested interests, but I have more respect for the ones who aren’t so sneaky about it.

This spud’s for you

I get a lot of email from people who have questions about the Couch Potato strategy, and I do my best to respond to all of them. It recently dawned on me that other readers would be interested in many of the questions and answers. So I’m happy to announce a new Q&A feature on the blog, which I’ll run a few times a month.

If you have a question about index investing—whether theory or practice—drop me a line and I will answer the best ones in future posts.

A few ground rules apply. I can’t dispense investment advice to individuals: since I’m not a licensed advisor, it’s irresponsible and potentially illegal. So please don’t ask me to review your portfolio, draw up a financial plan, or recommend individual securities. I’ll just refer you to a good advisor.

To get things rolling, I invite you to post a question below and I’ll enter you in a draw to win a copy of The Big Secret for the Small Investor. Even though I spoiled the ending, it’s still a worthwhile read for index investors with a value bent. Contest closes Monday, June 6, at midnight EST.

Monday’s post comparing one of my model ETF portfolios to one created by Dimensional Fund Advisors attracted a lot of interest from readers—and from some DFA advisors, too.

Shortly after that post went live, I was contacted by a DFA advisor whom I’ll call John (his compliance department keeps him on a short leash). John ran some numbers to compare how the original Über-Tuber might have performed alongside a DFA portfolio over the last 15 years.

Of course, none of the ETFs in my suggested portfolio were around in 1996. So John used index data to estimate the returns of the Über-Tuber, subtracting the MERs of the funds to account for costs. For the DFA portfolio, he subtracted a 1% advisory fee from the fund returns. Here’s the breakdown he used:

Here are the results from July 1996 through April 2011:

And here’s how the path of those returns would have looked during the period:

As you’ll see, the returns of the two portfolios over the 15 years were almost identical. The Über-Tuber trailed the DFA portfolio by just half a dozen basis points annually, and it accomplished that result with a lower standard deviation—which means lower volatility.

What’s it all mean?

So what conclusions can we draw from these data? First, it seems the ETF portfolio would have done a respectable job of mirroring DFA’s small-cap and value strategies. However, the simulation assumed that trading costs were zero, that the investor rebalanced religiously, and that the ETFs all tracked their indexes very closely. It’s safe to say that a real-world investor would have been hard-pressed to accomplish all of that.

What’s more, assuming our ETF investor did manage to do everything right for 15 years, the DFA portfolio still delivered slightly better results, even after deducting a 1% fee for the advisor. An experienced advisor would certainly have added value if he or she handled all of the heavy lifting during this turbulent period, which included three roaring bull markets (1996–2000, 2003–06 and 2009–10) and two swift kicks in the groin (2001–02 and 2008–09).

There’s one more interesting thing to add. John also ran the same simulation with the trusty old Global Couch Potato—which includes just three or four funds—and the results fell right in the middle: an annualized return of 6.40%. There was a bit of divergence between the three portfolios during some periods, but after 15 years it was essentially a wash, no matter which one you used.

Maybe it does pay to keep things simple after all: diversify widely, keep your costs low, rebalance and stick to your plan. If you can do that, you’re at least 90% of the way to the perfect portfolio.

On Monday, I took issue with the argument that cap-weighted bond indexes are fatally flawed. Rob Arnott, the creator of fundamental indexing, has argued that the classic model is “patently ridiculous.” The Research Affiliates website frames the problem like this: “Traditional bond indices give their greatest weights to the biggest debtors. Should investors buy more of a company or nation’s debt solely because it increases its issuance?”

My previous post looked at this idea as it applies to government bonds. However, there are currently five RAFI fixed-income indexes, and all of them cover corporate debt—three for investment-grade bonds, and two for high-yield bonds. And right now there’s just a single ETF tracking one of these indexes: the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). This fund has been around since 2007, though it didn’t start tracking the RAFI High Yield Bond Index until last August.

The other side of the argument

In a recent conversation with Steven Leong and Oliver McMahon, who handle product management for iShares, I brought up the idea that traditional bond indexes overweight companies with the most debt. “On the surface that is true, but it totally ignores the size of the company relative to the size of the debt,” Leong said. “It should surprise nobody that a company like Royal Bank has issued more debt than a company like Shoppers Drug Mart, for example. Nor should it be something that anyone is afraid of.”

Remember, companies don’t necessarily borrow for the same reasons that consumers do. When we get a loan to buy a house or a car, it’s because we’re simply not able to pay cash. Yet just this month Google issued $3 billion in bonds despite having some $35 billion in cash reserves.

“If a company’s internal rate of return is higher than the interest they pay on their bonds, it’s smart for them to issue more debt,” McMahon explained. “They’re creating value for their shareholders. An alternative might be for them to issue more stock, and that’s not always a sensible thing to do, because you’re going to dilute the value of the existing stock. You definitely can get to a stage where you issue too much debt. But the simple fact that a company has a large amount, in and of itself, is not indicative of a problem.”

No regard to fundamentals?

The RAFI website states that “traditional bond indices weight issuers solely by the market value of each firm’s outstanding debt with no regard to underlying firm fundamentals.” As I argued in my earlier post about sovereign debt, this isn’t quite true. Bond indexes funds always screen for credit risk. So if a company is drowning in debt and has little capacity to pay it back, its bonds will get a junk rating and they won’t make into indexes that hold only investment-grade issues.

If you want to avoid companies with bad fundamentals, all you need to do is buy an ETF such as the iShares DEX All Corporate Bond Index Fund (XCB), the Claymore 1-5 Year Laddered Corporate Bond ETF (CBO), or one of BMO’s corporate bond ETFs that hold nothing rated lower than A by Standard & Poor’s. The likelihood of a bond defaulting in any one of these bond funds is very low.

Using a fundamental index for a high-yield bond fund seems to make more sense, since the likelihood of default is much greater. The RAFI High Yield Bond Index includes nothing less than BBB, whereas more than 14% of the iShares U.S. High Yield Bond Index Fund (XHY) is rated CCC+ or lower. “RAFI corporate bond strategies will tend to have higher credit ratings than their market-weighted counterparts,” the website confirms. Of course, lower credit risk may also mean lower returns. Both PHB and XHY have similar durations, but PHB’s yield to maturity is almost a full percentage point lower.

During his recent talk in Toronto, Rob Arnott said, “I think fundamental indexing in bonds is going to be bigger than it is in stocks.” I’m not at all convinced of that—the RAFI strategies seem to offer far more potential in equities. US investors, however, do seem to be receptive: PHB has more than doubled its assets from $202 million before the index change to about $480 million today. (Although for some perspective, its iShares counterpart holds $9 billion.) PowerShares also has an ETF in the works that will track a RAFI index of investment-grade corporate bonds.

Canadians will get a chance to vote with their money soon enough: last month, Invesco announced that it plans to launch a version of PHB on the Toronto Stock Exchange, this one hedged to Canadian dollars.

When Rob Arnott, the creator of fundamental indexing, spoke in Toronto last week, his presentation focused exclusively on equities. When he took questions at the end of his presentation, I asked him a question about the lesser-known RAFI fundamental bond indexes.

Recall that the goal of fundamental indexing is to address the flaws in capitalization-weighted indexes, which give the most influence to stocks that may be overpriced. Traditional bond indexes are cap-weighted, too: the more bonds a country or corporation issues, the greater their weight in the index. Arnott and others have criticized this methodology, so I asked him to comment. Here’s what he said:

“If you’re bond investor, you’re a lender. If you’re cap-weighted, then you’re lending the most to whomever has the most debt. What is the rationale behind that? If you’re investing in a global sovereign bond fund and Greece decides it wants to double its debt, as an index investor you would have to own twice as much. What’s the sense of that?

“Cap-weighting in bonds is patently ridiculous. Cap-weighting in stocks has a lot of theoretical justification, but when you use the same theories and apply them to bonds, it just becomes more obvious that the rationale is stupid.”

Ridiculous, stupid — these are strong words. But before you rush to dump your bond index fund, let’s take a closer look at Arnott’s argument.

A red herring

On the surface, the criticism of cap-weighted bond indexes seems to make sense. If you’re a mortgage lender, do you want you lend more money to people who already have the largest home loans? If you’re credit card company, do you look for customers who owe the most on their existing cards? Of course not. You look for borrowers with good “fundamentals”: a reliable job, a low debt-to-income ratio, a good credit history and the like.

But this has no relevance to the vast majority of index funds and ETFs that hold government bonds.

For starters, most investors hold all of their bonds in their own country—as they should. Unlike with equities, there are sound reasons for keeping your fixed income in your home country and currency. Some investment gurus, such as David Swensen and Larry Swedroe, even argue that you should avoid corporate bonds and stick to bonds issued by your own government. In other words, global sovereign bond index funds are few and far between, and I have never seen anyone recommend them as a core holding.

Even if you did decide to add foreign bonds in your index portfolio, the reference to Greece (or any other country at high risk of default) is a red herring. Cap-weighted bond index funds screen for credit risk, so no investor is in danger of being unwittingly saddled with a bunch of fiscal basket cases.

For example, the CIBC Global Bond Index Fund, the only one of its kind in Canada, tracks the cap-weighted J.P. Morgan Global Government Bond Index, which includes only investment-grade bonds. Most of the fund is in Japan, the United States, France, the UK, Germany, the Netherlands and Germany. (There are small allocations to Italy and Spain, which may concern you, but this is a criticism of bond-rating agencies, not cap-weighted indexes.)

The SPDR Barclays Capital International Treasury Bond ETF (BWX), listed in the US, is a perfect example of the methodology in action. This ETF used to have an allocation to Greece (according to this February 2010 article), but it doesn’t anymore, because the country’s credit rating has since been lowered and it’s no longer eligible for the index.

Other safeguards

Other sovereign bond ETFs use different methods to make sure deeply indebted countries are not overrepresented. The US-listed iShares S&P/Citigroup International Treasury Bond Fund (IGOV) starts with a cap-weighted index but makes adjustments “designed to distribute the weights of each country within the index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding.”

If you’re an investor who wants high-risk bonds issued by emerging countries, you’re still not likely to run into any problems with index ETFs. BMO’s Emerging Markets Bond ETF tracks an index “weighted by gross domestic product as a measure of economy size.” The recently launched iShares J.P. Morgan USD Emerging Markets Bond Index Fund (XEB) uses the same safeguard as IGOV.

Designing a bond index fund that systematically overweights countries in danger of defaulting would indeed be “ridiculous” and “stupid.” Which explains why no bond index fund seems to be doing it.

Earlier this week I discussed the promise of fundamental indexing. This strategy takes aim at the shortcomings of traditional cap-weighted indexes, which overweight growth stocks and are prone to bubbles. In 2005, Rob Arnott and his colleagues unveiled the Research Affiliates Fundamental Indexes (RAFI) and produced data showing that they would have outperformed cap-weighted indexes by about 2% to 3% per year over the long term in almost every market.

Any strategy that can outperform by a couple of percentage points is certainly worth a look. However, the proof is in real-world performance, not in backtested computer models. The question for investors, then, is whether the ETFs and mutual funds based on RAFI indexes have lived up to their billing.

One crucial point before we look at the data. I wasn’t interested in whether the fundamental ETFs have outperformed their cap-weighted counterparts: over a period of five years, this is virtually meaningless. Lots of actively managed funds can make the same claim, but over longer periods, that outperformance generally disappears. So I was more interested in whether the RAFI funds are tracking their own indexes closely.

Cap-weighted index funds are not perfect, but they do have several things going for them: they are cheap and usually have very low tracking errors. The iShares S&P 500 Index Fund (IVV) has tracked its benchmark within six basis points (0.06%) since its inception more than 11  years ago. In Canada, the iShares S&P/TSX 60 Index Fund (XIU) has a tracking error of just 0.19% over the same period.

I wanted to know if ETFs based on fundamental indexes could make the same claim. Remember, the data suggest that the RAFI indexes can deliver excess returns of about 2% to 3%. However, higher fees and larger tracking error could easily wipe out that advantage. And fundamental ETFs typically have management fees 20 to 50 basis points higher than their cap-weighted counterparts, and their indexes may be harder for a manager to follow.

The real-world performance

Let’s take a look at the most popular funds based on the RAFI indexes:

• Since its launch in February 2006, the Claymore Canadian Fundamental ETF (CRQ) has returned 6.37% annualized, versus 7.01% for its index, a difference that’s actually a bit lower than the fund’s MER of 0.69%. Incidentally, it has also outperformed the S&P/TSX 60 over that period and was ranked second out of 93 Canadian Equity funds by Morningstar during its first five years.

• The Claymore US Fundamental ETF (CLU) and International Fundamental ETF (CIE) have fared much worse. Both lagged their own indexes by huge margins in years past. Part of the reason is that these funds relied on representative sampling rather than owning all 1,000 stocks in the RAFI indexes. The ETFs now own all the stocks in their indexes and they improved their tracking errors in 2010, but both still lagged their benchmarks by more than two percentage points.

• In the US, the RAFI indexes are licensed by the PowerShares family of ETFs. Since December 2005, the PowerShares FTSE RAFI US 1000 (PRF) has returned 5.03% annually, compared with 5.54% for the index. That shortfall is entirely accounted for by its 0.45% MER. Another good result.

• The PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (PXF), which tracks the same index as Claymore’s CIE, has a tracking error of –1.13% since its launch in June 2007.

Canadian investors can also get access to the RAFI indexes through mutual funds from Invesco PowerShares and Pro-Index Funds. However, these funds are designed to be sold through advisors, so they may have front-end loads and trailer fees added. They typically have MERs in the range of 1.6% to 1.8%. That guarantees that these funds will lag their benchmarks.

Another issue to consider is taxes. If you’re not investing in an RRSP, you’ll receive a tax bill for any capital gains your fund incurred during the year. Cap-weighted ETFs tend to be extremely tax-efficient: the iShares S&P 500 Index Fund (IVV) has never distributed a capital gain in its 11 years of existence. In Canada, XIU and XIC have done so in the past, although not since 2008. In 2010, both CRQ and CLU also distributed significant capital gains that would have lowered returns for investors holding these funds in a taxable account.

The jury is still out

Fundamental indexing is one of the most important innovations to come along in passive investing. If it were possible to create a mutual fund or ETF that tracked the RAFI indexes within a few basis points, I have little doubt that its long-term performance would be superior to that of a traditional index fund.

But in the end, fundamental indexing must overcome the same hurdles as active management. That is, it must add value after accounting for fees and taxes. So far the results have been encouraging, but it would be hard to argue that investors should expect a 2% to 3% outperformance over the long term. I would expect any outperformance to be less that because of the added costs of administering the funds. And a poorly run fund would instantly forfeit any advantage at all.

Cap-weighted index funds may be flawed, but they do have at least one thing that fundamental indexes don’t yet have: a long track record of delivering on their promises.

Last Friday, I had the pleasure of attending a talk by Rob Arnott, the creator of the Research Affiliates Fundamental Indexes (RAFI). The Toronto event was hosted by Claymore Investments, who use the RAFI indexes for their flagship equity ETFs.

If you’re not familiar with fundamental indexing, here’s a primer. Most traditional indexes are weighted by market capitalization, which means that a company’s influence is determined by its size (as measured by the number of shares outstanding, multiplied by the price per share). If a stock doubles in price, its influence in a cap-weighted index will also double. Similarly, if a company’s stock price declines, so does its weight share in the index.

This methodology makes perfect sense if the goal of an index is to be a barometer of the market. Indeed, the cap-weighted S&P 500 was created in 1957 to measure the performance of the U.S. stock market, and other traditional indexes (including the S&P/TSX Composite in Canada) perform the same role.

However, proponents of fundamental indexing point out that these benchmarks were never designed to be the basis of an investment strategy. And in that respect, they argue, cap-weighted indexes have a major flaw: they give the most weight to overvalued companies and the least to undervalued companies.

The trouble with bubbles

The most glaring example of this problem occurred during the dot-com bubble. As the price of technology companies inflated to absurd levels, so did their influence in cap-weighted indexes. Meanwhile, profitable business that fell out of favour saw their stock prices and their index weight plummet. When the bubble finally burst in March 2000, the S&P 500 was decimated.

The RAFI fundamental indexes remove stock prices from the equation. They assign each company a weight based on four factors: total sales, book value, cash flow and dividends. What’s more, they use an average of these factors over five-year periods to smooth out any short-term aberrations. The result is an index that measures companies based on their footprint in the economy, rather than their footprint in the market.

Nortel is the most obvious Canadian example of how big a difference this can make: in 2000, the company made up more than 29% of the S&P/TSX Composite, but would have been less than 4% of a RAFI index based on its fundamentals.

A fundamentally different method

As the ETF marketplace grows, all manner of new indexes are cropping up in attempt to address the supposed flaws of cap-weighting. Many have more to do with marketing than anything else. But the RAFI indexes are in a different category. While they don’t have universal support in the academic community, they are based on peer-reviewed research and have been endorsed by none other than Harry Markowitz, the Nobel laureate and creator of Modern Portfolio Theory, the rock upon which index investing is built.

They’re also popular with advisors who use Dimensional Funds, which isn’t surprising, as the strategies have some similarities: both are designed to get away from the “growthiness” of cap-weighted indexes and place more emphasis on value stocks.

As Arnott described during his talk, indexes weighted by company fundamentals would have outperformed cap-weighting by an average 2.8% annually in 22 of 23 developed countries since the 1980s. His book, The Fundamental Index, goes in to much more detail and makes a deeply compelling case for the strategy. It’s a must-read for anyone thinking about building a portfolio with the RAFI-based funds from Claymore and PowerShares.

The promise of fundamental indexing is enormous. However, it’s important to remember that the long-term performance of the strategy is hypothetical. The data assume that funds based on the RAFI indexes would have tracked their benchmarks perfectly—and that’s always a big assumption. The first ETFs and mutual funds based on the RAFI indexes have been live for only five or six years, with mixed results. Later this week I’ll look at how some of them have stood up in the real world.