Back in January, BlackRock—the parent company of iShares—announced that it had acquired Claymore Investments, the second-largest ETF provider in Canada. Since then, BlackRock has been gradually integrating the former Claymore funds into its family. The ETFs were officially rebranded last week and all of them now trade under the iShares name.

Many readers have wondered about what this acquisition will mean for individual ETF investors. On Monday, I had an opportunity to sit down with Mary Anne Wiley, the newly named Head of iShares for BlackRock Canada. Here’s part of our interview—more to come later in the week.

I was surprised when I first heard about the acquisition, but after a bit of reflection, it was clear that the two ETF families actually had very little overlap.

MAW: I think that was the reaction of most people: “I never saw that coming.” But then they took a step back and realized that it made a huge amount of good sense for us, and for the market at large. We have one of the most trusted brands in ETFs, and Claymore had done a really nice job of building a platform that was where iShares was not. They were very smart in building their business.

We had always focused on cap-weighted equities and fixed income based on the DEX benchmarks, whereas Claymore’s equity lineup was not cap-weighted, but rather fundamental indexes. They had also been very creative in the way they built out their bond exposures with the traditional laddered approach, which was very appealing, particularly to advisors. And they have done a great job in the commodity space. So at the end of the day there was almost no overlap.

Does that mean there will be no fund closures?

MAW: We have just announced the closure of one fund: the inverse bond ETF. When we looked at the product lineup and started to make our decisions, there were three criteria we used. The first was whether there was a long-term sustainable place for the ETF in the market. That doesn’t mean it has to be buy-and-hold-forever, but we are not looking for the hottest thing that is going to sell a lot today but have no longer-term appeal. Second, it had to be something unique or additive: there needs to be something that differentiates it from what is already available. The third was that it had to be consistent with the iShares brand, and what we stand for. And we don’t do inverse. That product was designed to be very short-term; it’s speculative. And the market hasn’t really embraced it. So as a result, we announced that fund would be closing.

But outside of that, we have come out and said we are going to continue to promote the Advisor Class ETFs, which is new for iShares. The laddered bond ETFs, the RAFI indexes, the commodities—we are supporting all of these other families of products, which hopefully confirms that we stand behind what we said, that these are a great complement.

That said, there is a little bit of redundancy in the two families, and I think the most obvious is CWO and XEM, which both invest in broad emerging markets, and according to your website, both track the same index. Will we see these funds merged?

MAW: If we go back to the three criteria I talked about earlier, I think we all agree that emerging markets has long-term sustainable merit. So, are the two products unique? Their holdings today are actually different, and we want to make sure that going forward they are sufficiently different. If not, then we would consider merging them. I don’t have the answer for you today, but it might make sense to take CWO and convert it to a RAFI strategy. That is one of the things we’re looking at doing.

Another example that I have been asked about are the two dividend funds: XDV and CDZ. They are quite different, but at first blush, they are going after the same segment of the market. XDV is focused on dividend yield, while CDZ is focused on dividend growth. So the composition is different, and an investor can actually make a decision on whether one makes more sense than the other. That is another instance where we will support both, because there is a market for both.

How does this affect your plans to launch your own new products? I know you already had a number of your own new products in the pipeline. Now that you have just added dozens of new ETFs, will these be delayed?

MAW:  No, not at all. There will be new products. The iShares brand now has new products because of the acquisition, but the marketplace doesn’t. There are still needs that haven’t gone away, and we want to be the player who meets those evolving needs. I don’t think the world needs another large-cap Canadian equity ETF: that’s covered. But there are strategies and segments of the market that are appearing in the ETF space, and we want to be the provider that brings them out. As long as they are additive, and there is a long term place for them in the market, and that they’re consistent with the iShares brand.

BlackRock surprised almost everyone in January by announcing that it would be buying Claymore Investments, the second-largest ETF provider in Canada. The move takes another step forward today when the former Claymore ETFs start trading with new names. With a couple of exceptions, all of the Claymore exchange-traded products have been rebranded with the iShares name. The Claymore website has been taken down and all links now take you right to the iShares site.

If you’re an investor who owns any of these ETFs, you should notice the name change when you log in to your brokerage account, but the ticker symbols will remain the same. iShares has also pledged to honour any existing preauthorized cash contributions (PACCs) and distribution reinvestment plans (DRIPs). Claymore pioneered the PACC plans several years ago in an effort to eliminate one advantage that mutual funds still have over ETFs, and both Horizons and XTF Capital have since followed suit.

Whether iShares plans to eventually extend the PACC program to all of its ETFs is one of several unanswered questions. Another surrounds Claymore’s “Advisor Class” ETFs, which charge an additional trailer fee. iShares has never offered such versions of their own ETFs, but they will retain the Advisor Class versions of the former Claymore funds.

The big questions, of course, are whether there will be fee changes or fund closures. The answer to both questions is no, at least in the short term. When I first wrote about the acquisition in January, many readers expressed concern that eliminating a competitor would open the door for BlackRock to hike its fees, but I would be shocked if this happened. With Vanguard now on the scene, any ETF provider that starts raising fees is going to see a flood of redemptions. It makes no sense as a corporate strategy, and BlackRock knows that.

BlackRock has also said that it has no immediate plans to close or merge any ETFs. It’s actually quite remarkable how little overlap there is among the 83 funds now in the iShares lineup. The axe may fall on a few of them eventually, but there really are no obvious candidates.

On Monday, I wrote a post about a new Canadian dividend fund from XTF Capital. That fund is one of five new products from the newest ETF provider in the country, all of which are based on indexes provided by Morningstar Canada. Two more began trading on Wednesday: the XTF Morningstar Canada Value Index ETF (FXM) and the XTF Morningstar Canada Momentum Index ETF (WXM).

In my original post, I criticized XTF Capital and Morningstar for not making the Index methodologies public. It turns out that wasn’t quite fair:  XTF president Barry Gordon contacted me and explained that the index construction rules are indeed fully transparent, and although they were not on the XTF website at the time, they are now.

I ended up speaking with Mr. Gordon about his company’s partnership with Morningstar, and it’s an interesting story. Although XTF Capital is a small firm compared with its competitors, it has partnered with one of the most well-known research firms in the investment industry, and the result is some unique and interesting ETFs. They are all passively managed, but they use rules-based strategies designed to deliver better risk-adjusted returns than the overall market.

A new family of strategy indexes

XTF Capital approached Morningstar and asked them to create indexes based on their Computerized Portfolio Management Services. CPMS is a service that Morningstar sells to advisors and portfolio managers who are interested in executing particular investment strategies—such as those based on dividends, value factors, or momentum. Rather than doing their own security analysis, subscribers pay Morningstar a fee for comprehensive research and recommendations.

The long-term performance of the CPMS strategies are impressive—albeit hypothetical. Their Earnings Value strategy, which is the basis for the new value ETF, returned 19.35% over the last 10 years, compared with 7.54% for the S&P/TSX Composite. The CPMS Momentum strategy claims an annualized return of more than 20% since 1985.

Gordon readily admits that investors should not expect returns like that: rules-based strategies don’t always live up to their promise in the real world, where they face the headwinds of management fees, transaction costs, market impacts and human behaviour. Indeed, the CPMS data do not include investing costs or tracking error of any kind, and they assume that all recommendations are implemented instantly. The ETFs will have management fees of 0.60%—not including HST—and will incur trading costs and other expenses that will lower their returns compared with the CPMS numbers.

Moreover, Morningstar had to make sure that its new indexes were truly investable, which meant eliminating small, illiquid stocks and rebalancing quarterly rather than in real time. Gordon says the company will not announce the exact rebalancing dates to discourage front-running.

As for human behaviour, that’s one area where the new indexes might prove to be superior to your average portfolio manager. Gordon says he knows many people in the industry who subscribe to CPMS, “but I rarely find anyone who does exactly what the methodology tells them.” Like most human beings, fund managers tend to ignore data or recommendations that go against their intuition—and usually they’re wrong. “So it will be interesting to see what happens in the index context, where there will be no discretion,” Gordon says. “We can’t override it and say, ‘No, that’s too heavy a weighting to X.’ The index will generate whatever it generates, and we will replicate that.”

That’s music to the ears of a passive investor.

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 anything but: 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 like this one suggest that 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.]

If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.

The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.

Forward thinking

Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are design for investors who want current income.

Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.

You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.

Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.

More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.

If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.

H&R Block software giveaway

Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.

When Vanguard announced its arrival in Canada this summer, investors welcomed the company with open arms: perhaps no country would benefit more from Vanguard’s devotion to low-cost investing. The company’s first Canadian ETFs started trading on the TSX on December 6.

On the day of the launch, I had the pleasure of sitting down with Atul Tiwari, managing director at Vanguard Investments Canada; Dennis Duffy, Vanguard’s director of business development for non-US markets; and Joel Dickson, a principal in Vanguard’s Investment Strategy Group.

Here are some highlights from the interview dealing with Vanguard’s overall strategy in Canada. Later this week I’ll run another excerpt that focuses specifically on the new ETFs and Vanguard Canada’s plans for the future.

Why did you decide to enter the Canadian market with ETFs rather than mutual funds? And why did you target advisors rather than retail investors?

AT: Having looked at the Canadian market for at least 14 or 15 years, Vanguard considered a number of different entry strategies. The reason we executed now is that the Canadian marketplace is changing. We are seeing a lot more advisors moving from a commission-based approach to a fee-based approach, and that fits in squarely with the Vanguard model. We don’t pay for distribution anywhere in the world, so to enter the Canadian market with mutual funds would be kind of tough, because it is a very commission-oriented business.

About 20% of advisors’ overall business in Canada uses a fee-based model, whereas in the US it is about 65%. Canada is probably where the US was about eight years ago. The other thing is, there are a lot of regulatory changes going on globally. By the end of next year, commissions will essentially be banned in the UK. Same thing in Australia. In the US, they are discussing the fiduciary standard for brokers, and even the OSC [Ontario Securities Commission] has said recently that they are going to consider a fiduciary standard. So with a little help from the regulatory changes, we think we will be well-positioned.

What were some of the uniquely Canadian challenges that you faced? For example, low-cost, direct-sold mutual funds are extremely popular in the US, but investors in Canada haven’t really embraced them.

AT: You’re absolutely right: a number of companies have tried, but direct-sold funds just haven’t caught on in Canada. And a lot of that is because mutual funds are sold and not bought. We haven’t got any plans to launch mutual funds at this stage, but that is not to say that in the future we won’t. We entered the market with the product that we thought would be the best entry point for Canada, and that is ETFs.

One of our other challenges—and certainly one of the key components of our Canadian strategy—is investor education. We will be doing a lot of thought leadership, a lot of seminars—we will do whatever we can to get the message across to investors and advisors about the effects that costs have on your returns over the long run.                                  

Index investors are well aware of the benefits of low costs. But how do you make that case to advisors?

DD: This has been a challenge for us in every market. Even before ETFs, we had a pretty significant advisor business in the US, but the fee-based business was a relatively small percentage of the overall market back in the early 2000s. We went into the UK prior to the legislation banning commissions: we felt there was enough fee-based business there, and we were willing to make the commitment. We are very patient company: look at how long it took us to get into Canada! But there is a lot of education that is going to be needed.

JD: It’s important to recognize that the advisor’s compensation doesn’t need to change at all [if they start using Vanguard ETFs]. Even if they are getting 1% or 1.5% or whatever for their services, we would hope that there is an opportunity to lower fund costs: if you can show 24 basis points with your ETF holdings as opposed to another 1.5% on underlying mutual funds, that’s a huge benefit.

Yet many advisors—and their clients, for that matter—continue to insist that active management is part of their value-added, despite overwhelming evidence to the contrary.

JD: That is a key issue: the value-added model has been disrupted. We talk about a concept we call advisor’s alpha, which is to say, how do you as an advisor position your value to clients in a world where it is not about picking the best funds, or the best managers? It’s about focusing on things you can control, like costs, and risk, and taxes and behaviour.

The problem is, these things are sometimes hard to measure. Some of the best “performance” an advisor could have provided came when the client called them up in the depths of the market in 2009 saying, “Get me out now!” and the advisor said, “Remember our overall asset allocation for the long run?” That doesn’t show up on your statement as the performance of your portfolio versus some benchmark. But if the investor would have sold out on their own, there is huge value added.

No new models yet

Many readers have emailed to ask me whether I will be updating my model portfolios with the new Vanguard ETFs. I’m not planning to do that just yet—for a couple of reasons.

First, the funds have been trading for only a couple of weeks, and while I have little doubt that Vanguard will do a good job keeping tracking errors and bid-ask spreads low, I would like to wait and see.

Second, Vanguard Canada’s US and international equity ETFs use currency hedging, which I have avoided in my model portfolios. It is possible that Vanguard will eventually launch unhedged versions of these ETFs, at which point I would be more likely to incorporate them.

I am resisting the urge to tinker with the model portfolios every time new ETFs are launched. However, this time next year I will re-evaluate the marketplace, and it’s likely that I’ll make some changes to the portfolios to reduce their cost.

Quicken winner

Thanks to everyone who entered the draw for the copy of Quicken Home & Business 2012 money management software. The lucky winner is Chris, who contributes some of the wisest comments on this blog. Congratulations!

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.

It’s not easy to make a splash in the crowded ETF space these days. Many of the new products we’ve seen in the last year or so have been clones of existing ETFs or exotic specialty funds. Any Canadian investor who wants to build a diversified portfolio with ETFs has more than enough choice already.

That was the challenge for Vanguard Canada when they announced they’d by launching a family of ETFs this year. Given the company’s reputation for rock-bottom fees, there was a lot of speculation about whether they would try to compete on price. Even if none of their ETFs are radically different from their competition, they could grab some market share from their competitors by offering similar products with much lower fees.

Well, Vanguard has just released the costs of its new ETFs, which will start trading in the coming weeks. It looks like they’ve lived up to that promise:

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Note that the above figures are the management fees, not the entire management expense ratios (MERs). According to the press release, “Vanguard expects the MERs of its ETFs to be substantially similar to their management fees, as the Vanguard ETFs should incur only nominal other costs that would be included in the MER calculation.” They will have to add the 13% Ontario HST, which would bring a 0.20% fee up to 0.23%.

Even if you add a few basis points for HST, these are very competitive fees: in fact, all of them are lower than comparable products from iShares, Claymore and BMO. The Vanguard  MSCI Canada (VCE) will be the second-cheapest ETF in Canada, behind only the Horizons S&P/TSX 60.

I would suggest that Vanguard has now changed the game in the Canadian ETF market. Any bank or other financial institution that is planning to launch a family of broad-based ETFs will likely find there is no way to compete: it was hard enough to go against iShares, and now the pricing pressure is all but insurmountable. Any new players will probably stick to specialized products, wrap programs, or some other strategy to package and sell ETFs through advisors.

In other news…

We’ve just updated the Model Portfolio performance results for the period ending October 31. The year-to-date performance of the Complete Couch Potato is 1.28%—hardly cause for dancing in the streets, but given the state of the global economy and the extreme daily volatility, that’s a surprising result. Have a look at the five-year performance numbers of the major asset classes: with a couple of exceptions, these are not nearly as bad as you might think considering this period includes the 2008–09 financial crisis and this summer’s huge declines.

Many thanks to everyone who attended or tuned in to the ING DIRECT panel discussion on Wednesday evening. I enjoyed meeting the readers who came by to say hello in person, including Mike from MoneySmarts, and hearing from those who Tweeted their comments. It was an honour to share the stage with Rubina Ahmed-Haq and Ellen Roseman. Preet Banerjee was also present.