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. 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.