Your Complete Guide to Index Investing with Dan Bortolotti

Barry Gordon on Building an Index

2017-12-02T22:30:56+00:00October 15th, 2012|Categories: ETFs, Indexes|Tags: |7 Comments

Back when dinosaurs roamed the earth, all ETFs tracked well-known third-party indexes like the S&P 500. But it wasn’t long before all of the major benchmarks were spoken for and ETF providers began to commission new indexes for their products. In most cases, they formed partnerships with firms that specialize in index creation, such as Standard & Poor’s, MSCI, Russell, Morningstar and PC Bond Analytics, creators of the well-known DEX bond indexes.

I’ve always been curious about how these new ETF indexes were created, so I called Barry Gordon and asked him to share his experience. Gordon is president and CEO of First Asset, one of the youngest ETF providers in Canada, and he’s launched a handful of funds in 2012. These include four equity ETFs tracking new indexes based on Morningstar’s CPMS strategies, which advisors and portfolio managers use to select dividend, value and momentum stocks. First Asset also launched three bond ETFs using barbell strategies pegged to DEX indexes.

Here’s part one of our interview. I’ll post part two later in the week.

When you created your new ETFs, why did you decide to base them on existing methodologies from Morningstar rather than creating your own rules-based strategy?

BG: As a new player in the ETF industry, I think it adds a lot to our offering in terms of people’s confidence in dealing with us. If Morningstar believes in us, and has partnered with us, there is some additional credibility that comes with that.

Any newly created index, whether it is cap-weighted or it uses another rules-based methodology, is subject to manipulation or data mining. That’s why you have to respect the index provider and believe they have integrity, so they are not going to say something like, “You know, if we got rid of everything under a $250-million market cap, this would look a lot better.” That’s why we chose Morningstar. They have integrity in spades: they are very well respected, and we were looking for that in a partner.

How collaborative is the process when you work with an index provider?

BG: Not very. When I approached Morningstar, we said we love the CPMS methodologies and they are well respected with advisors, so can we turn them into indexes that we can replicate and you can put your name on? They went away and we didn’t talk to them again for about six weeks. Then they came back to us and said, “Here is the basis on which we will do this and attach our name to it.” For example, they said they would have to get rid of the small and micro-cap stuff because it isn’t scalable and investable.

Now to be fair, they asked us for our thoughts. I asked questions like, “Why 50 stocks [in the US dividend index]?” or “Why 30 stocks [in the Canadian dividend index] when your original CPMS methodology has 25?” And they would give me the reason. For example, they believed their indexes offered better diversification in an ETF, because there is a lower concentration per name when you use equal weighting.

So it’s collaborative in that I’m able to ask questions about what they’re doing. We had an open dialogue as they created the index, but there wasn’t a single time where we said, “We don’t like that, please change it.” If we had done that they would have said no—to their credit.

That’s interesting, because I remember back in 2009 the S&P Dividend Aristocrats Index kicked out several of the big banks because they’d failed to raise their dividends. The Globe reported that Claymore was considering approaching S&P about changing the index rules “to make sure that anomalies are taken into account.” And I thought, you’d better hope they said no, because if they ever did that their credibility would go up in smoke.

BG: S&P would never do that. Never.

[Note: A reader pointed out that S&P actually did go on to change the index methodology in response to this “anomaly.” A company can now qualify for the Aristocrats index even if it does not raise its dividend for five consecutive years: it is permitted to “maintain the same dividend for a maximum of two consecutive years within that five year period.”]

Yet there’s a potential conflict of interest for index providers. If you decide you don’t like their index, you’ll stop licensing it and they lose revenue. But if they’re thinking longer-term, they don’t want to get a reputation as an index provider that makes arbitrary changes to suit their ETF providers.

BG: That’s exactly right. Morningstar understands that in the States there are billions of dollars in ETFs from iShares and Northern Trust that are linked to their indexes, so are they really going to risk that? Are they going to put their reputation at risk by doing something [inappropriate] with a small Canadian outfit? The answer is no. So they really told us how it would work and we trusted them on that. This goes back to that notion of having trust in the index provider.

How close to the original CPMS methodology is the Morningstar Canada Dividend Target 30 Index tracked by your ETF?

BG: It’s fairly close, but with some subtle differences. All of the changes they made were to ensure the index was liquid and replicable. That effectively gets rid of the very small-cap stuff. And interestingly, when we were talking to advisors who are using CPMS, they were not disappointed with that. I had thought it might be a detractor, but they told us they’ve learned from experience that sometimes with the smaller-caps, if there is a sell recommendation after the stock has performed very well and there are a hundred investment advisors following that stock, it is hell getting out. So they were actually quite happy that we don’t have the small-cap stuff in there.

That raises an important point, because I assume the performance data of the CPMS methodology assumes that transaction costs are zero.

BG: No, that’s not true actually. Again, the more credible your index provider is, the more confidence you can have in them. The published CPMS numbers actually assume a cost of seven cents per share traded. For something with high turnover like the momentum index, that works out to about 2% to 2.5%. For the methodologies that have much lower turnover, it’s less than 1%. But the point is Morningstar is very conscious about having those numbers reflect real life.

As the index provider, does Morningstar provide you with rebalancing instructions?

BG: Yes. The indexes are published: there is a Bloomberg code you can look up any time. But in terms of managing the portfolio, the rebalancing is done quarterly, and they say, “Here are the changes to the index that are coming into effect on Monday at close,” and then we buy and sell stocks appropriately by the close on Monday, and our job is to try to make that as seamless as possible.


  1. Danno October 15, 2012 at 10:13 am

    Question/thought: The last question says that the index provider would rebalance at some frequency (whether quarterly, or whatever), and that the ETF provider is then given the information and seeks to follow. My question or thought is, is there any correlation, advantage, or need for awareness about when your index or ETF are rebalancing, and when you as an investor ought to seek to rebalance your own portfolio? Suppose the ETFs I hold in my portfolio, and their indices, tend to rebalance semi-annually. Is there any difference if I rebalance my portfolio immediately before? Or after? Or with higher frequency? Etc. I bet for a smallish portfolio like mine, the answer is no. But for someone with 7 figures plus, I wonder.

  2. Canadian Couch Potato October 15, 2012 at 10:19 am

    @Danno: The rebalancing schedule of your ETF should have no influence on your own decision to rebalance. When an ETF rebalances, its value remains exactly the same, and therefore its proportion in your portfolio remains exactly the same also. You only need to rebalance when a fund in your portfolio is higher or lower than your personal target.

  3. Andrew F October 15, 2012 at 3:20 pm

    Thanks, this was interesting. I am definitely intrigued by the CPMS index ETFs. The Canadian value and momentum funds have performed well in their first six months. On the other hand, these funds haven’t grown from their initial float. Hopefully First Asset will stick with them. Once they have 1 year under their belt they can start advertising their actual performance.

  4. Barry Gordon October 16, 2012 at 8:47 am

    Thanks Andrew F. We will indeed stick with them. We are aware that as strategy based indexes, many people will sit on the sidelines until there is a realtime track record people can review. Naturally there are skeptics. But as I always like to say “with every challenge there is an opportunity”. The opportunity is to educate investors on the use of strategy beta in their portfolios and win market share. Our job is to make the process transparent and investor friendly – which we are trying our best to do. We believe in these ETFs.

  5. Barry Gordon October 17, 2012 at 10:52 am

    Dan points out that S&P did actually change their methodology on the Dividend Aristocrats, contrary to both of our beliefs! Boy, I feel a little silly. Regardless, I think the key point is that you have to believe in the integrity of the index provider. I’m sure that when S&P made the change, they did so after a thorough review of the matter and not in a knee-jerk response to a request from the ETF provider. My point was really that credible index providers don’t act at the whim of the ETF providers.

  6. Canadian Couch Potato October 17, 2012 at 11:11 am

    I apologize for not noticing this until it was pointed out to me. Obviously I don’t know what S&P considered when they made the change to the methodology, but I’m a bit disappointed. I have written before that I think an index based on dividend growth is arbitrary, but if you are going to create a rules-based index, I think you should stick to the rules.

    What is the “anomaly” that occurred in 2009? The banks had difficulty during the financial crisis and they did not raise their dividends. That is hardly an anomaly: companies stop raising their dividends all the time. The only difference is that Canadians love their banks and they probably kicked up a stink when they were removed from the ETF. I’m sure many excellent companies have been kicked out of the US Aristocrats index, which has much stricter criteria (25 years of dividend growth). I’m not aware that the index provider changed the rules in any of those situations.

  7. […] indexes are created – Part One and Two on Canadian Couch […]

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