In January, RBC launched the Quant Dividend Leaders ETFs, a family of dividend-focused funds covering the Canadian, U.S. and international markets. I recently had a chance to speak with Bill Tilford, Head of Quantitative Investments at RBC Global Asset Management, to learn more about the new ETFs:
The funds do not track a third-party index: rather, the portfolios are built using a rules-based methodology. Unlike the popular S&P Dividend Aristocrats indexes, which focus on past dividend growth, Tilford says the RBC ETFs try to be forward-looking. So in addition to screening for stocks with above-average dividend yield, the strategy also looks at three measures of financial strength to determine the sustainability of the dividends.
The first is called the Altman Z-score, which has been used since the 1960s to estimate the probability of a bankruptcy. “It also does a great job of forecasting dividend growth,” says Tilford. The other factors are the volatility of the firm’s return on equity (ROE) and the amount of short interest. “Companies that have higher volatility in ROE are obviously less inclined to increase dividends, or even to sustain them. The short interest on the company is a market-oriented indicator about whether the company is under duress.”
Finally, the strategy looks at current and forward-looking ROE to estimate the likelihood that dividends will grow.
Watching your weight
The next stage in building the RBC dividend ETFs is weighting each of the stocks in the portfolio. Again, Tilford stresses the strategy is designed to look forward. “A cap-weighted index, by definition, is always looking in the rear-view mirror,” he argues. There is no reason to believe that the largest companies will continue their dominance. “When companies exert leadership—like Apple has over the last few years, for example—we know that creates competition. A cap-weighted index will unfortunately suffer because it always assumes an industry leader like Apple will persist.”
The RBC ETFs use a “modified cap-weighting” strategy that tends to underweight large companies and give more influence to mid-cap and smaller stocks, especially those that are more liquid than their market cap might suggest. The specific methodology is kept under wraps, however. “It is transparent to any investor in the sense that you know what we own every day and what the weights are. But the method itself is treated as proprietary.”
Bending the rules
The fund managers may also bend the rules on occasion. “In exceptional circumstances we would review the rules. Those exceptions would have to be situations where it clearly makes sense to override. An obvious one would be an M&A situation developing: clearly the stock’s performance is going to be more influenced by a takeover situation, and the rules won’t know anything about that. So very rarely and selectively we would get involved and adjust.”
There will be some discretion involved in the rebalancing of these funds as well. Like most index funds, these ETFs will be rebalanced quarterly, but not on the customary dates (the last day of March, June, October and December). “We will effectively target mid-quarter,” says Tilford, “so mid-February, mid-May, and so on. This allows us to digest all of the quarterly information, and more importantly, it gets away from month-end or quarter-end rebalancing, which creates extra costs in the market.” (Here Tilford is talking about the front-running that can take place when well-known indexes add or remove companies.) The rebalancing dates won’t be announced in advance.
Nothing passive here
Rather than labelling investment strategies as either passive or active—as though there were only two absolute categories—I think it’s more helpful to place each one along a continuum. I’d put the RBC Quant Dividend ETFs quite far to the active side. There are a lot of rules, they’re created in-house rather than by a third-party index provider, they’re not transparent, and they can be ignored at the discretion of the manager.
Tilford is quite unapologetic in RBC’s marketing material that these ETFs were specifically designed as an alternative to passive investing. “We argue that if you’re building a rules-based solution, who would you rather have? We would argue that active money management provides you a great leg up.”
Bottom line, these funds aren’t a good fit for Couch Potatoes, but they will appeal to dividend-focused investors looking for active management at low cost.