Do ETFs Need an Index?

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.