Disclaimer: Morningstar receives fees for licensing its indexes to XTF Capital. These fees are mainly based on fund assets under management. The ETFs are not sponsored, issued, sold or marketed by Morningstar.
It's good practice to view the back-tested strategy results touted by new investment products with a skeptical eye. Such advice rings particularly true in today's rapidly expanding exchange-traded fund industry, where next-generation products seem to be launching at a feverish pace.
Canada's newest ETF provider, First Asset Investment Management's XTF Capital, recently rolled out a suite of strategy ETFs that track value, momentum and dividend-themed indexes. While the new products have yet to generate significant assets under management, they've already raised plenty of interest. Most of the questions we've received from investors so far have been related to XTF's new dividend-themed Canadian equity fund. Therefore, we decided to put XTF Morningstar Canada Dividend Target 30 Index DXM under the microscope.
The Morningstar Canada Dividend Target 30 Index tracks the performance of 30 equally weighted dividend-paying Canadian equities. Constituents are selected from the universe of Canadian stocks that trade on the Toronto Stock Exchange. For a stock to be considered for inclusion, it must be one of the 100 stocks with the highest 12-month average trading volume, and it needs an expected dividend yield of more than 1%.
The list of eligible securities is then assigned a weighted average score based on five fundamental factors: expected dividend yield (33.33%), cash-flow-to-debt (20%), five-year normal EPS growth (13.33%), return on equity (20%) and EPS estimate revision (13.33%). The top 30 stocks, ranked by their total fundamental scores, make the cut for inclusion in the index. Finally, to maintain broad market diversification, the index allows a maximum of eight securities per GICS sector, which amounts to a sector cap of 26.67% at each quarterly rebalance. ( Click here for detailed index construction rules.)
Performance attribution analysis
On the fund's fact sheet, the back-tested results of the index appear impressive. But what exactly were the sources of return for DXM's index? And how was it able to beat the S&P/TSX Composite by 3.72% annually over the past five years?
Below is a summary of some of the key take-aways from my attribution analysis of DXM's index, obtained using Morningstar's institutional data software platform, Morningstar Direct. I looked at the five-year period ended Jan. 31, 2012, during which the Morningstar Canada Dividend Target 30 Index returned 5.66% compared to 1.94% for the S&P/TSX Composite.)
It turns out that the largest contribution to DXM's index returns came from the energy sector, where it picked up 1.85% of its return -- the majority of which (1.16% out of the 1.85%) was due to superior security selection within the sector. With an average 27% energy sector weighting, DXM's index was nearly 3% underweight relative to the benchmark. However, its picks within the sector rose 7.3% annualized, versus just 1.7% for the energy component of the S&P/TSX Composite.
Utilities were the next largest contributor of return. During the five-year period, DXM's index had an average weighting in the utility sector of 12.7%, representing a significant overweight versus the 1.65% benchmark average. This allocation decision added another 1.01% of return to DXM's index, versus the 0.12% that the S&P/TSX Composite picked up with its minimal exposure to the sector.
Another performance boost came from a sizable overweight allocation to telecommunications firms. In the period we studied, DXM's index maintained an average weighting in telecoms of 12.2%, versus 3.5% for the benchmark. Being in this sector helped DXM's index tack on 0.71% of outperformance relative to the S&P/TSX Composite. We should point out here though, that while the sector allocation paid off, the stock picking within telecoms didn't add any value. In fact, the benchmark's telecom return was approximately 7%, but DXM's index only earned 5% from its telecom holdings.
Overall, sector allocation decisions led to relative outperformance in all but three out of the 10 GICS sectors: industrials, materials, and health care. The only industrial firm held by DXM's index over the five years was Bombardier Inc. BBD.B, whose 2.6% annualized return trailed the 4.5% earned by the S&P/TSX Composite's industrial sector exposure.
Materials and health care companies were not included in DXM's index, but on average, made up 19% and 1% of the benchmark, respectively. This caused DXM's index to fall behind the benchmark, as materials returned 7% and health care stocks were up 12% during the period.
Even though the technology sector allocation of DXM's index led to a negative 0.08% return contribution, it was still able to beat the benchmark handily through security selection. In fact, tech turned out to be the greatest example of the strategy's stock picking prowess. The tech sector allocation sizes were relatively in line -- technology had an average weighting of 3.2% in DXM's index, compared to 3.5% in the benchmark. But, the tech exposure within DXM's index declined by only 2% annualized, while that of the benchmark plunged a whopping 15.5%. A good part of this outperformance was due to the dividend mandate employed by DXM's index, which helped it avoid getting burned in stocks like Research in Motion RIM. The benchmark, on the other hand, had a weight in RIM as high as 4%, before the shares came tumbling down.
Another useful framework for analyzing past performance is size, as measured by market capitalization. Here we find that mid-cap stocks ($2 billion to $7.8 billion) contributed 1.84% of outperformance versus the S&P/TSX Composite. At first, this led me to believe that the primary source of outperformance was simply its smaller capitalization exposure to the market. After all, DXM's index had a large relative overweighting to mid-caps of nearly 20%. However, a big part of the story was that DXM's index simply proved to be a better stock picker; the 6% return it generated from mid-caps trounced the 2% earned by the benchmark.
Interestingly, megacaps (market caps greater than $32 billion) were the only segment of the market, in terms of size, in which the index's stock picking led to underperformance. Here DXM's index picked up 3.8% of return, compared to 5.5% for the benchmark.
While the overall size profile of the index influenced performance, it's hard to ignore the index's superior security selection. This comes down to the index's ability to screen for academically proven fundamental factors while also integrating Computerized Portfolio Management Solutions' (CPMS) methodology.
For more information on Morningstar Direct and Direct's Attribution Analysis tool, please check out our product page or call (416) 484-7887.