PrefBlog

It looks like ZPR – BMO Laddered Preferred Share Index ETF, a $1.5-billion fund, has been operating contrary to the terms of its prospectus and the promises of its advertising for a significant period.

In the September PrefLetter I reviewed the salient characteristics of the fund as part of a (mostly!) regular series, in which I review the key investment characteristics of ZPR and CPD. This allows those interested to review the composition of their own portfolios – or of Malachite Aggressive Preferred Fund, which regularly reports the statistics in the same format – against those of the big funds, which may be taken as a reasonable approximation of the underlying indices. These articles may not be the most exciting things ever, but I found in November 2012 that the trading generated by the deletion of issues from the indices (due to insufficient trading volume) was sufficient to have the issues added back during the following revision. The index provider changed its rules the following month to stop this costly process (it appears that Solactive considered reinventing the wheel towards the end of 2017).

In the current review, an anomaly with ZPR was found with the ‘Reset Buckets’ of ZPR. These are supposed to be evenly weighted annually over the next five years, so that an equal value of the index resets over each year for the period, at which point the cycle begins again. This was not the case upon checking, though: in years measured from the evaluation date of 2023-7-31, PrefLetter’s table ZPR-6 showed that the highest weighted bucket was 1-2 years, with a weight of 26.46%, while the lowest weighted period, 3-4 Years, had a weight of 10.16%. That’s a lot of variance! Tabke ZPR-6A performed much the same calculation but with buckets defined by calendar years; issues resetting in 2024 had a weight of 27.15%, while 2027 came in at 11.55%.

The relative weights of the reset buckets were in much better alignment at the time of the 2020 ZPR Review: at that time the bucket weights ranged from a low of 16.72% to a high of 22.53%.

An analogous calculation is not available on ZPR’s main page, but fortuitously I found another report via another BMO page, which may be found by:
1. Go to the BMO ETF Dashboard at https://www.bmoetfs.ca
2. Type “Monthly Metrics” into the search box and search
3. The results page shows a link to “Monthly Metrics Summary – ZPR Canadian Preferred Shares”
4. Click to download the document.

This report shows the results of BMO’s analysis:

Note that minor differences are expected between my figures and theirs, because:
i) I calculated as of 2023-7-31; BMO claims their “Data as of September 6th, 2023”
ii) I use bid prices; I believe BMO uses closing prices.

I surmise that the relatively low weightings for the 2026 and 2027 buckets developed from the wave of redemptions in 2021 and 2022. A quick count of my records indicates that 23 FixedResets were redeemed in each of these two years which will, of course, have affected the weightings for the bucket in which the next reset was supposed to take place.

But it is clear from their own analysis that BMO is not delivering what it has promised:

From the prospectus for ZPR:

Solactive Laddered Canadian Preferred Share Index
The Solactive Laddered Canadian Preferred Share Index includes preferred shares that generally have an adjustable dividend rate and are laddered using equal weights in annual reset term buckets. Securities are market capitalization weighted within the annual term buckets. Constituents are subject to minimum market capitalization, quality and liquidity screens. Further information about the Solactive Laddered Canadian Preferred Share Index and its constituent issuers is available from Solactive on its website at www.solactive.com.

BMO Laddered Preferred Share Index ETF
The investment strategy of BMO Laddered Preferred Share Index ETF is currently to invest in and hold the constituent securities of the Solactive Laddered Canadian Preferred Share Index in the same proportion as they are reflected in the Index. The Manager may also use a sampling methodology in selecting investments for BMO Laddered Preferred Share Index ETF to obtain exposure to the performance of the Index.

As an alternative to or in conjunction with investing in and holding all or some of the constituent securities of the Solactive Laddered Canadian Preferred Share Index, BMO Laddered Preferred Share Index ETF may invest in or use Other Securities to obtain exposure to the performance of the Index.

BMO ETF	Current Index	Rebalancing and Adjustment
…	…	…
BMO Laddered Preferred Share Index ETF	Solactive Laddered Canadian Preferred Share Index	Rebalanced monthly
…	…	…

From BMO’s main page on ZPR:

Portfolio Strategy
BMO Laddered Preferred Share Index ETF has been designed to replicate, to the extent possible, the performance of the Solactive Laddered Canadian Preferred Share Index, net of expenses. The Fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index.

Benchmark Info
The Solactive Laddered Canadian Preferred Share Index includes Canadian preferred shares that meet size, liquidity, listing and quality criteria. The Index uses a five year laddered structure where annual buckets are equal weighted while constituent securities within each bucket are market capitalization weighted.

We can also look at the Index Provider’s (Solactive) role in this affair:

From the Solactive Methodology:

The Solactive Laddered Canadian Preferred Share Index includes preferred shares that generally have an adjustable dividend rate and are laddered using equal weights in annual reset term buckets. Securities are market capitalization weighted within the annual term buckets. Constituents are subject to minimum market capitalization, quality and liquidity screens.

2.1 Selection of the Index Components
The initial composition of the Index as well as any ongoing adjustment is based on the following rules:
The Solactive Laddered Canadian Preferred Share Index includes preferred shares that generally have an adjustable dividend rate and are laddered using equal weights in annual reset term buckets. Securities are market capitalization weighted within the annual term buckets. Constituents are subject to minimum market capitalization, quality and liquidity screens.

On the Selection Days, Solactive AG defines its Selection Universe. All instruments that fulfil the Solactive Laddered Canadian Preferred Share Index Universe criteria stated under 4. are eligible for inclusion in the Solactive Laddered Canadian Preferred Share Index.

The preferred shares in the Solactive Laddered Canadian Preferred Share Index Universe are clustered by their Maturity bucket. There are 5 Maturity buckets available: 1 year, 2 years, 3 years, 4 years, and one bucket covering instruments for 0 and 5 years to maturity.

Each Maturity bucket (except from the bucket covering instruments for 0 and 5 years to maturity) must consist of at least 5 preferred shares. If less preferred shares are part of one bucket, than the bucket will be refilled with preferred shares that are closest to the respective Maturity bucket. If still less than 5 preferred shares are included in one bucket, the Index Committee will decide about the composition of the respective Maturity bucket.

2.3 Extraordinary adjustment
If an instrument included in Index is removed from the Index between Adjustment Days due to an Extraordinary Event, if necessary, the term bucket would be reweighted based on the market capitalization of the remaining issues. This is announced by Solactive AG after the close of business on the day on which the new composition of the Index was determined by the Committee. The Index is adjusted with one Business Day notice if possible.

In particular an “Extraordinary Event” is
– a Merger
– a Takeover bid
– a delisting
– the Nationalisation of a company
– Insolvency.

An Index Component is “delisted” if the Exchange announces pursuant to the Exchange regulations that the listing of, the trading in or the issuing of public quotes on the Index Component at the Exchange has ceased immediately or will cease at a later date, for whatever reason (provided delisting is not because of a Merger or a Takeover bid), and the Index Component is not immediately listed, traded or quoted again on an exchange, trading or listing system, acceptable to the Index Calculator,

But this is the Solactive announcement with respect to IAF.PR.I, which was redeemed effective 2023-3-31:

Redemption | IA FINANCIAL CORP INC NON-CUM CONV RED PERP PFD REGISTERED SHS A SERIES I | 3rd April 2023
Due to the redemption of IA FINANCIAL CORP INC NON-CUM CONV RED PERP PFD REGISTERED SHS A SERIES I, the following treatment will be applied to the following indices:

IA FINANCIAL CORP INC NON-CUM CONV RED PERP PFD REGISTERED SHS A SERIES I will be removed from the Index.
The weight of IA FINANCIAL CORP INC NON-CUM CONV RED PERP PFD REGISTERED SHS A SERIES I (IAF_pi.TO) based on its last close price will be distributed pro rata to remaining Index constituents.
Effective Date (open): 03/04/2023
Solactive Laddered Canadian Preferred Share Index
Solactive Laddered Canadian Preferred Share Index PR
Solactive Canadian Rate Reset Preferred Share Index (TR)

However, this announcement was not followed by the announcement of an “Extraordinary adjustment”, which would seem to be required by Section 2.3 quoted above. I have sent a query to Solactive.

But oddly enough, it’s hard to find anything that says explicitly that the so-called Maturity Buckets (they’re actually reset-date buckets!) are to be equally weighted and how this is to be accomplished, other than the general statement in the Index Specifications listed above. The closest I can find is:

1.6 Weighting
On each Adjustment Day each Index Component of the Solactive Laddered Canadian Preferred Share Index is weighted according to the Market Capitalization of the respective preferred share within the term buckets. The weights are capped twofold on a Selection day, whereas a cap on an issuer basis is applied of 12.5% per issuer on a selection day as well as a Cap of 20% per Maturity Bucket.

A “Cap of 20% per Maturity Bucket” sounds pretty good, but does that refer to the issuer weight within each bucket or the weight of the bucket relative to the total index? It’s not clear at all. There are only six references to “Maturity Bucket” in the entire document and section 1.6 is the only one that refers to anything like a cap.

So I currently have inquiries in at both BMO and Solactive and we’ll see what comes of those in the coming weeks. I suspect that right now both parties are enthusiastically blaming each other; my own conclusion is that:
1. The index definition is flawed in that it is insufficiently precise regarding what they call “Maturity Buckets”, what their weighting should be, and what happens when their relative weights get distorted by new issues or redemptions. The parties are equally to blame for this.
2. If, as I surmise above, the problem developed due to the wave of redemptions in 2021 and 2022, then it is clear that, whatever one part of BMO was doing with its “Monthly Metrics” report, there was no internal monitoring happening by which a problem such as this could be caught early and corrected.

Update, 2023-9-27 : I found an academic reference that looks like it will be useful when I write this up formally, a paper by Adriana Robertson titled Passive in Name Only: Delegated Management and ‘Index’ Investing:

This Article provides the first detailed empirical analysis of the landscape of U.S. stock market indices. First, I hand collect detailed information about the universe of indices used as benchmarks for U.S. mutual funds. I document substantial heterogeneity across indices and find that the overwhelming majority of the indices in my sample are used as a primary benchmark by only a single fund. I then turn to “passive” index funds and find that both these phenomena are even more extreme among the indices that these funds track. Far from being “passive,” my findings indicate that index investing is better understood as a form of delegated management, where the delegee is the index creator rather than the fund manager. Finally, I turn to ETFs and find that a substantial fraction of these funds track indices that they or their affiliates create. Even controlling for other factors, I find that these funds have, on average, higher expense ratios. My findings shed light on an overlooked part of the financial market and have substantial implications for investor protection.

Update, 2023-10-6: Further reference data to be used in a formal write-up can be found in the Statistics Canada page Distributions of household economic accounts for income, consumption, saving and wealth of Canadian households, second quarter 2023, specifically the table used as source data for the article’s tables: Distributions of household economic accounts, wealth, by characteristic, Canada, quarterly (x 1,000,000) with the “Statistics” setting at “Value per Household”.

Update, 2023-11-2: See the October, 2023, PrefLetter for more information.

Update, 2024-3-1: See the post HIMI Releases Research Into ZPR for more information.