Would you buy a pig in a poke? Probably not. But when you buy some index-based exchange-traded funds, the sponsors are asking you to buy an investment with some key features left unseen.
Of course, its not phrased that way. The preferred term of art is that the index provider employs proprietary criteria to arrive at the group of stocks in that particular index.
Most indexes are transparent, relying on a set of rules that are available for advisors and their clients to see. There are some traditional exceptions among U.S. stock indexes: Both the Dow Jones Industrial Average and Standard & Poors 500 Index are not rules-based. Instead, they rely on stock selection by committee. Since the committees work in secret, neither benchmark has ever claimed to have a transparent selection process.
S&P 500 Dividend Aristocrats Index, which includes stocks in the 500 that have increased dividends for 25 consecutive years, is based on rules. The same is true of the S&P High Yield Dividend Aristocrats Index, a benchmark of 20-year dividend boosters based on the broader S&P 1500 index. But since committees select both parent benchmarks, you can never be completely certain what will turn up in these dividend indexes.
On the other hand, though the Dow Jones Industrial Average is a committee project, other DJ-branded indexes, including the Dow Jones U.S. Dividend 100 Index and the Dow Jones U.S. Select Dividend Index, are constructed using published rules.
Basic rules governing index construction can be fairly broad. The WisdomTree Dividend Index has liquidity and capitalization requirements, but the main criterion is that a stock pays dividends.
NASDAQs set of Dividend Achievers indexes is rules-based and more restrictive. Most of these indexes require stocks to have 10 consecutive years of higher dividend payments to qualify. But there is one benchmark to which NASDAQ adds a secret sauce. The NASDAQ US Dividend Achievers Select Index forms the basis for the Vanguard Dividend Appreciation ETF (VIG), the most popular dividend-oriented ETF in the country. What are the proprietary criteria used to narrow the selection of stocks that are included in VIG? Nobody will say.
|Index-based, Exchange-Traded Funds|
|Based on indexes that are transparent about their methodologies, and others that keep the details under wraps.|
|Dividend indexes mentioned||ETFs tracking them||Ticker|
|Rules-based but derived from committee-selected parent index:|
|S&P 500 Dividend Aristocrats||Proshares S&P 500 Aristocrats ETF||NOBL|
|S&P High Yield Dividend Aristocrats||SPDR S&P Dividend ETF||SDY|
|Dow Jones U.S. Dividend 100||Schwab U.S. Dividend Equity ETF||SCHD|
|Dow Jones U.S. Select Dividend||iShares Select Dividend ETF||DVY|
|Morningstar Dividend Leaders Index||First Trust Morningstar Dividend Leaders Index Fund||FDL|
|WisdomTree Dividend Index||WisdomTree Total Dividend Fund||DTD|
|Rules-based using proprietary criteria:|
|NASDAQ US Dividend Achievers Select Index||Vanguard Dividend Appreciation ETF||VIG|
|Northern Trust Quality Dividend Index||FlexShares Quality Dividend Index Fund||QDF|
|Source: Company websites|
Whatever the restrictions, the evidence suggests that Vanguard created the proprietary criteria used in this ETF and its underlying index. In the first place, some hidden criteria were in place before NASDAQ acquired the index from Mergent in 2012. Vanguard launched the fund in 2006. Secondly, Vanguard has the sole right to use the index. As the Vanguard website notes: This index is a subset of the NASDAQ US Broad Dividend Achievers Index and is administered exclusively for Vanguard by NASDAQ.
Strange that a fund company owned by its clients will not tell its owners what methodology is used to create this investment.
Although VIG is the most prominent example of proprietary selection criteria, it isnt the only one. At the end of 2012, Northern Trust launched its FlexShares Quality Dividend Index Fund (QDF).
The ETF is based on the companys own Quality Dividend Index. According to Northern Trusts website, the first screen used to select stocks for this index is quality, as defined by our proprietary scoring model.
The dictionary defines proprietary as pertaining to ownership. Although the definition implies exclusive use, it does not imply secrecy. Since 2006, investors have been able to buy the First Trust Morningstar Dividend Leaders Index Fund (FDL). As First Trusts website indicates, the ETF is based on an index that uses Morningstars proprietary multi-step screening process. Although that may look like a dead end, a quick search of Morningstars website will uncover the complete index methodology.
With dividend ETFs, you dont have to buy a pig in a poke.
Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poors weekly investment advisory newsletter, The Outlook.