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Claymore ETF offers new indexing twist

A lesson the ETF crowd could learn from the mutual fund business is how to market a product properly.

What could very well be the next wave in exchange-traded funds began trading on the Toronto Stock Exchange yesterday under the oh-so-catchy name of ClaymorETFs FTSE RAFI Canadian Index Fund. FTSE RAFI? Doesn't he play right wing for the Czech hockey team?

There are some unique wrinkles to this new ETF that deserve attention from both investors and the financial industry. But with a handle like ClaymorETFs FTSE RAFI Canadian Index Fund (CRQ is the symbol), you have to wonder how retail investors, at least, are ever going to get the message.

A fund firm would have used a snappier name, maybe something like Index Beater or Index Plus. Because, really, this is what the ClaymorETFs fund is all about.

The proprietor of the fund, Claymore Investments of Toronto, describes the process used in its construction as fundamental indexation, or you can call it enhanced indexing. Whatever the term, the process is about discarding the basic indexing principal of simply mirroring a stock or bond index and instead screening the index to remove certain stocks while including others.

An indexing purist might scoff at this, saying that the screening process isn't much different from the active stock picking used by conventional mutual funds. This stock picking can help a fund beat the index, but it routinely fouls things up so that a fund underperforms.

The ClaymorETFs fund is based on the FTSE RAFI Canada Index, which comprises 63 stocks that stand out on the basis of four criteria: total cash dividends, free cash flow, total sales and book equity value, which measures the total value of capital and undistributed profits that have been generated throughout a company's history and is available on its books.

Incidentally, FTSE refers to FTSE Group, a manager of stock indexes that is owned by the London Stock Exchange and the Financial Times newspaper, while RAFI stands for Research Affiliates Fundamental Indexation, in honour of Research Affiliates LLC, the company that created the indexing strategy used in the fund.

The purported advantage of this strategy is that you avoid doing what typical index funds or ETFs always do, which is put the most emphasis on companies with the biggest presence in the index. Arguably, the biggest companies as measured by market capitalization are the most highly valued and thus vulnerable to a pullback.

While the ClaymorETFs fund does provide some active management, its 0.65-per-cent management expense ratio is far cheaper than the average Canadian equity fund at about 2.5 per cent. Then again, comparable Canadian market ETFs have MERs as low as 0.17 per cent.

Claymore Investments says $10,000 invested in the FTSE RAFI Canada Index in 1999 grew to $34,092 by the end of last year, while the same amount invested in the S&P/TSX 60 index would have turned $10,000 into $17,769 with dividends included. Don't put too much credence in these numbers, impressive as they are. People have been trying to outsmart the major stock indexes since forever, and almost no one can seem to do it consistently.

Does that mean fundamental indexing is just a fad? Not at all. The PowerShares ETF family in the U.S. market (owned, interestingly, by the fund company Amvescap PLC, which runs the AIM and Trimark names in Canada) also uses this strategy for its products.

And then there's Dimensional Fund Advisors, a well-respected U.S.-based company with Canadian operations that offers a family of funds based on a process of enhanced indexing.

Expect to see more ETFs and index funds that use enhanced indexing strategies, not only because of the belief that they can outperform, but also because they help ETF issuers out of a problem they've created out of their own success.

In an effort to sustain the flow of new products, these firms have exploited almost every stock and bond index known to humankind. It's hardly an exaggeration to say that there's not much left, other than to base ETFs on the benchmark stock index in places such as Uzbekistan or Bolivia.

For individual investors, the biggest benefit to investors of the ClaymorETFs fund's appearance on the scene yesterday is a greater selection of ETFs. Barclays Global Investors, with its iUnits family, dominates the sector and the only other player, Toronto-Dominion Bank's fund arm, is pulling the plug on its unpopular family of four ETFs on March 13.

Claymore Investments is mindful of TD's ignominious retreat and expects to do better with its new fund. A suggestion to help things along: Change the name.

rcarrick@globeandmail.com

© 2007 The Globe and Mail. All rights reserved.

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