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Introduction - BMO's Promises for BMO Laddered Preferred Share Index ETF (ZPR)

It has become clear that BMO must withdraw and revise its prospectus dated January 17, 2024 for its Exchange Traded Funds: the description of BMO Laddered Preferred Share Index ETF (ZPR) is inaccurate. Clients must be advised of the past inaccuracies in the description of the fund and compensated for the risks they unknowingly shouldered.

The prospectus states:

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.

Regretably, this is not correct. The investment strategy of the fund is not, in fact, to "hold the constituent securities of the Solactive Laddered Canadian Preferred Share Index in the same proportion as they are reflected in the Index." Not even close, as will be seen in the following discussion.

The fund's main web page is more specific than the prospectus in describing the fund's holdings:

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.

Again, this assertion regarding the fund's holdings are not true, as will be demonstrated below.

These statements are repeated in the humorously titled "ETF Factsheet" dated 2023-12-31 available via the fund's web page:

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.

The "ETF Facts" publication dated 2024-1-17 is more circumspect:

What does the ETF invest in?

The ETF seeks to replicate, to the extent possible, the performance of a Canadian preferred share index, net of expenses. Currently, the ETF seeks to replicate the performance of the Solactive Laddered Canadian Preferred Share Index (the "Index"). The Index includes rate reset preferred shares that generally have an adjustable dividend rate and are laddered with equal weights in annual reset term buckets. Securities are market capitalization weighted within the annual term buckets.

BMO has been very careful in the "ETF Facts" publication to make only minimal claims regarding ZPR - it is the Solactive Index that is described in loving detail. However, even the tepid claim that "The ETF seeks to replicate, to the extent possible, the performance of a Canadian preferred share index, net of expenses." is not well supported by the facts regarding the fund's holdings or its performance, as will be demonstrated below.

Reset Date Distribution

"Laddering" is obviously considered crucial to the fund's success according to BMO's marketting staff - the concept is emphasized in the very name of the fund! The following table shows the distribution of reset dates by calendar year:

There a very significant difference between the index weight and the ZPR Weight as calculated by HIMI. The differences between the HIMI and the BMO assessments of the portfolio weight by calendar year of reset may be explained as being due to market movement in the period between the two assessments and the fact that HIMI uses bid prices, rather than closing prices, to determine position values.

The Index weights are within reasonable tolerance of the 20%-per-calendar-year ideal; the ZPR weights are grossly different,varying in a range of 11.38% to 27.69% (according to BMO's own figures) - that is, BMO reported that the heaviest weighted reset year had more than double the weight of the least weighted year on 2023-10-31.

This is not only contradictory to the statement of the prospectus, it also contradicts assertions made on the fund's main web page, as highlighted in the Introduction.

Issuer Concentration

In the December edition of PrefLetter I published the following tables:

and

These are very large variances for a fund that purports to be a passive index fund. Of particular concern is the very large degree of underweighting of the Brookfield empire ("the BN Group"). Such huge variances from index weights are not at all appropriate for a self-styled "index fund".

Individual Issue Weight Variances

As I remarked in my December report:

Table ZPR-1A is very similar to its equivalent published in the November issue, with the change that not all of the highlighted issues are in the 2026 term bucket. I can think of nothing better to say than repeating my observations from the November issue, most importantly:

There may be a reason for this: a good reason would be that BMO is experiencing difficulties in filling up the bucket and so is scrambling buy whatever it can that can be counted towards meeting its 20% commitment for this term. A bad reason would be that we also notice the severely underweighted issues all have relatively high index weights; BMO highlights [on their website] the top ten holdings in [the ZPR Portfolio], which range in weight … and they may have determined that showing higher weights (particularly the large index allocation to BCE.PR.K!) would worry their customers; in other words, deviating from the index methodology for purely cosmetic purposes. Having five members of their ‘Top 10’ all being in the same bucket could, possibly, be deprecated similarly.

BMO’s highlighted ‘top ten holdings’ in ZPR has changed a bit from that reported in the November issue and the weights of these issues now ranges from 1.62% (RY.PRJ) to 1.22% (TD.PF.I).

It is also notable that over 12% of ZPR's value was held in issues that were not present in the index.

Performance

The December edition of PrefLetter also included a table reproducing the performance figures provided by BMO:

I cannot stress highly enough how ludicrous these number are: ZPR outperformed its index by nearly 4% (after fees! The underlying portfolio outperformed by over 4%!) in the year to October 31 - we would normally tip our hats and cheer portfolio managers with this ability, but ZPR is advertised and sold as an index fund!

Well over half of the tracking error of the fund appears to be due to the horrific performance of the BPO preferreds, which had a total return of about -50% in the year to October 31. It will be recalled from the section "Issuer Concentration" that ZPR was grossly underweight in BPO's preferreds - I estimate that well over 200bp of the tracking error was due to this particular circumstance alone.

BMO has informed me of a statement from the Portfolio Management Team:

We optimize the portfolio given the nature of the market, we’ve also been underweight BPO (given its downgrade concerns all last year and which it finally did get downgraded).

Credit Anticipation is certainly a valid strategy - for an actively managed fund. Optimizing the portfolio given the nature of the market might be thought of as being the entire philosophy of active management, albeit subject to disputes regarding the exact nature of the optimization. But the fund is sold as an index fund and, as outlined in the introduction, active management in any form is not part of the fund's mandate; the word "index" is part of the name of the fund; this fund is being sold to investors who have seen the downside of active management and have attempted to avoid the inherent risks that an active manager will get it wrong.

This enormous tracking error is at distinct variance with the repeated claims that "The ETF seeks to replicate, to the extent possible, the performance of a Canadian preferred share index, net of expenses." At the very least, this calls the basic competence of BMO to manage any index fund at all into question.

BMO's Stonewalling

On 2023-9-7, I asked BMO:

Can you comment on the relative distribution of the reset effective dates, in light of the assertions that "annual buckets are equal weighted" and "The Fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index."?

Despite almost weekly follow-ups in the five months since then, BMO did not answer these questions, although they intermittently responded with unrelated comments.

A Response, of sorts, from BMO

I notified BMO of my intent to issue a press release and provided them with a draft, together with access to a draft of this web-page.

They responded with:

Re: BMO Laddered Preferred Share Index ETF (TSX: ZPR)

We acknowledge receipt of your email sent to BMO ETFs Client Services on February 8, 2024 containing your draft press release relating to ZPR. The draft press release is inaccurate.

ZPR’s portfolio holdings are consistent with its investment objective, strategies and risks set out in the prospectus dated January 17, 2024 (Prospectus) and associated marketing materials.

To achieve ZPR’s investment objective, the portfolio manager, in its discretion, may use and does use the following investment strategies as disclosed in the Prospectus:

• Invest in, and hold the constituent securities of, the Index in the same proportion as they are reflected in the Index.
  • The Index currently includes Canadian preferred shares that generally have an adjustable dividend rate and are laddered using equal weights in annual reset term buckets. Constituent securities are market capitalization weighted within the annual term buckets and are subject to minimum market capitalization, quality and liquidity screens.
  `
• A sampling methodology may be used to select investments for ZPR.
  • Sampling means that the portfolio manager selects securities from the Index to obtain a representative sample of securities that may resemble the Index in terms of key risk factors, performance attributes, industry weightings, market capitalization and other appropriate financial characteristics.
• The selection of securities will also consider each security’s liquidity and trading cost when determining its inclusion in ZPR’s portfolio.
• As an alternative to, or in conjunction with, investing in and holding all or some of the constituent securities of the Index, ZPR may invest in or use other securities to obtain exposure to the performance of the Index.
• ZPR may also hold cash and cash equivalents or other money market instruments to meet its current obligations.
• ZPR may also invest in or use derivative instruments and may engage in securities lending transactions to earn additional income for ZPR.

As disclosed in the Prospectus, the risks associated with an investment in ZPR include, but are not limited to, index tracking risk, index investment strategy risk and general risks associated with preferred shares which may impact ZPR’s performance. Within index tracking risk several factors may contribute to a difference in performance between the Index and ZPR such as management fees, trading costs, applicable taxes, sampling differences, regulatory constraints and liquidity events.

We trust that the above adequately addresses the issues you raised in the draft press release.

Well! There's a lot there about what the fund can do, but precious little about what it does do! So I wrote back:

Thank you for your letter of February 14.

You emphasize that the prospectus provides a number of avenues towards achieving the fund's investment goals, which include both investing in and holding the constituent securities of the Index in the same proportion as they are reflected in the index; and a sampling methodology, in addition to other avenues of investment.

Unfortunately, you have neglected to take account of the phrase from the prospectus that I quoted in my draft press release: "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." This assertion is found on page 107 of the prospectus, which is page 116 of the PDF.

This statement is unequivocal regarding the current investment strategy of the fund, while preserving the option for the Manager to alter the investment strategy in the future. The statement is unqualified by any further statements and has been considered so important to the marketing of the fund that it has been substantially repeated on the fund's web page at https://www.bmogam.com/ca-en/products/exchange-traded-fund/bmo-laddered-preferred-share-index-etf-zpr/ under the heading "Portfolio Strategy" and in the Factsheet downloadable from the same page.

Regrettably, this statement is false. The fund does not currently "hold the constituent securities of the Solactive Laddered Canadian Preferred Share Index in the same proportion as they are reflected in the Index". The variances are enormous and have led to gross distortions in the laddering of the portfolio as the term is understood by investors and a huge tracking error that could quite possibly have been unfavourable. I will also note that, as discussed in the supporting material, I have been advised by BMO staff that the fund's underweighting of BPO issues was due to downgrade concerns - this is Credit Anticipation, an active management strategy most certainly not permitted by the prospectus.

It seems possible that our disagreement is due to a difference in interpretation of the prospectus' phrase in question. How do you interpret the phrase? How does your Compliance department and the OSC interpret the phrase?

... and received the answer ...

The phrase in question relating to ZPR’s investment strategy cannot be read in isolation and is qualified by other statements in the prospectus. For example, see the disclosure under the sub-heading “Specific Investment Strategies of the Index BMO ETFs” on page 100 of the prospectus.

Thank you for your inquiry. We have answered your questions and now consider this matter closed.

Well, if they "consider this matter closed", there's not much point in writing them again! So I noted in my press release:

BMO claims that the quoted sentence “cannot be read in isolation and is qualified by other statements in the prospectus”, but this is not well-supported by the evidence – a discussion is embodied in the supporting commentary linked below. Hymas remarked that he will leave it to investors to determine for themselves whether they believe BMO’s claim, noting that the ‘same proportion’ claim is repeated on the fund’s web page without any qualifying statement; the fund’s “Factsheet” – which may be obtained from the fund’s web page – repeats the web page’s unequivocal yet false assertion.

Sadly, the press release was never issued. I contacted two major press release distribution companies and was firmly informed that disparagement of other companies was not allowed in press releases - this being interpreted as any material that might cause members of the public to hesitate before buying the target company's stock. This is a far cry from the halcyon days of 2006, when I issued three press releases denouncing some specific new issues as being overpriced! But now I understand why Muddy Waters' et al. issue "research notes" on their websites publicized, no doubt, by an eMail blast to journalists on a carefully maintained distribution list.

The full section referenced by BMO in the fund's prospectus dated January 17, 2024 reads (page 107 of the prospectus, which is page 116 of the PDF):

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.

I interpret the prospectus language as: 'In order to meet our obligations, we employ strategy A. We may switch to strategy B in the future. As an alternative or in conjunction with strategy A or B, we may also employ strategy C.'

Neither of the two succeeding sentences qualifies the word "currently" in any way - and, in any event, the first sentence is substantially repeated in the fund's main web page and the "Factsheet" as highlighted in the Introduction, without any qualifications whatsoever.

And if the prospectus sentence "cannot be read in isolation and is qualified by other statements in the prospectus", why is BMO substantially repeating that sentence in isolation in their advertising?

Again, there are two distinct concepts being addressed: what the fund can do and what the firm does do. I suggest that the prospectus is unequivocal in stating what it does do in the first sentence of the extract.

Investors and other interested parties may make up their own minds about the prospectus and advertising language - but I think most will be surprised at the huge variance between the fund's holdings and the notional portfolio of the index.

It is also worth noting that an active management strategy is employed by the fund to some extent, as discussed under the heading "Performance".

What Should BMO Do Now?

As demonstrated above, BMO Laddered Preferred Share Index ETF cannot be thought of as being either laddered or an index fund.

BMO needs to make frank and full disclosure of its lapses in management and the inaccuracy of both its regulatory documents and its advertising, while explaining how it happened.

Investors must be compensated for the risks they were subjected to; risks which they had specifically attempted to avoid by investing in an index fund emphasizing laddering of reset dates. A one-year waiver of management fees for the fund seems appropriate to me - that amount of foregone revenue might attract some badly needed attention from upper management! Another possibility is to compensate investors for all the fees they indirectly paid while the fund's holdings did not reflect the information provided.

Further Resources

The information published in this web-page is derived from review articles in my monthly newsletter, PrefLetter. There were mistakes along the way (the project would have been much easier had BMO responded frankly to my questions!), but I have chosen to make my entire investigation public - some may find the mistakes amusing, other informative.

• September edition: This is a bare-bones effort, routine monitoring intended simply as a benchmarking guide for clients. It was quickly apparent that there was a big problem with the "laddering" of the portfolio, but this was discovered too close to the publication date to do anything more than write a query to BMO.
• October edition: In this issue I looked at some of the problems inherent in index investing and then reviewed ZPR's regulatory and advertising material. The Solactive index methodology was also reviewed. Unfortunately, a misreading of Solactive's communications to me resulted in my thinking that the problem with the Reset Date bucket weighting originated with Solactive - the index provider. I deeply regret not having performed a similar analysis of the index - but it simply did not occur to me that an "Index Fund" would have holdings so grossly divergent from the index!
• November edition: In this edition, I reported that the redemption of TD.PF.K, effective October 31, had provided me with the opportunity to check for changes in Solactive's methodology with respect to redemptions. But there were no changes from past practice, leading me to make further inquiries with Solactive; this in turn led me to analyze the index in conjunction with the ZPR portfolio, with surprising results! Another cause for regret: Solactive challenged my figures for their index and I had neglected to retain screenshots of the data, simply copy-pasting it into a spreadsheet.
• December edition: And, finally, in the December edition I presented another analysis of both ZPR and the index, this time being careful to retain screenshots of the Solactive data! There were no substantive differences from the November report, but I did add two new sections: one discussing "edge effects" as they relate to quantitative investment strategies and one of the relative performance of the two portfolios.
• September, 2020 edition: Routine monitoring, showing little variance from expected reset-date distribution
• December, 2012 edition: A discussion inspired by the launch of ZPR.
• ZPR: Serious Problems with Reset Date Bucketting: A post on PrefBlog summarizing the problem as I understood it in September.

As an external resource I thoroughly recommend the following academic paper which discusses various ways in which index investing is more complex, both philosophically and legally, than is often thought:

• Adriana Z. Robertson, Passive in Name Only: Delegated Management and “Index” Investing, 36 Yale Journal on Regulation 795, available on-line at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3244991 (accessed 2024-02-24)