Dan Hallett

From Our Canadian Bureau: New iUnits S&P 500 ETF

After a long delay, Barclays Global Investors officially announced the launch of its much anticipated fully RRSP-eligible exchange-traded fund (ETF) tracking the S&P 500 index. One might wonder why all the fuss, given the wide availability of U.S.-based ETFs and Canadian-based index funds tracking the S&P 500. The answer is twofold: cheaper fees and full RRSP-eligibility. While we are still awaiting Barclays' similarly structured EAFE offering, this week's announcement is good news for Canadian investors and potentially bad news for Canadian index fund providers.

RRSP Eligibility

Canadian tax deferred savings plans, such as RRSPs (registered retirement savings plans - analogous to IRAs), RRIFs, (registered retirement income funds), and other variations thereof have long had restrictions on the amount of foreign content holdings permitted in such plans. It increased to 30% in 2001, based on book value. In 1992, the fund industry unveiled its first innovation designed to skirt this foreign content limitation - funds using index futures. Basically, any mutual fund that itself adheres to the foreign content limit by keeping at least 70% of its book value in Canadian content holdings is actually considered 100% Canadian content. Hence, the idea was to use index futures to gain foreign exposure without going offside on the foreign content limits.

The leveraged nature of futures contracts is what makes this work. Since they are leveraged securities, a fund need only hold about 10% to 20% of the fund's assets in index futures (considered foreign content) to effectively gain index exposure equal to the fund's total assets. The other 80% to 90% of the fund's assets are held in cash (i.e. - money market instruments) to cover the futures' margin requirements. Having this much sitting in Canadian-issued money market instruments is what qualifies the fund as Canadian content. The beauty of this, of course, is that it allows full exposure to the S&P 500 index without using up any of the precious 30% foreign content limit. Again, this is nothing new to the fund industry, but this is a first for ETFs in Canada.

Fund Industry Competition

In the table below, basic details of this new ETF are highlighted.

There exist approximately 55 investment funds tracking a large-cap U.S. stock index - mainly the S&P 500 index. However, only 17 actually have expense ratios under 1%, while just a handful can be found with expenses of 0.50% or lower. In the table below, RRSP-eligible US index funds with expenses under 1% are highlighted.

*Minimum of $150k in CIBC index funds is required to qualify for reduced MER.
**The assets of the A and e series are aggregated and total $561.9 million. The e-series of funds are only available over the Internet (i.e.- paperless transactions).

All of the funds listed in the table, along with the new Barclays ETF, are suitable only for tax-deferred accounts. The large cash component and the "marked-to-market" nature of futures results in a significant amount of annual taxable distributions. Hence, these funds are very inefficient from a tax standpoint.

It's also interesting to note that not all of the funds track the identical index. While all of the funds listed track the S&P 500 index, some have full exposure to the U.S. dollar while others don't. Over the past several years, it has been more beneficial for investors to have full currency exposure, since the Canadian dollar has depreciated against the greenback over time. Also, the currency exposure arguably adds to the diversification benefits sought by investors who deploy some of their investment dollars beyond Canadian borders. The new i500R fund tracks the S&P 500 index in Canadian dollars. This gives investors full exposure to the currency movements of the Canadian dollar against the U.S. dollar.

While U.S.-based ETFs offer some threat to Canada's fund industry, those traded on Canadian exchanges pose a much greater threat. Why? A large part of the reason stems from the fact that high net worth Canadians could get nailed with estate taxes if they hold securities domiciled in the U.S. at the time of death. With this "death tax" ranging from 18% to 55% of the value of U.S. property, it is much more attractive to find a homegrown low-cost alternative. Hence, a good case can be made for Canadian investors holding all of their U.S. stock exposure inside of RRSPs using these derivative-based funds. While futures contracts suffer from occasional mispricing, this is generally smaller than the cash drag and transaction costs involved in running a regular ETF or index fund holding stocks. Add in the lowest fees in the industry and the i500R fund, and future Canadian ETFs, could make a big dent in the market share of current index fund providers - primarily banks.

While we continue to anxiously await the launch of Barclays' fully RRSP-eligible EAFE ETF, investors can click here to get more information on the i500R fund and to keep updated on the status of new offerings.

Update on Canadian Equity ETFs

Shortly after my February article detailing the new Barclays Canadian equity capped index and sector offerings, TD Bank (one of Canada's largest index fund managers) launched the only ETF tracking the TSE 300 Total Return Index (TSE: TTF) and the TSE 300 Total Return Capped Index (TSE: TCF). The latter caps any individual holding at 10% of the fund. Fees are capped at 0.25% per year. Below is an update of diversified Canadian equity index ETFs currently available.

Dan Hallett, B.Comm., CFP is Senior Investment Analyst with Sterling Mutuals Inc. Sterling Mutuals Inc. is registered as a Canadian mutual fund dealer in Ontario, British Columbia and Manitoba.