Dan Hallett

New Canadian ETFs

Yesterday, Barclays Global Investors unveiled the finishing touches on a much-anticipated line of exchange-traded funds (ETFs) for Canadian investors. Back in October, I wrote about the newly announced issues, but most of them only begin trading this and next month, with a couple delayed until the second quarter of this year.

Over the past couple of years, Canadian indexes have been the subject of over-concentration. At its peak last summer, Canadian-resident gorilla Nortel Networks occupied a mammoth 45% weighting in the large cap S&P/TSE 60 index. Despite the low cost of the original i60 units (MER of 0.17%), an ETF tracking this index, the once appealing index fund had grown into a concentrated play on technology, and Nortel in particular. A slowing economy and reduced corporate growth projections have cut Nortel's share price by nearly 75%, though it still accounts for more than 17% of the large cap index.

This concentration was a real problem because it violated one of the fundamental tenets of index investing - broad diversification. In response, Barclays is launching the i60 capped units, which will track this same large cap index, while limiting any one issue to no more than 10%. While that solves one problem, it could create another. When a stock has strong relative strength and it exceeds the 10% threshold, this ETF will be forced to continue to trim exposure by selling shares, resulting in higher turnover and realized capital gains. However, unless Nortel regains strength sometime soon, it shouldn't be an immediate issue.

Another announced offering is the iMidCap fund, which tracks the S&P/TSE MidCap index. Unlike all of the other new ETFs, this one has no constraint on the weighting of any one company. Other new funds are sector-specific ETFs tracking energy, information technology, gold, and the financial services subindicies. All of these sector ETFs will constrain an individual company to a maximum of 25% of the respective funds.

While I still maintain that investor behavior can render sector-specific ETFs more dangerous than helpful for some, the growing Canadian ETF universe is a positive for two reasons. First, giving investors more investment alternatives to gain stock exposure is a positive, especially when low fees are attached. Second, Canadians with a net worth of at least US$1.2 billion face potential U.S. estate taxes when buying ETFs domiciled in the United States. Since U.S.-based ETFs still dominate in terms of fees and variety, many remain invested in such securities as "diamonds" (DIA) and "spiders" (SPY). A wider variety of domestic ETF choices could reduce or eliminate this issue for some.

What's next? We're anxiously awaiting the launch of fully RRSP-eligible ETFs tracking the S&P 500 and the MSCI EAFE index. Canadian investors are still limited to holding no more than 30% of the book value of their registered retirement savings plans (RRSP - the Canadian version of IRAs) in "Canadian content" holdings. However, index funds get around this rule by simply putting up about 20% of the fund's assets to purchase index futures, while keeping the remainder in Canadian treasury bills. Effectively, it gives a fund full exposure to the underlying index while counting as Canadian content, since at least 70% of the money is actually sitting in Canadian cash. Index funds are currently available for such exposure with fees as low as 0.50% per year. It is the hope of Canadian indexers that fees will be no more than 0.30% per year, but only time will tell. These derivative-based ETFs are scheduled for launch early in the second quarter of this year.

02/20/2001

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.