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iShares S&P500 Index

The iShares S&P500 Index fund, as its name implies, aims to closely mimic the performance of the S&P500 index. At the end of 2003 the fund had recorded a one-year total return of 28.51% compared to the index's 28.68%. Created in May of 2000, the fund was down an average of 4.14% annually over three years compared to the index's average 4.05% annual loss. The difference in long-term performance, the fund's so-called tracking error, is mainly due to the fund's very low management expense ratio of 0.09%.

As one of the iShares series of exchange-traded funds offered by Barclay's Global Investors, the fund is managed by Barclay's Global Fund Advisors. Its investment strategy is simply one of replication, which means that the fund buys all of the stocks in the S&P500 in quantities sufficient to reproduce the index weights. As a rule the fund holds at least 90% of its assets in the stock of index components. In practice that figure is usually much higher.

The fund can charge very little because passive strategies are usually less expensive to implement than active strategies. One can point to two main reasons for this. First, the makeup of its portfolio is determined by the components of the index which means that the fund doesn't have to do detailed in-house security analysis. Second, the index is a relatively static list of stocks, which means that the fund doesn't do a lot of trading, which reduces brokerage costs. Indeed, the fund's average turnover is remarkably low at less than 5%.

Most investors must go to the stock market to buy units of the fund. It trades on the American Stock Exchange (AMEX) under the IVV ticker symbol. However, big institutional investors (usually called authorised participants) can purchase (or redeem) so-called Creation Units, which represent 50,000 regular fund units. When a Creation Unit is purchased, the number of regular units increases. The buyer pays for Creation Units by delivering a basket of stocks corresponding closely to the fund's portfolio. This means that the fund doesn't have to buy these stocks on the stock market, and thus avoids brokerage comissions. Large market players can also choose to redeem Creation Units. When this happens the fund delivers a corresponding basket of stocks to the seller and 50,000 regular fund units cease to exist.

The fund currently holds 501 stocks and a 0.04% cash position. 500 of these stocks are components of the S&P500 index. The extra stock is Piper Jaffray Companies Inc. (PJC), which was spun-off of index component U.S. Bancorp(USB) at the end of 2003. U.S. Bancorp shareholders received shares of Piper Jaffray in the form of a stock dividend, which explains the presence of the stock in the fund. This holding will no doubt be sold shortly. At the end of the year the index sported a 3.5% earnings yield, a 1.8% dividend yield, and a price-to-book ratio of 3.1. The 3.5% earnings yield is equivalent to a price-to-earnings ratio of 28.3. As a result, the index, and therefore the fund, was quite expensive from a value perspective.

Because it is traded on an exchange, market supply and demand may cause the price of the fund to differ from the net asset value (NAV) of the underlying portfolio of stocks. This makes exchange-traded funds (and closed-end funds) different from conventional mutual funds, which are always priced at their NAV. However, the Creation Unit mechanism used by exchange-traded funds means that any significant price mismatch creates an arbitrage opportunity for authorised participants. As a result, premiums and discounts to NAV for exchange-traded funds are expected to be neither very significant nor long-lived. By way of illustration, the iShares S&P500 index fund closed at $113.82 on January 15th, whereas its closing NAV was $113.53 (a 0.25% premium). Moreover, during the fourth quarter the market price discount to NAV exceeded 0.5% on only two days. In contrast, closed-end funds, which have a fixed number of units, often trade at a very significant premium or discount.

The Creation Unit mechanism is often claimed to have favourable implications for the tax efficiency of exchange-traded funds. For instance, no taxable capital gains are realized when institutional investors redeem Creation Units because the fund doesn't have to sell stocks on the market to raise cash. At least that's the theory. There exists conflicting data regarding the relative tax efficiency of exchange-traded funds and traditional index funds. Strong counter-arguments have been made that suggest that the tax efficiency benefit may be marginal at best. A resolution of this ongoing debate will have to wait until exchange-traded funds fully mature.

The iShares S&P500 Index fund offers all of the advantages of an exchange-traded fund for a very low 0.09% management expense ratio. The fund is suitable as part of the core component of a Canadian investor's foreign equity holdings. However, because of brokerage commissions, the fund is inappropriate for investors who want to make small periodic investments. Frugal investors who find the simplicity of indexing appealing, and are looking to stay invested for the long term, may want to consider adding the iShares S&P500 Index fund to their well-structured portfolio.

FF: Q4 2003

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Disclaimers: Consult with a qualified investment advisor before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...