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NEW BARCLAYS' S&P 500 ETF
Could be stiff competition for index fund providers

After a long delay, Barclays Global Investors officially launched its much anticipated fully RRSP-eligible ETF tracking the S&P 500 index ("i500R fund"). One might wonder why all the fuss, given the wide availability of US-based ETFs and Canadian-based index funds tracking the S&P 500. The answer is two-fold: cheaper fees and full RRSP-eligibility. While we are still awaiting Barclay' s 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 has increased from 10% many years ago 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% or 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

Basic details of this new ETF are highlighted below.

Fund Name: iUnits S&P500 Index RSP Fund
Short Name: i500R
TSE Ticker: XSP
MER: capped at 0.30%
Trading Debut: May 29, 2001

There exist approximately 55 investment funds tracking a large-cap US 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.

The cheapest RRSP-eligible S&P 500 index fund is the TD US RSP Index e-Class with a MER of 0.48%. CIBC also offers its US Index RSP with a MER of 0.32% for those willing and able to invest a minimum of $150,000 in CIBC's family of index funds (which actually qualifies investors for a fee rebate on all index funds). CIBC's MER is 0.96% for investments of less than $150,000.

All fully RRSP-eligible funds ("RSP funds") use derivatives and, as such, 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 US equity RSP funds track the identical index. While most of them track the S&P 500 index, some have full exposure to the US dollar while others do not. 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. Among RSP funds tracking the S&P 500 index, the CIBC US Index RSP is the only one tracking the index in Canadian dollar terms. The new i500R fund also tracks the S&P 500 index in Canadian dollars. This gives investors full exposure to the currency movements of the Canadian dollar against the US dollar.

While US-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 US at the time of death. With this "death tax" ranging from 18% to 55% of the value of US 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 US 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 visit Barclays Canadian ETF site www.iunits.com to get more information on the i500R fund and to keep updated on the status of new offerings.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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