" It's a tough decision to cap an index constituent"
Canada can lay claim not only to creating the world's first exchange-traded fund and its first fixed income ETF (see ETFR, January 2001), but also to having what is currently the cheapest ETF in the world (Dow Jones Canada 40). Quite a track record for a country with a small market and a small-but growing-cadre of ETFs.
And while it may be difficult for people in the US to admit that Canada could have the first of anything, the fact remains that the TIPS (Toronto Index Participation Units) was launched on the Toronto Stock Exchange in 1989. By comparison, the venerable Spider was launched on the American Stock Exchange in 1993.
There's no denying that the markets on both sides of the border are very different creatures. And it's not merely a question of breadth and depth or a less or more stringent regulatory environment. Much of the difference lies in the so-called Nortel effect.
The Nortel effect
Last year, the Canadian market went up very quickly and came down very quickly because of Nortel, a telecoms giant, says Keith Matthews, a Canadian financial advisor. As a result, some of the new Canadian ETFs are now restraining and restricting the dominant share-which for Canada is Nortel-to 10%.
But by capping ETFs, as Matthews and other industry observers suggest, the products approach active management, and thereby no longer exactly mirror the market. 'You almost have to be a little bit active on the Canadian equity portion of your client's portfolios, or you're forced to have a market with a dominant position,' says Matthews, a partner in PWL Capital Inc. 'Part of what an investor buys when purchasing a broad market ETF is diversification, and you're not really getting that when you index without a cap in the Canadian marketplace.'
The indexation problem facing Canadian is not new, and it's indicative of many small markets where a few companies are heavily weighted, says Howard Atkinson, principal of Barclays' National iUnits Marketing division. 'There was oil and gas many years ago, and there were mining issues some years before that, and recently it has been Nortel,' he says. Last year, Nortel climbed to a significant weighting within the iUnits i60, rising to over 40%.
One effect of the increase was to prompt Barclays to launch a capped ETF on February 22. The iUnits S&P/TSE 60 Capped Index Fund is a constrained market capitalization-weighted index calculated by S&P that tracks the S&P/TSE 60, which is the barometer for Canada's large cap blue chips. The two iUnits-the S&P/TSE 60 Index and the S&P/TSE 60 Capped Index-are identical, except that one is capped at 10%, and the management expense ratios of both are 17 basis points.
'Currently, the difference between the two isn't that great: a 10% weighting versus a weighting in the teens,' says Atkinson. 'However, at the time we were designing the capped product, the difference was between 10% and 30-40%.'
In addition to these two iUnits offering variations on Canadian Large Cap exposure, a third ETF trading on the TSE essentially tracks the same group of Canadian companies. The DJ Canada 40, launched by State Street Global Advisors, tracks a Dow Jones index, the composition of which has a high correlation with the S&P/TSE 60.
'We are basically in competition with the i60,' says Louis Basque, principal, SSGA/Canada. However, he adds, there is a cost advantage: The Canada 40 is an eight basis point product, which is less than half of the i60.
The Canada 40's low cost makes it a popular product. Yet the i60 still has the advantage: It has a large and historic asset base. When the i60 was created, it received all the rollover money from the TSE's two original products, the TIPS and HIPS (see sidebar), which had about a 10-year track record. And the very accumulation of such assets suggests an active investor base comfortable with ETFs and the i60 in particular.
While the i60 is still approximately 80% institutional, says Atkinson, the real momentum for these products seems to be on the retail side. 'I think when the product was originally launched by the TSE, it was a way for institutional fund managers to equitize cash and diversify,' he says. The wooing of the retail market is a recent marketing strategy.
Atkinson estimates that when the TIPS 35 was folded into the i60, the iUnit gained some $3 billion in assets, which makes it a hard product to dislodge. (For the week ending March 16, the i60 had C$4.8 billion-US$3.1 billion-in assets.)
Before the DJ Canada 40 can match the i60, institutions will have to start using it as a benchmark, and retail investor awareness will have to increase. The Canada 40 is still a young fund, launched October 2000. For the week ending March 16, it had some C$175 million (US$111 million) in assets, placing it at the top end of Canada's ETFs. (In comparison, in the US, the Spider closed with US$26 billion.)
And similar to the iUnits, the DJ 40 comprises the 40 largest and most liquid of Canadian stocks. The index is not capped; it's passive, permitting the underlying stocks to fluctuate based on their respective float. Nortel represents roughly 18% of the DJ 40 right now, and similarly in the i60, Nortel represents around 15%. But that overweighting corrected itself, to some extent, when Nortel declined recently.
Capping the index
'It's a tough decision to make whether to cap or not an index constituent,' says Basque. There are advantages to capping as well as drawbacks. Barclays' solution was to offer a capped and uncapped version of the same index, thereby giving investors a choice of company exposure.
'For the market we targeted, we thought it better to leave Nortel, or any index component, to fluctuate at will,' says Basque. The problem of capping a position at 10%, say, is that the portfolio is continuously traded as the stock gets readjusted within the index, which triggers capital gains, he says.
If a 10% ceiling is imposed, and if Nortel goes up, say, 12%, that two percentage point increase would have to be sold and additional buys placed on the 59 other stocks. If the next day, or the next revision date or quarter Nortel slides, the portfolio manager is still selling the stock along with the ETF's other constituents. 'It creates a lot of friction in the portfolio,' says Basque.
On the other hand, if the stock fluctuates at the market's will, there are fewer capital gains because there are fewer positions traded within the ETF, says Basque. And there were some unpleasant surprises this year due to larger than anticipated distributions, which were caused to some degree by portfolio construction issues, caps, rotation, portfolio revision and merger activity, he says.
Although capping is not a panacea, it is an attempt to solve the problem, says Matthews. There are two Canadian capped ETFs right now, the iUnit i60 and the TD TSE 300 Capped Index Fund, launched by TD Asset Management. 'But as a Canadian investment advisor, the call on the Canadian equity market has to be made as to how much Nortel our clients are comfortable with,' he says.
'That's very different from an American (or for that matter Canadian buying US market exposure) who can achieve US market diversification by purchasing one of many broad market ETFs tracking benchmarks, such as the S&P 500 or the Russell 3000,' says Matthews. 'The single dominant stock effect is simply not there.'