Field Notes Get Ready for the i60s
IN PRINT ARCHIVE CIR Fall 1999
|Get Ready for the i60s|
|by Eric Kirzner|
One of the most efficient investment products for passive investors is the so-called index participation unit (IPU). IPUs are exchange-traded securities that represent a basket of stocks, which in turn replicates a specific underlying market index. IPUs trade on exchanges just like stocks, at a specific designated IPU-to-index ratio.
After some false starts in the United States, the first successful IPU saw its debut in March 1990. It was the Toronto Stock Exchange's Toronto Index Participation Shares (TIPS), based on the Toronto 35 Index. This early success was followed by another IPU, originally named HIPS and based on the TSE 100 Index. The products were subsequently renamed TIPS 35 and TIPS 100 respectively.
The TIPS structure has served as a prototype for subsequent IPUs, including SPDRs based on the Standard & Poor's 500 Composite, and WEBS based on individual Morgan Stanley Capital International indices.
The S&P/TSE 60 share index, introduced Dec. 31, 1998, is a capitalization-weighted index comprised of 60 of Canada's largest companies, including the big five Canadian banks. The S&P/TSE 60 Index is scheduled to replace the Toronto 35 and TSE 100 indices over the next year or so.
In April 1999, the S&P/TSE Canadian Mid-cap and S&P Canadian Small-cap indices were introduced as well.
All of the TSE indices, including new and existing transitional ones, will be calculated and maintained by Standard & Poor's. Instead of a 100-company arbitrarily chosen and rounded index, the new S&P/TSE 60-share index is designed for institutional investors--since it contains stocks institutions actually want to invest in. The emphasis is on liquidity.1
A More Representative Index
The i60s are almost identical to TIPS. It trades at approximately one-tenth the value of the S&P/TSE 60 Index. If, for example, the S&P/TSE 60 Index is quoted at 404.19, the IPU will trade at about $40.42.
Any tracking error (deviation of the IPU from one-tenth of the index), will reflect rounding effects due to index adjustments, accrued dividends, accrued management expenses and impending takeovers.
Like TIPS, the new IPU will collect dividends on the underlying companies as paid, but will pay quarterly dividends to unit-holders. The management expense ratio (MER) will be 17 basis points; thus there will be a small tracking error.
TIPS, in contrast, have covered their expenses through security lending and the dividend float--operating with virtually no expenses and maintaining a near perfect tracking record as a result. Nevertheless, 17 basis points is a competitive MER.
The new product will be RRSP-eligible. If the IPU is not approved by U.S. regulators for ownership by U.S. residents, Barclays intends to produce a U.S. version and list it on the American Stock Exchange.
What Happens Next?
Although i60s are almost identical to TIPS, there is an interesting difference. TIPS 35 and TIPS 100 are both based on passively-managed indices--i.e. inclusion in the index is subject to a set of specific inclusionary ranking rules that are not subject to interpretation. On the other hand, the S&P/TSE 60 is an actively-managed index. An S&P selection committee manages the inclusion of companies in the index using fundamental valuation criteria. The key criteria are size (assets and market capitalization), liquidity and sector leadership.
Only time will tell whether the active approach to index management will prevent Bre-X and YBM Magnex-type scandals passing through the analytic screen and making it into the index.
2. The Montreal Exchange, to which all Canadian derivative trading will be transferred by Nov. 1999, unveiled its S&P/TSE 60 share index derivatives products in early September.
3. A number of index derivatives have been introduced and subsequently de-listed in Canada over the past 15 years. Canada's index derivative trading volume and open interest in both absolute and relative terms has been much smaller than expected, given the size of Canada's equity market.