Field Notes Get Ready for the i60s

Field Notes
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.

Something New
A new Canadian IPU debuted in September 1999. Based on the S&P/TSE 60 Index, this new IPU--called iUnits S&P/TSE 60 Participation Units (or i60s)--trades on the Toronto Stock Exchange under the trading symbol XIU.

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
As a more representative index, it should foster more interest in derivatives trading.2 This is turn could mean improved liquidity for the Canadian index derivatives market.3 Furthermore, since the indices are managed by Standard & Poor's, it will mean the separation of the listing and indexing functions.

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?
What will happen to the existing TIPS 35 and TIPS 100? There are three possibilities. First, the existing TIPS could be merged into the new S&P/TSE 60 Index. Since TIPS have historically had virtually no tracking error, and assuming that the new IPU is maintained in the same manner (except for the MER), such a merger could be performed in a perfectly seamless manner. Second, the Toronto Stock Exchange may choose to list and quote the Toronto 35 and TSE 100 indices for the indefinite future and allow the two TIPS products to continue to trade. Third, the TSE may choose to de-list the two TIPS products, as per the trust agreement, by selecting a specific date at which all TIPs are closed in a manner similar to the expiration of a cash-settled futures contract. Given the near zero tracking error of the product, this approach should work in an equitable manner.

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.

1. Since there will be a single large cap index instead of both the Toronto 35 and TSE 100, liquidity will be consolidated.

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.

Transcontinental Media G.P.