Silent Partner

From Our Canadian Bureau: Canadian impact of MSCI index changes may be small

Silent Partner

MSCI's change in index construction methodology has been well covered by's resident experts. In summary, the change in methodology will increase market coverage to about 85% by excluding stock holdings held by governments and company insiders. This will result in a higher weighting in energy and technology stocks, while decreasing the weights of telecommunications and other utilities stocks. On a country level, Japan will be cut while the U.S. will be bumped up a few notches. However, the impact on Canadian investors has not yet been assessed.

Index mutual funds are relatively new to Canadians. Though many charge high fees, there are approximately 220 index funds available to Canadian investors (excluding institutional pools), according to Morningstar Canada. This number is somewhat inflated because it includes funds with the word "index" in the name even if it's not an actual index fund, so let's call it 200. Only about 45 track some non-North American index - Europe, Asia Pacific, Eurasia, EAFE, emerging markets, and Japan. Only 13 of those funds have a three-year track record to the end of May 31, 2001, and all have a compound return under 8% annually for that period. Since most international index funds available in Canada have only been around for four years or less, the tax impact of MSCI's changes may be minimal to nonexistent, so there may be not much of a tax hit to avoid.

For instance, the TD International Index fund is the oldest Canadian fund tracking the MSCI EAFE index, but it was only launched in June of 1997. Its top fourteen holdings add up to nearly a quarter of the entire portfolio. Based on year-end cost and market values, and the planned adjustments by MSCI, the top holdings should see turnover of about 12 to 15% - resulting in a net capital loss of about 3% of net assets. It's important to note those numbers are only relevant for one-quarter of the fund at the end of 2000, but the figures are consistent with TD Quantitative Capital's internal estimate of 15% turnover for the entire fund. (TDQC runs all of TD's index products.) TDQC plans to coordinate its implementation of the index changes with MSCI's November 2001 and May 2002 conversion dates. Hence, it is too early to give any good estimate of tax implications.

Canada's other major index fund sponsor, CIBC, is taking a slightly different approach. CIBC plans to implement the index changes over the next twelve months, but won't necessarily be sticking to the November and May dates set by MSCI. TAL Global Asset Management, a wholly owned CIBC subsidiary, manages the affected CIBC Index funds and will be given the flexibility to be opportunistic (i.e. active management) in their timing of adding and deleting constituent stocks. (TAL is best known in Canada as an active management shop, both in the retail and institutional segments of the industry, making extensive use of quantitative models.) While that might sound like voodoo to index purists, CIBC index fund investors shouldn't fret. Despite the active management flexibility CIBC is granting, TAL has also given fairly tight constraints under which to exercise its opportunistic approach so as to minimize tracking error.

For instance, TAL is constrained to making the transition within two months of MSCI's set dates (i.e. can't start before September 2001). If TAL fails to identify any suitable opportunities in that time frame, the funds will simply implement the changes in synchrony with MSCI.

Here is a guide for what you can do:

  • Look through your portfolio to determine if you hold index funds.
  • Verify which indexes your funds track. For those funds not tracking some MSCI index, the changes discussed here will have no impact. If one or more of your funds tracks a MSCI index, some changes may be necessary.
  • Starting in mid-November 2001, start contacting your index funds' sponsors for estimates of capital gains distributions. They are normally available during the second half of November or early December.
  • Determine the gain that has built up on your affected index fund holdings. If it's less than the estimate given by your index funds' sponsors, it may not be worth taking any action.

This should help you decide on the course of action that is best suited for you, but for most it is a good idea to consult a qualified advisor. My suspicion is that most Canadian index fund investors won't need to do anything, but of course each case is different. Also, market activity and your index fund sponsor's chosen implementation strategy can significantly influence the final impact on investors.

Dan Hallett, B.Comm., CFP is Senior Investment Analyst with Sterling Mutuals Inc. Sterling Mutuals Inc. is registered as a Canadian mutual fund dealer in Ontario, British Columbia and Manitoba.