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I've done some research into the S&P500 index funds that are fully RRSP elligible. Most of you probably recall the earlier messages we posted questioning why the performance of these funds does not truly match the S&P 500. I called up CIBC Securities to get some info. I spoke to Mark Smith, Client Line Supervisor. He can be reached at 1-800-465-3863. Here's what I found.

First - these funds work by buying future contracts to the S&P500. For example, for every 100 dollar contribution, about 5 dollars will go towards buying the contract (on margin). The other 95 dollars will go into T-bills which pay interest. When the future contract matures, the fund is obligated to take the profit or loss, rather than an option, which you don't have to do anything with. This should help you to understand how the fund operates.

Second - why aren't the returns faithful to the S&P500? Well, this is because of a few things.

1) the MER is 0.9% on CIBC's fund.
2) CIBC's fund is not hedged against currency movements . Their fund buys contracts in $US, so if, for example, the US dollar appreciates relative to the CDN dollar, this fund will show outperformance relative to the S&P. If and when the CDN dollar corrects, this fund will lag the S&P. If you believe that in the long run there will be no significant movements, then this fund will faithfully follow the index over the long haul.
3) The fund recieves interest on the T-bills. This interest will more or less offset the interest charged to the fund on the margined purchase of the contract. Of course, the net interest is not going to be zero. If they gain from interest, it will help the fund and if they lose from interest, it will hurt the fund.

My conclusion is that this type of fund is good for Canadians because it allows them to invest in the US market without any foreign content limits. For most of us on this board, however, we are not going to invest that much in an index because we would rather do our own research. I feel that this type of fund could be used in much the same way as the Fool port (Rule Breaker Port) uses SPYders. Something to hold your cash in while looking for BETTER investments.

Does anybody have questions about this? I want to make sure we have a good understanding of how these funds work.


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FrozenCanuck wrote "..for every 100 dollar contribution, about 5 dollars will go
towards buying the contract (on margin). The other 95 dollars will go
into T-bills which pay interest."

I am not sure I understand this completely. If the fund invests 95% of its contributions into T-bills, how is it ever going to outperform S&P 500 overall?

For example, let us say T-bill returned 5% and futures returned 15% then the overall return should be (0.95x5% + 0.05x15%) = 5.5%

Am I doing this wrong?

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<I am not sure I understand this completely. If the fund invests 95% of its contributions into T-bills, how is it ever going to outperform S&P 500 overall?

For example, let us say T-bill returned 5% and futures returned 15% then the overall return should be (0.95x5% + 0.05x15%) = 5.5%>

I can't say I know exactly how it is done, but I suspect the answer has to do with the leverage that comes with investing in S&P 500 futures. A future is an obligation to buy or sell the underlying security or thing (eg, stock indexes or pork bellies)) at a certain time for a certain price. With stock index futures, the trade is settled in cash. (With "thing" futures, the trade can be settled in the underlying thing (eg, 10000 pounds of coffee, or whatever is the proper trade size for the commodity in question).)

The scary thing about futures (as compared to options) is that your loss is potentially extremely high. Correspondingly, the potential gains can be extremely high. That's because a future contract allows you to control a large amount of the underlying thing/index for only a small amount of money (the margin). Look in the newspaper under "future prices" and find the one for the S&P 500. In the National Post, you see "250 x index points; 0.10 pt. = $25 per contract". Someone who knows better can correct me, but I think this means that one contract controls 250 x the index value on any day. If the S&P is at 1200, each futures contract would be worth $300,000. But because you can buy on margin, you'd only have to put up some small percentage. I don't know what the margin is. If it's 5%, that would be $15,000. If the market rises 10%, to 1320, the future is then worth 250 x 1320 = $330,000, which means you've doubled your money in our example(or you've lost everything, or worse, if it goes the other way). So, because of the leverage, you only need to invest a relatively small proportion of your entire portfolio in futures to achieve the same results you would have from making a direct investment in the underlying index. At least, I think that's how it works.
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Jacko2, you seem to have all the answers.

Well. Here is what scares me:

Suppose there was a crash, and the S&P 500 lost half its value in one day. Would this be enough to blow the lid off the whole equation and sink the fund?

Might the loss exceed their margin, forcing them to liquidate so many T-Bills that they end up with nothing?

Someone would have to convince me that the fund would track the S&P through abnormal events (like a crash) as well as normal trading before I'd put my money in.

For now I do keep 1/3 of my money in indexes, but I have been using TSE:HIP and AMEX:SPY (I also refuse to give my money to an index MF that charges me a large MER, where large is anything >0.25%).
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Whether or not a synthetic index fund carries a super risk depends on the nature of the futures contracts they hold. For a fund trying to mirror the S&P 500, they would use 20% of their assets to purchase SPX options. If all they do is buy puts or calls, the most they can lose is 20% per quarter. If they sell naked puts and are on the wrong side of a market crash, they would have to cash in T-bills to deliver on their mistake. Since they are leveraged to the gills, one bad mistake like that could sink them.

I would bet that they only buy options, or that if they sell, they sell in covered combinations to limit their risk (i.e. if they short the S&P by selling a 975 put, they also buy the 950 put to cover their tail).

I used to own TD's US RSP fund, and they do not even begin to explain their options strategy in their prospectus. I bailed out in August because I was sure the melt-down you described above was going to happen. It didn't, but I'm still not comfortable with investing in a "black box mutual fund."

Hey Bubba! Give me $10,000 and I'll invest $8,000 in money market instruments and give the other $2,000 to a suit on Bay Street and let him try to track the S&P. Trust me, he's good. He just got out of college.

I'll pass.

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<Jacko2, you seem to have all the answers. >

I've been trying to convince my wife of this very thing, lo these past nine years. Without success. :)

Your point about what would happen to these synthetic index funds is a good one. I think the answer lies in knowing, exactly, how any particular fund makes its investments. They aren't all the same; you've got to go fund by fund. From what I've read, some use only index products, while others use a combination of index products with actual stock (though of course they can't break the 20% limit, there). To the extent the stock didn't have to be liquidated in a sell off, there would be some recovery possible.

Also, if the fund uses only options to make its foreign index investments, then the risk will be quantifiable and limited only to the amount paid for the option. If the market drops 50%, the options will be worthless, but there won't be any call on the rest of the fund assets.

It's when the fund uses straight futures contracts that the possibility of huge losses arises, as the fund would have to meet margin calls. But the fund managers are smart enough to figure that out. Any bet on the market rising can be hedged to a greater or lesser extent. It's too bad you haven't been helped by the fund reps you've talked to. It's probably a case where you have to talk to the people pretty much doing the day to day trading for the fund.

But if the fund does meet its margin calls, it will be able to hold on to the position and hopefully see some recovery. There may be political ramifications, too: Would the CIBC, for example, allow one of its funds to tank? One hopes that someone would pony up the necessary margin. (Someone who knows more about how futures markets are played would be more help here.)

A further complicating factor for Canadians comes from currency. Take the CIBC US index fund, for example (I forget its exact name). It's performance has been beating the socks off the S&P 500, its target index. One explanation I've read is that that fund didn't hedge for currency. So when the Canadian dollar fell significantly against the US$ this past Spring, the fund got a huge boost to performance. (And as you rightly point out, it will take a whack if (when?) the Cdn$ ever rises against the US$.)

Another point is this: You talk about liquidating the T-bills to meet the margin. I have only a bare understanding of investing in futures, but I don't think you've framed the question correctly. As I understand things, the T-bills would be held to fulfill the margin requirements. They don't disappear; while they are margin, they still belong to the fund. I think the danger would come where the fund has committed all of its liquid assets to margin, and then the market drops, triggering a margin call which the fund wouldn't be able to meet. (Or that the market is still down, thus locking in any loss, when the contract matures.) I would guess that the fund would have investment guidelines that would prevent this sort of thing from happening.

Here's a basic example of the danger you're talking about: a fund holds one futures (long) contract on the S&P500, which they bought when the S&P was 1000. Such a contract is worth US$250 a point, so it controls $250,000 when bought. On the buy the fund has to put up a margin of 5% of $250,000 = $12,500. Index futures contracts are settled in cash, by the difference between the contract price and the index on the closing date of the contract. Say the market drops to 500 at delivery. The contract is then worth $250 x 500 = $125,000. The loss would be 250000 - 125000, which is 10 times the margin. Whether that's a big loss to the fund depends on how much they started out with, and whether they hedged or not. (The cost of hedging will chip away at returns, of course.) These derivative funds are typically quoted as having almost all their assets in T-bills. If that is so, then on this example, a 50% drop in the derivative could cost a fund its entire asset base. (Which is your point.)

I hope that someone in the financial press will write more about these things.
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