© Copyright 2000 Rogers Media. The following article first appeared in the November 2000 edition of BENEFITS CANADA magazine.

Grab an index

Exchange-traded funds are an effective investment instrument for pension funds. They can provide sector exposure with low risk.

By Barbara Clapham

Exchange-traded funds (ETFs) are gaining popularity with retail investors, particularly those who are tired of paying high management expense ratios for mutual funds that often do not beat the market. ETFs closely replicate the performance of an index such as the Toronto Stock Exchange (TSE) 300 composite index, with correlations as high as 99%. They cost less to boot.

Institutional investors, on the other hand, have been slow to embrace this product. Is there a place for ETFs in your pension plan?

ETFs are offered by a number of financial institutions and can be used by pension plans in several ways:

* A temporary place to park money. Pension plans tend to amass cash flows due to monthly contributions from employees. If these funds are earmarked for equity investment, they can be put to work in an ETF and benefit from immediate diversification and exposure to the marketplace.

* A passive investment tool for smaller pension plans. Such funds typically don't have the resources to engage in indexing on their own. Through one single transaction funds can effectively be indexed.

* A hedging instrument. Smaller pension plans often don't have access to traditional hedging instruments such as futures and options contracts used by larger institutions. As well, the use of derivatives may be prohibited by a plan's investment policy. ETFs are an alternative. The fact that ETFs are exchange-traded like a stock means an investor can borrow the security and sell it short.

For example, if a pension plan with $500,000 in exposure to major stocks on the TSE is concerned that the market is overvalued and may drop 10% to 15% over a given period, the manager can sell short the equivalent underlying amount of ETFs, thereby hedging the position. If the market declines, the plan will lose money on the $500,000 long position, but gain on the ETFs and offset the losses.

Bob Bertram, senior vice-president of investments at Teachers' Pension Plan Board in Toronto says that Teachers' would use this type of instrument on a short-term basis. "It is simply a way of trading in and out of a representative basket of Canadian equity. We alternately will use derivatives or exchange-traded funds or basket trading to be in and out of the market, wherever we can find liquidity," Bertram says. "However, they are not a long-term solution for us."

As a long-term investment, Bertram thinks ETFs are better suited to smaller pension plans, due to the cost, which is generally in the range of eight to 16 basis points. "Once the assets of a plan get up to, say, $3 billion or $4 billion, you should be able to get your costs on the cash index side down to about four or five basis points," Bertram says. "For smaller funds, it's a very efficient way to grab an index."

Through ETFs a pension plan can grab an index practically anywhere in the world. Don Lindsey, president and chief executive officer of the University of Toronto Asset Management Corporation points out that you can get sector exposure as well, "so if you want to overweight or underweight a particular sector [ETFs are] a good way of doing it." Although Lindsey is only considering the use of ETFs at present, he envisions buying them as a temporary tool to gain allocation to a market. "When we found an active manager to implement that strategy, we would reduce our exposure to the ETF and allocate to the active manager."

Barb Clapham is editor of Canadian Investment Review and a contributing editor to BENEFITS CANADA. bclapham@rmpublishing.com.

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CONFERENCES

Asset Securitization
November 21-22,2000
Courtyard by Marriott Hotel, Toronto

This conference will explain how to derive maximum value from the use of asset-backed securities. To register, phone the Institute for International Research at 1-800-941-9403 or e-mail cnadat@iir-central.com

Asset Securitization
Nov. 21-22, 2000
Courtyard by Marriott Hotel, Toronto

This conference will explain how to derive maximum value from the use of asset-backed securities. Call the Institute for International Research at (800) 941-9403 or e-mail cnadat@iir-central.com.

The Romanow Commission has released its final report on the future of healthcare in Canada.

For Commissioner Romanow's recommendations, click here.

Click here for Senator Michael Kirby's report, "The Health of Canadians – The Federal Role: Recommendations for Reform."