March 14, 2005

Foreign content implications
Further impact of rule change

The federal budget's lifting of the foreign content limit caused joy across the mutual fund industry. But it also caused some confusion about the timing of changes in response to the cap's lifting.

Clone funds and the PR coup

Starting on the day after the budget was tabled, mutual fund companies – starting with Brandes – began dropping fees on clone funds. In some cases, press releases say that clone fund management expense ratios (MERs) are being brought “in line with the MERs of underlying funds”. But mutual fund companies seem to have triumphed from PR - even though such measures are potentially misleading.

True, MERs on clone funds – if reduced – are approximating fees of the underlying funds they were designed to mirror. However, the MER is not the total cost. Recall that clone funds use customized derivative contracts – usually forward or swap contracts – to effect the same exposure as an existing foreign fund. For instance, TD Global Select-I is designed to mirror TD Global Select RSP-I.

But even with the same MER, a clone fund will lag its underlying sibling by about the cost of the customized derivative contracts. Let’s use the two TD funds above to illustrate. Over the past five year, the two funds had nearly identical MERs. Yet TD Global Select RSP-I trailed TD Global Select-I by an average of about 0.5 percentage points per year. How so?

The performance gap (which will vary from year to year and is also affected by fund flows) is almost precisely equal to the cost of the derivative contracts noted in the prospectus. See page 4 of this TD Asset Management prospectus, which states,

“Although the performance of each RSP Clone Fund is linked to that of its corresponding underlying fund, the cost of entering into the forward contracts may cause the performance of each RSP Clone Fund to lag behind that of its underlying fund. Based on the contracts negotiated by the RSP Clone Funds, we estimate such costs will be approximately 0.20% to 0.40% per year. There is no assurance these costs will not increase.”

If this still doesn’t make sense, consider the wording above taken from the TD prospectus. At the top of page 15, the cost of derivative contracts is referred to as a transaction cost. Recall that transaction costs of non-clone funds – i.e. costs of trading stocks – are not included in the MER. Instead, they are treated as capital expenses. As such, they are embedded into the amounts of securities purchase and proceeds from securities sold.

The point of all of this is that clone funds still cost more, even if they sport a MER equal to the fund that it tracks. So, reducing MERs is a good measure but the extra cost remains. However, even this is of little consequence since the budget is likely to be passed and – as a result – clone funds will be merged into the history books.

Canadian equity funds

An outstanding question remains how companies will change their respective investment policies of Canadian equity funds. As it stands today, there are those that hold little or no foreign content (i.e. ‘Canadian Equity (Pure)’ category). And there are those that make liberal use of the foreign content limits. It is this latter group about which questions remain.

Will some Canadian equity funds effectively turn into global funds? Will such funds keep operating under a foreign content limit of about 30%? Will they turn into ‘pure’ funds?

These are questions on the minds of investors, advisors, and mutual fund executives. What we’re likely to see is a split. The ‘pure’ funds are likely to remain as such. But to continue qualifying for inclusion in the CIFSC’s Canadian Equity category, such funds will have to hold at least half of all assets, and 70% of all non-cash assets in Canadian stocks.

Those managers that have become accustomed to holding 20%-30% foreign content are likely to want to exceed the limit. This likely includes the largest funds in the category, in addition to those managed with a GARP (growth at a reasonable price) or strict value style. Most of these price-sensitive managers are finding better investment ideas outside of our borders. With Canadian stock prices having capped a second consecutive strong year, there are few – if any – bargains left in Canada with enough liquidity for these managers to buy.

So, expect many funds to be redesigned around the criteria that define the Canadian Equity category. More flexibility is always a good thing but the problem that already existed – that of Canadian equity funds holding relatively little in Canadian stocks – will worsen. And this is, and will continue to be an issue for those desiring greater asset allocation control.