Why Do Index Funds Use Derivatives?

Earlier this week I described how several US and international equity index funds get their market exposure by using index futures rather than holding the stocks directly. This structure is partly a holdover from the days when Canadians could keep only a small portion of their RRSPs in foreign investments. But the question remains: now that foreign content rules are long gone, why don’t these funds just move to a traditional structure and buy all the stocks in the index?

I put that question to Paul Mayhew, RBC Global Asset Management’s VP of Research and Product Development. He explained that the non-hedged version of the US Index Fund actually does hold all the stocks in the S&P 500. However, RBC decided to continue with the old structure in the US and international index funds that use currency hedging, because futures contracts provide an easy way to manage the foreign exchange risk. More important, however, was the potential tax advantage of keeping the derivative structure intact.

Their loss is your gain

This is actually pretty counterintuitive. Funds that use index futures are not normally tax-efficient, because any gains are treated as interest income, which is fully taxable at your marginal rate. That didn’t make any difference when these funds were designed for RRSPs, of course, but if you hold these funds in a non-registered account today, the derivative structure could be a drawback.

However—in RBC’s case, anyway—it turns out to be a benefit. The reason is that over the years the funds have built up significant “non-capital losses” as they’ve renewed the futures contracts. The fund can carry these losses forward and use them to offset future gains.

A look at the funds’ financial statements (available on the SEDAR website) shows that the US Index Currency Neutral fund carried forward $64.9 million in non-capital losses last year, compared with $89.9 at the close of 2009. The RBC International Index Currency Neutral fund booked $101.9 million in losses at the end of 2010, down from  $117.2 million a year earlier.

No distributions doesn’t mean no returns

It’s important to understand why this is a good thing. Normally when you hold a mutual fund in a taxable account, dividends, interest and capital gains are automatically reinvested as soon as they are received. Then at the end of the year you get a T3 slip telling you how much you need to report on your tax return. In the case of these RBC index funds, however, you would not have received a T3, because all of the gains—which came via futures contracts, not actual dividends or stocks being sold at a profit—were offset by previous losses.

Sure enough, while RBC’s regular US Index Fund has always made annual distributions, the Currency Neutral version did not do so in the last three years, nor from 2001 through 2003. The RBC International Index Currency Neutral has paid taxable distributions in just three of the last 10 years. (See page 2 of the PDFs linked in this paragraph for the details.)

Mayhew says that about 90% of the assets in the two RBC currency neutral index funds are held in registered accounts, where this tax shield is irrelevant. And the benefit certainly isn’t guaranteed: the funds paid very substantial distributions from 2005 through 2007, when the S&P 500 and MSCI EAFE indexes saw large gains in Canadian dollar terms.

“They are still more appropriate for registered accounts,” Mayhew acknowledges. “But the losses provide a significant tax shield that should last for at least a few years.”

Disclaimer: I own RBC index funds in my own RESP accounts. The information in this post should not be considered tax advice. Always consult an accountant or tax advisor before making any investment decision for tax reasons.

8 Responses to Why Do Index Funds Use Derivatives?

  1. Lewin July 14, 2011 at 9:04 am #

    I’m a novice so correct me if I’m wrong, but aren’t all of those losses bad news for people who held the fund? Yes they might have some tax savings now, but presumably they’ve had significant capital losses over the past few years, right?

    (Maybe somebody will create an investment strategy based on looking up which funds have capital losses to carry forward and investing in those…!)

  2. Canadian Couch Potato July 14, 2011 at 9:58 am #

    @Lewin: A good question, and I have asked RBC for a response. However, it’s important to note that we’re talking here about non-capital losses. I’m trying to get clarification on how these differ from capital losses from the investor’s standpoint.

  3. Dan Hallett July 14, 2011 at 2:58 pm #

    Dan B – the treatment of those respective losses are basically the same for the fund as if incurred directly by any individual. Non-capital losses can be carried back three years or forward seven years. NCL can be used to offset any form of income.

    Capital losses can be carried back three years and forward indefinitely. CL can only be used to reduce taxable capital gains.

    To my knowledge, funds don’t tend to carry back losses but can and do carry them forward. Because of the time limit, a fund will generally elect to use non-capital losses first, then capital losses.

  4. Lewin July 15, 2011 at 2:54 am #

    Sorry, I guess I used the term “capital losses” incorrectly in my comment. I meant ‘capital loss’ for the individual, in the sense that the investor’s shares have gone down in value and are worth less than they were before, which probably outweighs any tax benefits.

  5. Canadian Couch Potato July 19, 2011 at 10:34 am #

    I received a reply from Paul Mayhew at RBC, which I think will clarify some of the confusion:

    “Dan Hallett has already accurately explained the differences between capital and non-capital losses.

    “I think the real question is about how the tax losses relate to investors’ experience owning the fund – i.e. ‘losses are bad news for people who held the fund.’ The underlying assumption seems to be that tax losses mean all investors lost money. That isn’t necessarily true.

    “As strange as it sounds, as an individual investor in this fund, your personal gain or loss has no direct relationship to the fund’s tax loss position.

    “Timing, for instance, is a much bigger factor. If you bought the fund in August 2008 – just before the market crashed – you might still be in a loss position. But if you bought it in March 2009 – just seven months later and before the market took off – you’ve probably made a double-digit gain. Either way, the fund’s tax position is the same.
    Another point to keep in mind with this fund is that gains and losses are realized every month. But only net gains can be distributed each year. Net losses are carried forward.

    “Timing plays a role again here. For example, if the fund earned a $2 net gain last year, that would have been paid out. If it then went on to have a $1 net loss this year – that would be carried forward. In this very simplified case – the books show a loss of $1 when the fund is actually up $1 when you go back and look at the gain paid out the year before. In other words, when you look at the tax position at a point in time, any losses are not offset by gains paid out in previous years.

    “I hope this clarifies things.”

  6. Jas March 28, 2013 at 6:57 pm #

    @CCP:
    Are these funds using derivatives good for taxables (non-registered) accounts?

    From what I understand from your post, index funds using derivatives can either be tax efficient if they have built up significant “non-capital losses” or not tax efficient if they didn’t since capital gains will be taxed as regular income.

  7. Canadian Couch Potato March 28, 2013 at 10:28 pm #

    @Jas: Yes, you’ve got the right idea. If the fund has not had any distributions in recent years, that’s a good sign.

  8. Jon August 3, 2013 at 8:29 pm #

    Just curious… but for your own RESP’s, why use RBC funds vs TD’s given the lower costs?

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