In a series of posts last month, I looked at ETFs from Horizons and Claymore that use derivatives rather than simply holding the stocks or bonds in their underlying indexes. A number of readers responded by saying that they were wary of non-traditional index funds and preferred to use the plain-vanilla variety. What they may not realize is that several Canadian index mutual funds also use derivatives to get exposure to foreign stocks. You may even own one without even being aware of it.

Here’s a list of the funds that fall into this category:

RBC US Index Currency Neutral (RBF558)
RBC International Index Currency Neutral (RBF559)
Altamira US Index (NBC846)
Altamira US Index Currency Neutral (NBC856)
Altamira International Index (NBC839)
Altamira International Index Currency Neutral (NBC877)
Scotia CanAm Index (BNS351)
Scotia NASDAQ Index (BNS397)

The above funds hold well over 90% of their assets in T-Bills and cash equivalents, and they get their market exposure by holding index futures. These are  agreements to purchase the stocks in the index at a contracted price on a specific future date. (Index futures are traded on an exchange, so they are transparent, highly liquid, and carry no counterparty risk.) The funds never actually take delivery of the stocks, however: they close out each futures contract before it settles and then enter into a new one. This is similar to the way many commodity funds get exposure to oil, natural gas, and precious metals.

A legacy from the past

To learn why these index funds don’t just hold the stocks directly, I spoke with Paul Mayhew, RBC Global Asset Management’s VP of Research and Product Development. He explained that the structure is a legacy from the past. “To understand the current versions, you have to go back to when the funds were launched in 1998,” Mayhew says. “Back then we had foreign content limits in RRSPs.”

For investors too young to remember the 1990s, in those days you could hold no more than 20% of your RRSP in non-Canadian assets. This foreign content limit was raised a few times in the early 2000s and then abolished altogether in 2005.

“There were a lot of ‘clone funds’ at that time,” Mayhew explains. “Because of the derivative structure, they could hold, say, 95% of the assets in Canadian money market instruments while the rest was set aside as margin for futures contracts. That allowed you to treat the fund as Canadian from a content perspective, but it got you exposure on a dollar-for-dollar basis to the foreign stocks in the S&P 500 or the MSCI EAFE.”

These old foreign content rules explain why the funds were originally set up using derivatives, but why do they still operate this way? Why not just switch to a traditional strategy and buy up all the stocks in the index? I’ll answer that question later this week.