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.