TORONTO - Indexing is gaining popularity with Canadian fund investors, especially when it comes to playing the U.S. market. Over the past 15 months, the number of passively-managed open-end funds available to small investors has nearly doubled to 85. That is up from 44 at the end of 1997.

With $7.1 billion in combined assets (all figures in Canadian dollars), index funds still represent a small part of the fund universe. By comparison, mutual fund assets managed by member firms of the Investment Funds Institute of Canada (IFIC) totaled $340 billion at the end of the first quarter.

But index funds are growing at a much faster rate. In the first three months of this year alone, index funds - either mutual funds or insured funds known in Canada as segregated funds - attracted an estimated $1.5 billion in new money.

Of that total, index funds investing in the U.S. market garnered the lion's share of more than $1 billion. U.S. equity funds also have by far the most assets of any index category. Assets in U.S. equity index funds totaled just over $4 billion as of March 31, more than twice as much as the $1.6 billion held in Canadian equities, which were a distant second.

The rise to pre-eminence of U.S. equities in the index universe has been driven by a combination of factors, including the investment case for indexing in the U.S. - most actively managed funds underperform the S&P 500 - the desire of an increasing number of Canadians to diversify internationally, and cost savings on sub-advisory contracts.

"In general we're seeing this desire for more international exposure, particularly for the U.S.," said Karl Schulz, managing director of TD Asset Management, a unit of Toronto Dominion Bank of Toronto which is among the most prominent players in passive investing. "They want U.S. exposure, and the U.S. markets have done tremendously."

Schulz said the popularity of indexing in the U.S. equity category mirrors fund trends in the U.S. itself, where actively-managed funds have historically had a difficult time beating the benchmark Standard & Poor's 500 index.

"Index funds have done extremely well in that market," he said.

TD's Green Line U.S. Index Fund, launched in 1986 and investing directly in the S&P 500 stocks, was the first U.S. index fund available in Canada. Now there are a total of 33, the most numerous of any index fund category. Green Line alone has three U.S. index funds, with the two others being a Dow 30 fund and a derivatives-based fund which buys S&P 500 futures contracts.

One of the marketing challenges for fund companies is the relative lack of access to the U.S. market by Canadian investors saving for their retirement. Canadian tax rules impose a 20 percent limit in registered savings plans on foreign property, a quota which includes mutual funds investing mainly in U.S. or other foreign stocks.

The fund industry found a way to sidestep the quota by launching derivatives-based funds that hold most of their assets in Canadian money market instruments, and also buy derivatives such as S&P 500 index futures to mimic the performance of U.S. stock markets.

Twenty of the 33 U.S. index funds are derivatives-based and the total investments qualify for registered plans. The marketing advantage of this type of fund structure was evident during the first quarter of this year, the peak season for investing in tax-deferred plans. Led by the CIBC U.S. Index RRSP Fund, with estimated net flows of $150 million in the first three months, all five of the top selling U.S. index funds were derivatives-based and fully eligible for registered accounts.

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