What are the pros and cons of using index participation units instead of equity mutual funds?

Index participation units (IPUs) are a passive rather than actively managed investment, which let you match the returns of the corporations that make up a particular stock market index. IPUs are created by stock exchanges.

When you buy IPUs, you are signing on with a trust whose assets are the shares of the particular index. These shares are held by the trust in the same proportions reflected in the index. The trust pays quarterly dividends to unit holders based on dividends and other distributions received on shares held by the trust. Stock dividends, rights, warrants and other distributions received by the trust are sold and the proceeds distributed to unit holders. The IPU units themselves, unlike a mutual fund, trade on a stock exchange.

When you invest in i60s, you are buying a share of a fund made up of the 60 companies in the Standard & Poor's/TSE 60 Index. The index is supposed to be representative of Canada's economy and the companies in it are among the biggest and most heavily traded in the country. These companies include Royal Bank, Canadian Pacific and Nortel Networks.

Each i60 unit is worth about 10% of the value of the S&P/TSE 60 Index. If the index is trading at 400, a unit would be worth about $40. The trading symbol is XIU.

Here are some advantages of using index participation units:

• IPUs can be a cheaper alternative. The annual on-going expenses you paid through the management expense ratio (MER) for an actively managed Canadian equity mutual fund in 1997 averaged 2.19 % of the value of the funds' assets, according to The Globe and Mail. Unlike mutual funds, there are no, or relatively low, management fees to pay on IPUs, but there is a commission to buy or sell them. Some Canadian equity mutual funds -- index funds -- are similar to IPUs because they buy the stocks which make up a particular stock index. Their MERs average about one per cent.
• IPUs are a simple product since you don't have to decide on which stocks to buy and sell.

Here's some disadvantages of using IPUs.

• If the stock market falls, your returns will fall with it. A mutual fund manager may be able to take action to minimize losses in a bear market by shifting some of your money into non-equity assets such as cash or bonds.
• You may be better off using an actively managed equity mutual fund if you pick a manager who beats the stock index return.

You can hold IPUs inside your RRSP. But if you do, the earnings, when you take them out as income, won't qualify for the special tax treatment available on capital gains or on dividends from Canadian corporations. That's because Revenue Canada taxes all income coming out of an RRSP at your full tax rate, the same as interest. It doesn't matter how the earnings were generated. IPUs would produce gains mainly in the form of capital gains and dividends from corporations.

Here are examples of other IPUs:

SPDRS (pronounced "Spiders"):   The American Stock Exchange's Standard and Poor Depository Receipts (SPY/AMEX), link your returns to the S&P 500 Index.

Diamonds:   The American Stock Exchange's Diamonds (DIA/AMEX) -- based on the Dow Jones Industrial Average (DJIA).

WEBS:   World Equity Benchmark Shares. Offered by the American Stock Exchange, WEBS let you invest in one or more of 17 countries outside of the U.S. Each WEBS Index Series seeks investment results generally matching the performance of a given foreign stock market, using the Morgan Stanley Capital International (MSCI) index for that country.

Index participation units can be bought through your broker.

You should consider seeking professional advice before making any investment decisions. An investment or strategy appropriate for one investor might not be right for you.