Sometimes I kind of look at what I do as similar to a sell side analyst at a big I-bank. The only difference is instead of looking at stocks in a particular industry sector, I study ETFs. So consider this when reading below, as the first half is news regarding a revamping of index constitution and the second half is my speculation on changes to Canadian ETFs as a result.Thanks to Credit Suisse’s Quantitative Trading and Derivatives Strategy group for their “Index Analysis” report last week on some changes that will occur to S&P/TSX Canadian equity indices:

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- S&P has announced that the S&P/TSX SmallCap index methodology has been revised and the index will now be independent from (and may include overlaps with) the S&P/TSX 60 and Composite indices.

- The S&P/TSX MidCap index will be renamed the S&P/TSX Completion index - containing the stocks in the Composite index that are not in the S&P/TSX 60.

- These changes will become effective at the March quarterly review on March 16th, 2007.

- There are relatively few assets indexed to the current MidCap or SmallCap indices, so there should not be much index trading resulting from the changes.

Structurally, the new SmallCap index will have significant overlaps with the S&P/TSX Completion index (and by association the S&P/TSX Composite as well). Best guess, roughly 67% of the SmallCap index cap will be in the Completion/Composite indices (conversely, about 25% of the Completion index cap will be made up of SmallCap constituents). Therefore, this means that funds indexed to the Composite index would be “double-counting” a sizable portion of stocks if they decided to track the SmallCap index as well.

S&P decided to make this change after consulting with the Canadian investment community and feeling that this was what they wanted. In many ways, it is similar to Russell’s introduction of their MicroCap index in the U.S., which overlaps with the Russell 2000 SmallCap index. So far, it doesn’t seem as if the Russell MicroCap index has gained much traction, with many investors questioning the logic of having two indices that overlap so much.

At the same time, MSCI decided recently to do the opposite with their global index products. MSCI is moving from an independent small cap index, which also had overlaps with their standard indices, to a modular set of indices that fit together by cap.

It will be interesting to see who makes the most headway in the small cap space, and if the modularity of the MSCI indices entices any index funds away from S&P in Canada.

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In the Canadian ETF space, specifically in traditional market cap weighted equity index ETFs, Barclays has the dominant, if not exclusive market. I don’t know what MSCI can do in Canada within the ETF market since BGI basically has all its ETFs aligned with S&P indices.

As S&P makes the above changes, I see little doubt that BGI will make adjustments to the mandates of its ETFs. The problem is that there will likely be some confusion as the small cap and “completion” index have underlying positions that overlap. This double counting will make both indices partial small/mid cap indices or or the commonly termed “SMid”. It will be interesting to see how BGI deals with these changes by S&P. Changes to mandates is not new as BGI’s bond ETF changed from a fixed government bond ETF to one linked to the Scotia Capital Bond Universe Index. In addition, BGI recent revised its gold company ETF from Canadian miners only to a global mandate.

With all the potential changes described above, after all is said and done, we could see (although I can not guarantee this as it will of course be dependent on BGI Canada):

1. XIC to cover the broad market

2. XIU for the large caps

3. XMD for the mid caps with some small cap exposure, or as they call it the “completion” index

4. X?? for small caps with some mid cap exposure

From this link bringing you to the following Standard and Poor’s website (http://www2.standardandpoors.com/portal/site/sp/en/ca/page.topic/indices_ts xsml/2,3,2,3,0,0,0,0,0,5,2,0,0,0,0,0.html) I have found the following information on their existing Canadian small cap index as of November 30, 2006:

Probably not surprising that there is a heavy (60%) weighting to commodities.

Bottom line: We could be seeing a new small cap ETF from BGI in the 2nd quarter of 2007. There has been considerable ETF development in the small cap scope globally especially from WisdomTree, but I don’t know of anything specific in terms of Canadian equities.

For interested investors, the idea of the existing mid cap ETF (ticker: XMD on the TSX) becoming more of a Smid ETF may sound interesting for some resource tilted exposure on the lower end of the capitalization scale.

For those familiar with the US ETF industry, you’ll know that the US equity market has been overly sliced and diced by market cap, style, industry, etc. For investors interested in exposure to the Canadian equity markets, the choices have been relatively limited. Although the potential addition of a small cap ETF provides only a small, incremental addition for investors, it could be a sign of future growth potential in the industry. We could see more slicing and dicing of other geographic regions in a similar manner, although likely not to the same extent as the US market. Although good in terms of choice, this could increase the average costs of ETFs.

Take the Canadian ETF space as an example: With XMD, the Canadian mid-cap equity ETF currently at 55bps MER (same as BGI’s sector ETFs), I would guess that a small cap ETF would be at best 55bps but wouldn’t be surprised if it were a bit more expensive.

This push to relatively expensive niche ETFs will hopefully be offset in kind by relatively large and broad ETFs with sub-10bps MERs. The ETF industry clearly appears to be moving in this direction of polarized product development.