It happened in July. After 5 years of eating the dust of the Dow Jones Industrial Average, the TSE 300 Composite Index finally caught up to and crossed the level of the world's best known stock market benchmark.

By any yardstick, the comeback was impressive. After all, the Dow enjoyed a 3000 point lead at the start of this year. As of August 1 this year, the TSE 300 was up a healthy 23 per cent, while the Dow was down 8 per cent.

But to find out why the TSE 300 has performed so well, you need only look at one of the component stocks in the index. And that stock is Nortel. It's up more than 50 per cent on a split-adjusted basis since January 1, closing at $107 a share on August 1.

"What about the other 299 stocks in the index?" you ask. Well, they just don't matter to the same degree-- not even close. To understand why, you need to look at how the TSE 300 is compiled.

To say the TSE 300 tracks 300 companies listed on the Toronto Stock Exchange tells only part of the story. Unlike the Dow Jones, which is a price-weighted average of 30 stocks, the TSE 300 is a float-weighted index.

What's a float-weighted index?

That means the index takes into account the number of shares available for the public to buy as well as the company's share price. So a huge company like Nortel, with almost three billion shares outstanding, and a market capitalization (number of shares times the stock price) of almost $320 billion, exerts an especially large influence on the TSE 300's performance figures.

How large? As of August 1, Nortel represented 33.47 per cent of the index; the other 299 companies accounted for the rest. (The number two company, Seagram, accounted for just 2.85 per cent.)

In the S&P/TSE 60 index, a more concentrated index that includes only the 60 biggest companies trading on the TSE, Nortel's influence is even greater. It accounts for a staggering 43.87 per cent of the S&P/TSE 60.

And the higher Nortel goes, the greater its weight.

Implications for investors and managers

The Nortel effect has huge implications for investors and money managers. For one thing, it has made it virtually impossible for the manager of a diversified Canadian equity mutual fund to beat the benchmark index (which is the goal of any fund manager, and the wish of every fund buyer).

That's because under Canadian securities regulations, actively-managed mutual funds are limited to holding no more than 10 per cent of their assets in any one stock.

When Nortel is rising like it has (its stock price more than tripled last year), and with a fund manager bound by that 10 per cent limit, it's very difficult to outperform an index that has a 33 per cent exposure to a stock that's beating the pants off everything else.

In 1999, for instance, the TSE 300 Composite Index rose by almost 30 per cent, eclipsing the Dow's 25 per cent rise. But take away Nortel and BCE, and the TSE 298 was up only 6.5 per cent.

Now that BCE has spun off most of its stake in Nortel, the Nortel effect is even larger. In the last couple of years, the stocks that have performed best are the ones that have accounted for the biggest share of the TSE 300.

Managers search for solutions

The Investment Funds Institute of Canada, the lobby group for the mutual fund industry, has begged regulators to increase the 10 per cent limit. The regulators have refused, arguing that managers can always choose to concentrate their investments in a particular sector that's performing well (like technology).

A handful of science and tech funds enjoyed triple digit growth last year while staying within the 10 per cent limit on each stock purchase. But those are sector funds, and many investors want the comfort of broader diversification.

Fidelity Investments, for one, has decided to turn the 10 per cent limit from a liability into a selling feature. In June, it decided to shift three Canadian equity funds to a new benchmark-- the TSE 300 Capped Index. This index places a 10 per cent limit on the weighting for any one company.

"This decision reflects the fact that the TSE 300 is no longer an investible index," the company said, referring to Nortel's 33 per cent weighting in the index. So from now on, Fidelity will compare those three funds to the capped index for performance purposes. It will consider its managers to have succeeded if they exceed that benchmark. Will their investors? It may be a hard sell, no matter how well intentioned their argument.

Other heavy hitters

By the way, the TSE 300 isn't the only index to reflect the weight of an elephant in its midst. Nokia represents an incredible 60 per cent of Finland's main index. Ericsson accounts for 32 per cent of Norway's. And Telefonica represents about 28 per cent of Spain's benchmark index.

Investors in the U.S., though, don't have similar overweighting issues. One of the biggest companies in the world, Microsoft, still makes up less than five per cent of the S&P 500, another market-weighted index.

But as long as the price of Nortel stock soars on the TSE, we can expect the 10 per cent debate to intensify in Canada. We can also expect the Nortel effect to add to the growing interest in products that track the indexes--so-called "passive" mutual funds and i60s (they track the S&P/TSE 60 index).

Sometimes, 299 just can't do the trick.