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By Jonathan Chevreau
National Post
FP Special Report “Income Trusts”
Monday, March 21, 2005 |
Demand for funds of income trusts has soared in the past six months and the industry has responded with a blizzard of new products.
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "Income trusts are ‘equities’ with yield. Nothing is guaranteed.”
There have been 42 new issues of income trusts and structured products since October, with total proceeds of $3.3-billion, according to CanWest Interactive.
But a report on royalty trusts issued last week by Canaccord Capital warns trees don't grow to the sky. "The record level of 'fund of funds' IPOs in the last two quarters has been one of the key driving forces supporting strong unit prices in the royalty trust sector," wrote Bruce McDonald. He noted the withdrawal of one offering and a decreasing size of a recently closed fund of funds.
The seemingly insatiable demand for income trusts was born of low interest rates and a paucity of high-yielding alternatives. But it would be a mistake to characterize income trust valuations as a bubble, says Stephen Pincus, chairman of the income funds group at Goodmans LLP. "A bubble connotes something empty inside but these are real businesses producing real cash flow."
Canadians embraced income trusts after the technology bubble popped, Pincus says. By contrast, income trusts are "not speculative ventures trading at infinite multiples of no cash flow."
The inclusion of income trusts in the S&P/TSX composite index suggests they are here to stay. They are more liquid now individual investors automatically have 8% exposure to the sector merely by owning Canadian index funds. Similarly, large pension funds will feel more comfortable with income trusts.
For those overweight domestic income trusts, the end of the 30% foreign content limit in February's federal budget was another litmus test. In theory, income trusts were a large beneficiary of the former requirement that registered retirement savings plans and pensions hold 70% Canadian content. Canadians held them because there were few other choices.
But neither have plummeted since the announcement, which is further evidence income trusts have become a permanent feature of Canada's investment landscape.
Just how mainstream they have become is evident at Gluskin Sheff, where more than $700-million of its $2.5-billion under management is in income trusts. "I'm saying it's a very solid investment," says Ira Gluskin, "It's less risky than a portfolio of stocks."
In theory, Canadians now are free to buy more of comparable investments in the United States. However, the U.S. income trust market is less developed. "There really isn't a large universe [in the U.S.]," Pincus said. "There are REITs and resource LPs but there are only a few specialty business funds." So the removal of the foreign content limit is neutral for Canadian investors, he says.
Income trusts should be considered equities when setting asset allocation. But they should be viewed as being riskier than large-cap Canadian stocks, since most income trusts are small- or medium-cap Canadian securities.
Not all advisors are convinced of their merits. "I have never been a real fan of trusts," says Warren Baldwin, regional vice-president, "If you want fixed income, buy bonds. Don't have additional risk in the 'secure' side of the portfolio and then be surprised if there is an unexpected downside."
Adrian Mastracci, investment counsel for Vancouver-based KCM Wealth Management Inc., is also cautious. Income trusts are "equities with yield. Nothing is guaranteed," he tells clients. Because of their diverse nature, Mastracci doesn't think average investors should be cherry picking individual trusts, particularly new issues.
The glut of funds of income trusts are aimed at average investors unequipped to assess individual issues. Such a "basket" approach can be executed with open or closed-end funds [their MERs are similar] or with index funds.
The major income trust index funds are SCITI Trust 1 and 2, and Barclays Advantaged S&P/TSX Income Trust Index Fund. There is also iREIT, which holds a dozen real estate investment trusts.
Fund analyst Dan Hallett says "you could make an argument for indexing this market. The only caveat is the index still has a fairly significant weighting in the energy sector, which is pricey.
"I'm leery of anything that proposes to repay capital on top of fulfilling other investment objectives like growth of capital and high distributions," he says
Unlike in the United States, Canada's new issue market has been focused on income trusts, structured products and commodities, Hallett says. "You want to be careful when they are dominating the IPO market. Prices aren't cheap, so this is where active management can come in." For do-it-yourself investors, he suggests Saxon High Income. With a MER of 1.34%, it is "the cheapest of the lot."
Other solid managers are the fund companies that pioneered this asset class in the mid-1990s. That includes Bissett [now Franklin Templeton], Dynamic Mutual Funds and the Guardian Group of Funds. Last week, Templeton introduced the Bissett Income Trust Fund for investors wanting exposure to the large-cap portion of this market.
But even believers in active management think retail investors can be well served by indexing the sector. Gluskin says it's much harder for active managers to add value by picking income trusts relative to the index than it was three or four years ago.
While proponents of active management will argue index funds own names you might not otherwise choose, Eric Kirzner, a University of Toronto finance professor dismisses that argument. "I go back to portfolio theory. I don't have a concern when I look at a 60-unit portfolio and they have something I don't like. It doesn't matter. The risk is diversified away and you know it will match the index."
Kirzner's pick is a bit of a hybrid. The Lawrence Payout Ratio Trust holds 40 equally weighted 2.5% positions on the most stable income trusts. "It may be a lower yield than some but it is less risky."
If you are sold on the asset class and like the basket approach, you could split your income trust allocation between index and actively managed funds. So far, it has served me well.
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