November 19, 2006

The future of income trust funds
Stand-alone trust funds may become extinct

Much has been written about the Conservatives' move to tax cash distributed by income trusts and the individuals harmed by the new tax. Many mutual fund investors - and advisors - are wondering what fate awaits the now significant category of income trust mutual funds. More importantly, what are fund managers doing now, before the new rules kick in for existing trusts. In short, we see astute fund managers adding to trusts that fell more than is warranted. But I also expect that the income trust mutual fund category, as we know it, will not exist come 2011.

Pick your number

I've read a few articles and reports estimating what sort of price decline is justified by the new tax. Some suggested the full 31.5% should immediately be sliced from trust prices. Others implied hits of 12%-15% was sufficient. Yet another pegged the 'right' decline at 22%. I tend to agree with the latter. Assuming trust values are a function of the future of after tax cash distributions, it makes sense that the 31.5% tax that begins in 2011 is the same amount that should be sliced from trust prices.

However, this ignores the value of the four-year transition period (a tax deferral) until the beginning of 2011, which is worth some ten percentage points, implying a decline of 21.5%. But that's for trusts spitting out 100% of fully taxable distributions. To the extent that a trust pays out tax-deferred return-of-capital (unaffected by the new tax) and has lots of taxable Canadian unitholders (whose after-tax positions don't change), the 'right' number is lower. That trust indexes dipped by 15%-18% is probably about right but it took several days to get to there.

Fund managers nibbling

With the exception of firms that shunned income trusts throughout their impressive run, fund managers have been closely monitoring the universe. They've been looking for any trusts whose prices have been hit more than is warranted. Isolating the tax impact is actually quite easy. Diligent fund managers that have already done the in-depth fundamental analysis are easily able to jump on opportunities to add to quality trusts that have fallen by more than the tax hit.

Income trust funds

I have always considered trusts to be nothing more than high yield equities with unique tax treatment. Now that trusts are facing a future tax regime that is effectively equal to corporations; trusts and stocks are more alike than ever before. But businesses that converted to trusts merely for the share price bump - like CI Financial and many others - are likely to revert back to corporations. In terms of size, the trust universe will be flat at best. At worst, it will shrink substantially as many businesses revert back to corporations. If the latter is closer to reality, mutual funds investing exclusively in income trusts are likely to either see a mandate change (to a broader dividend or high yield equity mandate) or merge with a dividend fund sibling.

Some funds may require unitholder approval to broaden the mandate, while others may not. Dynamic Focus + Diversified Income Trust, for instance, has a rather restrictive investment objective and list of securities to be used (i.e. only trusts, interest-bearing securities, and derivatives are mentioned). On the other hand, GGOF Monthly High Income has a much more broadly worded investment objective and lists a full range of securities that can be used.

If the trust universe emerges in 2011 with still a substantial 'members list', income trust funds, as we know them today, have a better chance of survival. However, with no unique characteristics, I still don't see why a trust would hold any special appeal over a stock. Hence, it makes no sense to me that income trust funds would exist as a stand-alone class instead of as a more flexible high yield equity fund.

Besides, a flexible mandate is best in the hands of a skilled money manager. For instance, I have long favoured the old Dynamic Dividend fund, managed by Oscar Belaiche over his other more popular offerings for its lower cost and broader mandate. And when I spoke to Mr. Belaiche in February, it was also his favourite - and that was before the tax change. So, there were enough reasons to favour diversified funds before, and Mr. Flaherty just added to the list.