Shelter of income trusts
Won't always offer shelter from storm

Falling interest rates and sagging stock prices have made dividend, income trust and bond funds hugely popular with mutual fund investors and advisors. Over the past two years (ending October 2003), stock funds have seen more than $1 billion walk out the door while bond and dividend funds have attracted nearly $12 billion in net new sales. Strong returns have offered investors some peace of mind but can trusts escape future bear markets smelling like roses?

1998 summer decline

For a little historical perspective, I draw on the summer market slump of 1998. Using month end data from Morningstar Canada, the S&P/TSX Composite Index fell 27.5 percent during the four months ending August 1998. Sectors that were clobbered even more than the broad market included financial services, energy and other commodities. Income trust funds were a small group back then but the median in the category fell just 17 percent over the same period.

While that doesn't debunk the idea that income trusts offer bear-market protection, consider that the group was a bit different back then. Some of the then-existing funds that now invest predominantly in trusts were more balanced portfolios back then. Isolating the funds that focussed purely in income trusts at that time shows a decline of 24 percent - pretty much in line with the broader market.

Bear market drivers

Of great importance in drawing on recent experience to form expectations for the future is a careful examination of bear market drivers. A group of stocks or some other asset class won't always respond the same to all bears. In 1998, trusts fell by about the same amount as the overall market. However, the 2000-2003 bear market saw trusts outperform the broader Canadian market by nearly 900 basis points.

The median trust fund rose 59 percent while the S&P/TSX Composite dropped by 30 percent. But can you expect trusts to outperform - or at least avoid losses - in future bears? It depends on what drives the next bear.

The 2000-2003 bear was driven primarily by intolerance for high priced technology and concept stocks. It just so happened that things like small caps, bank stocks, and income trusts were extraordinarily cheap in 2000. The beginnings of an economic slowdown put a damper on the tech stock parade and the market suddenly had an epiphany - i.e. that valuations and real cash generation actually mattered.

Small caps, bank stocks, and income trusts were the beneficiaries of the market's sentiment shift. Not to mention that an economic slowdown usually signals falling rates - which is good news for all of these segments to varying degrees.

In short, trusts soared as the broad market fell in large part because they happened to be dirt cheap at the market's peak. Hence, valuation and the market's sentiment shift in favour of cheap stocks combined to push trust prices up. There's nothing special about trusts that allows them to offer any great shelter.

Portfolio advice

Recent fund flow figures continue to indicate that fund investors (most of whom are directed by an advisor of some type) continue to favour the bond and dividend funds that have excelled over the past few years. During the past three months, stock funds have seen net redemptions of $988 million while bond and dividend funds have attracted more than $2.3 billion in net sales.

The Scotia McLeod Income Trust Index still boasts a healthy distribution payout rate, but yields have been coming down as a result of price appreciation and a few distribution cuts. Further, energy trusts make up almost a third of that index so the high 'yield' of the index is a bit skewed.

Diversification by asset class remains key to avoiding the disappointment that so many are still facing from the most recent bear. But loading up on bonds and income trusts could simply be a set up for a repeat of past mistakes. Diversifying is an old story, but one that works over time.