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Income trusts: Some options for a strong portfolio

The vehicles are tricky to evaluate, maybe even more so than stocks. Investors would be wise to get some help making their selections, ROB CARRICK writes

Well-chosen income trusts can do great things for your portfolio, but a dud trust is just poisonous.

Not sure you're up to telling the difference between the strong and the weak in the trust world? Then get some help.

There are about 36 different mutual funds that focus on trusts, as well as more than a dozen closed-end funds trading on the Toronto Stock Exchange. If you prefer an indexing approach, there's a brand new TSX-listed fund that tracks a prominent index for the trust sector, with another one soon to come.

Income trusts, also called income funds, are based on an underlying business that can be anything from a burger chain to oil and gas properties to a collection of commercial real estate. Earnings from the business are distributed to investors each month or quarter, creating a flow of income that can typically yield anything from 6 to 20 per cent a year. (The higher the yield, the riskier the trust.)

Returns like this have been a godsend to many an investor these past few years, but let's not forget that trusts can hurt you, too.

Take Halterm Income Fund, for example. After losing two key customers, this Halifax-based shipping terminal suspended its quarterly 24.37-cent distribution in March. Investors have since hammered the unit price down to about $3.50 from just under $9.

A few other trusts have lowered their distributions and had their unit prices shaved by lesser amounts. Still, there's no getting around the double blow a struggling trust can deliver: Your regular distributions -- the very reason you bought your trust in the first place -- could be reduced while at the same time you're handed a capital loss.

It's possible to successfully choose your own trusts, especially with Standard & Poor's Corp. and Dominion Bond Rating Service Ltd. offering unbiased assessments on the stability of payouts from a couple of dozen players.

But even with these stability ratings, you could still end up buying a fully valued trust that is vulnerable to a pullback in its unit price. Some market watchers think there are big pockets of the trust sector that are in this situation.

Then there's the fact that trusts are tricky to evaluate, maybe even more so than stocks.

"From my point of view, it's harder to analyze a trust because many of the standard measures that you use for equity analysis don't really apply, like price/earnings," said Leslie Lundquist, manager of the $487-million Bissett Income Fund.

Many trusts are new to the market, which makes it difficult to assess the historical performance of their underlying businesses.

"The best source of information is the prospectus," Ms. Lundquist said. "Well, trust prospectuses go on for 135 pages or more. There's an awful lot of information to wade through and an awful lot of it is not that user friendly."

The main benefit of using a fund to buy into the trust market is diversification, the same advantage as you get when you buy an equity fund instead of selecting a few stocks for yourself.

SCITI Trust, a brand new index fund that began trading this week on the Toronto Stock Exchange under the symbol SIN.UN, comprises 67 income trusts, while the upcoming Barclays Advantaged S&P/TSX Income Trust Index Fund includes 41 trusts. An income trust mutual fund or closed-end fund might have 50 to 80 different holdings.

Just as importantly, these funds include all types of trusts, including real estate investment trusts, oil and gas royalty trusts, business trusts and power-generating and pipeline trusts. With that level of diversification, the impact of having a Halterm in the mix is minimized.

Another benefit of funds versus individual trusts is a single T3 tax slip. The distributions paid by income trusts enjoy certain tax advantages, but tax treatment remains a complex matter because each trust has its own nuances. Having a single fund is a lot easier to manage than multiple tax slips from various trust holdings.

Having a single fund also means you get your distributions all at once, instead of in bits and pieces.

Beyond these benefits, the merits and demerits of the various fund options for playing trusts differ widely. Let's take a detailed look at each type of fund.

Index funds

Description: These funds strive to deliver the same return as a target index used in measuring the performance of income trusts. Your choices are SCITI Trust, which includes the larger trusts by market capitalization in the Scotia Capital Income Trust Index, and the soon-to-be-listed Barclays fund, which tracks a trust index of the same name. A third option focuses on an index that tracks real estate investment trusts. It's called the Barclays S&P/TSX Canadian REIT Index Fund, or iREIT (XRE-TSX).

Pro: These funds have much lower management expense ratios than traditional mutual funds, but you'll need to pay a brokerage commission to buy them (and, obviously, have a brokerage account). The Barclays fund has the highest MER of the bunch at an estimated 1.5 per cent, compared with 0.50 per cent for SCITI Trust and 0.55 per cent for the iREIT. With the Advantaged fund, you're paying extra for an arrangement under which distributions are mainly considered tax-deferred capital gains. Trust distributions generally include a significant portion classified as income, which faces a higher tax burden.

Con: The rap on index funds is that they fall harder during bear markets.

If trusts go into a serious slump, then a trust index fund may fall more than a mutual fund, where a manager can get out of riskier trusts and into more stable ones that are likely to hold up best.

Note: Prospectuses for the two new index funds can be found on the Sedar.com Web site. For more information on the iREIT, go to the Barclays Web site at http://www.iunits.com.

Sorting through the choices: The Barclays fund is an option for unregistered accounts because of its tax advantage, but its high MER makes it inferior to SCITI Trust units for registered retirement accounts. If you like REITs, and there's reason to, then the iREIT has some appeal.

Mutual funds

Description: Fund companies such as GGOF Guardian, CI, Dynamic, Franklin Templeton, Mackenzie, Saxon and Elliott & Page are part of the small but growing Canadian income trust category of mutual funds. Typically, these funds strive to pay a consistent amount of cash each month to unitholders.

Pro: Easy to buy through a financial adviser or on-line broker or fund dealer. Also, it's easy to have your monthly distributions reinvested back into the fund instead of accumulating as cash.

Con: The average management expense ratio for this category is a hefty 2.33 per cent.

Note: You can compare income trust mutual funds on Globefund.com by clicking on "reports" and selecting the "Canadian income trust" category.

Sorting through the choices: The analysis firm FundMonitor.com says its top two picks on the basis of consistent outperformance of their peers are GGOF Monthly High Income and Dynamic Focus Plus Diversified Income Trust.

Closed-end funds

Description: Think of these as regular mutual funds that are listed on stock exchanges and bought and sold like any other stock. Whereas exchange-traded funds give you exposure to a specific stock index, closed-end funds rely on a portfolio manager to select the mix of securities.

Pros: Lower management expense ratios than traditional mutual funds is the main attraction. Expect an average 1.5-per-cent MER for these funds.

Another benefit is that you can buy closed-end funds on the open market during regular trading, which allows you to take advantage of temporary price fluctuations. Mutual funds, by contrast, are bought and sold at end-of-day prices.

Cons: Closed-end funds commonly trade at a discount to their net asset value, except when they happen to invest in a market niche that's in vogue. So it is that some income trust closed-end funds now trade at a small premium.

The problem here is that in buying these funds now, you'd be paying more than their actual worth according to net asset value per unit. You'd also be setting yourself up for a decline in the value in your investment if and when these funds start to trade at a discount.

Another negative is the lack of research and data on closed-end funds. For example, it can be difficult to find information on their management expense ratios, even on the Web sites of companies that run closed-end trust funds.

One last point is that you'll need a brokerage account to buy these funds.

Note: You can get information on fund premiums and discounts in the closed-end fund area of Globefund.com (look under "tools").

Sorting through the choices: There are two closed-end income trust funds that have earned the top SR-1 stability ratings from Standard & Poor's, which speaks well of their ability to maintain steady monthly payouts. One is Brompton Stable Income Fund, the other is Citadel S-1 Income Trust Fund. Another fund, Citadel's Series S-1 Income Fund, has earned a preliminary SR-1 rating as it heads toward an initial public offering.

© 2007 The Globe and Mail. All rights reserved.

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