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Mutual funds for grownups

For a more sophisticated investor, investment trusts can be a good alternative, ROB CARRICK writes

The trouble with mutual funds is that they're so square.

What if you're a small investor and you want to play hedge funds, or the Asian fixed-income market? Or what if you're disgusted by low interest rates and yearn for high yields that won't get whacked by the taxman?

Mutual funds don't have much to offer here, but investment trusts do. In fact, investment trusts can be a worthy alternative to mutual funds if you're a more sophisticated investor who understands and accepts their many idiosyncrasies.

An investment trust is a kind of closed-end fund, which is basically a less rule-bound mutual fund that trades like a stock and is listed on an exchange. The term trust simply means an entity that pays no tax and instead distributes its income to unitholders, who in turn pay taxes according to their personal circumstances.

There are now about 75 investment trusts listed on the Toronto Stock Exchange, most of them focused on providing high yields by using income trusts, bonds and even stock portfolios that are torqued with options-trading strategies. There are also some exotic equity and bond funds, plus several hedge products.

Investment trusts go where mutual funds don't in many cases, and they often do it at lower cost. You'll have to pay brokerage commissions to buy and sell trusts, but their management expenses can be quite reasonable.

Consider the Brompton VIP Income Fund (VIP.UN-TSX), which holds a portfolio of income trusts. It has a management expense ratio of 1.60 per cent, which compares with an average 2.33 per cent for a mutual fund holding income trusts.

"We find investors are increasingly concerned about the size of fees they pay," said Don Lillie, president and chief executive of Brompton Capital Advisors. "As such, we've tried to slash fees back as much as possible."

It's much easier for an investment trust to be run on the cheap than a mutual fund because trusts don't require sustained marketing and client support.

Once a trust has its initial public offering, investors must buy and sell the trust on the open market. Conventional mutual funds, technically called open-ended funds, differ in that they have to be ready at all times to redeem units held by investors.

This fact is a huge advantage to the manager of an investment trust and, in turn, to unitholders.

When a mutual fund hits a rough patch, it's quite likely some unitholders will redeem their holdings. To stay ready for this, the fund manager must keep some of his or her investments in liquid securities that might otherwise be more profitably engaged. In a worst-case situation, a manager might have to sell perfectly good holdings to pay for unitholder redemptions.

Investment trust managers can be fully invested at all times because they never have to worry about disgruntled investors who want to sell their holdings.

Sandy McIntyre, manager of the Sentry Select Diversified Income Trust Fund (SDT.UN-TSX), tells a story that sums up the edge that closed-end funds have over conventional mutual funds. It happened back in early 2000, when the income trust market was bottoming out and tech stocks were at the height of their popularity.

"We were getting phone calls from trading desks soliciting bids on good [trusts] at fire-sale prices," Mr. McIntyre said. "It was open-ended fund guys having to sell."

The Sentry Select fund was able to make some bargain-priced pickups at this point, but it also had the advantage of being fully invested and not having to sell any holdings to finance unitholder redemptions.

"When we came out of the bear market for trusts, our performance rocketed because we had the entire portfolio in place," Mr. McIntyre said.

It's not hard to see the appeal investment trusts have to asset management companies. With a captive pool of money, they can sit back and apply their management fees without worrying that investors will sell and wear down their asset base. It's for this reason that investing newsletter publisher Patrick McKeough says investment trusts can be a "cash cow" for an asset management company. How do you avoid trusts that are treated as fee-generating livestock?

One way is to check whether the trust trades at a discount to its net asset value. The bigger the discount, the more skeptical investors are about the trust itself or the sector in which it invests.

Mr. McKeough says discounts are actually a good thing, certainly better than a closed-end fund trading at a premium to net asset value, as some in the income trust area now do.

"The basic rule is that you never buy a fund at a premium to net asset value," Mr. McKeough said. "I wouldn't dream of it because it's almost certain that the fund will eventually trade at a discount."

Discounts are less of a problem than they used to be thanks to measures that trusts are increasingly using to keep their unit prices in line with their net asset values.

Some trusts use share buybacks to support their unit prices, while others provide a once-a-year opportunity for unitholders to redeem their holdings for net asset value with no fees.

There are a few other peculiarities of investment trusts that will have a bearing on how well they fit your investment needs.

Leverage: Trusts can borrow to invest, which means additional management fees but also the potential for higher -- and lower -- returns.

Limited lifespans: Most trusts have fixed termination dates, after which they're wound up and the net assets distributed to unitholders.

Liquidity: Some trusts trade very thinly, which means you could have trouble getting rid of one at an acceptable price if things go badly. Several trusts also use derivatives, which Warren Buffett recently described as "financial weapons of mass destruction."

Among the most notable derivative users are structured funds -- trusts that use options-trading strategies to flog greater returns out of a portfolio of stocks so that unitholders receive a steady flow of income.

Structured funds, also called enhanced-yield products, have been a huge disappointment for the most part because many have had to drastically cut their distributions of income.

There are those who feel these funds are a buy at current prices because of their capital guarantees, but Mr. McKeough isn't one of them.

"If you ever feel an urge to buy one of these funds, lie down until the feeling goes away," he joked.

Forward contracts are another derivative you'll increasingly find in investment trusts. Using this strategy can help a trust guarantee unitholders will get their money back on termination, or it can bestow tax advantages on distributions so they're treated as capital gains and not income.

To get an idea of what investment trusts are available on the TSX, go to and click on "Closed-end Funds" under the "Tools" banner. You'll also find data here on premiums and discounts for each listed trust.

You can use's filter function to create a list of all units listed on the TSX -- units are designated by the .UN after the symbol and include investment trusts and individual income trusts. Remember, you have to go looking for investment trusts because they'll rarely come to you through the sort of advertising mutual fund companies do.

Brompton's Mr. Lillie says his firm markets its three income trust-based investment trusts (a fourth is on the way) entirely to brokers who in turn recommend them to clients. There's simply no money for billboards, magazine ads and glossy brochures.

"We can send people a dozen golf balls and some pens, but we can't compete with the CIs and Manulifes of the world with respect to marketing," he said.


Investment trusts that have been listed on the Toronto Stock Exchange this year.

Trust Invests in

Barclays Advantaged S&P/TSX Income Trust

Index Fund (BAI.UN) Income trusts*

Citadel Multi-Sector Income Fund

(CMS.UN) Income trusts

Faircourt Income Split Trust (FCI.UN) Income trusts

Investment Grade Trust (BND.UN) Bonds*

Maxin Income Fund (MXZ.UN) Income trusts

Mortgage-Backed Securities Trust (MF.UN) Mortgage-backed securities

SCITI Trust (SIN.UN) Income trusts

Series S-1 Income fund (SRC.UN) Income trusts

Skylon Global Capital Yield Trust II (SPO.UN) High-yield bonds*

Tremont Capital Opportunity Trust (TT.UN) Hedge funds*

*Offers tax advantages beyond those provided by underlying securities


One of the arguments in favour of investment trusts is that they often have lower management expense ratios than mutual funds, which means there's more left over for investors after fees are paid. Here's a selection of how the MERs on some recently issued trust compare with mutual funds:


MER: 0.50 per cent

Invests In: Income trusts in the Scotia Capital Income Trust Index

Comparable mutual fund MERs: 2.45 per cent on average

Series S-1 Income Fund (SRC.UN)

MER: 1.6 per cent

Invests In: An actively managed portfolio of income trusts

Comparable mutual fund MERs: 2.45 per cent on average

Skylon Global Capital Yield Trust II


MER: 2.25 per cent*

Invests In: High-yield bonds

Comparable mutual fund MERs: 2.15 per cent on average

Tremont Capital Opportunity Trust


MER: 2.9 per cent (plus MERs for underlying funds)*

Invests In: An actively managed portfolio of 18 hedge funds

Comparable hedge fund MERs: 2.5 per cent to 4.5 per cent

*0.65 percentage points of the MER pay for a forward contract that creates tax-advantaged gains in non-registered accounts.

© 2007 The Globe and Mail. All rights reserved.

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