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Labour-sponsored love lost

With tax breaks disappearing, the cliff is fast approaching for labour-sponsored investment funds

The days of reckoning could be coming for those of you invested in labour-sponsored investment funds (LSIFs). My advice is to run for the cash-me-out hills--now! ASAP! Dilly-dalliers who hang on may have to fight over the illiquid and possibly worthless asset scraps in their funds' portfolios.

That may sound like selling in a panic, but in this case, there may be no other option. In August, the government of Ontario--where more than $4 billion of LSIF money was raised--announced that it would start phasing out tax breaks for the funds. The wheels are coming off, and vehicles that lose wheels usually crash.

Back in the 1980s and early 1990s, LSIFs seemed like such a noble idea. Ottawa and most of the provinces introduced tax breaks for funds sponsored by labour groups that were supposed to raise money from ordinary folks and invest it in innovative new job-creating companies. But most investors viewed the funds as a stick-it-to-the-taxman vehicle, and didn't look closely at where the money went. LSIFs followed in the wake of scientific research tax credits, oil and gas flow-through thingamabobs and incentives for Canadian films. Those boondoggles all ate into government revenue and stunk like skunk as investments.

The sheer amounts poured into LSIFs proved to be one of the biggest problems. By 1995, the funds were providing more than half the new venture capital in Canada. Yes, there were winners, such as the funds that invested early in Research In Motion. But there was too much money chasing too few genuine opportunities.

For LSIF managers, the funds were half-decade pennies from heaven. The annual management expense ratios (MERs) on many LSIFs were a steep 6% or more. If investors redeemed the funds in less than five years, they had to forfeit their tax credits, so the fund assets on which the fees were based tended to stay put, no matter how lousy the funds performed.

Most labour-sponsored funds have been lousy performers. Of the 40 LSIFs monitored by ScotiaMcLeod that have at least a three-year track record, only 12 have a positive average annualized return for the three years to Sept. 30, 2005. Of the 22 funds with a five-year track record, the Golden Opportunities Fund is the only one in the black, with an annualized return of--hold onto your hat--1.4%.

LSIFs haven't helped the true, unfettered venture capital sector much either. Since 2001, my business has looked to invest in promising new technologies for financial markets. But we couldn't compete with the so-called pacing requirements for LSIFs. Each year, the funds have to invest a minimum amount--no matter what the quality of the ventures--or face a financial penalty. As a result, many LSIFs are full of holdings in so-so, illiquid private companies, plus some cash.

People who put in money years ago shouldn't be too worried for the moment. Investors in Ontario who plunked down $5,000 at, say, a 50% marginal tax rate have only about $1,000 at risk. There was a 15% provincial tax credit and a 15% federal one. Putting the LSIF in an RRSP meant another $2,500 or so in tax savings.

But all LSIF investors should think about bailing soon. First, there's probably no tax reason to hold on. Ontarians who invested before 1996 had to wait five years to redeem without penalty. The waiting period was then extended to eight years. Much of the money was invested between 1995 and 1998.

It would also help to sell while funds are still flush. Many have 20% or more in cash and short-term securities, ready for your redemption call. (Attention, fee cheapskates: That makes a 6% MER more like 8% on the fund's actual investments. On the other hand, if a fund has less than 10% cash, I wouldn't even finish reading this article. I'd dial my adviser now.)

Once that cash is used up to pay off early redeemers, the fund will likely have to sell its most liquid--i.e., best--public investments, then the private ones. This will lead to a "new," lower asset value. Redemptions will accelerate. Post-1997 investors who bail early will get the double whammy: They'll lose on the asset value and their tax credits. But if they hang on, only the fund holdings that suck will remain, and the fund will be marked down to market before you can blink.

The net asset value of the fund quoted in the newspaper? That's an estimate--and perhaps an optimistic one--based on the independent valuations that managers can get for private investments.

The bright side of all this? I'd bet that the real venture funds that are left will make a pile as the LSIF venture capitalists head for the hills. The time for you to invest is, like, right now.

© 2007 The Globe and Mail. All rights reserved.

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