Income trusts coming to TSX Index

(January 26, 2005) Standard & Poor’s has announced it will include qualified income trusts in its benchmark S&P/TSX Composite Index, ending months of debate over whether trusts belong in the benchmark index. S&P will continue to offer a “classic” version of its Toronto index, however, which will not include income trusts.

“The decision to include income trusts in the TSX, while continuing to offer a version of the index that excludes trusts, reflects Standard & Poor’s ongoing adaptation to the marketplace as it changes, as well as our commitment to providing quality products that reflect the diverse needs of Canadian investors,” said Steve Rive, vice president of Canadian index services at Standard & Poor’s.

The firm has not set a date for the launch of the new “super-composite” — as some have labeled it — but say trusts will likely be added by mid-year. Over the next few months S&P plans to draw up the rules which will govern inclusion of trusts in the composite, in consultation with market participants.

As an exercise in November, the S&P index committee assessed the trust market using the rules in place at that time, which included capitalization and liquidity considerations. Rive says that using the criteria of the day, about 50 trusts would be added to the TSX.

The trusts that do eventually make it will be split among the existing sub-indices, giving a massive boost to the energy sector’s weighting due to the value of energy royalty trusts. The financial sector would also receive a boost, with the inclusion of real estate investment trusts (REITs) which make up the lion’s share of the Canadian real estate market.

“This announcement is a recognition and acknowledgement of the importance of the income fund sector in Canadian capital markets”, said Margaret Lefebvre, executive director of the Canadian Association of Income Funds, saying the move may lead to significant investment by institutional investors in income trusts and REITs. The decision was similarly praised by the Canadian Institute of Public and Private Real Estate Companies.

As of December 31, 2004 there were 175 income trusts listed on the TSX, with a market capitalization of over $118 billion. Trusts now represent 8% of the total market capitalization of the TSX.

“As income trusts have become a significant component of retail and institutional investing activity, Standard & Poor’s is ensuring the benchmark index represents the broadest interests of our various constituents,” said Richard Nesbitt, CEO of TSX Group. “Under Standard & Poor’s guidance, the evolution of the index business ensures that relevant needs of market participants are addressed in the domestic and global capital markets.”

To date, the trust market has largely been driven by retail investors, most of whom likely did not have any notion of the theoretical liability risks they were taking. Many have been hoping for increased institutional participation as a chance to cash in, just as unit prices have risen with more mutual fund participation.

“Inclusion in the ‘super composite’ will certainly add liquidity to the market but, historically, securities added to a widely followed index have experience only a short-term share price ‘bump’,” says Dan Hallett of Dan Hallett & Associates.

“Hedge fund firms tend to pay lots of attention to such events, but for fund investors and advisors selling funds, this is not all that relevant from the standpoint of an index-driven price bump,” he says.

There have been several hurdles facing wider acceptance of trusts by institutional investors, including liquidity issues and corporate governance.

Perhaps the most talked-about, though, was the issue of limiting liability for unit holders — an issue has been resolved in several key jurisdictions, most recently Ontario. Alberta, which is home to many energy royalty trusts, and Quebec had led the pack in resolving the issue, but British Columbia remains a hold-out on such legislation.

Rive downplays the importance of limited liability, though, saying the jurisdiction of a given trust will not play a part in the decision to include it in the TSX.

There are still several kinks to be worked out in the coming months, though. In a conference call this morning, Rive explained that trusts will not be eligible for inclusion in the TSX 60, saying this “blue chip” index needs to reflect the market’s sector balance more closely than the overall index.

S&P also has yet to decide if it will phase in the trusts to be included, as the decision is made on each trust, or whether it will take a “big bang” approach, announcing the successful candidates all together.

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Rive says there are currently no plans to include TSX-listed limited partnerships (LPs) in the index, but there is a chance that some might make it in anyway. The constituents of the S&P/TSX Capped Income Trust Index will be eligible for composite inclusion, should they meet the new criteria, but there are already LPs included on the trust index. Rive says S&P is not interested in revisiting its definition of an income trust, indicating that these LPs may be reviewed for composite inclusion.

What is certain, though, is that Standard and Poor’s hopes the revamped composite will be considered The Index for the Toronto Stock Exchange, stressing that the parallel “ex-trusts composite” will in fact be the “new” index, best used by those precluded by law or investment criteria from trust participation.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(01/26/05)

Steven Lamb