Income trusts: Don’t wait but underweight

(June 20, 2005) Retail investors expecting valuations to gallop ahead once income trusts are incorporated into the S&P/TSX Composite Index may want to rein in their expectations: pension funds may be wary about investing in what is for them a new investment vehicle.

While some pension funds have been active in the income trust space, most have held off, for a variety of reasons. Concern about unlimited liability under the trust structure was one reason, though Ontario, Quebec and Alberta have all passed legislation to give trusts the same legal status as limited liability corporations. Still, some pension fund investors and consultants expressed wariness at Barclays Global Investors Canada (BGI) regional conference this week.

Other doubts focus on the external management of trust assets, often with low hurdles for performance fees, a practice that has been steadily receding as trusts bring managers in-house.

Still, though doubts linger, the imprimatur of Standard and Poor’s means pension funds will be looking at income trusts. They will have to, if they want to keep pace with their benchmarks. However, even before the legislative changes, half of plan sponsors said they wanted income trust exposures, and of those 80% said they wanted them as part of their Canadian equity allocation and not as a separate allocation, as reported in a January BGI survey.

To be sure, income trusts offer greater opportunities for active managers, says Mary Anne Wiley, client relationship officer with BGI. There are 224 trust securities, and 65 of them are expected to be included in the index in a two-stage process. They will make the indexed market more representative of specific industry sectors, especially the real estate portion of the financial services sector. Currently, there is only security; 11 real estate investment trusts are expected to be added.

Similarly, the energy sector has been hollowed out with trust conversions, and more are likely. In fact, the inclusion of trusts is beneficial to investors since it opens up investment opportunities. “Without the inclusion of income trusts, it’s reasonable to think our universe will shrink further,” Wiley says.

Trusts would represent about 9% of the current market capitalization of the composite index. They won’t be added to the large-cap sub-index because of the difficulties in shorting them — which would impair the functioning of futures trading based on the S&P/TSX 60. (Trust units may be hard to borrow, and what’s more, the short-seller is on the hook for the distributions until the short sale is covered.)

Still, they will have a sizeable impact on the other sub-indexes, accounting for 15.6% of the mid-cap index and a whopping 43% of the small-cap index. In the small-cap index, they will more than double the size of the energy sector.

With those changes, it will be hard for managers with specific mandates to ignore trusts, if they want to hold close to their benchmarks.

But, Wiley advises, managers shouldn’t necessarily follow the S&P timelines. A provisional index will be released in September, allowing managers to buy trusts according to their own schedule. On the composite, half of the income trust weight will be added December 16 and the other half March 16.

Managers who choose those two dates could face high execution costs — similar to what happens with an IPO, where there’s often a one day bump in prices before traders tamp down their exuberance — if, for example, smaller trusts are thinly traded. Another factor is that trading in trusts is pretty much limited to Canadian brokerages, since the listings are in Canada. Extra supply won’t be forthcoming from U.S. brokers. Also, the income trust market is largely retail, so large blocks of shares will be harder to assemble.

For benchmarked pension fund managers, the problem lies in the fact that, to minimize tracking error, they must buy the day the trusts are listed — a day when the excess demand may lead to elevated prices. On the other hand, if passive managers do nothing, the income trust exposure will come automatically, as the benchmarks are reconstituted, Wiley says.

In any case, because income trusts are relatively new for many managers with pension mandates, they are likely to be underweighted. Wiley suggests that managers will likely hold one or two of the most liquid trusts, representing perhaps 1% of their portfolio.

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(06/20/05)