S&P weighs including trusts in TSX Composite

(October 28, 2004) Since the late 1990s, income trusts have enjoyed explosive growth on the Toronto Stock Exchange, especially after the tech implosion, by investors seeking shelter from the bear market in yield-bearing vehicles. The number of trusts has grown from a handful to 160 in September 2004 and as a group they account for 9% of the total TSX market capitalization.

In a white paper released this week, Standard & Poors lays out the dramatic effect trusts would have on the index, if included in the S&P TSX Composite Index. If selected trusts were included in the last quarterly rebalancing, the market capitalization of the index would increase by $64 billion to $895 billion, with the number of issues rising from 223 to 279.

Sector weightings would shift slightly, with the Energy sub-index accounting for nearly 21% of the entire index, an increase of 2.52%. Financials would retain the heaviest weighting, although that sub-index would see a drop of 1.31% to 32.55% of the total, partially cushioned by the increased weight in the real estate component within financials. Utilities would pick up the half percentage point dropped by technology, but would still account for less than 2% of the index.

The main purpose of the white paper, however, was to lay out the arguments heard by S&P on both sides of the question of index inclusion.

“A good index should be representative of the asset class or sector that it is intended to reflect,” the preamble to the report reads. “This would be an argument in favour of including trusts in the Composite. At the same time, a good index should be investable — it must be possible for real-world investors to replicate the investments made by the index; otherwise the index is not meaningful.”

The paper points out that many major market participants, such as pension funds, have policies against investing in trusts, usually citing the liability issue. Some notable investors have called this a red herring, including Ira Gluskin, president of Gluskin Sheff & Associates. He has repeatedly said in the past that this is simply an excuse for missing out on the early run-up in income trusts.

“The majority of outside-managed pension funds basically missed income trusts completely,” he said at The Canadian Institute’s Third National Summit on Income Trusts in January. “Having missed it, they have rationalized there is a reason they missed it, which is [trusts] are no good.”

Furthermore, trust unitholders have already enjoyed limited liability in Quebec and Alberta, comparable to corporation equity holders. Meanwhile, Ontario, British Columbia, Manitoba and Nova Scotia are either considering similar legislation or are in the process of passing it.

Opponents of index inclusion expressed serious concerns over corporate governance or trusts. While investors elect the trustees to oversee the trust, they may not fully understand their role.

“Trustees have a fiduciary duty to oversee distributions, but the amount of power they have over the operating company underlying the trust is unclear,” the report says. “Unitholders believe the trustees can intervene if management is incompetent, but the amount of power trustees have varies considerably from trust to trust. Trustee knowledge and experience also varies widely due to the low compensation levels.”

But those in favour of inclusion argue that since trusts are relatively new creatures, they tend to be ahead of the curve on governance issues.

“In contrast to many public companies, income trusts have long separated the roles of chairman and CEO, and have maintained independent majorities on their boards of directors,” they told the panel. “The fund’s trustees are bound by the highest fiduciary duties — a standard at least as high as that imposed on corporate directors.”

Proponents also argued that distribution requirements forced on income trusts impose closer scrutiny and stricter discipline upon the management of the operating companies. They also point out that the trust structure does not free them from securities legislation or listing requirements.

Another bone of contention between the two camps is whether or not income trusts are equities or not. If they are not equities, as opponents claim, they should not be included in an index designed to reflect the Canadian equity market.

“Investors invest in equities for the purpose of achieving long-term capital appreciation. The investment purpose of income trusts is for enhancement of current income — they are “no growth” investments,” opponents claim. “Therefore inclusion of trusts in the Composite would render it useless as a benchmark. If trusts are added to the Index, pension funds and passive indexers may adopt a different benchmark because it will no longer represent their investment universe.”

Those in favour of inclusion point out that trusts’ liquidity, volatility and residual claim on earnings are intrinsic characteristics of equities and they should be considered on the same terms as high-yield dividend stocks.

R elated Stories

Institutional investors already in trust market Income trusts discipline company management Closed-end trusts bite into mutual fund sales

With such strong feelings on both sides of the issue, Standard & Poors has yet to decide on the inclusion issue. One interesting suggestion was that they launch a separate “Super Composite” index, which would include trusts as well as the traditional Composite. While this would allow institutional investors the option of including trusts or not, it is unclear how this would differ from the current choice such investors face.

Others have called for maintenance of the status quo.

“S&P already has indices related to income trusts,” said one submission. “If investors decide they want exposure to those securities, they have the freedom to make the explicit decision to amend their investment benchmark.”

This would, of course, have essentially the same effect as introducing the Super Composite Index, as investors would still have the option of portfolio inclusion or not.

Other suggestions include the gradual phasing in of trusts into the Composite and allowing only those domiciled in limited liability jurisdictions.

Standard & Poors has scheduled a meeting of its index advisory panel for November 3 to consider the arguments from both sides, before deciding on inclusion.

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

(10/28/04)