Trust inclusion has proven unpredictable

There’s no question that the inclusion of income trusts into the country’s most closely watched index has had an impact on the benchmark, but the transition has proven far from predictable.

When Standard & Poor’s announced it would include trusts in the S&P/TSX Composite, retail investors who had been driving trust performance reckoned it was the last step before the big pay-off — meaningful participation of institutional investors.

Strangely, trusts may have had a greater impact on the overall index than the index inclusion has had on trusts. The number of issues on the index has risen from 206 to 274; overall market cap of the index is higher by 10.8%; and the market now has a dividend yield of 2.4%, up from 1.6%. We may even see the term “dividend” dropped from usage, in favour of “distribution,” reflecting the return of capital that often makes up income trusts’ output.

The effect inclusion has had on trusts, however, has been far less predictable.

“Frankly, I can tell you it was a disaster in December for just about every market participant involved,” said Peter Haynes, managing director of index products for TD Newcrest, speaking at the Canadian Institute’s 5th Income Trusts Summit in Toronto.

December 16, 2005 marked the last day of trading before the first group of trusts joined the benchmark. On the close of trade that day the TSX Comp’s value would be reset to ensure the trust-included version of the index would be of the same value as the common equity-only version.

Haynes said TD Newcrest expected about 50% of Canada’s indexers to adopt the trust-included index on or about the December 16 benchmark date, representing about $1.7 billion in new capital flowing into trusts.

Hedge funds and proprietary traders, often seen as opportunistic villains in such instances, played an important role by absorbing much of the risk for indexers, Haynes said.

“As much as people think of hedge funds and pro traders as the devil, in this process they were an extremely important stop-gap measure,” he said. “They were willing to take the risk of an extended period of market exposure to give these indexers the trusts they needed on December 16.”

Between November 23 — when Finance Minister Ralph Goodale announced that trusts would not face additional taxation — and December 16, the market saw increased volumes and prices among trusts as hedge fund managers positioned themselves to take advantage of indexers’ demand.

“Typically hedge funds trading around index changes will be profitable,” Haynes said. “I can tell you in this case they got absolutely slaughtered.”

Hedge funds and pro-traders seemed to overestimate that demand. At 3:40 on December 16, 2005, the Market on Close book reflected $228 million in unmatched income trust sell orders. With twenty minutes left to the trading session, indexers were able to match their buy orders to the excess supply.

Compounding their predicament, these hedge fund managers had bet the rest of the market would drop, as indexers sold off their common equities to pay for their trusts purchases. They timed their short contracts to be unwound on December 16 as well. Their short positions provided excess demand for stocks, driving equities higher.

The remaining trusts to be added to the index will be added in March, but Haynes says the market can expect a more traditional reaction, with trusts rising and the broader equity markets sliding.

Many of the traders who were burned during phase one of the inclusion process in December were foreign hedge funds. Haynes said they will likely still be smarting from that episode and are unlikely to attempt the same strategy in March.

There is now talk that MSCI is considering including trusts within the Canadian component of its North America index. Should trusts be included in that index, foreign-based indexers should stoke the markets further. Haynes expects to see better liquidity in the trust market and improvements in accounting practices, possibly leading to a definition of “distributable cash.”

Billion dollar midcaps

When Standard and Poor’s included trusts in its benchmark S&P/TSX Composite Index, all but two of the trusts were placed in the Small Cap index, with Canadian Oil sands and Precision Drilling being listed on the Mid Cap index, with market caps of $13.7 billion and just under $4.9 billion respectively.

No income trusts were included in the large cap S&P/TSX 60 index, because there are too many derivative products based on the 60, according to Jasmit Bhandal, director of business development, Canadian index services at S&P.

Haynes says this decision has radically altered the sector allocations within the small cap index, from 16.9% energy, to a massive 39.9%. Further distortions arise because many of the income trusts listed as small caps have far higher enterprise values that would preclude small cap fund managers from buying them.

Haynes says TD Newcrest predicts there will be some movement of trusts from the small cap index to the mid cap index eventually. He also predicts that S&P will be virtually forced to include trusts in the 60, as corporate Canada is “hollowed out” and listings disappear due to mergers and acquisitions. He predicts such a move could come as early as the middle of 2006. Among the top candidates for this graduation, Haynes lists Canadian Oil Sands, Yellow Pages, Enerplus Resources, Penn West Energy and Fording Canadian Coal.

Haynes also advocates the elimination of the tell-tale “.un” extension currently assigned to trusts’ ticker symbols by the Toronto Stock Exchange. So far, the extension has proven largely beneficial to the group, helping them stand out from common equity listings, but Haynes says dropping the extension would be seen as a further signal that these high-yielding equities had become mainstream.

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

(01/23/06)