A little over a week ago, mutual fund manager Ben Cheng addressed an audience of 40 or 50 investors who gave him a startling insight into how retail investors view income trusts.
"I asked how many of them had an income trust in their portfolio, and all their hands go up," Mr. Cheng recalls. "And then I said, how many people in this room have more than 50 per cent of their investable assets in income trusts? More than half of the hands go up.
"That scares the hell out of me," says Mr. Cheng, who manages an income trust fund -- CI Signature High Income. "At the end of the day, it looks like retail investors have jumped again with both feet into an asset class thinking that it's invulnerable and it goes up forever. I don't think that's the case."
Trusts will definitely go into 2004 on a high note, given that a bill was introduced in the Ontario legislature this week to address the problem of unlimited liability. Demand for trusts could spike higher if investors no longer have to worry about the theoretical possibility of being held liable for the actions of a trust whose units they own.
Still, Mr. Cheng and others in the trust sector believe that 2004 is the year that trusts finally stop going up. Don't read this the wrong way. No one forecasts a major correction for trusts, although some experts see the sector as being overvalued and others can construct a plausible blueprint for a serious pullback.
Rather, the consensus seems to be that gains from trusts next year will come mainly from their quarterly or monthly distributions. Forget about big price gains -- the expectation is that the price of trust units will be up or down a few percentage points based on what happens with interest rates and the economy.
"If we make our distributions next year, that would be very decent," Mr. Cheng says. You may have heard this before.
A year ago, some in the trust sector were trying to lower investor expectations by saying trusts would deliver their distributions and not much more.
What happened was yet another incredible year for trusts. As of mid-month, the Scotia Capital Income Trust Index was up almost 19 per cent in 2003.
You can't really fault anyone who believes this is how trusts typically behave. The Scotia Capital trust index has risen at a compound average rate of 11.5 per cent annually over the past four years, and this just represents the price of the trust units. Throw in those monthly or quarterly distributions that are supposed to be the main reason for owning trusts and you end up with average annual total returns of 25 per cent for the sector.
Forecasts of a much quieter year for trusts contrast with fundamentals for the market that aren't too bad at all.
Interest rates are expected to rise somewhat, but trusts will still deliver competitive returns for income-seeking investors. Anyway, only about 20 per cent of the trust universe is vulnerable to rising rates, in the estimation of Sandy McIntyre, vice-president and portfolio manager at Sentry Select Capital Corp. This group mainly comprises power-generating and pipeline trusts.
The other 80 per cent of trusts -- oil and gas royalty trusts, real estate investment trusts, resource trusts and business trusts -- are much more sensitive to the country's economic output, measured by gross domestic product.
"The most important call to me is GDP, and we're looking at good GDP growth," Mr. McIntyre says.
With a stronger economy, trusts will be better able to make their distributions and even increase these payouts.
That's the good news.
The bad, according to Mr. McIntyre, is that there has been so much money pouring into trusts.
"It's an overbought market currently and has been overbought for about four months," he says.
The trust market could stay like this for a while before adjusting, Mr. McIntyre says. When it does adjust, it could either be by drifting sideways for a while or by falling.
Mr. McIntyre leans toward the drifting-sideways view, because there are no compelling alternative investments for people who want income.
All right, let's say you've got some money you want to put into trusts. Is now a good time to dive in?
"Probably not," says Bill Procter, who holds income trusts in several funds he manages for Mackenzie Financial. "But it really depends on your perspective. If you were to take an income trust index and maybe look out three to five years, I would think that the index would give you maybe 7- to 10-per-cent rates of return. If someone is looking at a 5-per-cent bond or a 3-per-cent Treasury bill, they might be very happy."
Then again, a 7-per-cent return from trusts might not look so appealing if stocks are providing similar returns, Mr. Procter said.
Trusts built their reputation with retail investors by outperforming stocks during the bear market, but Mr. Procter said the two will probably move more in concert looking ahead.
The bright side here is that it's unlikely trusts would plunge while the stock market chugs along nicely. There are now about 200 income trusts listed on the Toronto Stock Exchange with a combined market capitalization of $60-billion.
That's about double the level of three years ago.
Despite their marketplace heft, trusts are not factored into the performance of the S&P/TSX composite index. The main reason for this is concern that unitholders can theoretically be held liable for the actions of a trust in a way that shareholders of a corporation cannot.
The Ontario government has started the process of resolving this problem by introducing legislation to limit the liability of trust unitholders. Anything that brings trusts closer to inclusion in the benchmark Canadian stock index is seen as a huge positive for the sector, because it hastens the day when big pension funds will routinely buy trusts through the portion of their portfolios devoted to index investing.
Another potential lift for trusts could come from improved corporate governance and investor disclosure measures that are being discussed right now. The point is to make trusts more transparent and forthcoming in areas such as financial reporting and the writing of prospectuses.
More disturbing is speculation that Ottawa is looking at the question of whether trusts are causing a serious loss of tax revenue. The whole raison d'etre for trusts is that they allow companies to largely avoid paying taxes by channelling earnings down to unitholders in the form of distributions. In some cases, trust unitholders enjoy tax benefits in non-registered accounts that allow them to pay less in taxes than they would with income from a bond or guaranteed investment certificate.
Mr. McIntyre argues that the amount of foregone taxes is not serious. He also points out that if Ottawa were to make trusts less attractive, it would risk angering the many seniors who rely on them for income.
"My mother would tear the ear off Paul Martin if he made a change in this sector," he jokes.
The ultimate fear for trust investors is a repeat of the correction of 1998, when the entire sector plunged close to 25 per cent. What would it take for a repeat to occur?
Mr. Cheng lists four factors -- too much supply, too little demand, rising interest rates and falling oil prices. "You get those four factors in place and it could be a very disturbing market for income trusts," he says.
The supply of trusts has certainly been robust. A record $3.5-billion worth of new trusts came to market in the third quarter of 2003 and Mr. Cheng says the fourth quarter hasn't slackened.
Investor demand has so far kept up with supply, but continued gains in the stock market could have an impact. "If the stock markets continue to perform very well, there's always going to be a natural migration of investors saying, well, we've had a good run in trusts, let's put some more money in equities," Mr. Cheng says.
Interest rates could well rise in 2004, though most experts say not by much. As for oil, a recent forecast from BMO Nesbitt Burns called for lower but still respectable prices next year.
So what's an investor to make of all this?
Here's the course chosen by Mr. McIntyre, who is an investor in the Sentry Select Diversified Income Trust as well as the manager. "I exercised a bunch of options in my own fund as recently as three weeks ago," he says. "I put my own capital up."
His reasoning: It's better to move now and collect distributions than to try to time a market drop at some future date.
Money continues to pour into income trust funds, so it's clear that many investors continue to see value in this sector as well. That's fine, as long as they understand the big returns are most likely finished for a while.
© The Globe and Mail
Only GlobeinvestorGOLD combines the strength of powerful investing tools with the insight of The Globe and Mail.
Discover a wealth of investment information and and exclusive features.
