Income trusts can be gorgeous investments. Between the yield and the capital gain, you can bag a 30-per-cent annual return. But you might be less excited about the juicy profits if you knew how much the Bay Street underwriters were skimming off the top, the bottom and bits in between.
If you're like most unwealthy investors, you buy a closed-end income trust fund as opposed to an individual trust because there is security in diversity. There are a ton of options, including the Faircourt Split Seven Trust, Fairway Diversified Income and Growth and Skylon Growth and Income Trust. Most have performed well.
The funds are usually priced at $10 a unit. But there are costs. An "agent's" fee of 5 per cent comes off the top. That essentially covers the underwriting charge, which is split between the underwriter and the retail broker. The fee does not include assorted lesser expenses, such as legal fees. Include them, and you get close to 6 per cent. So you're down to perhaps $9.40.
Of course, you also have to pay a management fee of about 100 basis points a year and a small trailer fee. The amounts add up, but you're not getting your Y-fronts in a knot because a) mutual funds charge management and trailer fees too, and b) you know trust funds can be fine performers and you're not in this for the short haul. You're thinking a few years, minimum. Or so you thought.
Indeed, you forgot to respect the power of the annual redemption option. A standard feature in many, perhaps most, trust funds, it allows unitholders to redeem their investment at net asset value (NAV) once a year. Goodbye annoying little holding company discount. Your broker thinks it's a good idea, too.
The redemption feature has been a big hit with investors. Take Faircourt. In March, in announced it had received redemption requests from 47 per cent of its trust unitholders. Other trust funds have similar redemption rates. In these funds, the trading volume soars just before the redemption date. As the heavy trading pushes the price up, the NAV discount shrinks. After redemption day, the trading volumes shrink and the NAV discount widens. Repeat in the following year.
If you're happy with the redemption feature, the underwriters and the brokers are even happier. First, you get charged a 1-per-cent fee to sell. Then, guess what? You're put into a new fund that charges you another 5-per-cent agent's fee.
So let's add it up. You paid 5 to 6 points to get into your fund, 1 point to get out, then, if you opted for a redemption, 5 to 6 points to get into another fund -- about 12 per cent in a year. Plus, if you had sold your fund back to the underwriters' arbitrage desk before the redemption date, as some investors make the mistake of doing, you sold at a NAV discount, leading to another 5-per-cent cost. That can take your total costs up to 17 or 18 per cent. If a mutual fund charged you that amount, you would storm the offices with torches and pitchforks.
The underwriters can barely disguise their glee over this perpetual money machine. In April of last year, in a memo marked "For Internal Use Only," CIBC World Markets noted that the proliferation of funds meant redemption dates weren't just coming in December. They were coming in other months as well. The title of the memo: "Not Just a Christmas Event!"
Christmas is still coming month after month for the underwriters. They will argue that the annual redemption feature is a good thing because it can protect the investor from the dreaded NAV discount. It does (assuming you don't sell before the redemption date), but churning investors in and out of income funds is an even better thing for Bay Street.
Some day, investors will realize that they will get richer if they avoid turning over their trust investments every year. You don't churn your mutual funds because you don't want to pay the fees, so why would you churn your trust funds? Avoid it and you'll save the agent's fee year after year. Add it all up and you're talking real money. Churning your trust fund is even more ridiculous when you realize that the new fund you bought at the end of the year might look pretty much like the one you just sold.
Don't count on the feature disappearing soon. Bay Street wants to milk it for every cent. It wants keep going when the going is good, and it's very, very good at the moment.
© The Globe and Mail
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