With the average Canadian income-trust fund having yielded an 18-per-cent total return in 2005, it's hard to resist the temptation to buy.
But income funds aren't just the "it girl" of the moment. Over three years the annualized return including dividends in this sector is 22 per cent, and over five years it's 16.5 per cent, according to fund analysis firm Morningstar Canada.
So should you surrender to the seduction of higher yields?
Not if you expect a repeat performance in the years to come, said David O'Leary, a senior analyst at Morningstar.
"It can continue to do well and be a seasonal part of the investing strategy, but investors should know it can't continue at this rate," he said.
In addition to the conventional investing wisdom that nothing goes straight up forever, some fundamental changes in the trust industry have reshaped the investing landscape, Mr. O'Leary said.
Specifically, many institutional money managers loaded up on trusts last year, satisfied that the new limited liability legislation in Ontario, Alberta and Quebec meant unitholders aren't at risk if the trust is unable to meet its obligations.
As the big investors waded in, they brought their fancy calculators and analysis tools and re-evaluated many of the income trusts that had been priced by comparably inexperienced individual investors, Mr. O'Leary said. The professionals were able to identify trusts that were under-priced; they bought them and did well, he added.
"Fund managers and particularly pension managers are beginning to open up (to income trusts). Those opportunities for finding inefficiencies are starting to disappear," he said.
Another reason income trusts won't appreciate as quickly now is that many inexperienced investors bought late into the rally and paid too much, Mr. O'Leary said.
In fact, there are already signs the love affair with income trust funds may be cooling.
According to an analysis by Frank Hracs of research firm Canadian Mutual Fund Analyst, a "significant slippage" will occur this year for seasonally adjusted net new sales of income trust funds. They ranked fourth-fastest for growth in 2005 out of 29 long-term fund categories but will likely rank about 10th in 2006, Mr. Hracs's research shows. After peaking at $355.3-million last July, seasonally adjusted monthly net new sales of income trust funds began to drop and actually went negative in October to the tune of $168.1-million and have remained at less than $100-million ever since, Mr. Hracs' data shows.
Investors have many reasons to be cautious about income trust exposure, whether buying units in funds or owning them outright, said Dan Hallett, president of Dan Hallett & Associates, an investment research firm focused on mutual funds.
"This is an asset class that is not cheap, that people are going hog wild over," he said. "Investors have been tripping over themselves to put lots of money in these types of funds. People are usually not right when they're putting large amounts of money into a particular asset class."
Because institutional investors usually do a better job of valuing trusts than inexperienced investors, it's generally best to own a mutual fund, Mr. Hallett said. And there is the added advantage of diversification thanks to a large pool of money.
Over the past five years, the top three performing Canadian mutual funds in Morningstar's Canadian Income Trust category are the GGOF Monthly High Income Classic fund, with a 22.2-per-cent annualized return; the Renaissance Canadian Income Trust Fund, at 21 per cent; and the Bissett Income Class A at 18.8 per cent, according to Morningstar.
In the past three years, the best performers have been the Dynamic Focus & Small Business Fund, with a 32.7-per-cent annualized return including distributions; Sentry Select Canadian Income Fund, at 29.2 per cent; and Sceptre Income Trusts Fund, at 27 per cent.
This year, however, managing director Matt Baillie of Sceptre Investment Counsel is expecting a more modest return of 10 to 12 per cent.
"These income trusts were massively undervalued for many years, and now that it's a more mature market, they're more rationally priced," Mr. Baillie said. "Now that more institutions are involved, you can still get a good return but perhaps more in line with the market."
Even with smaller gains ahead, Mr. Baillie said, investors have many reasons to remain invested in the income trust sector. First, the danger of Ottawa changing income-trust taxation has passed, with the new Conservative government having promised to uphold the Liberal decision to reduce taxes on dividend-paying stocks to try to make them competitive.
Second, income trusts' full entry into the Standard & Poor's/TSX Composite Index in March will guarantee heavier institutional buying. Finally, he said, low interest rates will keep retirees clamouring for higher yields.
Income trust yields should stay at least 3 percentage points above bonds indefinitely, Mr. Baillie predicts. Business trusts yield about 8.8 per cent, according to CIBC World Markets Income Trust Daily Valuation Report, based on Monday's close. REITs yield about 7.5 per cent, and royalty trusts about 11.2 per cent. The 10-year Canadian bond yields about 4 per cent.
Of these sectors, Mr. Baillie's fund is comprised of 40 per cent business trusts, 26 per cent REITs, 28 per cent oil and gas and a handful of utilities.
Part of his fund's success has been due to a relatively large weighting in REITs that was established four years ago, he said.
"In Canada, the vacancies in the office and residential sides are going down, the industrial properties have stable vacancies, and you're seeing more and more demand from pension funds," he said. "Our REITs are still cheap compared with the U.S., and it's much more stable than, say, the royalty trusts and the business trusts in general."
When selecting business trusts, he watches out for low debt loads and good management teams that can grow the business without large capital expenditures. Two of his consistent performers have been the Liquor Stores Income Fund and the Aeroplan Income Fund. As a general rule, Mr. Baillie is wary of trusts that pay out more than 95 per cent of their cash. He also monitors trusts for foreign exchange risk, particularly if they have more than 25 or 30 per cent of their revenue in U.S. dollars.
He also owns small trusts that are off the radar of many analysts, including Gamehost Income Fund, whose assets include casinos in Fort McMurray and Grande Prairie.
"It's one way to play the Alberta oil boom," Mr. Baillie said, adding that many trusts "started out very small and grew and became big enough that they started to get coverage."
His fund's bigger bets on the West this year include Precision Drilling Trust, Builders Energy Services Trust and Cathedral Energy Services Income Trust.
Theresa Ebden is an associate producer for Report on Business TV.
© The Globe and Mail
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