When the dust settles on income trusts

Although a few weeks have passed since the news effecting the taxation of income trusts, time isn’t helping investors forget the Oct. 31 announcement.

The spectrum of comments in the media has ranged from general acceptance to outrage.  Two things are certain-  investors dislike negative surprises and the federal government is not going to reverse this announcement.

Investors who overweighted income trusts for a long period of time have profited handsomely.  One could surmise that it was good while it lasted.  The best way to combat volatility and uncertainty in the market is to diversify your portfolio.

The first step in diversifying your portfolio is to establish an Investment Policy Statement (IPS).  An IPS provides the framework for developing a disciplined investment approach.  A disciplined investment approach nearly always prevails in the long run.  Every individual has to obtain an understanding of the level of risk they are comfortable with.

An IPS also highlights the need to rebalance individual positions and asset classes periodically.  Determining an appropriate asset mix between cash, fixed income and equities is the most important decision investors need to make and a critical component of an IPS.   Any change in your personal situation or the taxation of investments should result in individuals reviewing their current IPS.

Illustration:  Mr. Patterson has the following asset mix – 5 per cent cash equivalents, 30 per cent fixed income and 65 per cent equities.  The cash equivalents component is invested in a money market fund.  Fixed income is comprised of Guaranteed Investment Certificates (GICs), bonds and treasury bills.  Mr. Patterson’s 65 per cent equity component is invested as follows:  common shares (25 per cent), preferred shares (10 per cent), mutual funds (10 per cent), exchange trade funds (10 per cent), and income trusts (10 per cent).  In the first week following the October 31 announcement, the income trust sector index declined on average approximately 14 per cent.  Some of Mr. Patterson’s exposure was to real estate income trusts which were not impacted.  There is no doubt that Mr. Patterson’s portfolio was negatively impacted from the income trust news.  Fortunately, other components of his investments, primarily his common shares, performed positively during this same period and his combined portfolio actually increased in value.

Concentration and Timing

Mr. Patterson’s portfolio mix described above provides one example of a diversified portfolio.  In many cases a diversified portfolio really shines when negative market events occur.  Individuals that chose to concentrate or overweight a portion of their portfolio within income trusts have been impacted the most, as were those people who purchased income trusts recently.  We encourage investors to understand the asset class weightings in their portfolio.  What component of your portfolio is comprised of income trusts?   Once determined, this should be compared to your overall investment plan.

Structured Products

As the income trust market has grown in popularity so too has structured products that pool these types of investments.  Many of these pooled products are structured as “closed end funds.” They trade on an exchange and may not be readily redeemable from the fund company.  As these structures trade on an exchange they may trade at a discount or premium to the actual Net Asset Value (NAV) of the underlying investments.  Some closed end funds have very low trading volumes and in the absence of individuals wanting to purchase, individuals entering market sell orders may receive a discounted value.   These structures often provide investors the ability to redeem at NAV at predetermined times.  We encourage investors to obtain an understanding of these dates and the various redemption privileges.

Active versus Passive

Individuals who have purchased structured products may want to determine whether the fund is actively managed or whether it has a passive structure.  Fees for actively managed funds are generally a little higher than passive structures.  Examples of a passive structure may be a basket of 100 of the largest income trusts, equally weighted.  Certain actively managed structures may provide a flexible mandate to change to other income asset class types, while others may be restricted to income funds only.  Investors should determine whether their funds hold income trusts and whether the mandate is flexible or not.  Investors holding active and passive income trust structures should assess these strategies in light of the recent news.

All Or None

For those investors that are holding individual income trusts the options are a little different.  The recent news highlights the need to hold quality investments.  Investors should clearly understand that the recent announcement does not wipe out the fact that many of these trusts are solid businesses that will continue to pay a stream of consistent income.  The tax efficiency will continue until 2011.  Often at times investors feel they have to make an all or none decision.  If you are undecided as to the best course of action then sometimes the middle road is the best option.  Selling half of a position that you are uncertain about will reduce your overall exposure but still provide you some income and hopefully the benefits if the trust market stabilizes or improves from its current state.

Stop Loss Orders

When uncertainty still exists regarding a specific investment many investors choose to put a stop-loss order to minimize further downside risk.  This type of order is used not only to reduce further losses but also to protect unrealized gains. This type of order is automatically triggered once the security’s price declines to the stated limit within the determined time and becomes a market sell order.  Investors should be cautious when entering stop orders on thinly traded positions.

Tax Consequences

Individuals that hold income trusts within a taxable account should assess their current tax situation.  Most individuals that have held these investments for a significant time may still have significant unrealized capital gains.  Selling prior to year-end may realize these gains and create a taxable capital gain.  Others that have recently purchased income trusts may have unrealized capital losses.  Tax loss selling is a strategy that can be used to offset capital gains from other investments.

What type of investment would you purchase today?  Some individuals may see value in those income trusts that have declined in value.  Others may choose preferred or common shares.  Solid research on blue chip equities has been a long-standing successful approach to equity investing.

Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors.