Income Trusts - Amazing Returns During a Disappearing Act

A little over a year ago, this blog asked whether Income Trusts, with their exceptionally high yield at the time, presented the investor with a Neglected Opportunity? It turns out the answer was an emphatic Yes!

While the overall TSX Composite total return (which includes both dividends and the market price rise) in the year since last March 16th, in the rebound from the 2008 market crash has been an outstanding 47.6%, the Income Trust sector index has gained an even more amazing total return of 66%!

Income trusts had on average cut their high distributions drastically during late 2008 in response to the market crash and lowered petroleum prices (many income trusts are energy companies). However, many did manage to maintain their distributions and even start increasing them during 2009 as seen in the chart below of the price and cash distributions of the iShares Canada Income Trust Sector Index ETF (symbol XTR) that tracks the overall index. Nevertheless, yields are lower but still very attractive today at around 8.8% vs over 10% a year ago - because the market price of income trust units has risen strongly. (For details of yields of individual trusts, see this listing on Investcom.)


What About the Future?
It's perhaps interesting to look back and think "what if" but the future is what really counts so what factors will influence the future prospects for income trusts? Here are some probable and potential consequences:

Income trusts will continue to disappear - the October 2006 federal government tax policy decision to tax all but qualifying REITs as corporations eliminated the advantage of the income trust structure and the slow demise of the income trust has been proceeding before the new tax rule comes into effect in 2011 (see TaxTips.ca description of taxation an investor faces and will face as an income trust investor). From a peak of about 247 trusts in 2006, there are now only 163 left. So far, a minority of the departed trusts - about a third of them - converted to corporations. The rest have been bought out and taken over by tax-advantaged pension funds or foreign companies or investment funds (see sample names on The Marshall Plan). It is likely the mix will change more to conversion to corporations rather than takeovers since the majority of remaining trusts are in the Business sector (see TSX website for breakdown and complete list). The options and the consequences for investors break down as follows.

1. Remain as Income Trust - most REITs are expected to remain as income trusts, and a few non-REITs may do so too if they still have tax losses that permit tax-free distributions, according to Blakes law firm which specialises in this sector. High distributions in this group may not decline at all or may even increase if economic conditions remain in the upswing.
   
2. Conversion to Corporation - cash distributions will get cut after conversion due to the extra tax to pay by the corporation but for the taxable payer/account, the net effect after tax for the investor can be a wash since the investor now receives a dividend tax credit (see PriceWaterhouseCooper report mentioned in the original posting). Someone holding such an income trust in a RRSP or other registered account will see a real decline in income - 30% is the amount of the new tax rate and is a reasonable starting guess for the reduction. After conversion, the usual business assessment techniques will need to be applied to judge the on-going viability of the business, the stock and the dividend.
   
3. Buyout - there may be a healthy premium to market value when a takeover occurs and the income trust owner may receive a good capital gain (e.g. the 300% premium for PrimeWest Energy Trust in 2007 paid by the Abu Dhabi national oil company or the 47% premium for Harvest Energy Trust in October 2009 by the Korea National Oil Corporation. That kind of result is not assured in every case and no doubt speculators are looking closely at remaining trusts to spot likely candidates, which tends to bid up prices, so an investor is not assured of success playing the takeover premium guessing game. If there is still a buyout premium value amongst income trusts overall, one way to play the game is to invest in a fund with many holdings, such as XTR or a Closed-End Fund with income trust contents amongst the CEFs listed at GlobeInvestor.

It is also not easy to decide which outcome, status quo, conversion or takeover, will apply. Checking out each trust's website for management statements in annual reports or press releases may give the answer as to which way the trust will go.

Bottom Line
The combination of the looming deadline along with economic recovery that is reviving takeover activity means there will be a lot of action that may interest readers inclined to a bit of speculation in the hope of short term gains. Last year's post suggested factors to consider and should help readers get started with the research that is required for success. Foresight takes more work than hindsight.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Different and Better(?) Ways to Invest in the Broad US Equity Market

A couple of previous posts compared total market and S&P 500 ETFs as a way of participating in the broad US equity market. There is yet another way that may be even better, one based on alternative indices similar to the S&P 500 but which weight companies differently. The attraction is potentially higher long term returns with a better risk to reward trade-off in the bargain.

The choices:

1. Traditional Cap-Weighted S&P 500 - stocks are weighted according to their total market capitalization (stock price x number of shares); the oldest and largest ETF in this category is the US-traded SPDR S&P 500 (symbol: SPY)
2. Fundamental Index - stocks are weighted according to a mix of four accounting measures of company size - sales, cash flow, book value and dividends; the ETF here is the Powershares FTSE RAFI U.S. 1000 Portfolio (PRF)
3. Equal Weight Index - each stock in the S&P 500 receives the same weight of 0.20% (100% / 500); the one and only ETF that follows this method is the Rydex S&P Equal Weight ETF (RSP)

ETF Comparison Table
The table below shows some of the characteristics of each ETF and recent performance data, with green cells highlighting the ETF that does best for each element. Though each ETF has the same number of green cells, the really important figures to the investor are ultimately the total return (a combination of dividends and stock price increase) with consideration of the risk. These key factors at the bottom of the table, which come from Morningstar.com, are highlighted in bold text.

Fundamental Weight and Equal Weight Out-Perform Cap-Weight
The Google Finance chart of SPY, PRF and RSP market price since PRF was launched at the end of 2005 gives a visual confirmation of the comparison table numbers.

• on both 3-year and 5-year total return, PRF and RSP have done significantly better than SPY - between 1.3% and 1.8% per year better
  
• on a risk-adjusted basis, as measured by the Sharpe ratio, which divides returns by volatility of returns, PRF and RSP both do better than SPY

Will the Out-Performance Last?
Of course, three years and even five years is a short time to judge investing success and the question is whether the better performance would be sustained in the long term through many economic cycles and conditions.

Some measure of support, though it can never be absolute proof, comes from academic studies. In March 2008, the EDHEC Risk Institute, a body associated with a university in France, published A Comparison of Fundamentally Weighted Indices: Overview and Performance Analysis. The study found that both Fundamental and Equal-Weight indices out-performed the S&P 500 by around 2% per year over the period from 1965 to 2006. The study also found higher Sharpe ratios for the Fundamental index. Finally, the study calculated the Sortino ratio, which considers only the downside return vs risk, and it too showed that the Fundamental index (they did not figure out the Sortino ratio for the Equal Weight index) did much better than the S&P 500. That the recent performance figures follow the same pattern of out-performance, during a subsequent time period of singularly traumatic market stress, is reassuring.

What's are the Risks?
If these alternate indices and associated funds have done so well, what could go wrong and what are the potential downsides?

• the future may not be like the past - though 45 years of data is starting to get long, it may still not be enough to ensure success
• the ETF lags the index - the research paper studied the performance of the ideal, the index; matching that in real investing must overcome the practical implementation issues and these are more of a drag on the fundamental and equal weight indices than the cap-weighted; the comparison table shows a much bigger negative tracking error for both PRF and RSP than SPY. Will that performance drag stay the same and allow lesser but still appreciable return advantage to continue?
• the equal-weight and fundamental strategies will likely under-perform by a lot for lengthy periods; the study again helps demonstrate the possible size of this risk - for over seven years from 1993 to 2001, the fundamental index fell behind the S&P 500, reaching a maximum 22% lag. The nature of the fundamental index means that it will do less well in comparison to the S&P 500 when there is a really strong bull market or bubble. The fundamental fund returns won't be negative, they will not be nearly as attractive. Will the investor be able to watch and hold tight for that long in the hope or expectation that later returns will rebound and more than make up for the lag?

Alternative Index Funds Traded in Canada
There are no broad US market equal-weight funds available in Canada at the moment.

Fundamental weight - four funds are available based on the same RAFI 1000 index:
1) Claymore Canada offers two ETFs, one of which hedges US vs Canadian dollar currency shifts and the other does not.

• Claymore US Fundamental Index ETF (non-hedged) (CLU.C, MER 0.65%) and
  
• Claymore US Fundamental Index ETF C$ Hedged (CLU, MER 0.65%)

2) Powershares FTSE RAFI U.S. Fundamental Index Fund (AIM57203 for Class A, MER 1.44%) - a mutual fund, new since January 2010
3) PRO FTSE RAFI US Index Fund (PRO901 for Class A DSC, MER 1.6%) - another mutual fund, started up in March 2007

Note that the currency factor, whether hedged or not (see previous post discussing this issue), and higher MERs will greatly affect net returns for the Canadian investor.

Alternative index schemes are an intriguing investment possibility that have attracted much discussion and criticism, as well as quite a bit of investment money (see net assets of RSP and PRF in the above comparison table). For the online DIY investor, as usual, whether to buy in is a decision you must make for yourself. Or, you can always seek professional guidance.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Income Tax Season: Resources to Help You Prepare a Return

One of the good things about online investing is that when it comes time to prepare the annual income tax return, almost everything needed is available online. Here is a collection of links to help with your tax return:

Tax Advice and Rules:

• Canada Revenue Agency - the official source for forms, guides and bulletins and electronic filing, due dates, or use the toll-free number 1-800-959-8281 for specific questions
  
• TaxTips.ca - rules explained in common language, tips, tables of tax rates by province, calculators, special section on taxation of investments
  
• Canadian Tax Resource - blog by an accountant, clear explanations, good links
• Grant Thornton - tax tips from an accountancy
  
• KPMG Tax Planning for You and Your Family 2010 - a book! - readable, clear explanations, well-indexed, onward references, which you can buy at Chapters
  

Tax Breakdown (Interest, Dividends, Return of Capital etc) of Distributions

• iShares Canada 2009 Table for all its ETFs
• Claymore Canada - look for the ETF Tax Information in the drop down box on the Literature page
  
• Mutual Funds - follow links to fund companies at FundLibrary.com and look for Tax or Distribution info at each company's site
• Income Trusts and Closed-End Funds - ACB Tracking Inc has a pay service that simplifies the tracking
  

Tax Return Software - two types exist: downloadable software to run on your own computer and web-based software that can be used from anywhere connected to the Internet; the better packages have lots on built-in help and advice on paying the least amount of tax, legally of course; all are NetFile certified, meaning you can use them to electronically file your return with the CRA, which in turn means getting your refund a lot sooner

• QuickTax - the dominant player
• UFile - hot on QuickTax's heels
• H&R Block - add-on access to live advice
• Taxnic
  
• eTaxCanada
• FutureTax
• GenuTax
• myTaxExpress
  
• StudioTax
• TaxFreeway - PC and Mac versions
• TaxTron - another with PC and Mac versions
• UDoTaxes - free regardless of income, asks for donations if you like it
  
• AceTax Online
• EachTax
• FileTaxOnline
• MBOTax
• TaxChopper
• WebTax4U.ca
• Impôt Professionel (Québec only; return to be mailed in only)
• 5DollarTax (NetFile for 4 provinces only - QC, ON, AB and BC)
  

Software Reviews and Comparisons

• Canadian Tax Resource - handy table lists basic features and exceptions (e.g. some don't do Québec returns), prices and freebies (e.g. seniors, low income, students)
• CanadianFinancialDIY - tested and rated all the web packages last year and promises to do the same again this year
  

Tax Calculators

• Ernst & Young - enter your taxable income and it shows you by province total tax as well as marginal rates on ordinary income/interest, capital gains and dividends
• RRIFMetic - sophisticated tool (and it costs a fair amount) for planning and optimizing for retirement income including taxes on types of accounts (taxable, RRIF, LIF, TFSA, RESP) and types of income (dividends, interest, capital gains)
• TaxTips.ca Tax Planning Calculator - simpler (and free) but still quite detailed calculator to help decide when there is some flexibility to take income from RRIF/RRSP, or taxable capital gains, interest and dividends
  

Tax Discussions

• Financial Webring Tax Forum - register and you can take part, ask questions and perhaps get good answers
• Canadian Money Forum Tax Thread - another place to read and participate
• Canadian Business Online - forum plus articles on tax topics
• Taxing Issues - Vancouver Sun columnist Don Cayo on all sorts of taxes
• Tim Cestnick - tax columnist at the Globe and Mail
  

These resources won't mean you will be able to avoid taxes altogether but at the least they will make it easier and faster to do so correctly and probably to pay less as well.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

TSX Composite and S&P 500 Total Market Return

Investors always need to be wary that they are comparing apples with apples when measuring returns.

Dividends Left Out!
Every day the news trumpets the latest rise or fall of the major stock indices such as Canada's TSX Composite or the USA's S&P 500 but the number the news media quotes is only the Price level of the stocks in the index. A significant part of the return an investor receives over the long term, especially investors who buy and hold, is the dividends paid out by the companies. When reinvested, those dividends have a powerful long term compounding effect.

Take a look at the steadily diverging lines of the two measures of the TSX in this GlobeInvestor.com chart of TSX Price Index vs Total Return Index. In the relatively short period of the past five years, the TSX return is almost double - close to 40% Total Return vs 20% Price return - when dividends are included. The TSX Composite dividend yield may seem small at around 2% these days but it matters a lot.


The same holds true for the USA. This article at SimpleStockInvesting.com discusses Total Returns for the S&P 500 and shows this chart for the period 1950 - 2009 of the Index Price Return vs the Total Return.


Where to Get Total Return Figures
What is available on many popular investment websites like Google Finance, Yahoo Finance, MSN Money and TMX Money (the TSX's own website) is the Index Price level only. Total Return figures are hard to find for free online but a few sources contain this valuable data.

S&P 500 - the performance data webpage of the index publisher Standard and Poors has YTD, 1,3 and 5 year annualized returns but only in US dollars, which means a Canadian investor cannot tell his/her return in Canadian dollars. Wikipedia also has an article containing year by year and compound returns for 5, 10 and 15 years but again this is only in USD.

TSX and a Few Other Indices - GlobeFund.com has a table of mutual fund benchmarks with several Total Return Indices amongst other indices showing returns from 1 month to 10 years. GlobeFund also lets you chart any ETF or mutual fund against several other Total Return benchmarks such as the S&P 500 or the Dow Jones Industrial Average (DJIA in the list) both in US dollars and Canadian dollars, and the Chinese Hang Seng and Japanese Nikkei in Canadian dollars as well as the home currency. The value of GlobeFund is mainly to see the evolution of the Total Return Index not the fund since the fund returns do not assume reinvested distributions or dividends i.e. it is not an apples to apples comparison.

It is important to remember also that the Total Return results do not include the commission costs of reinvestment, such as normally is required for ETFs, nor do they take account of the effect of taxes, which would affect taxable accounts.

Total Returns are important for two reasons. First, they are a reminder that because dividends contribute greatly to long term performance, it is essential to reinvest them during the years of savings and growth prior to retirement. Second, using the better-known Index Price performance instead of Total Return to benchmark your own portfolio results will lead you to over-estimate your true success. Remember them apples.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

ETF Comparison: USA S&P 500 or Similar Equity Index Funds

The S&P 500 Index is a well-known and widely-reported indicator of the state of the equity market in the USA. The index comprises the 500 largest and most actively traded companies in the USA. The 500 companies are deliberately chosen to represent all sectors of the economy and they make up about 80% of the total market value of all US equities.

A Canadian investor has several good reasons to invest in the US equity market and in the S&P 500:

• diversification from the relatively restricted range of the heavily financial and resource-based companies of the Canadian equity market into sectors more prevalent in the USA, such as manufacturing, health care and consumer goods
• diversification into a much larger number of companies in a market which has historically provided very good returns (US equities provided a 6.2% annual real return between 1900 and 2009 vs 5.8% for Canadian equities in the same period according to the Credit Suisse Global Investment Returns Yearbook 2010)
  

ETFs provide a very convenient and cost effective way to invest in the S&P 500, with both US-traded and TSX-traded versions being available online through discount brokers. There are also similar indices and ETFs other than those that track the S&P 500, providing the investor a wide choice. All the ETFs below share the feature of passively tracking US large cap stocks (i.e. merely mimicking the market and not trying to outperform in any way or by any means) that make up the bulk of the equity market.

S&P 500 Trackers

• SPDR S&P 500 (symbol: SPY) - a long established ETF, it is the monster fund in terms of net assets, in fact the biggest ETF in the world by far, which means the best liquidity and lowest bid-ask spreads
• iShares S&P 500 (IVV) - another massive fund and very little to distinguish it from SPY

Other Large Cap Funds - these three funds include 250 or so more companies, which has two effects:
1) lowers the size of the companies held from about $43 billion average market cap to $37 billion
2) slightly reduces the concentration of holdings from over 19% made up by the top ten holdings to 18%.

• Vanguard Large Cap ETF (VV) - the largest of the second tier funds but is much smaller than the S&P 500 heavyweights
• Schwab US Large Cap ETF (SCHX) - very new entrant founded only in November 2009 but has attracted sizeable assets in a short time
• SPDR Dow Jones Wilshire Large Cap ETF (ELR) - around since 2005 but has not caught on in a big way

Canadian-Traded ETFs - both these funds attempt to remove the effect of currency swings between the Canadian and US dollars through hedging and to provide the performance of US equities to Canadian investors

• iShares CDN S&P 500 Index (hedged to Canadian dollar; symbol: XSP) - holds IVV and adds hedging, a very large fund by Canadian standards
• BMO US Equity Index ETF (hedged to CAD; symbol: ZUE) - tracks an index of 729 companies but only holds a sample of 244 stocks, no doubt due to the small size of the asset base built up since the May 2009 launch

Comparison Tables

• US-Traded ETFs

• Canadian-Traded ETFs

Which ETFs are the Winners?
It is hard to pick a best fund since several are so similar. SPY, IVV, VV are all excellent funds with very low costs (Expense Ratio, Bid/Ask spread, Premium/Discount to NAV) and close tracking of their index (see image of Google Finance chart below - it is hard to tell the lines apart from each other and from the S&P 500 index itself).

SCHX appears to be heading to join the top group if it continues to attract assets and build trading volumes to lower the bid/ask spread. ELR has a much higher expense ratio and too low trading volumes, shown by the red cells in the table.

The Canadian entrants suffer a lot from the burden of hedging, which seems to lower net returns not only by the expected supplementary direct cost of the hedging but also through much less effective tracking of the index. Larry MacDonald describes the issue in Check the Tracking Error Margin for Currency ETFs on Seeking Alpha. The chronic and seemingly ever-widening gap in the Google Finance chart below between XSP and IVV, the US fund whose performance it attempts to clone, illustrates the problem.

However, currency effects can far outweigh the tracking under-performance so a hedged fund may still make sense (see previous posts The Historical Effect of Inflation and Currency on an Investor's International Portfolio and Foreign Investments: to Hedge or Not to Hedge Currency). Canadian investors may thus still want to buy XSP or ZUE.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.