This commentary was first published in the Financial Post on November 9, 2006.
With the surprise announcement last week by the Conservative government that distributions by income trusts would no longer be exempt from corporate-level taxation, investors in income trusts have suffered material losses to those investments.
Interestingly, investors with diversified portfolios of Canadian equities would have hardly noticed a difference in their wealth and are probably wondering what all the fuss is about.
While the TSX composite index suffered a substantial loss on the day immediately following the government's announcement, it has already made up most, if not all, of those losses. Since the announcement, then, the TSX Income Trust Index has underperformed the broader TSX Composite Index by approximately 10%. Even taking into account the current yield disparity in the two indexes (approximately 9% for the Income Trust Index and 2% for the TSX Composite Index), the TSX Composite Index still comes out ahead of the Income Trust Index by approximately 3%.
While investors in income trusts have been handsomely rewarded over the past few years, so have investors in the TSX Composite Index, who have been rewarded with double-digit returns over the last five years, without even taking into account dividends. The subsequent divergence in performance in the two sectors has revealed what should have been obvious from the beginning: that investors in the trust sector were taking on greater risk than investors in the broader securities market.
Part of the risk that investors were taking on by investing in the income trust sector was regulatory risk: the risk that Canada would cease preferential taxation of income trusts. Part of the risk was ordinary business risk: while older income trusts represented stable companies with stable and predictable cash flows, over the last eighteen months many income trusts were formed out of otherwise marginal businesses in order to take advantage of retail investors' focus on yield. This obsession with yield has now come home to hurt many retail Canadian investors who invested in income trusts on the assumption that they represented a "safe" source of income, especially in a low interest-rate environment in which it was difficult to earn more than 3% or 4% on fixed-income securities.
Far from being low-risk, income trusts were a riskier than the overall market for at least three reasons. The first was lack of diversification, since income-trusts represented only approximately 10% of the TSX Composite Index on a weighted basis. The second was regulatory risk. Regardless of official representations to the contrary, as more and more Canadian corporations adopted the income trust structure for tax reasons, the pressure to clamp down in order to preserve the integrity of the corporate tax system would have only increased. The third was ordinary business risk. As more and more issuers converted to the income trust structure for tax reasons, the relative quality of the issuers declined, increasing the risk in the sector.
None of this would be problematic if investors had rationally appreciated these risks. News reports, however, suggest that many retirement-age Canadians had become dependent upon the relatively-high distributions provided by income trusts to fund their income needs post-retirement in reliance on the mistaken belief that these were relatively safe investments. No doubt, many such investors are feeling betrayed by the current government, which had promised not to do precisely what it just did. Nevertheless, the regulatory lesson to be learned here is not that governments should maintain otherwise unjustifiable taxation policies simply on the grounds that a sector of investors has come to rely on that policy. Instead, the lesson ought to be that adopting policies that encourage investors to maintain a broadly diversified portfolio is at least as worthy a regulatory goal as insuring timely and accurate periodic disclosures of financial results by public companies.
To the extent that Canadian investors were over-exposed to the income trust sector, fault lies with their investment advisers, not the Canadian government. Canadian investors who were over-exposed to the trust sector should ask their investment advisers why they were not advised to maintain a diversified portfolio rather than insisting that the government return to the status quo ante.
Canadian securities regulators, in turn, should be thinking of ways to educate investors on the benefits of diversification across industry sectors and asset classes, as well as encouraging the financial service industry to develop low-cost, retail-friendly investment options that provide diversification at lower costs than are presently available in the Canadian securities markets. The fees of Canadian index funds are currently several orders of magnitude greater than their American counterparts. While the smaller size of the Canadian market may justify some of this difference, regulatory induced inefficiencies such as barriers to entry may also be to blame. By prodding the market to provide Canadian investors with more low-cost investment options, securities regulators can help prevent another group of investors from incurring too much risk in their pursuit of yield.