The trust market has grown significantly so far this decade and, in the last year, has gained the institutional credibility so sought after by many market participants. Income trusts have been part of the flagship S&P/TSX Composite Index since December 2005. They were added to MSCI’s Canada Index in May 2006, and five provinces have now passed legislation to limit the liability of trust unitholders. Despite this widespread endorsement of and enthusiasm for income trusts, it is interesting to step back and look at whether they have lived up to their billing as “the next big thing” for institutional investors.

The modern trust market existed as a minor portion of the Canadian capital market for much of the last two decades. While early data is scarce, there were a handful of royalty trusts—mainly oil and gas enterprises formed in the mid- and late-1980s to take advantage of tax rules available to resource companies.

The next key development was the downturn suffered by the real estate market in the early 1990s. Several real estate funds were faced with mounting redemption requests and a portfolio of illiquid assets. They found their way out of this dilemma by morphing into Canada’s first REITs in 1993 and 1994.

The market continued to grow slowly in the 1995-1998 period with a heavy emphasis on energy trusts. As the energy market slowed dramatically in 1998 and 1999, so to did the trust market. However, new issuance activity increased dramatically following the downturn in the equity market that began in 2000. Since that time, retail investors have shown a massive appetite for trusts(and most other yield-producing investments). The investment banking community responded by offering a new flavour of trust, the business trust, to the market. This broadened the available investment opportunity set beyond what had been an energy and real estate dominated group.

The trust market just keeps growing. When Standard & Poor’s(S&P)made its initial announcement in January 2005 that trusts would be added to the S&P/TSX Composite Index, there were approximately 175 income trusts and REITs listed on the TSX. By the end of July 2006, that number had grown to 243 income trusts, REITs, and limited partnerships with a combined market cap of over $212 billion.

Trusts represented more than 12% of the S&P/TSX Composite Index at the end of July 2006. That makes them a considerable portion of the Canadian equity market. However, trusts will not be taking over the market any time soon. To put the trust weight in perspective, the three largest stocks on the TSX—Royal Bank, Manulife and EnCana—had a combined weight of 12.6% of the TSX market cap at the end of July.

The most noticeable effect on the Index has been the increase in the weight of the Energy sector. As can be seen in the table that follows, by adding income trusts to the Composite Index, Energy becomes dominant. Another development was the inclusion of numerous real estate and utility trusts in the Composite Index, which should add some diversification options for investors as these sectors have shrunk in recent years.

A related point is that while the Composite Index and the new S&P/TSX Equity Index have very large weightings of Energy stocks, the situation is even more dramatic with the Scotia Capital Income Trust Index. The Energy weighting in the Income Trust Index is over 43% and, if pipelines are included(as they are in the S&P/TSX indices), then the weight approaches 50%. This pokes something of a hole in the “income trusts as a diversifier” argument as, by adding trusts to a Canadian equity mandate, there is an increase in what is already the largest benchmark exposure.

With the first year of trust inclusion in the Composite Index well underway, it is interesting to see how the institutional investment management industry has changed and investor mandates have evolved.

So far, there has been limited interest on the part of investment managers in including many trusts into large cap mandates. There are several key reasons that may account for lack of trust buying:

Liquidity – Some managers prefer to focus on the larger securities in the Index and as most trusts can be classified as small cap, this leaves little choice for these managers. This may slowly change as larger trusts emerge(witness the recent consolidation in the Energy sector)and as trusts are included in the S&P/TSX 60.

Capacity – Several investment managers have been running separate income trust mandates for years(generally called income products of some kind), often through their mutual fund groups or affiliates. These firms have tended not to include trusts in their institutional equity mandates. In general, they have regarded trusts as a distinct product group and, sensing general institutional indifference and/or hostility, have kept trusts out of institutional products. Some of these firms now have an interesting business problem. They are already such large owners of individual trusts that they have their own unique liquidity issue. If these managers already own a significant portion of a trust and they want to buy a reasonable allocation for institutional mandates, then they will end up owning very large portions of some trusts. Most investment managers do not seek to be major owners of any company, so it will be interesting to see how these firms respond.

Valuations – Depending on the approach an investment manager uses to value stocks, it may argue that trusts are overvalued. Trusts have traditionally appealed to an audience that valued yield more than most other factors. When trusts are evaluated on an earnings or cash flow basis and compared to traditional equities, they will look expensive in the eyes of some managers. This is a legitimate concern arising from a manager’s investment style. However, it should not keep trusts out of that manager’s benchmark. Most managers who believe trusts are overvalued will likely want them in their benchmark as they provide an opportunity to outperform the Composite Index if trusts decline.

One option for investors is to hire a dedicated income trust manager to complement their traditional equity manager. However, many of the specialist income trust managers are, as a group, currently underperforming the S&P/TSX Income Trust Index. Generally, this appears to be the result of relatively conservative sector bets as many managers are underweighting the Energy sector, which has been the best performing sector. At the extreme, at least one institutional manager holds no Energy trusts because of doubts about the long-term prospects for oil and gas trusts.

To some extent, the underperformance demonstrated by many managers in the last one to two years is surprising. That is due to the seemingly large number of trusts that have experienced sharp(40% or greater)price declines. The regular appearance of these ‘blow-ups’—a term borrowed from the hedge fund world—would normally be a strong argument against indexing a trust mandate, as active managers should, theoretically, be able to avoid the blow-ups and beat the Trust Index. However, active managers have not been able to capitalize on the opportunity recently.

There is also some concern about the capacity of some of the large active trust managers. Those that have built up a significant trust business may now be managing a total trust asset base that represents 1 to 2% of the total trust market cap. While there is no definitive guideline on how large a manager should become relative to a given asset class, one might question a manager’s ability to add significant value when its assets exceed 1% of an asset class. This is especially true when smaller cap securities are involved as there are often greater liquidity problems with smaller cap issues.

Canadian equity benchmarks are normally a key part of every institutional investor’s Investment Policy statement. Investors have two options when determining how to respond to the changes implemented by S&P:

1. Stick with the broad S&P/TSX Composite Index. The number of securities in the Index has increased dramatically: 72 trusts are currently included in the Index.

2. Change to the new S&P/TSX Equity Index that excludes income trusts. This Index was created in December 2005 and contains just the 207 equities that are in the Composite Index.

Investors with active Canadian equity mandates should generally adopt the Composite Index that includes income trusts, principally for diversification reasons(in the non-energy areas especially). These reasons include having more securities to choose from, additional industry representation (e.g., REITs), and the different return patterns of trusts and equities. For those investors with indexed Canadian equities, the major index managers all offer the choice of investing in the broad or the trust-free indices.

Active managers should be given the option to purchase trusts and be measured against a benchmark that includes income trusts. The key word, however, is option. The managers should be benchmarked against the broad Composite Index as that is the opportunity set that has been defined by S&P with input from Canadian market participants.

Income trusts as a separate asset class were a great idea five, four, even three years ago. The outstanding performance of the asset class was due in large part to the massive yields that used to be available from trusts. The Scotia Capital Income Trust Index yield is now roughly half of what it was six years ago. As trusts have been re-priced upwards, impressive capital gains have resulted. However, given current trust yields, this is not likely to continue; the current yield on the trust Index is almost certainly a better estimate of future returns. Therefore, the average Canadian institution would probably not benefit from a specialist trust mandate at this point if it is hoping to outperform conventional equities.

David Kaposi BA, CFA is the Director of Manager Research in Hewitt Associates’ Toronto office.

For a PDF version of this article, click here.