Investors beware

Income trust mutual funds have had a great run. Over the five years to March 31, the average fund in this category posted an annual return of 18.7 per cent, making this one of the best places to have invested your money in the initial years of the 21st century. But what now? In a recent webcast for financial advisors, Leslie Lundquist of Franklin Templeton offered her assessment of the greatest risks facing Canadian income trusts funds at present and listed the qualities she looks for in making new purchases.

Lundquist is widely regarded as one of the country’s top experts in the trusts field. She is the manager of the Bissett Income Fund, which was capped a couple of years ago, and now has a new fund to work with, the Bissett Income Trust Fund, which was launched in March.

In her presentation, she identified three major threats to the income trust sector which could compromise returns going forward.

1. Rising interest rates. Trust investors get twitchy at the mere suggestion of higher rates. Lundquist blames rate fears for the sharp correction that hit the trust market in the spring of 2004 and the virtual repeat of that event this year.he most vulnerable trusts are those that have bond-like characteristics, she says, particularly power-generation trusts and utilities trusts. Those that are able to raise distributions should be least affected by rate hikes. Oil and gas trusts and some business trusts fall into that group.

2. Currency fluctuations. The rapid rise of the Canadian dollar in 2003-04 hurt trusts with significant U.S. sales. (Many investors don’t realize that a number of Canadian income trusts do more than half their business in the United States and some are almost 100 per cent American in terms of sales and profits.) In some cases, trusts have used hedging strategies to mitigate the currency risk but Lundquist sees this as a short-term solution at best. Trusts that do most or all of their business in Canada are not vulnerable in this way and that is where she is concentrating her portfolios although she acknowledges that U.S.-based trusts “may represent pretty good value” right now because it is unlikely the loonie will continue to rise at anything like the pace of the past two years.

3. High valuations. Make no mistake about it, the trust sector is expensive right now. “Many are priced to perfection, or even better than perfection,” she noted. “But there is no such thing as a perfect company. Glitches can and do occur.” Even the recent pull-back didn’t improve the situation significantly. “Trusts are still on the expensive side, at best they are fully-valued,” she said.

She also expressed concern about the exposure to commodity prices in the sector, noting that almost half of the income trust market is based on resources like oil and gas and minerals. We may see US$50 a barrel oil continue for a while, “but how long will resource prices stay strong, especially if the economy slows?”

In short, she sees little in the way of real value in the sector today, which should serve as a warning to investors who believe the next five years are going to be as good as the last five were or who are considering jumping into an income trust fund for the first time.