Umbrella funds can defer taxes

A number of companies now offer so-called “umbrella funds”, which make non-registered investments more tax efficient.

New ones are coming on stream all the time. The list currently includes CI (which started the idea), Mackenzie, Dynamic, Franklin Templeton, Clarington, Fidelity, AGF, and AIC.

Although the products have different names, the structure is the same in all cases.

How funds work
A master fund is created, structured as a corporation (most mutual funds are trusts).

Under this umbrella, a number of investment pools are set up, each with a different focus: Canadian equity, U.S. equity, global equity, etc.

These pools are usually called A classes, although the name may differ. CI calls them A sector shares.

No penalty switches
The advantage is that you can switch assets from one class to another without triggering a taxable capital gain.

If you make a switch from one ordinary mutual fund to another, it is considered to be a sale, and therefore a taxable event.

Within an umbrella fund, you are only taxed if you sell your units and exit the fund entirely. This makes the strture useful for fund investors who trade actively in non-registered accounts. (RRSP and RRIF investors do not benefit in any way.)

Charge higher MERs
However, there’s a price for this tax sheltering. Most of these classes (but not all) carry higher MERs (management expense ratios) than a comparable mutual fund trust.

That has a negative impact on returns, but it’s not the only factor that accounts for the difference in returns between an investment pool within an umbrella fund and a comparable stand-alone fund.

Cash inflow patterns will create discrepancies in the timing of the purchase and sale of new securities for the separate portfolios as well.

Next page: Some comparisons

Some comparisons
Here are some comparisons between tax-advantaged classes and a corresponding parent fund within the CI group.

I picked these because they’ve been around for awhile, but the same pattern can be seen in most of the newer tax-sheltered pools. Figures are to February 28th, 2002:

FundMERAverage Rate of Return
1 year3 years5 years
CI Landmark American Fund2.50%-11.6%-2.0%5.8%
CI Landmark American Sector Shares2.94%-12.1%-2.6%5.1%
CI European Fund2.59%-10.8%-1.5%1.6%
CI European Sector Shares2.45%-11.1%-2.1%0.8%
CI Global Fund2.53%-20.7%-0.7%6.6%
CI Global Sector Shares3.01%-20.8%-1.3%6.0%

Regular fund outperforms
As you can see, in all cases you would have been better off from the perspective of total return by holding units in the regular mutual fund rather than in the tax-sheltered sector shares.

Over the past three years, any switches within the sector shares actually may have cost you additional money, because no capital loss for tax purposes would have been allowed.

This is another downside of using umbrella funds.

It should be noted that some companies do not offer regular fund equivalents to some or all of their A class units.

For example, you can only invest in AGF American Growth Class, one of my preferred U.S. growth funds. There is no regular mutual fund option.

When to use:
So when should you use an umbrella fund? Here are some guidelines.

  • Only in non-registered accounts.
  • Only if you are an active trader, making switches several times a year.

But remember, you are only deferring taxes. You (or your estate) will eventually be taxed on the accumulated capital gain when the asset is liquidated.

  • If you want to buy a quality fund that isn’t available in any other format.

If you are a long-term investor, making only infrequent switches for purposes of portfolio rebalancing. The umbrella funds are not worth the extra costs.

Adapted from Mutual Funds Update.