With the exception of a couple of star performers, Canada’s labour-sponsored investment funds are delivering sorry returns to their investors, making most of them a risky play for clients — despite the enticing tax credits offered by the federal and provincial governments.

The LSIF market segment has been plagued by serious troubles at at specific funds: Toronto-based Retrocom Growth Fund Inc. and Manitoba’s Crocus Investment Fund. In addition, the Ontario government is phasing out its 15% provincial tax credit on LSIF contributions up to $5,000, as well as the 5% research-oriented investment fund credit that applies to some funds.

“Overall, the picture for this asset class is quite ugly,” says Rudy Luukko, investment funds editor at research firm Morningstar Canada in Toronto. “Many funds have had difficulty attaining critical mass in terms of assets. Furthermore, venture-capital investments are primarily small, private companies that require hands-on involvement from fund managers, making these funds more costly to manage than regular funds that invest in publicly traded securities.”

LSIFs sprouted like weeds in the 1990s, thanks to the generous government tax breaks, and overall performance was strong later in the decade. But the bloom wilted after 2000, when the technology stock implosion hurt many of the funds. Biotech and technology companies tend to be popular areas for venture capital, although LSIFs may invest in anything from manufacturing to medical discoveries.

Although some provinces allow LSIFs to invest a portion of their holdings in publicly traded companies, the lion’s share must be in fledgling private companies, which can be difficult to liquidate quickly and profitably.

Assets in the LSIF category stand at almost $4 billion, but of the 88 funds tracked by Morningstar, only eight have assets of more than $100 million, and only two show a positive average annual return for the past three years. The catch is that, to hang on to their tax credits, investors must remain in the funds for eight years, and many are now stuck aboard sinking ships.

“It’s been a difficult environment for venture-capital funds to exit their investments, with a dearth of IPOs and lack of acquisitions for venture-backed companies,” says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “Funds need a realistic expectation of an exit on the horizon for their investment in private companies to pay off. Without that, they can’t write up the value of their assets.”

Morningstar’s figures show that, in the year ended Dec. 31, 2005, the median fund in the LSIF venture capital category posted a meager gain of 0.4% — a far cry from the median return of 16.7% for the category’s closest relation, the median Canadian small-capitalization category. A weak 2005 was even an improvement for many LSIFs compared to the longer-term performance, with the median fund showing an average annual loss for three years of 3.3%, vs Canadian small-cap average annual gain of 20.7%. For five years, LSIFs had an average annual loss of 9.1%, again a sad comparison to Canadian small-cap annual gain of 10.5%.

Investors have paid heavily to see their capital eaten away. The median management expense ratio on LSIFs, says Morningstar, is 5.5%, almost double the 2.8% on Canadian small-cap funds. The MERs are higher than for any other category monitored by Morningstar, with the runner up being the alternative strategy segregated funds’ median MER of 3.9%. If an LSIF fund doesn’t have a large pool of assets, the expenses can take a disproportionately large bite out of its value every year.

Steve Kelman, president of Toronto-based Steven G. Kelman & Associates Ltd. and a fund industry consultant, notes that LSIF managers don’t have the luxury of simply dumping a holding if it underperforms. Most LSIF holdings are in illiquid private companies, for which it takes time to find a buyer or to get the company to the stage that it can do a public financing and list its shares. LSIF managers must work closely with management of the companies in their portfolios when problems develop, and are often actively involved in helping to recruit new marketing staff or even senior executives.

“These fund managers require a different skill set than regular mutual fund managers, and expertise in venture capital is useful, as well as knowledge in a specific industry area if the fund is narrowly targeted to particular niche,” says Kelman.

@page_break@While the median fund returns for LSIFs are dismal, there are some exceptional performers in the category. Front Street Energy Growth Fund 1, 11 and 111, which all focus on the energy sector, show three-year returns of 24.1%, 22.7% and 22%, respectively, and were the top performers for the category.

The worst three-year performer was Centerfire Growth, with a loss of 29%. Only eight funds have a 10-year history, and half were losers during the past decade. The top performer was Dynamic Venture Opportunities Fund, with an average annual gain of 4.9%, while the worst was First Ontario Labour Sponsored Fund Ltd. , with an average annual loss of 6%.

Because the tax credits for LSIFs are so generous, it’s important to consider them when weighing the overall returns, says Kelman. For example, a $5,000 investment in an LSIF generates a $1,500 tax savings for Ontario investors, including a combined 30% from federal and provincial credits. If that tax credit had been invested for the past eight years at the 7.3% return achieved by the median Canadian equity fund, it would have grown to $2,685. Theoretically, the investor could lose more than half of his or her original $5,000 investment and still break even.

“Even if the value of an LSIF dropped to nothing, the tax credit can be worth something, and that can offset the losses,” Kelman says, adding it also makes sense to hold LSIFs outside of an RRSP so that any capital losses can be deducted against capital gains on other investments.

Within a tax-deferred plan, such as an RRSP, capital losses cannot be employed in this manner. Furthermore, if an LSIF does happen to provide seed capital to a company that becomes the next Microsoft Corp. and soars to great heights, it may be better for the investor to have the profit taxed advantageously as a capital gain outside his or her RRSP, than as fully taxable income down the road when the LSIF profits are ultimately withdrawn from the RRSP.

Ontario’s credits are scheduled to be eliminated by 2011. The 15% provincial credit and 5% ROIF credit will remain in place until the end of the 2008 taxation year, which matches the RRSP deadline. In the 2009 taxation year the 15% credit will be reduced to 10%, and then to 5% in 2010 before it’s gone entirely in 2011. The ROIF credit will be similarly erased. The provincial credit remains in Ontario for now, and various other provinces offer a credit, complementing the 15% federal credit, which remains intact. Without a provincial tax credit to counter any losses, however, the funds will become an even riskier proposition.

LSIFs such as Crocus and Retrocom indicate just how risky some funds can be. Retrocom suspended redemptions in December, after the rate of redemption requests accelerated. In a press release, the fund blamed its lack of liquidity on the Ontario government’s decision to phase out the provincial tax credit and the funds subsequent difficulty in raising new share capital. Recently, Retrocom, which invests in construction projects, announced a delay in audited financial results for the year ended Aug. 31, 2005. It warned investors to expect a “significant reduction” in asset value.

The fund expects the audited financial statements and updated net asset value to be available by the end of February. The board is reviewing strategies to protect the value of the fund, including strategic asset divestitures, a merger, privatization of the fund or an orderly windup.

Crocus halted trading in its shares slightly more than a year ago due to concerns about the true value of its holdings. A few months later, the fund estimated the value of its shares at $7 each, about a third less than their estimated value when trading was halted. Subsequently, a Manitoba court appointed Deloitte and Touche Inc. as receiver, and the firm will be selling off Crocus’s assets over the next five years. Private companies and other venture funds are possible buyers. But it’s unknown how much investors will recover. The wheels are in motion for a class-action suit against the fund, naming 22 defendants, including the fund itself, its directors and officers, the fund’s auditors, two brokerage firms that handled Crocus’s prospectuses and the Manitoba Securities Commission.

Investors considering buying LSIFs should also be aware that such funds may be vulnerable to a wave of redemptions when the original investors reach the end of their eight-year holding period. If the fledgling companies in the fund portfolios can’t be sold or taken public at a fast enough rate to meet redemptions, some funds could run into liquidity problems. Funds with positive returns are less likely to suffer redemption problems, Kelman says.

“If an investor is astute enough to buy into a rising fund, combined with the tax credit, it can be great opportunity,” Kelman says. “There could be a young company in the LSIF portfolio with a lot of potential. But it’s important to do the research and find out what the fund holds. Some people are familiar with certain industries; they know the scuttlebutt, they read the trade magazines and they can recognize opportunities. But these are speculative investments — there’s no way around it.” IE