Ottawa’s threat to change its taxation policy on income trusts has trimmed the value of the sector, creating a split in the income trust market. At one end of the spectrum are the quality, well-established trusts; at the other are some of the newer, more marginal players. All this will drive investors seeking balance and safety toward the most broadly diversified income funds.

Although every vendor offers some sort of income fund that puts dividend-paying common stocks, income trusts and bonds into a package that spits out cash every month, the Big Six banks have the stranglehold — roughly $18 billion — on monthly income funds. One stalwart is RBC Asset Management Inc. ’s $7.3-billion RBC Monthly Income Fund, an established fund that has registered a first-quartile return over the past five years. After producing a strong 16.2% return in 2003, the fund was also a sound performer in 2004, when it posted an annual return of 13.4%. For the nine months ended Sept. 30, the fund is up roughly 11.5%, producing a five-year average annual compound return of 11.9%. Annual payouts have averaged 56¢ a unit over the past five years.

Compare this with CIBC Securities Inc. ’s $4.5-billion CIBC Monthly Income Fund,
another strong performer. Up 15.2% in 2003, it delivered an attractive 12.3% in 2004. For the nine months, it is up another 14.9%, producing a 12.1% average annual compound return for the five years — more than most funds in the balanced income category. It currently pays 6¢ a unit each month in income.

Both funds receive four-star risk-adjusted rankings from Morningstar Canada and have outperformed the average fund in the category over various periods. It’s important to remember, however, that such tremendous capital appreciation is less likely in the future and that these funds will probably produce numbers more in line with their goals of steady income and capital preservation.

CIBC manager Stephen Gerring started out with Prudential Insurance, later working for Citicorp. He joined TAL Global Asset Management Inc. in Toronto 13 years ago.

Gerring has altered the fund’s asset allocation several times over the past five years.
When the market took a downturn in 2000, he deftly increased the fund’s exposure to bonds, reaping the benefits of falling interest rates and bonds yields. More recently, he has tilted sharply toward stocks.

With the probability of higher rates ahead, Gerring has reduced interest rate risk, allowing cash to rise to 17% of assets and bonds to fall to just 14% of assets. He has also sharply reduced the bond portfolio’s duration to protect capital. This has left him with a 54% equity holding, higher than virtually all his peers, as well as a heavier weighting in energy and telecommunications securities than most. Add a further 13% in income trusts and the profile seems rather imbalanced, boosting risk at the same time.
However, the fund has only lost money in two of the 84 one-year periods since its inception, with its worst being a 1.9% loss, Morningstar reports.

John Varao has been with RBC and its predecessor companies since 1991, and has looked after its monthly income fund for the past five years. His primary focus is on high-quality, dividend-paying stocks with stable earnings and dividend growth. He tends not to make big bets with the fund’s asset mix, trying to add value by trading within the fund’s existing and highly liquid names.

Recently, about 36% of the RBC fund’s holdings were in equities, with 38% in bonds, 18% in income trusts and roughly 8% in cash. Historically, the fund’s bond holdings run between 36% and 50% of assets. Varao is leaning toward the lower end of that range, with slightly shorter than market duration. This suggests his stance on rates is fairly neutral; if there are hikes, he expects them to be modest.

On the equity side, the fund is overweighted in resources, financials and utilities, all areas in which Varao has been increasing his exposure in recent months.

There are several common names among the two funds’ holdings, and many of their bigger bets are similar. The RBC fund holds about 70 stock positions, whereas the CIBC fund holds closer to 100. RBC’s top 10 holdings account for 25% of assets, whereas CIBC’s represent more than 40%. Neither one has any significant foreign holdings.

@page_break@The conventional valuation ratios of both funds are similar to the average Canadian balanced income fund. The RBC fund has a slightly lower price/earnings ratio and sports a lower average market capitalization. But its 4.8% dividend yield puts it in the category’s top quartile.

Both funds are already very large, so burgeoning cash may become an increasing problem, given their focus on large-cap, dividend-heavy stocks. RBC recently announced that its fund will no longer accept new registered money as of Dec. 9. It will continue to accept new purchases through non-registered accounts.

Both have delivered less volatile returns than almost all their peers. RBC’s profile was the less risky of the two in the past three years, but both have a five-year standard deviation of 4.2, far lower than the benchmark’s 7.4. And both funds’ similar Sharpe ratios of about 2.0 for five years eclipse the median fund in the category and the benchmark.

Both are solid offerings, but RBC comes out slightly ahead as its 1.19% MER is more than a full percentage point lower than the median fund’s. Holding both in a portfolio would be counterproductive. IE