The principle of natural selection is as relevant in the business world as it is in nature. Calgary-based fund company Citadel Funds Corp. is experiencing that first-hand as it moves to adapt to a retail investment landscape that has been turned on its head in less than two years.

Initially designed to take advantage of the blossoming popularity of income trusts, Citadel is instead now witnessing their decline, brought about by an abrupt change in federal tax policy in 2006.

It is finding ways of adapting to a market in which corporations are shunning the income trust structure, opting instead to remain as corporations.

Citadel is dealing with the turmoil by expanding its activities to include flow-through shares, mutual funds and high-yield equity funds, the apparent successor to income trusts. Its primary objective remains to provide investors with regular income.

“High-yield equity funds are simply common shares of corporate entities with an above-market dividend rate,” says Citadel’s president and CEO, James Bruvall. “What we’ll see is a lot of the income trusts that we’re following will convert back to corporations. So our portfolio will change, but in names only. We’re still investing in the same businesses.”

But investors haven’t returned to their customary range, still unsure of what will happen to remaining income trusts and unfamiliar with high-yield equity.

“A lot of people are waiting for the smoke to clear,” says Bruvall. “We are sure of where the markets are going, but the retail investment public isn’t.”

At the time of the company’s inception, Bruvall was witnessing firsthand the rapid proliferation of income and royalty trusts as a lawyer with Stikeman Elliott LLP in Calgary. He realized their investment potential.

“Income trusts weren’t known,” says Bruvall. “There were no analysts covering them. Investors didn’t know how to use them.”

Citadel created a family of tax-efficient, closed-end funds that were strongly rooted in income trusts. They offered clients an income-generating investment and an alternative to mutual funds. Citadel provides clients with tax data on an annual basis to help them judge the tax effectiveness of their fund investments.

The company introduced its first fund — Citadel Diversified Investment Trust, a closed-end fund that raised $99 million — soon after it launched.

The fund provided investors access to higher distributions than typical dividends. It invested in oil and gas royalty trusts, real estate investment trusts, income funds and qualified limited partnerships, and was diversified among geographical regions and industries. Citadel hired Toronto-based Bloom Investment Counsel Inc. to take the helm of Diversified Investment Trust.

“We tried to determine what the needs were for retail investors,” says Bruvall. Citadel has expanded over the past 10 years, creating and consolidating up to 15 closed-end funds, serving a bigger and broader spectrum of investors.

But, in 2006, federal Finance Minister Jim Flaherty unveiled the Tax Fairness Plan, effectively ending the boom in income trusts.

It was designed to throttle the widespread move to trusts on the part of big companies, which, Flaherty said, would significantly reduce the amount of federal tax revenue Ottawa garnered from corporations.

The plan put a tax on distributions from publicly traded income trusts (starting in 2011 for existing funds and 2007 for new trusts) and diminished the benefit corporations gained by converting to trusts. The federal plan had the desired impact; the income-trust market was hit hard. The sector reportedly lost $20 billion in market value as the dust settled.

Citadel itself has seen its assets under management decrease by nearly a third, to slightly more than $2 billion, and its core business come under attack.

“[The Tax Fairness Plan] has driven people out because they’re fearful,” says Bruvall. “They’re taking some of their money off the table to be safe.

“What Flaherty has done — naively and shortsightedly — has taken away a tremendous investment sector,” says Bruvall.

Having built the bulk of its business on income and royalty trusts, Citadel has been forced to re-evaluate its business strategy.

As a result, it has shifted its product emphasis slightly, introducing securities that invest outside the income-trust arena but also focus on providing steady income to investors.

Flow-though shares are one product that takes Citadel away from its income-trust focus. Flow-throughs are attractive because of the big tax breaks they provide to investors.

@page_break@These deductions are available to Canadian resources companies for exploration expenses, but the companies don’t have the income needed to use the deductions. In a flow-through structure, the deductions are passed along to investors, who, in many cases, can write off the full cost of their original investments. Citadel’s first flow-through was in 2006; it is now in the market with CGF Resources 2008 Flow-Through LP.

Meanwhile, it is preparing to offer investors a fund that invests in firms involved in climate change.

Climate Change Opportunity Fund was prepared with a nod to investors’ social conscience and an indication of the direction Citadel intends to take. “The name is appropriate,” says Bruvall. “It invests in companies that will profit from and are engaged in the reduction of the effects of climate change, and those adapting to its effects.

“At one time, income funds were a unique structure,” he adds. “Once they go away and there’s just high-yielding equity, it gives us a reason to focus on different themes that are attractive to investors.”

As Citadel adds to its product shelf, it is careful not to let go of its core mandate.

“We’re delivering sustainable income to retail investors who rely on that income,” says Bruvall. “We have to be careful to deliver on what we say. We have to be conservative because you can’t let them down.”

“The demand for investments that distribute regular amounts of cash is not going away,” says Dan Hallett, president of Dan Hallett & Associates Inc. , an investment research firm based in Windsor, Ont. “The tax laws have just made trusts less attractive to corporations.”

In addition to its role as fund manufacturer, Citadel administers its funds and keeps an eye on external managers.

“We’re a fund manufacturer and developer. So, we have to decide what the market is looking for, design a product around those needs and bring it to the market,” says Bruvall.

Citadel is responsible for choosing the best fund manager to take on the new project.

Over the years, the roster of managers has featured a few recurring names — Galileo Global Equity Advisors Inc. of Toronto, Calgary-based Shaunessy Investment Counsel Inc. and Bloom Investment Counsel.

Citadel’s staff takes care of the day-to-day work a group of funds requires, such as calculating the net asset value and preparing annual reports; staff also scrutinizes the firm’s ongoing funds.

“Our third role is to monitor the fund managers,” says Bruvall. “We’re not going to second-guess their decisions, but we are going to hold them accountable. In this role, we’re here to act as the voice of the investor.” IE