I received an e-mail from a do-it-yourself investor — let’s call him John — about a year ago. He wrote to ask a question about his portfolio, and what struck me as most interesting was that he viewed his holdings in five income trusts as a portfolio. More to the point, his view was consistent with how many DIY investors look at portfolios.

But with that flawed view comes opportunity. And advisors who want to forge relationships with DIY investors have to distinguish their value proposition.

That’s not to take away the value proposition that comes from the ancillary services advisors offer clients, such as tax preparation, retirement and estate planning, as well as insurance concepts. But on the investment side of the relationship — and that is just one value proposition — advisors should provide portfolio solutions that are constructed on the basis of risk-adjusted returns, which, if done properly, allow advisors to distinguish their proposition from the haphazard approach used by most individual investors.

To make that point, let’s return to John, who was a 58-year-old investor saving for retirement at the time he wrote that e-mail, which was also before the Oct. 31, 2006, income trust tax changes tabled by the federal Conservatives.

John held five income trusts inside his RRSP. As he did not provide a list of the trusts, I assume these were individual trusts and not exchange-traded funds that invest in a basket of income trusts.

John was reinvesting the monthly distributions into additional units rather than accumulating the cash, which led to his question: “Is there better growth potential by reinvesting the cash distributions into other assets rather than reinvesting the money into more income trust units?”

The answer seems obvious, but before I got to that in my reply to him, my first objective was to set the record straight. A basket of securities that represent a specific asset class does not provide the kind of diversification I associate with a well-constructed portfolio. Diversification across asset classes reduces volatility far beyond what a single asset class can do — a fact I am sure was crystallized for John when the income trust rules were changed this past Halloween.

I then proceeded to discuss diversification from another perspective. Specifically, were the five income trusts inside John’s RRSP diversified across sectors?

The income trust market is made up of four general sectors: oil and gas; commodities; real estate; and business trusts. Each sector can be affected very differently by the same economic scenario and — as it turns out — by how politicians view the business model. (It’s also important to note that real estate investment trusts were immune from the tax changes.)

On the economic front, a decline in the value of basic commodities or energy will negatively impact trusts in those sectors, but could benefit, say, business trusts.

Real estate, on the other hand, is impacted by changes in interest rates, both in terms of cash flow represented by the spread in the amount of rent collected vs the cost of carrying the properties and in terms of the impact higher interest rates have on property values.

Business trusts typically benefit from general economic growth, but can be subjected to company-specific issues related to their pertinent business models.

So, diversifying across sectors may help reduce volatility associated with sector-specific events, but even that does nothing to reduce the volatility associated with macroeconomic events such as political meddling.

As income trusts are hybrids that pay out most of their revenue, we can classify them as either equity assets or income assets. Given that, you could argue that John’s basket of income trusts is a balanced portfolio — 50% equity and 50% income — although I feel that would be stretching the point because, hybrid or not, we are really talking about small-cap equity investments with a debt twist.

If we return to John’s basic question (should he take the cash flow from the five income trusts and use it to buy other investment vehicles — specifically, other asset classes?), the answer is a resounding “yes.”

Whether the DIY investor did it when advised, though, is another question.

Assuming John bought into this view, the next question was: where to put the excess cash flow? And this is a question that continues to reverberate through the industry today.

@page_break@There is now a four-year window for existing trusts to get their affairs in order before they fall under the new tax structure. During this period, the trusts will presumably continue to pay their distributions. And throughout the next four years, it will be very important for investors who do not need to withdraw the cash flow to redirect it into other asset classes. In my opinion, this provides an excellent opportunity for advisors to talk with new prospects — many of whom are probably in such a situation.

So, where can the cash flow be redirected? You can start by looking at the type of investor you are dealing with. For example, a typical balanced investor should probably have something close to a 50% equity/40% income/10% cash mix.

That leads us to three approaches that a prospect such as John might consider. The first, assuming we are talking about five individual trusts that may or may not be diversified across sectors, is simply to reduce the exposure to income trusts. If this advice carries any weight, then John could use the proceeds from the sale of income trusts to buy, say, a large-cap Canadian equity fund (or the S&P/TSX 60 iUnits) and perhaps some government bonds and/or preferred shares.

If John does not wish to reduce his income trust position, then, at the very least, he should consider switching out of one or two individual trusts into a diversified basket of trusts using either a mutual fund or an ETF that invests in income trusts. At least, by doing this, he eliminates some of the company-specific and sector-specific issues associated with his investments.

Finally, if neither of those options seems appealing, then definitely John should use the cash flow to diversify away from income trusts, seeking out the large-cap equity, fixed-income and preferred share diversifiers discussed above. IE



If you have comments or questions, please contact Richard Croft at Croftfin@aol.com.