How to pack your trusts

OK, I'm an editor, but I'm a reader, too. So I have a question: I'm looking at buying an ETF or ETF-like product of income trusts. I know Barclays has one, Lawrence has one, Scotia has a couple. Which one is better? ...Scott Adams, FP Investing Editor

Scott, fair enough -- we suppose that editors have rights, too. For the benefit of our readers, we'll first describe the investment characteristics of income trusts and then talk about why taking a portfolio approach in general makes sense.

There are well over 200 of these products listed on the Toronto Stock Exchange alone. Their aggregate market value is now more than $150-billion.

Income trusts hold underlying assets, which can be anything from power-generating stations to hotels. All or most of the net cash flow earned by the trust is passed on to the unitholders in the form of payments called distributions. These are typically paid out monthly or quarterly. Failure to make a distribution is not a default, as it is with fixed-income securities, such as bonds.

Investors normally look first at the cash-on-cash yield. If a trust pays $1.20 a year in distributions and the current price per unit is $10, then the cash-on-cash yield is 12%. Currently, cash-on-cash yields ranged from about 5% to as much as 13%, not including the outliers. The periodic distributions from these trusts consist of one or more components of income (taxed as ordinary income), dividends (subject to the gross-up and tax-credit rule), capital gains (subject to the 50% inclusion rule) and return of capital (not taxable when received, but reduces the adjusted-cost base). The latter is created through capital-cost allowances, depletion allowances, repayment of debt principal and other capital transactions.

The term "income trust" encompasses a number of different investment types. Although linked by a common characteristic -- relatively high, often tax-advantaged, distributions to unitholders -- their risk and potential-return characteristics vary widely.

The four main groups are power and pipeline trusts, energy trusts, real estate trusts and general business trusts.

There's one thing you must realize about income trusts from the outset: they can be volatile. They are not government bonds. Their income is not guaranteed. They are businesses, and their returns are subject to the same vagaries as any other corporation. That means the value of their units can rise or fall sharply, depending on what's happening in the world in general and in their specific sector in particular.

The best way to avoid the risk of poorly performing trusts is through a diversified trust portfolio. Here are some representative ones:

- Barclays Advantaged S&P/TSX Income Trust Index Fund (BAIun/TSX) tracks the S&P/TSX capped income trust index, an index of 71 income trusts spanning the four main groups of trusts. The underlying index is weighted by market cap, meaning that larger trusts will have a greater impact on performance than smaller ones. The fund earned 23.8% in 2005. The MER is 0.98%.

- SCITI Trust (SINun/TSX) tracks the Scotia Capital income trust index. This very broad index contains 135 income trusts, but excludes all trusts with market caps of less than $200-million. The fund earned 36.4% in 2005. The MER is 0.39%. A companion fund, SCITI II Trust, (CITun/TSX) earned 35%.

- The latest offering in this area is the iUnits Income Trust Sector Index Fund (XTR/TSX), which tracks the performance of the S&P/TSX capped income trust index. Just launched in December, 2005, this fund has a 0.55% MER.

- For a more conservative approach, there is the Lawrence Payout Ratio Trust (LPUun/TSX). It holds an equally weighted portfolio of 40 different income trusts. The fund is a merger of three Lawrence funds. Trusts selected have a market capitalization of $200-million or more; have not reduced or suspended distributions for the previous 24 months; and have had their units listed on the TSX for at least 12 months. From this eligible universe, the income trusts with the lowest cash-payout ratios are selected from the various sectors. The investment strategy is based on the theory that the lower the payout ratio, the greater the likelihood the trust will continue to make its targeted payout. A predecessor fund, the Lawrence Payout Ratio Trust, returned 16.7% in 2005. The MER is 0.75%.

Which one for our editor? For a broad-based approach to the income trust market, pick the Scotia or Barclays, recognizing you have full exposure. For a more conservative approach, go with the Lawrence version.