Month: April 2006

A few days ago I introduced split shares/trusts and how they work. Now I will go into the downsides in more detail.

According to Larry MacDonald in this Moneysense article on split shares: “Split shares seem to be regaining popularity. One sign is an upsurge in public offerings. Demand is out there and dealers are rushing to fill it.”

It sounds like split shares are somewhat like other bad investments such as IPOs in the way that they gain in popularity immensely during bull markets (more so than plain vanilla common stocks become popular) as people are willing to take more risk, before the market takes its inevitable downturn. But more importantly in order to regain popularity it must have lost popularity at some point and you have to ask yourself why. Probably some investors got burned at some point, buying a split share and taking on more risk than they thought they were. Take this example from March 2004:

The Oil Sands Split Trust, linked to the Canadian Oil Sands Trust, recently demonstrated the downside risks. When cost overruns and project delays at its 35%-owned Syncrude oil sands plant were announced on March 5, the income trust units plunged 15% while the split capital trust shares plunged an even greater 23%.

Note that the Oil Sands Split Trust (unfortunately their trustee’s website is down right now) is a split trust whose underlying security is the Oil Sands Income Trust.

There are of course, a lot of little things/potential risks to think about when it comes to split shares:

Although the basic idea behind splits shouldn’t provoke any splitting headaches, looking into all the different wrinkles may. The investor needs to read up carefully, or have good advice, when it comes to purchasing individual split shares. As Brian McChesney, head of Scotia Capital’s structured products division, said, “In a lot of these products, the devil is in the details.”

And there are many little details involved with split shares. There are of course fees associated with split shares, “Apart from brokerage commissions, these products have annual management fees. For the most part, the fees are comparable to index funds or exchange-traded funds (i.e., less than 1% of assets). A few are actively managed and have management fees greater than 1%.” The Top 10 Split Trust, for example, has several fees. According to their prospectus:

• Fees payable to the agents for selling capital units and preferred shares: 6.00% per Capital Unit and 3.00% per Preferred Security.
• Annual fee payable to Mulvihill Capital Management (MCM) for acting as investment manager of the Trust (1.0% of the trust’s total assets).
• Annual fee payable to Mulvihill Capital Management (MCM) for acting as manager of the Trust (0.1% of the trust’s total assets).
• Trailer fee paid to each dealer whose clients hold capital units of 0.4% of the value of the capital units held by clients of the dealer.

Now that’s a lot of fees! Not to mention the commission for each purchase and sale, as these are traded on the stock market just like stocks and ETFs.

One huge concern concerning split shares is the distinct lack in interest in split shares from the institutional investment community:

Split shares are bought by retail investors. There is almost no institutional interest. “These products are sold with an up-front commission that the institutions just don’t like to pay,” explained one issuer. Another suggests that they don’t like the low trading volumes. Still, the absence of professionals — supposedly the smart money — might raise a yellow flag to some. [emphasis mine]

A few more downsides:

Retraction privileges allow holders to tender their capital shares, a feature reportedly aimed at protecting them from trading at a discount or becoming the target of arbitragers. It might be advisable to check if there are any restrictions on retractability, however. Another thing to consider is that many issuers can force early redemptions of the preferreds. This likelihood increases if the capital shares have risen sharply.

Not to mention their use of covered call options:

Some preferred split shares have their dividends boosted through covered call writing (selling calls on their portfolio of stocks and including the proceeds in the dividend payout). This strategy got a bad reputation a few years ago when it led to some miserable performances. Yet several new issues have recently been floated with the covered call feature. One risk is that the common shares could be called away if their prices rise past the exercise price of the call options sold. Said one money manger, “What investors … do not understand is that by selling covered calls against your portfolio, you are selling away all of your winners (when they are called away), and you are left with your losers.”

I discussed covered call options previously. The split trust my parents are invested in (the Top 10 Split Trust) which, according to the prospectus, will “from time to time, write covered call options in respect to some or all of the securities in the Financial Portfolio [which consist of 6 banks and 4 insurance companies].” This, they say, is done in order to “generate additional returns above the dividend income earned on the Financial Portfolio.”

In my opinion the downsides, risks, and increased costs of owning split shares far outweigh the benefits.

My parents’ investment advisor has got them investing in something called “split shares.” When I first heard about them I had no idea what they were. That worried me. What worried me was the fact that my parents were invested in some sort of investment vehicle that I had never heard about before, and that maybe the reason I hadn’t heard about them before, is because they are a bad/risky/costly investment. Either that, or they are an extremely conservative investment (like GICs) that just aren’t relevant to me right now. I think they are invested in the Mulvihill Capital Management Top 10 Split Trust and the Oil Sands Split Trust (see here and here; not to be confused with the Oil Sands Trust). There are several split shares trading on the TSX.

There is some decent information on the TSX Group’s website on split shares:

The “split share” structure is another unique type of financial structured product. The split share structure allows the risk-reward component of common shares to be broken down into two components and then allocated differently for investors who are more or less risk averse. A split share corporation will hold common shares of one company or more, typically a portfolio of common shares (based on a sector or industry). The split share corporation then issues two classes of shares – capital shares and preferred shares . . . Using this structure, a portfolio of regular common shares can be divided into capital shares that have a higher level of risk than the underlying common shares and preferred shares that exhibit less risk than the underlying common shares.

By the way, phrases like “unique type of financial structured product” scare me. So basically the way it works is some corporation (called “split share corporation” in quote above) buys common stock in some company or companies. They were able to buy those common shares by raising capital through the sell of two forms of shares in the “split share corporation”: capital shares and preferred shares. The capital shares pay no dividend and only experience capital appreciation or depreciation in value. The preferred shares do not go up or down in value and only pay a dividend. Note that the split share/trust does not purchase any preferred shares in the companies in the underlying portfolio, they issue preferred shares. They purchase common shares. Whenever I talk about preferred shares in this article, I am referring to the preferred shares that the split trust/share/corporation issues.

So why/how would I use them in my investment portfolio??

. . . Where the split comes in is the investor chooses to either receive all the dividends from the portfolio shares, or the capital gains, but not both. That’s what makes split shares different from direct common share ownership, where the investor gets both. Those who opt for the dividends buy what are called preferred shares in the trust, and those who opt for the capital gains buy what are called capital shares. Both types of shares then get listed on the stock exchange, so you can trade them, unlike regular mutual fund units. . .

Here’s a great example of how split shares actually work:

The common shares of ABC Corp. trade on the TSX at $35 and pay a $1.50 dividend to yield 4.3%. A sponsor sets up a company though a public offering to buy the shares and then split them into preferred shares priced at $25 and capital shares at $10. The ABC Preferred Split share gets the dividend, while the ABC Capital Split share gets the capital gains (or losses). Now assume the underlying ABC common shares rise over three years from $35 to $50 for a 43% capital gain. The ABC Preferred shares get an annual dividend yield of 6% ($1.50/$25), while holders of the ABC Capital shares earn a capital gain of 150% because their $10 shares are now worth $25 ($10+$15).

In case you still don’t get it and need another example, here it is:

. . . Let’s use the Split Sixty shares you cite as an example. This mutual fund trust was created by Scotia Capital Inc. and the portfolio shares consist of some $300 million invested in the common shares of the companies which make up the S&P/TSX 60 Index. The portfolio shares currently have a NAV of $44.32, and the MER is 0.36%.
To get dividend income, you could by the preferred shares in this split corporation (ticker SXT.PR.A), currently at $25.82 per share, and earn a yield currently of 5.52%. Compare that with the yield on the iUnits on the S&P/TSX 60, ticker XIU, which is only 1.60%.

To get any capital gains earned by the portfolio shares, you could buy the capital shares today at $9.30 (ticker SXT) . . . If the value of the portfolio shares rises between now and the final redemption date, the capital shares should rise at a greater rate than the portfolio shares (2:1 in the simple example). You could then sell for a gain through the stock exchange.

Note that, as mentioned here, “the returns are leveraged on split shares, somewhat like buying stocks, bonds or futures on margin.” Margin is defined as: “Borrowed money that is used to purchase securities.” This is the basic concept at work here. The capital share holders are essentially lending their shares to the preferred share holders who take all the dividends from it and the preferred share holders are lending their shares to the capital share holders, who take all the capital gains from it. Buying with borrowed money increases yours risk because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price – the potential for greater losses.

Basically what split shares allow one to do is trade off capital gains for dividends and vice versa, allowing you to receive either capital gains or dividends, and more of them. Are they worth thinking about? Not really in my opinion. The Top 10 Split Trust that I mentioned above invests in the top 10 Canadian banks and insurance companies in Canada. Personally I would rather invest in iUnits XFN ETF. It tracks the S&P/TSX Capped Financials Index. It has a lower MER and carries less risk, due to the fact that you are not restricting yourself to only dividends or only capital gains. Not only that but XFN is a larger basket of stocks thus reducing risk even further.

Tomorrow I’ll talk about some more of the downsides of split shares.