Split Shares: The Downside

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.

Split Shares: What are They?

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.

U.S. Housing Bubble Popped? Are We Next?

According to Bill Fleckenstein’s “The housing bubble has popped” article, the U.S. real estate bubble has finally popped. He gives many funny, I mean sad, stories about people stuck with homes they paid too much for, like one man in Stuary, Florida:

Concerned about his real-estate investment apparently going sour, he can’t afford to reduce the price to what homes now sell for in his neighborhood — which is about $100,000 less than he’s asking. Says the salesman: “If I got in a jam, I would have to drop the price, but I am not at that point.” His game plan: Rent the house, so as not to “lose my shirt.”

That’s the mentality often seen in manic markets — the belief that you can’t possibly lose, and, when the price goes against you, you don’t have to deal with it, because it will come back. This fellow (and millions more like him) is going to find out that his belief is a mistaken one, in the same way that folks did when the stock bubble burst.

Fleckenstein says the market is no longer leveling off, but is sliding downward:

We’re seeing signs of sales slowing and inventory accumulating, which are all quite classic, even though the timing of when this would begin was not possible to predict in advance.

Closer to home, Vancouver Housing Blog has an article going over some of the Mortgage Math for the new development in the old Woodward’s building (the “W”). First he calculates how much it would cost per month to mortgage a 2 bedroom:

The price range for 2BRs is supposedly 489-795K. Let’s just take the midpoint of these two prices to get a number to work with: $642K. Say you had a downpayment of 10%. You’d be financing $577.8. Take out a 5.25% 5-yr mortgage at ING direct, amortized over 25 years. Monthly nut? $3462.47. Using the 32% of gross monthly income rule, this means you would need an annual income of $129,842.63 to afford the mortgage.

Then comes the shocker, or not-so-shocker if you are like me and have been scanning MLS and noticing that you are completely priced out of everything:

Around half of today’s West Side inhabitants could not afford to buy at the W if they were first-time buyers and had to qualify based on their current incomes.

This can’t go on forever. Gotta love the working on the W‘s website: “The smart money gets in early.”

Covered Call Options

It is sort of unusual for me to write about a topic like covered call options. It is something that will come up in a future post about split shares I am drafting right now, and it is kind of a heavy topic so I thought I would give it a post all on its own instead of cramming it into a future post. I also find it a extremely interesting topic, even though I will most likely never take part in any options trading myself.

A book I read recently called “A Mathematician Plays the Stock Market” has a pretty good description of covered call options. But before understanding what a covered call option is, one has to understand what a call option is. A call option is a right to buy a stock (but not obligation) at a certain price (the strike price) within a specified amount of time. For example, stock options offered by companies to employees are call options (as opposed to put options). Although “stock options” involve the issuing of new stock whereas with call options, the shares are simply being transferred from one owner to another.

You can also sell a call to someone, ie. sell someone the right to buy shares in a company at a certain price within a specified time period. If the stock doesn’t move above the strike price, you keep the proceeds from the sale of the call option. If the price of the stock moves above the strike price and the buyer of the call option exercises their option, you have to buy some shares at the current market price and provide them to the buyer at the strike price. Essentially you are buying them at the current price (a high price) and selling them to someone else at the strike price (a low price). So selling calls is a bet that the stock price will decrease.

Another strategy is to buy shares and simultaneously sell calls on them (selling “covered” calls). You could for example, buy shares of ABC Corporation at $25 and sell 6-month calls on them with a strike price of $30. If the stock price doesn’t rise to $30 you keep the proceeds of the sale of the calls. If the stock does rise past the strike price of $30 to $35, and the buyer of the call exercises their option, you can sell your own shares to the buyer of the calls. Selling “covered” calls (calls in stock you own) is safer than selling calls because you don’t have to buy stock in that company at a high price ($35). You already own stock in that company which you bought at a low price ($25) and can sell it to the buyer of the calls for $30. You make money on the stock’s rise from $25 to $30 as well as the proceeds from the sale of the call option and the buyer of the call option makes money from the stock’s rise from $30 to $35 minus the purchase of the call.

Here’s an example from the Wikipedia article on call options:

  • An investor buys a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price) and an exercise date of June 1, 2006, and pays a premium of $5 for this call option. The current price is $40.
  • Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.
  • If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.
  • Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100).
  • From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller’s profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.

There is another example of selling covered calls at investopedia.org and another explanation here.

Use Your Tax Refund (a.k.a. savings) To Build Your Wealth

Great article from Clearsight called “Use Your Tax Refund To Build Your Wealth.” I have not really found many of Clearsight’s articles to be that insightful but this one was. I particularly liked their discussion about the different types of expenditures:

Three types of expenditures
Ultimately, whatever you do with your money can be broken down into three basic categories of expenditures.

No-value expenditures
For some expenses, once your cash is used the money is gone. Things like food, utilities, clothes, entertainment, etc. These expenditures do not contribute to building wealth. This category includes necessary expenditures (like food) but sometimes also far too many unnecessary expenditures (like entertainment). Filling your cash flow with too many unnecessary things is often fun — but not productive.

Depreciable expenditures
In this category, the item you purchase may have value, but that value depreciates over time. The most common depreciable expenditure is a car. Most of us consider a car an asset because it has value, but every year, the car we own has less and less value. Cars depreciate, and often faster than we would like them to. Obviously, a depreciable asset is better for wealth building than a no-value expenditure because it at least contributes to our net worth.

Appreciable expenditures
Using your money in this category is the most productive for wealth building. Assets like GICs, real estate, stock portfolios and bonds, go up in value over time. Using your cash flow for these types of investments will be the most fruitful use of your money. Often, they are not as fun or exciting as spending money on that new big-screen TV or fancy car, but it is the best for improving your financial picture.

This is a great read for anyone. A tax refund is an asset and you can transfer than into a appreciable asset, a depreciable asset, or an expense. They left out a fourth option, which is to transfer it into a liability, but this is similar to “appreciable expenditure” above. They go on to talk about net worth,

A key benchmark in your financial planning is your net worth. Your net worth is simply what you own minus what you owe. A primary goal of your financial planning should be to increase your net worth year over year.

As for the tax refund and what you should do with it:

The answer should be the same answer to, “What should I do with my cash flow?” The best thing to do with your tax refund is to use it productively — towards building your net worth. You may think all of this is really simple and full of common sense. If that’s the case, then why don’t more people do it? It’s not easy to do. Financial planning is all about trade-offs and discipline. The people who succeed are the ones who just do it!

It seems like a no-brainer to transfer your tax refund into an appreciable asset (see “Appreciable expenditures” above) first. Maybe even just an ING Direct Savings account. You can always make a “no-value expenditure” from that asset later. For me just getting money out of my hands works wonders. Any incoming cash flows I receive, gifts, tax refunds, web design work, adsense revenue goes straight into some form of savings account. Once the money is in the savings account, I think carefully about making expenses from it because I have saved up that money and I do not want it to go to waste. I become attached to that money. This thought process is completely bypassed when I cash a cheque or deposit it directly into a chequing account.

Vacation Time

It’s almost vacation time again for us. I just bought 2 flights to Havana last weekend for June. The flights are expensive, about $1000 each. We will be going budget once in Cuba though, staying in Casa Particulares, eating in Paladares, and taking the bus. It will be cheaper than an all-inclusive resort. I decided not to use Air Miles for our flights by the way (even though I said I might), because I decided to assume the higher $0.16 or $0.2 valuation for the Air Miles. I think they will get used for sure within the next year for flights to Calgary. We already know we will be going to a wedding in Canmore next January for a weekend and Air Miles are worth about $0.23 on flights to Calgary.

Since our last vacation, in October 2005, we have been saving about $600-700/month towards vacations. That amount is automatically transferred at the middle of every month from one of our chequing accounts into an ING account. We did this because we both have full time jobs and we both get 4 weeks of vacation per year now and we want to be able to use it. We have no kids right now, but we will eventually, and we want to make sure we take advantage of this post-marriage pre-children period. We are maximizing our RRSPs and slowly but surely paying off the student line of credit and putting away some more money for a rainy day so I think we can afford it. Last but not least, we just need a vacation!

WestJet Air Miles Gold Card

I was on the phone with a customer service representative at Air Miles recently, and she suggested that I get the Gold Westjet 1/$15 AirMiles Mosaik Mastercard. With this card, every $15 spent earns one air mile, however, there is an annual fee of $70 (which she neglected to tell me, but I knew there had to be a fee). Currently our only credit card is a Mosaik Mastercard 1/$40 card which has no annual fee. For the Gold Westjet card option to break even, the following must be true:

\left(\frac{x}{40}\right)C < \left(\frac{x}{15}\right)C - 70 where C is the value of one mile and x is the number of miles earned in our year. Assuming C=\$0.10 (conservative), solving we get x=\$16,800. Assuming a higher value per mile (C=\$0.2) we get x=\$8400. The latter value works out to $700/month, the former works out to $1400/month. So we would have to spend somewhere around that much per month on our credit card just to break even and make the card worthwhile. I do not think that is going to happen since we have stopped using our credit cards altogether, except when absolutely necessary (online purchases). The Gold Westjet card has some advantages besides the 1 mile for every $15 spent. For example it allows you to fly anywhere WestJet flies for 1,600 Air Miles. The disadvantage of this is that you have to fly on WestJet.


This article, “Cramer Google-Coaster (GOOG)” lists Cramer’s recent recommendations on Google stock:

January 3……….Buy…….$435.23 (going to $500)
January 4……….Buy…….$445.24 (going to $500)
January 13……..Buy…….$466.25 (going to $600)
January 23……..Buy…….$427.50
January 25……..Buy…….$433.00 (take profits)
February 2……..Buy…….$396.04
February 6……..Sell.. ….$385.10 (sell at $400)
February 14……Buy…….$343.32
February 27……Buy…….$390.38 (going to $500)
March 6………….Sell…….$368.10 (going down $15)
March 7………….Buy…….$364.45
March 13………..Sell…….$337.06
March 21………..Sell…….$339.92
March 23………..Buy…….$341.89
March 29………..Sell…….$394.98

I plugged them into Excel and set up some cash flows according to the following rules: purchase 100 shares of GOOG every time Cramer calls “Buy” and sell of half of the shares you own every time he calls “Sell.” I then used Excel’s XIRR function to determine the Internal Rate of Return, and got a -66% annualized return. Way to go Cramer. If you’d just bought 100 shares of Google on January 3rd and held it until March 29, you would have achieved a -34% annualized return. If you had of instead bought 100 shares of Google on all the dates above in order to dollar-cost average, you would have achieved an 8% annualized return by March 29th.

The analysts are always full of crap with their buy/sell recommendations and I am sure any reader of this blog is aware of that. What is sad is that Cramer’s show is insanely popular. What is even more sad is that a friend of mine’s dad is an investment advisor and he watches Cramer every day after work AND TAKES NOTES. To give him the benefit of the doubt, maybe he just watches the show and gambles 5% of his portfolio (his “mad money”) on some of Cramer’s picks. But still, I would not be happy if I suddenly found out my advisor watched Mad Money every day after work. I am extremely happy that I am not going to this person for financial advice/management. And I was very impressed when I first met my current advisor and he told me that he “does not pick stocks.” Nor does he sound like someone who would pay any attention to stock picks he heard on TV.

I only saw Cramer’s Mad Money once while in Hawaii (my only chance to watch the 24/7 American “news” stations). I think I watched for all of about 2 minutes until I dismissed it as crap and shut it off. Once in a while I hear about this Mad Money show. I remember Arrested Development poked fun at it and a little while back a stock recommendation on his show apparently caused Zarlink stock to increase 20% in one day.

Here are couple of comments on Cramer from “Ego Unleashed, or Everyman of the Market?“:

“What you are seeing when you watch that show is both a parlor game and real brilliance,” Mr. Bogle said. “But I think that when the final score is written, his return is very average, and below average when you factor in the costs of making the trades. We know that when you own the stock market and never trade, you will capture the market’s return. The more we trade, the greater the costs and the greater the loss. These are relentless truths that cannot be avoided.” [emphasis mine]

Another good article here: “Monitoring the ‘Mad Money’ Madness” by the Big Picture‘s Barry Ritholtz.

Canada Revenue Agency’s “My Account”

The CRA (Canada Revenue Agency) (which by the way was called the CCRA (Canada Customs and Revenue Agency from 1999 to 2003) has had some form of “My Account” service for a while now. In recent years it has gotten a lot better. You can now access:

  • Notice of changes and summary of assessment or re-assessment in full
  • Previous returns in full from 2003 onward. Information on refunds and filing dates is available going back to 1999.
  • Carryover amounts (such as tuition and education amounts and net capital loss carry forwards)
  • Account balace
  • Information about instalments
  • Current direct deposit information on record
  • Home Buyer’s Plan/Lifelong Learning Plan information
  • RRSP deduction limit and unused contributions available to deduct
  • GST and Child Tax Benefits information
  • Request changes to prior years’ returns.
  • Register formal disputes.
  • Change your address or phone numbers.

Essentially everything that is provided on those notice of assessment forms every year is now available online.

It has also gotten harder to log on to. One used to be able to log in quite easily by providing a social insurance number, a birthdate, and some information from prior tax returns (amount on line 150). Now you need to go through a more in-depth registration process. This requires you to get an ePass, a username and password which gives you access to various government services. I also used my ePass to apply for a new Canadian passport online last year (applying online allows you to jump the queue at the local passport office). CRA also requires you to type in an activation code that they will mail out to you.

Fortunately, their website now works with Firefox (despite a warning that it does not) which it did not last year. If you still have problems and you are using Firefox, try upgrading to Sun Java 1.5 (JRE 5.0).

BlogShares – Investing Intelligently

I was just playing around on Google, searching for my blog’s name and I found this: BlogShares. Interesting site. It’s just what it says, a “fantasy blog stock market.” So far 80% of my blog is owned by Gary LaPointe. Weird. His picture looks straight out of an ad for one of those stock trading systems, like Wizetrade (actually that was the one with the soccer kid, never mind).

Gary – Proud fantasy owner of Investing Intelligently