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.