Canada has had publicly traded, closed-end equity funds since the 1920s, although they have represented a relatively small segment of the market.
Over the past year, however, a number of well-established investment managers have introduced a new breed of closed-end funds to Canada.
Capital-protected closed-end funds are securities that have raised more than $3 billion, increasing the total market capitalization of closed-end funds in Canada to more $7.2 billion.
They have three objectives:
- Return an investor’s original capital on the termination date of the fund.
- Provide an income stream over the life of the fund.
- Provide the potential for modest capital appreciation.
Read Also
Topsy-turvy precipitation this year challenges crop predictions
Rainfall can vary dramatically over a short distance. Precipitation maps can’t catch all the deviations, but they do provide a broad perspective.
The funds have two components to help them achieve these objectives: the fixed portion of the portfolio, and the managed portion.
For example, if a new capital-protected closed-end fund issues shares at $25 per share, the proceeds are used to buy securities for both the fixed and managed portfolios.
The fixed component allows the investment manager to return the investor’s original capital on the termination date of the fund.
This portion comprises equity investments and is subject to a forward agreement. Essentially, the fund exchanges the fixed portfolio for a contractual forward agreement with a Canadian chartered bank. In exchange, the bank ensures the return of the original $25 per share investment on the termination date, which is usually 10 to 12 years from the original issue date.
Money earmarked for the managed portfolio is used to buy specific equities selected by the investment manager based on the fund’s investment objectives. Generally, these funds invest in a diversified portfolio of high quality, large-capitalization companies, with a mix of Canadian and foreign securities. While all the funds are eligible for tax-sheltered accounts, some may be considered foreign property for such plans.
The investment manager engages in various options strategies, principally covered call writing, to provide the investor with an attractive income stream. Covered call writing is a conservative strategy that allows additional income to be earned on securities already held in the portfolio.
Revenue earned by the fund from options strategies, plus dividend and interest income earned on the investments, provides the revenue for the monthly distributions. This provides the income stream and a yield to investors, typically targeted at 8.75-nine percent.
Because a substantial portion of the income stream is comprised of option revenue, it is treated as capital gains for tax purposes, currently calculated at a rate of 50 percent.
Investors will experience a gain if the value of the managed portfolio has increased above its original amount at the termination of the trust.
However, any upside may be limited by the covered call writing strategies used by the investment managers.
There are also risks to consider, one being the inability of the fund to reach its targeted distributions. Should the volatility of the option markets subside and premiums from the covered writing programs diminish, income available for distribution could be reduced. Other risks include interest rate risk and foreign exchange risk, associated with the portfolio’s non-Canadian securities.
Another risk is that the fund’s market price often trades at a discount to its underlying net asset value.
However, unit holders of capital-protected closed-end funds have the option of reselling their shares to the fund at the current net asset value either on a monthly basis, less a fee, or annually, without a fee, which provides support to the trading of these securities. The funds are listed on the Toronto Stock Exchange, and are currently trading at premiums to their net asset value.
Some examples are the Pro-Ams Trust, Years Trust and Aberdeen Scots Trust offering Canadian, U.S. and global exposure, respectively.
Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
