Labour
funds in your portfolio
I spent
last week briefing you on the risks of labour sponsored investment funds
(LSIFs). However, risk is only one dimension of an investment’s fundamentals.
The more positive aspects of this unique class of funds will be summarized this
week along with some guidance on incorporating LSIFs into your portfolio.
I’ll start
with a run down of LSIF tax benefits, since that’s the biggest attention
getter.
Tax credits
for LSIFs are available from the federal government, in addition to most
provinces. The federal credit is equal to 15 per cent of the amount invested,
for each $5,000 invested each year. Most provinces, such as Ontario, match that
federal credit. While BC and Manitoba offer provincial credits, they only do so
for a couple of funds. For instance, BC’s Working Opportunity Fund is the only
LSIF that qualifies for both credits; while Crocus Fund and Ensis Growth Fund
are the only two funds eligible for Manitoba credits.
LSIFs must
be held for eight years. Otherwise, all of the tax credits will have to be
repaid and a deferred sales charge (i.e. an exit fee) will be withheld. There
are exceptions, but that eight-year holding period applies to most.
Timelines
for purchases coincide with RRSP rules – i.e. anybody who invested in a LSIF by
March 1, 2002 will be able to use the LSIF credits on their 2001 tax return.
There is no carryforward of credits, as with RRSP contributions, but any
contribution made during the first sixty days of the year can be used either
for the previous or current year.
Also, any
investment in a LSIF inside of a spousal RRSP allows the tax credits to be
allocated to either the contributing spouse of the account holder (i.e. the
annuitant) – as long as each individual claims no more than the annual maximum
credit for any one year.
If held in
a RRSP, the 30 per cent foreign content limit we know all too well is actually
expanded. For each dollar invested in a LSIF, foreign content room expands by
$3 – to the extent that total foreign content is no more than an additional 20
per cent. Hence, with LSIFs, investors can actually hold up to half of their
RRSP, based on book value, in foreign investments.
Finally,
LSIFs should not be overlooked as an investment outside of a RRSP. We talked
about capital gains and adjusted cost base (ACB) just a couple of weeks ago.
Most tax shelters offer some write-off or tax credit. Generally, when an
individual invests in a tax shelter, the ACB of that investment is reduced by
the amount of tax assistance that accompanies the investment. No so with LSIFs.
Here’s the
bottom line. Let’s say I buy a LSIF for $5,000. As a result, I get total tax
credits of $1,500 (i.e. 30% of the investment). My actual cost is only $3,500,
but my ACB (which is my cost for tax purposes) remains $5,000. If the fund is
worth exactly $5,000 in eight years, it’s actually a gain for me. However, I
have no capital gain to report on my taxes. The net result is an annualized
after-tax return of 4.6 per cent per year. Not bad for an investment that flat
lined for eight years.
Tax credits
shouldn’t drive your decision, but they shouldn’t be ignored. Let’s shift our
attention to the sources of potential return for LSIFs.
What is
worth more to you – buying shares in a company that is traded on the Toronto or
New York Stock Exchange, or buying shares in a company which has no facility to
allow investors to liquidate shares? Of course, owning an investment that can’t
be liquidated isn’t nearly as attractive.
Hence, a
LSIF manager investing in a private company is compensated for the inability to
easily liquidate his holding (i.e. liquidity risk) by being able to negotiate a
big discount on the price of the shares. The LSIF manager can produce a very
handsome return if all she ever does is bring liquidity to a private
investment.
This can
happen by:
Ÿ
helping
a company “go public” (i.e. help it get its shares traded on a stock exchange);
Ÿ
selling
its stake in the company to another firm; or
Ÿ
selling
its stake back to the company’s management.
Perhaps the
more obvious source of return may simply result from improving the business.
Helping it track its business plan; grow sales, profits and cash flows; and
keeping good cost controls in place will go a long way toward enhancing the
value of its initial investment and attracting potential liquidity.
To most
investors, the power to exhibit influence on a business’ strategic direction
has real value. Hence, whenever one company buys control of another, the buyer
usually pays more than just the going value – something called a control
premium. This is a smaller, though still significant source of return for the
LSIF manager.
My top LSIF
picks, as published in an extensive proprietary report just last month are, in
alphabetical order, Canadian Medical Discoveries, Capital Alliance Ventures,
Dynamic Venture Opportunities, Ensis Growth, First Ontario, Vengrowth II,
Working Opportunity, and Working Ventures Canadian.
A good rule
of thumb for those interested in including this asset class into their
portfolios is to have no more than about 5 to 12 per cent of one’s total
portfolio in LSIFs Exactly how much depends of course on each investor’s
particular circumstance, but that’s a good rule of thumb.
LSIFs offer
great potential. In the U.S., we know that private equity investments have
produced returns that are well ahead of the returns generated by the S&P
500 and smaller U.S. stocks over the past twenty years. In Canada, we don’t have
a similarly long history. However, a good indication of its potential is the
growing interest in venture capital by Canada’s biggest public pension plans
(like OMERS, the CPP Investment Board, and Ontario Teachers’ Pension Plan
Board) and firms in the private sector. Recognizing both the potential risks
and rewards of venture capital and LSIFs; and prudently incorporating LSIFs in
your portfolio can produce real, long-term benefits.
While these
two articles on LSIFs provide a good overview, they really just scratch the
surface of both risk and return characteristics. Use these articles as a
springboard to do further research or to ask more questions of your advisor so
you can better understand where your money is going.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.