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New closed-end funds on TSX may offer better returns than mutual funds due to leverage

by Wayne Cheveldayoff, 2004-11-18

Four mutual fund companies recently announced that they are setting up TSX-listed closed-end funds that will mimic the mutual funds they manage except for one main exception – the use of leverage.

It’s an important difference since the ability to borrow money at today’s low interest rates has the promise of boosting returns if the money is invested in, say, income trusts yielding 8 to 12 per cent.

These closed-end funds will have the right to borrow up to 20 or 25 per cent of total assets in the fund. Mutual funds aren’t allowed to borrow.

The impetus for this wave of closed-end funds – all of them offering an initial 7-per-cent annual return through monthly distributions – does not appear to be the mutual fund mangers themselves, who get paid the same.

Rather, there appears to be genuine demand from investors, although this demand may have been helped along by the underwriting dealers who stand to earn commissions of 5.25-per-cent.

Aside from the potential of better returns, closed-end funds offer several other benefits to investors, such as being able to buy or sell units at anytime the TSX is open versus only being able to buy or sell mutual fund units once a day based on the closing price.

They may also appeal to investors who trade frequently since closed-end funds, unlike mutual funds, don’t carry a 2-per-cent fee on redemptions within the first 60 days.

But closed-end funds also have some disadvantages and may not be suitable for investors wanting to make small monthly contributions because of the minimum trading commissions charged by brokerage houses. For instance, a $50 or $100 investment would get hit with a minimum $25 commission at a discount brokerage and more at a full-service house.

An example of the recently offered closed-end funds is the Mavrix Balanced Income and Growth Trust, which will be managed by William Shaw of Mavrix Fund Management.

Mr. Shaw also manages the Mavrix Dividend and Income Fund, a mutual fund that was named the 2003 Canadian Dividend Fund of the Year by the sponsors of the Canadian Investment Awards. This mutual fund has recorded an average annual return of 19.5 per cent in the past three years, compared with 6.6 per cent for the large-cap S&P/TSX 60 Index.

The new closed-end fund he will manage will invest primarily in income trusts and North American stocks.

The annual fees will be 1.1 per cent to the manager, 0.4 per cent to the investment dealer as a trailer fee to the broker, and about 0.3 per cent for additional expenses – producing a management expense ratio (MER) of about 1.8 per cent.

MERs for load mutual funds are higher, usually around 2.5 per cent, but the difference is mainly accounted for by the higher trailer fees (0.5 to 1 per cent) paid on load funds.

The three other closed-end funds have identical fees and structures and provisions for leverage very similar to the Mavrix offering.

Sceptre Investment Counsel is offering the Sceptre Income and High Growth Trust, which will invest in income trusts and common shares of small and mid-cap Canadian companies. The 3-year annual return for the alternative mutual funds were 32.9 per cent for the Sceptre Equity Growth Fund and 20.2 per cent for the Sceptre Income Trust Fund.

Clarington Investments has launched the closed-end Clarington Diversified Income + Growth Fund, which will invest in income trusts, bonds and all equities and will be managed by KBSH Capital Management. KBSH also manages the closed-end Clarington Diversified Income Fund (no leverage or growth equities), which returned 13 per cent from May 15, 2003 to June 30, 2004.

Mackenzie Financial is offering the MSP Maxxum Trust to invest in income trusts and equities and to be managed by veteran Bill Procter, who also manages the Mackenzie Maxxum Dividend Fund (3-year annual return of 9.8 per cent to October 31).

One thing for investors to keep in mind is the impact of the broker’s 5.25-per-cent selling commission. The units are sold to you at $10 each but the managers start out investing with only $9.475 of that, which is not the case with mutual funds.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff