Income-trust mutual funds, a small but growing asset class in Canada, are about to get a higher profile with the launch of an income trust index by a unit of Standard & Poor's.

To be launched in June, S&P's Royalty Income Trust Index will be disseminated through the Toronto Stock Exchange, and its value will be continuously recalculated. Concurrently, S&P will also release an index history, along with lists of its component securities and their weightings. The new index will compete with an existing one now produced by Scotia Capital Markets, an investment house in Toronto.

There are now more than 100 income trusts listed on the Toronto exchange, and their market value has grown rapidly, according to S&P. As of the end of 2000, their combined market capitalization was $16.3 billion, up from less than $6 billion in 1996. This represents an average annual growth rate of 31 percent.

Glen Doody, director of S&P's Canadian index operations in Toronto, said the company has noted a growing demand for managed products that specialize in income trusts.

"Our new index will provide investors with a useful and much needed tool for developing and monitoring their portfolios," he said.

S&P's new initiative is all the more significant for raising the profile of income trusts because of their removal from the main Canadian stock market benchmark in 1995. Since they are not incorporated entities, income trusts were deemed at the time to be ineligible for continued inclusion in the TSE 300 composite index.

In addition to calculating an overall index for income trusts, S&P will calculate sub-indexes for REITs and the energy sector. This will enable the firm, in co-operation with the Toronto Stock Exchange, to launch exchange-traded funds based on one or more of the new indices.

Despite the low-fee competition that new exchange-traded funds might represent for existing open-end funds, mutual-fund managers in Canada view the upcoming index as a positive development for income-trust funds.

"That will give the group added credibility," said John Priestman, managing director of Guardian Capital in Toronto. "It will be a benchmark for all investors to look at." Priestman manages the $508 million GGOF Guardian Monthly High Income Fund, the largest Canadian based mutual fund investing mainly in income trusts.

Ben Cheng, a portfolio manager at CI Mutual Funds, also of Toronto, agreed that the new S&P index "lends a great deal of legitimacy" to an asset class that has been for the most part ignored by institutional investors.

Priestman said income trust funds have also been gaining a higher profile, and experiencing net inflows of new money, in the aftermath of the fall over the past year of high-tech stocks and the shift in investor preference toward more conservative equity investments.

Canadian investors have been attracted to the high yields of these funds, and their holdings in old economy sectors such as natural resources, real estate, pipelines and other infrastructure. It has not hurt, either, that funds specializing in income trusts have been delivering double-digit returns over the past 12 months during a difficult period for the mainstream equity markets.

As the income trust industry has grown in size and established longevity, it has become easier for money managers to analyze, said Priestman. The best trusts now have "credible five-year track records," he said. Cheng, of CI Mutual Funds, who is manager of Signature High Income Fund, said the liquidity and stability of income trusts have "grown tremendously" over the past 12 months.

Other pluses cited by Priestman include last year's two-stage reduction by the Canadian federal government in the capital gains inclusion rate to 50 percent of the reported gain, from the previous 75 percent, declining interest rates, and positive fundamentals in the real estate and energy industries.

Ned Goodman, chairman of Dynamic Mutual Funds in Toronto, said income trusts have tax-efficient structures that enable income to flow directly to investors, rather than indirectly through corporate dividends.

Usually, large portions of the distributions paid by income-trust funds consist of tax-deferred payments. Technically, they are deemed to be a return of capital, but they are not tax free. As such, they appeal mainly to income-oriented taxable investors who want regular cash flow, but want to put off paying income tax.

The return of capital portion of distributions reduces the adjusted tax base of the fund, which has the effect of increasing the capital gains tax payable by the investor when the fund units are sold.

Dynamic Mutual Funds effectively endorsed income trusts when it sought, earlier this year, unitholder approval to convert an existing money market fund into one that will specialize in income trusts. On May 8, investors endorsed the proposal, making the renamed Dynamic Diversified Income Trust Fund the category's newest entry.

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