Back on Halloween night 2006, Finance Minister Jim Flaherty dropped a bomb on the Canadian income trust sector. He announced that a new tax would be imposed on trusts that would put them in roughly the same position as corporations.

However, the minister offered a four-year grace period. The tax would only take effect on Jan. 1, 2011 so as to allow time for the industry, and investors, to adapt to the changed situation.

That honeymoon is just about over. In less than 11 months, the tax will kick in. The income trust sector may not completely cease to exist – there are some oil and gas trusts with huge tax pools that would allow them to shelter income for several years even while retaining trust status. But only a handful of companies fall into this group. Out of the more than 200 income trusts that existed at the peak of the trust boom, probably no more than 20-25 will remain after next Jan. 1.

That means we should expect some big changes in the trust sector in the next few months. Many will convert to corporations (some already have) and there will be numerous takeovers, mergers, and privatizations.

All this will have a profound effect on the funds that have specialized in the trust category, especially those that have not progressed very far in the transition from an income trusts fund to whatever they plan to evolve into (e.g. Canadian equity, diversified high income). For example, all of the top 10 holdings in the Bissett Income Fund are still income trusts or REITs. The quality of the portfolio is very good, but clearly there are going to be some significant changes in the next 12 months.

Despite the axe hanging over it, the Canadian Income Trust Equity category did surprisingly well in 2009, with the average fund in the group showing a 12-month gain of 36.6%. In fact, every fund in the category produced a double-digit gain in 2009 with several advancing more than 30%. Here are some examples:

Fidelity Income Trust Fund: +45.9%
Investors Income Trust Fund (A units): +47.7%
iShares CDN Income Trust Sector Index Fund: +40.4%
Mackenzie Saxon High Income Fund: +44.9%
Sentry Select Canadian Income Fund: +33%

Impressive, yes, but it was the last gasp. After this year, the category probably will no longer exist. The big question for investors in these funds is what should they do with their money: hang in and hope for the best or move on?

There is no simple answer. Each fund has to be looked at individually with a view to determining where it's going and how far along it is in the process. For example, the Fidelity Income Trust Fund still has 73% of its assets in Canadian income trusts with about 21% in stocks. This suggests it will eventually morph into a pure equity fund but it has a long way to go.

By contrast, the Acuity Diversified Income Fund, which was only recently moved out of the income trusts category, has a portfolio that is heavily weighted (70%) to high-yield bonds. Clearly, these two funds are moving in entirely different directions and investors have to decide whether they are comfortable with the changes.

One fund in this group that has already gone a long way towards repositioning itself as a high-yield equity fund is the RBC Canadian Equity Income Fund, which was one of my Fund of the Week selections in December. It is a relative newcomer to the RBC line-up, having been launched in July 2006. It is relatively small, with only $51.6 million in assets under management. The fund is run by RBC vice-president Jennifer McClelland who is in the process of transforming it from an income trusts fund to a broadly-diversified high-yield portfolio.

The managers of other income trusts funds are going to have to decide this year how they are going to transform their portfolios. Investors will need to keep a close watch on developments because there are many possible options, ranging from a high-yield bond portfolio (the Acuity solution) to an equity portfolio (Ms. McClelland's approach). If you aren't in agreement with the direction in the fund is moving, take your money and run.

The bottom line: Income trust funds are going to be a dog's breakfast this year. Be sure you know exactly where a fund is going before making any investment decisions.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides advice on fund selection and strategies. For subscription information:
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Gordon Pape's new book is The Ultimate TFSA Guide, published by Penguin Group Canada. Order your copy now at 27% off the suggested retail price by going to
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