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Jun 30, 2016

At-A-Glance: Split Share Corporations (Part 2 of 2)

by Michael Southern

Michael SouthernWhat makes investing in today’s markets so interesting is that, regardless of your strategy or outlook, there is likely an investment product that fits your need. Here, the split share fills a niche. However, as with many engineered products, the devil is in the details and investors need to perform a heightened level of due diligence to understand the unique set of risks present in split shares.

This is the second and final article on split shares, designed to examine the performance of the products. The first article in this series was a primer on split shares, discussing the structure and for whom they are appropriate.

TSX Universe Of Split Shares:

The TMX Group, which oversees the Toronto Stock Exchange, makes available through the TMX Money website a list of all the split shares currently trading. As of April 30, 2016, there are 30 split shares corporations trading on the TSX. Quadravest is easily the largest issuer with nine split shares listed. For the reader’s reference, the TMX site can be found here: http://www.tmxmoney.com/en/research/closed-end_funds.html

We will look at the performance of five listings. The majority of split share corporations are similar in terms of the portfolio of holdings. Most are entirely invested in the financial and telecommunication sector, or are at least heavily weighted there. With that, we decided to look at the top three split shares by market-cap, but also to highlight two funds that are focused in sectors other than the financial and communication sectors. We also tried to look for a diversity of issuers.

Below is the list of names for which we will examine performance.

Michael Southern

Note that while these are the tickers for the capital share component of the split share, the market-cap is for the corporation as a whole, which includes the preferred share component. The top three split shares by market-cap on the TSX are DFN, FTN and DGS. The portfolio is dominated by financial and communication names. For example, as of December 31, 2015, DGS had 80.0% of its portfolio in these two sectors. BBO and UST were two of the few names in our universe of 30 that were not tilted to financial and communications. Although the size of BBO and UST is much smaller, these split share corporations are focused on the energy and utility sector, respectively, which will provide a more diverse view of performance compared to the top three names.

Performance Characteristics:

For each class of split share, the tables above show the distribution and frequency as per the original prospectus. Preferred distributions are fixed and cumulative. Distributions on the capital share however, are targets and are not guaranteed. As per the UST prospectus: “The amount of capital share monthly distributions may fluctuate from month to month and there can be no assurance that the Trust will make any distributions in any particular month or months.” Indeed, UST initially offered a $0.0906 monthly dividend; since 2009, it has paid a $0.05 monthly dividend.

Michael Southern

The table also shows the share’s NAV and price. This is important as split shares, which are generally thinly traded, can trade at significant discounts/premiums to the NAV. Investors only transact at the NAV before the fund starts trading; otherwise, they do so at the prevailing market price. The market price of the capital shares is determined by, among other things, the relative demand for and supply of the units in the market; the performance of the underlying stocks; and investor perception of the fund’s overall attractiveness as an investment as compared with other investment alternatives. One will notice the initial and most recent NAV of the preferred split matches; this is because shareholders receive back their initial capital investment at liquidation. In reality, the preferred split share NAV may fluctuate slightly, but it is generally not material. NAV is far more important for the capital split shareholder as they only receive back principal once the preferred shareholders are paid. This issue is further addressed in the “Performance” section.

The final piece to the table above is the “Minimum Fund NAV for Distribution” column. Capital share distributions can be cancelled altogether. Most split shares quote a net asset value (NAV) threshold that, if breached, will cause all capital share distributions to cease. In the case of BBO, the NAV fell below 15.0 in late 2015 and the capital share distribution was cancelled. As per a BBO December 17, 2015 press release: “No distributions will be paid on the Class A Capital Shares if, in respect of a cash distribution, after payment of the distribution by the Corporation, the NAV per Unit (a “Unit” consisting of one Class A Capital Share and one Class A Preferred Share of the Corporation) would be less than $15.00 (the “NAV Restriction”). As the NAV per unit on December 17, 2015 was $14.57, no distribution will be declared or paid on the Class A Capital Shares for December. Unless the NAV Restriction is satisfied, no future monthly distributions will be paid on the Class A Capital Shares.” The NAV on BBO has since recovered and payments have resumed on the capital share; however, three months’ worth of payments were missed. This has contributed to BBO’s poor performance, discussed in the next section.

Michael Southern

Performance:

In calculating the performance for our sample of split shares, we used a methodology different than what you would see if an investor examined performance reports from a split-share corporation. To calculate annualized performance, most corporations assume distributions are immediately reinvested at the current NAV of the fund. Our methodology differs in two ways. First, we assume dividends were collected but only reinvested at the end of each quarter. (March, June, September and December). Second, we assume this reinvestment took place at the prevailing market price and not the NAV of the fund. As investors transact at the price level and not the NAV, we felt this was more realistic as the two can vary significantly.

We also provided a simple total return calculation, which assumes dividends are not reinvested, but simply collected. We then broke the total return down into its price component and dividend component.

The performance of the capital shares is shown below using our methodology. We have compared results to the iShares S&P/TSX 60 Index ETF (XIU) and adjusted performance to the inception date of the split-share corporation.

When examining annualized performance of the capital split shares, results are mixed. In two cases (DFN, DGS, UST), the capital split share outperformed the TSX; in two cases (FTN, BBO) the capital split share underperformed. The same “mixed” picture holds true when one looks at the total return, although the variance is to a larger degree.

Michael Southern

The performance of the capital share becomes more clear when we break down total return into its two components: price and dividend. With the exception of UST, the return from the dividend accounts almost entirely for any positive performance from the capital share. In fact, the price return on DFN, FTN, DGS and BBO is negative. Keep in mind that the dividend on the capital share is only a target and can be cut all together if the share violates the NAV threshold. Again, this total return assumes no reinvestment of dividends.

Compare these results to our benchmark, XIU. Here, price return plays a larger part in the total return picture and investors would not be completely reliant on the dividend. Only in the time period covered since DGS’ inception date did XIU show a negative price return.

From a price perspective, one may wonder why the capital shares are taking it so hard on the chin versus XIU when they hold similar large-cap, dividend portfolios. While the price of the capital share is affected by multiple factors, the answer likely has to do with the “VIP” status of the preferred split share and a subsequent lower demand for the capital share. In a falling market, the NAV of the entire portfolio is affected but the preferred holder has a put option on the portfolio in that they are promised back their initial capital. Thus, the preferred does not participate on the downside, assuming the NAV of the fund is sufficient to cover the initial NAV on the preferred share. The leveraged capital split share bears the entirety of the loss and this is certainly not an attractive feature. This, however, does work both ways.

Michael Southern

Moving on to the preferred split shares, results are more encouraging than for their capital counterparts. Overall the shares achieve their objective of providing holders with fixed, cumulative income and the shares have maintained the stated payout. Annualized returns are consistent across the sample and closely reflect the advertised yields. Again, the total return is largely reliant on the distribution, but this makes sense as the preferred split share is tasked primarily with generating income. One can see that the price component of total return is more palatable. In fact, the price return should be closer to zero. This is because investors in preferred split shares are receiving their invested principal back at fund termination. With that, the price should closely track the original NAV at inception. This helps to show why these products may be most attractive to individuals who are sensitive to their particular tax situation.

As an investor, we would far prefer to invest for total return and not have to choose between dividends and capital gains. It is easy enough to create your own portfolio of quality dividend names, save on the MER, and not have to read through the more complicated split share prospectus to ensure you have understood the unique risks of these products. However, we do think the preferred split share is a reasonable investment for the investor who is looking to generate some additional yield from the portfolio versus a traditional bond at a similar credit quality. Capital split shares, however, is the difficult half to sell to investors. Here, risk is heightened and investors need to understand the various clauses found in the prospectus that have the potential to affect overall performance. We would tend to avoid these shares unless your goal is leveraged exposure to the financial or telecom sectors.

Michael Southern is an Analyst with 5i Research in Kitchener, Ontario.