Refusal to include income trusts in Composite Index defies common sense.

As history buffs know, King Canute ruled England from 1016 to 1035 but is best remembered as the man who tried to stop the tide from coming in. Encouraged by his courtiers, he sat on the shore and ordered the sea to turn back. Needless to say, Canute was washed away, proving once and for all that it never pays to buck the inevitable. Yet, amazingly, a few weeks ago we had a repeat performance. A committee of the S&P/TSX tried to stem the tidal wave of income trusts by shutting them out of the Composite Index. I hope those people know how to swim.

Here’s the situation. The S&P/TSX Composite Index, originally the TSE 300 Index, is Canada’s most important investment benchmark. It’s the indicator that tells us how the market is doing; a continuing reference point. Portfolio managers measure their performance against the Composite because it is supposed to accurately reflect the velocity and direction of all the securities listed on the Toronto Stock Exchange. Unfortunately, however, that’s not the case. The truth is that the Composite represents just a part of the TSX. Income trusts with a total market value of about $45 billion, with $5 billion more in the pipeline, or about 9% of total capital on the Exchange, have been pointedly omitted from the calculation. Or, to put it another way, there is a large and growing gap in the database. As far as Standard & Poor’s is concerned, Canadian income trusts are not part of the market even though almost 150 of them are listed on the TSX. So the Composite is skewed and increasingly misleading. On Nov. 11, the index listing committee had an opportunity to correct the problem. Instead they chose to stay with their flawed index.

The committee gave no reasons for its decision but later an S&P official provided some excuses, none of which made much sense. For example, he said that trusts offered relatively little capital appreciation potential. That’s pretty ripe considering that large sections of the stock market are in ruins right now. As I write, the S&P/TSX index is down 14.8% for the year while the income trust sector has provided an average total return of about 14%. There was also a suggestion that trust units are primarily income vehicles. So what? The present Composite is riddled with blue chips that are supported by investors who buy them for their dividends. To cap it all, the official pointed out that trust units may not represent true equity and then went on to say that he was worried about unlimited liability because investors who buy these issues are owners in the truest sense. You can’t have it both ways.

My own feeling is that trust units were excluded from the Composite Index for one very simple reason. The giant pension funds, which have convinced themselves that they cannot buy income trusts, told the TSX to make sure the S&P committee, which is heavily weighted with Exchange representatives, opted for an all-stock index. That way they could continue to build their portfolios around the S&P/TSX Composite. If that is the case, it raises an interesting question. If the idea of indexing is to remain totally objective and dispassionately track the market, surely the whole purpose of the exercise is defeated if you have a say in what makes up the index? Right now we have an index that fails to recognize at least 9% of the market. Why not exclude a few other sectors that the pension funds dislike? It’s a slippery slope.

Does all this matter? Absolutely. Being added to the index would be a boon for any income trust. The units would jump in price because many institutions, known as “indexers”, are committed to buying securities in the Composite. For instance, one study shows that if RioCan REIT became part of the index, there would be an immediate demand for nine million of its units as investors realigned their portfolios.

Looking on the bright side, everything suggests that the indexing committee will soon have to reverse its decision. The sheer weight of new trusts being listed (despite the current “buyer’s strike”) has to be addressed. Keep in mind that until a few years ago income trusts were part of the Composite and already 30 of those currently listed on the Exchange meet the Composite liquidity requirements. So there are no mechanical problems. Also, Standard & Poor’s is not opposed to income trusts per se. The rating agency has 12 Real Estate Investment Trusts in its U.S. Supercomposite, although admittedly REITs in that country have a different structure. In Australia, S&P has gone overboard and the S&P/ASX 300 is 7.6% weighted in income trusts. Now all we have to do is win over the Canadian pension funds and the good news is that steps are being taken to do just that.

Because of their charters, pension funds are unable to buy income trust units that could theoretically expose them to unlimited liability. As a very fine point of law, an owner of a trust unit could be named in a lawsuit against the trust and held accountable for an amount well in excess of his or her original investment. It’s a very remote possibility. While trust unit holders are not protected from unlimited liability by statute, they are safeguarded by common and contract law. Moreover, many trusts actually invest in an underlying corporation that owns the assets and this provides another defense. So there is already plenty of protection but now the trusts are going the extra yard. Spurred on by the S&P’s shut out, Arc Energy has redoubled its lobbying of the Alberta government to enact laws providing trust unit holders with limited liability. No doubt the pension funds, which want to buy these investments, are also applying pressure.

There is another thing to consider. Induction into the S&P/TSX Composite would be a stamp of approval for income trusts. Apart from generating more demand for the units, the move would defuse a lot of the loose talk about an income trust bubble that is likely to burst and wipe out this sector of the market. That is not going to happen, even if some smaller, weaker trusts may run into trouble. Trusts are here to stay. They just need some more respect and acceptance.

I think that the S&P’s decision is a temporary setback. Hopefully the committee will see the error of its ways. If not, somebody should point out to them what happened to poor old Canute.