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Upside of LSIFs
Labour funds in your portfolio

I spent last week briefing you on the risks of labour sponsored investment funds (LSIFs). However, risk is only one dimension of an investment's fundamentals. The more positive aspects of this unique class of funds will be summarized this week along with some guidance on incorporating LSIFs into your portfolio.

Tax benefits

I'll start with a run down of LSIF tax benefits, since that's the biggest attention getter.

Tax credits for LSIFs are available from the federal government, in addition to most provinces. The federal credit is equal to 15 per cent of the amount invested, for each $5,000 invested each year. Most provinces, such as Ontario, match that federal credit. While BC and Manitoba offer provincial credits, they only do so for a couple of funds. For instance, BC's Working Opportunity Fund is the only LSIF that qualifies for both credits; while Crocus Fund and Ensis Growth Fund are the only two funds eligible for Manitoba credits.

LSIFs must be held for eight years. Otherwise, all of the tax credits will have to be repaid and a deferred sales charge (i.e. an exit fee) will be withheld. There are exceptions, but that eight-year holding period applies to most.

Timelines for purchases coincide with RRSP rules - i.e. anybody who invested in a LSIF by March 1, 2002 will be able to use the LSIF credits on their 2001 tax return. There is no carryforward of credits, as with RRSP contributions, but any contribution made during the first sixty days of the year can be used either for the previous or current year.

Also, any investment in a LSIF inside of a spousal RRSP allows the tax credits to be allocated to either the contributing spouse of the account holder (i.e. the annuitant) - as long as each individual claims no more than the annual maximum credit for any one year.

If held in a RRSP, the 30 per cent foreign content limit we know all too well is actually expanded. For each dollar invested in a LSIF, foreign content room expands by $3 - to the extent that total foreign content is no more than an additional 20 per cent. Hence, with LSIFs, investors can actually hold up to half of their RRSP, based on book value, in foreign investments.

Finally, LSIFs should not be overlooked as an investment outside of a RRSP. We talked about capital gains and adjusted cost base (ACB) just a couple of weeks ago. Most tax shelters offer some write-off or tax credit. Generally, when an individual invests in a tax shelter, the ACB of that investment is reduced by the amount of tax assistance that accompanies the investment. No so with LSIFs.

Here's the bottom line. Let's say I buy a LSIF for $5,000. As a result, I get total tax credits of $1,500 (i.e. 30% of the investment). My actual cost is only $3,500, but my ACB (which is my cost for tax purposes) remains $5,000. If the fund is worth exactly $5,000 in eight years, it's actually a gain for me. However, I have no capital gain to report on my taxes. The net result is an annualized after-tax return of 4.6 per cent per year. Not bad for an investment that flat lined for eight years.

Tax credits shouldn't drive your decision, but they shouldn't be ignored. Let's shift our attention to the sources of potential return for LSIFs.

Liquidity

What is worth more to you - buying shares in a company that is traded on the Toronto or New York Stock Exchange, or buying shares in a company which has no facility to allow investors to liquidate shares? Of course, owning an investment that can't be liquidated isn't nearly as attractive.

Hence, a LSIF manager investing in a private company is compensated for the inability to easily liquidate his holding (i.e. liquidity risk) by being able to negotiate a big discount on the price of the shares. The LSIF manager can produce a very handsome return if all she ever does is bring liquidity to a private investment.

This can happen by:

  • helping a company "go public" (i.e. help it get its shares traded on a stock exchange);
  • selling its stake in the company to another firm; or
  • selling its stake back to the company's management.

    Growth

    Perhaps the more obvious source of return may simply result from improving the business. Helping it track its business plan; grow sales, profits and cash flows; and keeping good cost controls in place will go a long way toward enhancing the value of its initial investment and attracting potential liquidity.

    Control

    To most investors, the power to exhibit influence on a business' strategic direction has real value. Hence, whenever one company buys control of another, the buyer usually pays more than just the going value - something called a control premium. This is a smaller, though still significant source of return for the LSIF manager.

    Top picks

    My top LSIF picks, as published in an extensive proprietary report just last month are, in alphabetical order, Canadian Medical Discoveries, Capital Alliance Ventures, Dynamic Venture Opportunities, Ensis Growth, First Ontario, Vengrowth II, Working Opportunity, and Working Ventures Canadian.

    Portfolio application

    A good rule of thumb for those interested in including this asset class into their portfolios is to have no more than about 5 to 12 per cent of one's total portfolio in LSIFs Exactly how much depends of course on each investor 's particular circumstance, but that's a good rule of thumb.

    LSIFs offer great potential. In the U.S., we know that private equity investments have produced returns that are well ahead of the returns generated by the S&P 500 and smaller U.S. stocks over the past twenty years. In Canada, we don't have a similarly long history. However, a good indication of its potential is the growing interest in venture capital by Canada's biggest public pension plans (like OMERS, the CPP Investment Board, and Ontario Teachers' Pension Plan Board) and firms in the private sector. Recognizing both the potential risks and rewards of venture capital and LSIFs; and prudently incorporating LSIFs in your portfolio can produce real, long-term benefits.

    While these two articles on LSIFs provide a good overview, they really just scratch the surface of both risk and return characteristics. Use these articles as a springboard to do further research or to ask more questions of your advisor so you can better understand where your money is going.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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