Dangling carrots

The pros and cons of labour sponsored funds

By Andrew Rickard

“I can show you a way to make a $5,000 investment that’ll only cost you $1,250 in cash. Not only that, but I can also help you boost the foreign content limit in your RRSP to 50%. Interested?”

The managers and distributors of the country’s 50-odd labour sponsored investment funds (LSIFs) are hoping that consumers will answer that question with an enthusiastic “yes” during the 2004 RRSP season. Because of generous federal and provincial tax incentives, many LSIF investors do stand to walk away with a refund worth somewhere between 70 and 75% of their initial deposit. But before running to sign up, Canadians need to think about why the deal was sweetened in the first place.

Endorsed by union organizations (hence the “labour sponsored” name), LSIFs are professionally managed, pooled investment funds. They’re similar to mutual funds, but with one important twist —- they have a mandate to provide start-up or expansion capital to small, often privately held firms in order to create jobs and encourage economic growth at a community level. Since many new companies fail or at least flounder in their first few years of business, there is a greater likelihood that an LSIF investor will experience a loss. Here’s where the carrot at the end of the stick comes into view.

To encourage Canadians to invest in these smaller firms, both the federal and provincial governments have decided to offer juicy tax rewards based on an annual maximum investment of ,000. First there’s the federal government, that hands out a credit worth 15% to an LSIF investor. Then this federal grant is matched or even exceeded depending on the province and the fund.

In Ontario, for example, an LSIF that also qualifies as a Research Oriented Investment Fund would generate another 20% in tax credits, making for a whopping 35% in total. Combine this amount with the tax deduction normally received for making an RRSP contribution, and it’s easy to see how LSIF marketers are able to capture the attention of everyday investors with promises of a “guaranteed 75% return” on their initial investment:

Invested in LSIF: $5,000
Minus 15% Federal Credit: $750
Minus 20% Ontario Credit: $1,000
Minus 40% Deduction for RRSP Contribution: $2,000 - assuming a 40% marginal tax rate
Equals Total out-of-pocket expense: $1,250

Besides the tax credits, there’s also the lure of what’s commonly referred to as the “3 for 1 bump.” Foreign content inside an RRSP is normally capped at 30% of book value, but that limit doesn’t apply to those who hold units of an LSIF. Changes introduced in the 2000 budget allow investors to increase the foreign content of their registered plans by $3 for every $1 of “qualifying small business property,” up to a maximum of 50%. The end result is that someone who puts $5,000 in an LSIF gets an extra $15,000 in foreign content room.

Larry Stubbs, a Certified Financial Planner and Chartered Financial Analyst who teaches financial planning at the British Columbia Institute of Technology, worries that many investors buy LSIFs without taking time to consider the fundamental merits of the individual fund. “If it doesn’t make sense as an investment, stay away from it,” says Stubbs. “Taxes should have no bearing on your decision to buy.”  He points out that the tax credits aren’t examples of political generosity, but rather compensation for assuming additional risk. “As with any investment, be careful! Take the time to research the fund and its management. Make sure they know their business.”

Besides facing higher risks, LSIF investors can also expect to pay higher management fees. While a typical equity mutual fund has a management expense ratio of about 2.5%, some LSIF investors will end up paying as much as 5 or even 6%.  LSIF fund managers justify these additional fees by pointing to the amount of additional research that must be done before buying into these private firms who operate in new, growth industries like biotechnology and medicine.

Unfortunately, in many cases the returns to date haven’t made up for the additional costs. In fact, the average returns for Canadian LSIFs have been something less than stellar, showing a five year group average return of minus 1.65% while the comparable benchmark — the BMO Nesbitt Burns Canadian Small Cap Index — has returned 11.90%1. The news is even worse for those who are fed up with poor performance and want out. LSIFs require a minimum investment period of 8 years — anyone who leaves before then will not only have to repay some or all of their tax credits, but they could also face a back-end redemption fee charged by the fund company. Ouch.

That’s not to say that there haven’t been some outstanding individual performances, like that of the BC based Working Opportunity Balanced Fund and the Dynamic Venture Opportunities Fund, which returned 7.11% and 15.85% over the last five years respectively.  But clearly the ups and downs of venture investing (for it is, after all, venture capital that an LSIF provides) are not for the faint-of-heart.

The most important thing is to make sure that the fund fits the need, rather than the tax credit or foreign content greed, of the buyer. In this respect, LSIFs are perhaps best compared to a fine wine — taken in smaller amounts it can enhance the meal, but consumed in massive quantities it’s bound to make you sick. Stubbs suggests that, in order to maintain equilibrium, LSIF holdings should be kept to around 5 to 10% of a total portfolio. “Just don’t go overboard”, he says.

Andrew Rickard (andrew.rickard@sympatico.ca) is a Certified Financial Planner and freelance writer based in Toronto.

1. All fund returns in this article are as of September 30, 2003.

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