As income trusts convert to corporations in response to Finance Minister Flahertys tax regime coming into force tomorrow, Jan. 1, 2011,some interesting situations are unfolding. One may be of interest, oddly enough, toindex investors. Another may be of interest to traders andbargain hunters.
1. Impact on index investors
As income trusts convert to corporations, they become eligible for inclusion in a number of indexes.This is having an impact on index investors in two ways.
First, as these new corporations become members ofmajor indexes, ETFs and index funds are obliged to buy their shares. Consequently, the composition of their baskets is undergoing a change. For example, the addition of corporations that were once royalty energy trusts could be inceasing therelative weight of the energy industry.
Second, the quants and traders know that the ETFs and index funds have to buy the new members, so they front runand flip to the funds for a quick profit. In a November research report, National Bank Financial analyst Menal Patel calculated an average 7% gain in the two weeks leading up to the inclusion of four former energy trusts.
This is the inclusion effect, which shaves off some of the returns fromETFs and index funds that tracka segment of the market, such as the S&P/TSX 60 Index.Better to own the funds that trackthe total stock market since they are not adversely affected by the index-inclusion effect (in fact, they benefit from it).
2. Opportunities for traders and value investors
Many income trusts are still in the process of converting to corporations. For the traders out there, Patel suggests five royalty trusts that might be of interest: Bonavista Energy ( BNP.UN), Canadian Oil Sands ( COS.UN), Northland Power ( NPI.UN), ARC Energy ( AET.UN) and Keyera Facilities ( KEY.UN). Given their averagenumber of shares traded each day, they could have some of the better pops in price, he says.
Patels study also noted there was an average 7% gain over the two-weeks following the addition of a converted trust to an index. This seems to suggest that a number of index funds build their position over a period as long as two weeks. As such, the index-inclusion effect could yield an average 14% return over 4 weeks to traders.
Patels report appeared over a month ago, so some, or even all, of the expected gains could already be discounted. Yet, only Bonavista Energy and ARC Energy,have outpaced the 5% gain in the S&P/TSX index since mid-November. Here is a chart showing the trendsfor the five trusts.
Canadian Oil Sands highlights the pitfalls. The price of its units were rising nicely from mid-November but then a bigger-than-expected cut to its distribution was announced in early December. Anyone buying to play the index-exclusion pop got whacked.
The price has come back about 5% since then butremains below the mid-November level. Given its cheapened price, could it perhaps now be an even greater opportunity for traders playing the index-inclusion game? And with much of the bad news relating to conversion out of the way, perhaps the recent setback in price will prove to be a good entry point for longer term investors who believe oil-and-gas prices will stay strong?