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Dale Jackson

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Hard to heave

Dale Jackson


TORONTO (GlobeinvestorGOLD) — Ever open the fridge door and nearly get knocked over by the smell of something rotten? The same thing happens occasionally when investors look into their portfolios. In the fridge, it's usually green meat. In the portfolio, it's often labour-sponsored funds. Unfortunately getting rid of labour funds is a little trickier than plugging your nose and tossing the offender in the trash can.

And who wouldn't want to ditch their labour fund? Only 10 of the 120 or so labour funds available on the Canadian market have been around for 10 years, and when you average out their performances, they've barely managed to break even. It gets even worse for the 24 funds with a five-year track record. On average they've lost almost 10 per cent annually.

Some have done better than others over the past five years. The New Millennium Venture Balanced Fund, managed by Covington Group of Funds, has broken even. The dog of the dogs is Triax Growth-I, also managed by Covington. It has lost 27 per cent a year.

But labour sponsored funds are unique and tempting investment products, and you can't judge them solely on performance, as you can most other equity funds. When you buy a labour fund, the federal government gives you a 15-per-cent tax rebate. Most provinces and territories match it with another 15-per-cent rebate for a total tax savings of 30 per cent. A labour sponsored fund re-invested in a tax-sheltered registered retirement savings plan could net the investor as much as a 70 per cent return right off the bat. Investors should at the very least consider the 30-per-cent tax rebate a return on their investment when valuing a labour fund. That 30 per cent translates to just under 3.5 per cent annually after eight years. So if your fund breaks even after eight years, you've really gained 3.5 per cent a year with the tax break.

Labour sponsored funds were created to provide financing to high-risk, small Canadian upstart firms that are too small to go public. In exchange for the generous tax rebates, labour fund investors are required to hold the fund for at least eight years. Fund managers also take advantage of the generous tax breaks by charging abnormally high management expense ratios (MERs) and back end loads.

If you have held your labour fund for more than eight years your decision to sell may be easy, according to Rudy Luukko, investment funds editor at Morningstar Canada. "If you hold it for the time period required, that weakens the case for continuing to hold it" he says. While labour funds do have the potential to make a lot of money he feels investors can find better returns for that level of risk elsewhere.

It's hard to compare labour funds to any other class of mutual fund, but he uses Canadian small-capitalization funds as an example. Over the past 15 years the average Canadian small cap fund returned 12 per cent each year. Even during the bear market of the past five years, Canadian small cap funds returned 8.3 per cent annually. The difference could be explained by the high failure rate of venture companies and the fact that labour fund returns are generally dragged down by large cash weightings — sometimes as high as 60 per cent of total assets.

What if you want to dump your labour fund but the eight year holding period isn't up? You must repay the entire 30 per cent in tax breaks to the two levels of government. "You would have to be desperate to cash out of your labour sponsored fund before eight years" says Rudy Luukko. If you're okay with losing the tax breaks, there's the huge redemption fee charged by the fund manager. But unlike the tax rebate, the back-end redemption fee begins dropping after the first year.

The Vengrowth family of labour funds provides a good example of how the redemption fee structure works. In the first year after purchase Vengrowth charges six per cent on the amount invested. Each year after, the fee is reduced by 0.75 per cent until the eighth year when the fee is wiped out. Redemption fees vary from fund to fund, but the longer you wait to sell during that eight-year holding period, the less you pay in fees.

Of course, there's always a chance the venture capital market could turn around and reap the investor big returns regardless of the tax breaks — but those gains could be diluted by the labour-fund structure of high fees and large cash weightings. If you bought a labour fund and you regret it, you're not alone. Rudy Luukko from Morningstar Canada has one bit of advice for those investors looking to at least come away wiser: "Don't let tax considerations drive your investment decisions."

Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.

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