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Defined portfolio trusts
Active/passive products have flaws

Long before exchange-traded funds (ETFs) were a big hit with thrifty North American investors, defined portfolio trusts (DPTs) - a similar product - had gained a huge following due to low fees, the combination of active and passive investing, and the narrow sector plays available through DPTs. However, times have changed. The industry has evolved, ETFs are a growing product class, and DPTs simply have not grown along with the industry and investor needs.

DPTs exlained

Mutual funds, ETFs and DPTs all are very similar in that they are all pooled investment funds. Mutual funds are "open-ended" trusts that are so named because they will simply issue additional units to investors wanting to buy, even if no current unitholders want to sell. If an investor wants to sell his/her units, the fund will buy them back. All mutual fund transactions occur at the unit price in effect at the end of each business day. ETFs are effectively similar, but differ somewhat mechanically due to the fact that they actually trade throughout the day on public stock exchanges, like the TSE and the AMEX. DPTs are somewhere in between.

In Canada, First Trust Portfolios were the first big sellers among mutual fund "look-a-likes" when they launched their First Trust Pharmaceutical Trust 1996. Here's how they work. An active manager selects stocks, looking for industry leaders with growth potential in the trust's respective industry. The trust is available for sale for a period of one year. Subsequently, the trust is closed to new investors and only "sell" transactions are accepted. The trust then has a life of four more years (five years in total). At the end of the trust's "life", the portfolio is wound up, with all investors given their share of the fund's assets. Hence, a new series is released every year. Though the stocks are actively selected in the initial stage, no changes are made for the remainder of the trust's life - similar to an index fund. That leaves the individual stock weightings to change only as a result of price changes, corporate merger activity, or other corporate events (i.e. default, legal issues, etc.).

Benefits of DPTs

Aside from the typical benefits of investing in pooled investment funds, DPTs have a unique benefit over mutual funds. Traditional mutual funds have caught criticism from some due to a fund's portfolio changes over time as a result of style drift and high turnover, in addition to mutual funds' impure asset class exposure. For instance, some "self-labeled " value managers were accused of loading up on Nortel when it was hot, even though it didn't jive with their style (i.e. style drift). Also, the sometimes-high cash balances in some funds (due to manager style or strong cash inflows) and rising foreign content limit mean that even the basic asset mix of some funds can vary significantly from time to time. With DPTs, the fund stays fully invested and is not affect by big inflows of cash (because new purchases are cut off after a year). Hence, the term Defined Portfolio Trust is appropriate since the stocks that investors bought into originally remain in the portfolio.

Here are a few disadvantages of DPTs.

Manager's current thinking and industry evolution

While the passive component of DPTs provides a known portfolio for investors, it also fails to reflect the manager's current thinking. To illustrate the point, let's compare the 2000 series of the First Trust Pharmaceutical Trust with its 1997 series. The 1997 series holds 97 per cent of its assets in its top fifteen stock holdings. In fact, Pfizer, Amgen, Biogen, Cardinal Health, and Elan Corporation are the top five holdings of that series, making up 53 per cent of the fund's assets.

The 2000 series is a bit less concentrated with 81 per cent of its assets in the top fifteen stocks. The top five holdings of the 1997 fund make up a little over 20 per cent of the 2000 series fund. Genzyme, Idec, Abbott Labs, American Home, and Eli Lilly are now the top five holdings - which make up about 31 per cent. While twelve of the top fifteen stocks of the two funds are common to both, only 62 per cent of the 2000 series fund (by weighting of individual stocks) is the same as the 1997 series fund. It becomes evident that the benefit of having a known portfolio is obtained at the expense of having a portfolio that reflects the manager's current opinions and the industry's evolution.

Fees and sales charges

When the First Trust trusts were launched they made a big splash for their innovation, asset class purity, and their low fees. While the fees can still be quite low, it's not as straightforward as it once was. These funds once sported low fees of about 1.15 per cent annually. However, in 1998 fees on all First Trust funds were bumped up by 0.80 to pay financial advisors a higher on-going service fee. Sales charges are a bit different than with most funds, offering class A, B and F series of shares.

Class A shares are bought only on a front-end load basis. The front-end charge ranges from 1 to 4 per cent, but the peculiar part of this is that First Trust takes the first 1 per cent of this charge. Even if you buy all of your funds with zero front-end charges, you'll still have to pay 1 per cent because that portion is charged by First Trust, not your dealer or broker.

Class B shares come with a front-end charge of 0 to 3 per cent and a 1 per cent fee if you sell your units before maturity (i.e. five years from its launch). In this case, your dealer or broker gets the entire front-end fee, but First Trust gets the back-end fee, if it is triggered.

Class F shares strip out all commission costs since they are designed for fee-based advisors and wrap accounts. Total fees on these funds are 0.95 per cent annually. Most dealers or brokers won't sell you the F class shares unless you pay an additional transaction fee or annual wrap fee.

Tax trap

There has always been a tax trap with these funds if held in taxable accounts. When the funds are wound-up at maturity, a taxable sale is considered to have taken place. That means you are deemed to have sold your interest in the fund, thereby realizing all of the gains and taxing such gains in the year of maturity. Of course, if you're considering these funds for your RRSP, RRIF, or other tax-deferred plan, this isn't as significant but it still results in bumping up the book value of your foreign content assuming the fund makes money over the five years. So, even in a RRSP, you' ll have to watch your foreign content when maturity nears to avoid penalties for excess foreign content.

If you like the benefits of First Trust DPTs, you may lean more towards the widely available ETFs or index mutual funds. ETFs and index funds seek only to mimic the performance of a specified stock index and offer benefits similar to DPTs but without the negatives. Don't go overboard on indexing though. Some index exposure - i.e. for US stocks - and good active managers elsewhere should give you a solid portfolio with low fees.

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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