Funds are required to file periodic statements of their holdings. And there’s no shortage of information available on performance, from the long-term to daily swings. Ratings services like Morningstar provide data on a wide range of technical and trading factors, such as “beta,” which measures a fund’s volatility relative to broad market indexes.

For the investor, however, the bottom line is you’re pretty much always buying what some folks call a pig in a poke. That is, all decisions about what the fund holds–and by extension what you as a fund shareholder own–are entirely at the discretion of those who run the fund. The investor never really knows just what they own from day to day.

To be sure, the fund’s prospectus will lay out the parameters of what it can own. But on a practical basis, you’re really just relying on guidance and skill of the people managing the money. Their successes are yours, as are their failures.

Everyone is a genius in a bull market. Conversely, in a crushing bear market like this one, it’s tempting to view every fund manager as a bum who should be out on the street. Dissatisfaction is without a doubt greatest with funds that had given the impression of being “safe,” such as the raft that held “secured mortgage” securities. But in truth, when the S&P 500 falls more than 50 percent from its high, there will be few if any markets or funds that will be able to make money.

Rather, success is measured by not losing as much as the next guy. And even that can be a tall order, since many markets around the world have fared even worse than the US. Even the US bond market has absorbed some mighty blows, as many investors have dumped everything in favor of holding only what’s perceived as the very safest paper–which right now is US Treasury bonds.

As Canadian Edge readers well know, Canada has certainly not been spared the markets’ carnage of the last six months or so. For the first year or so of this bear market–which by my reckoning began with the interest rate spike of mid-2007–the country was generally able to stay above the fray. The main reason was the dramatic shift in the country’s commodity exports toward Asia from near total dependence on the US market.

Asia’s rapid growth created seemingly insatiable demand for everything from energy to iron ore and potash. And even as the US economy slowed dramatically in the latter half of 2007 and into 2008, countries like China picked up the slack and then some. Commodity prices surged to higher levels than ever, and Canada’s overall export income continued to grow, though unevenly as the industrial East suffered from slower markets in the US.

The slowing US economy did claim its share of victims in early 2008, even as Canada’s resource economy was flourishing. And Canadian businesses were pounded by the strength in the Canadian dollar, which surged well past parity for a time in late 2007. For them, the rising Canadian dollar meant higher costs relative to competitors abroad and lower profit margins on the sales they did make.

Overall, however, Canada’s stock market was a major beneficiary of higher commodity prices and surging exports. The broad-based S&P/Toronto Stock Exchange Income Trust Index that we track in Canadian Edge for a time surged well past the level it held before Oct. 31, 2006, when Finance Minister Jim Flaherty announced the much reviled tax on trusts to kick in Jan. 1, 2011.

US investors got an extra kick from the strength in the Canadian dollar, which followed commodity prices higher during the boom. A rising loonie lifts the US dollar share value of Canadian trusts and high-yielding corporations, as well as their dividends.

How Funds Fared

Canadian mutual funds of trusts were, of course, also beneficiaries. US Securities and Exchange Commission rules forbade most US investor ownership of Canadian open-end mutual funds. But those of us on this side of the border can buy any of the myriad closed-end funds that hold Canadian trusts and high-dividend-paying corporations.

Like open-end funds, closed-end funds hold portfolios of securities at the discretion of the manager. They do, however, differ in one key respect. Mainly, rather than mint shares when an investor wants to buy or cancel when there’s selling, closed-end funds trade a fixed number of shares on a major exchange. You never cash out or in. You buy and sell on the exchange just as you would a common stock or trust.

This conveys several advantages for the manager, and by extension the investor. First, managers never have to sell positions to meet redemptions in a bad market and they never have to buy just because investors are putting money in. That gives them enormous discretion to stick with holdings that may be having a rough time in the market but still have strong fundamental value.

Many closed-end funds are also allowed to borrow against the value of their portfolios. This essentially allows management to capture the advantages of margin for capital gains. And it enables them to increase the fund’s yield above the distributions paid by its holdings and whatever capital gains are generated. That’s why many closed-end funds, for example, have boasted yields far above the average trust.

When the boom was on, leverage was a major advantage for closed-end funds, and a huge attraction for investors. Before mid-decade, there were only a relative handful of funds, and most of these weren’t pure trust-holders; they kept a variety securities, some of which didn’t pay much in the way of yield.

That changed with a vengeance as global economies and stock markets began to recover from the bear market/recession of 2000-02. With energy prices steadily rising, investors began to turn onto trusts in a big way. The number of energy trusts perpetuated, as did a wide range of trusts in other businesses, many of which were frankly ill-suited to be organized as flow-through entities.

By the time Flaherty was preparing to lower the boom on income trusts, there were more than 250 individual businesses organized that way. But there were nearly as many closed-end funds launched for the sole purpose of holding those securities.

Like Wall Street, Bay Street always produces to demand. With the public clamoring for yield, the ruling banks, brokerage houses and research firms delivered with product. And as was the case with many of the new individual trusts launched, only a handful was worth their salt. In fact, many were simply packages of junk with a big yield slapped on it to attract new money.

In the US, funds typically build their asset bases first with an initial public offering and then by accumulating securities in the market. In contrast, many US investors were surprised to find that Canadian closed-end funds employed another technique: unsolicited offers to swap a specified number of shares of their fund for shares of individual income trusts.

Over the past five years or so, I’ve fielded literally hundreds of questions from investors who’ve received such solicitations, some of which seemed to imply the shareholder had little choice in the matter. My advice was always the same: Ignore the offer and continue to hold your shares.

My reasoning was simple. First, if you’ve bought an individual trust, you know what you own. Swapping them for a fund, you’re going to wind up holding shares of dozens–possibly even hundreds–of other trusts that you did not make a decision to buy. In fact, there’s no way of knowing just exactly what you swapped your favorite trust for, as that’s entirely to management’s discretion.

Second, many of the funds doing the offering are brand new. The managers may have a rich resume. But it’s not at this fund or under this fund’s objective and rules. Again, you’re swapping a favorite for what amounts to a pig in a poke.

Of course, there have been some offerings by funds I’ve recommended. Former Canadian Edge Portfolio holding EnerVest Diversified Income Trust (TSX: EIT-U, OTC: EVDVF), for example, was famous for making this kind of offer. In fact, it made one last year for a wide range of funds, even with the potential dilution as its shares were trading at a huge discount to their net asset value (NAV).

Even in those cases, however, I’ve advised against taking the deal. Even the best funds hold dozens of trusts and high-yielding corporations you may not want to own, and they impose management fees as well. Why substitute your own judgment after you’ve made a decision that you want to own a trust?

Worst of all, as this bear market has unfolded we’ve seen a new vulnerability emerge for closed-end funds that hold trusts: the dark side of leverage.

Just as borrowing magnified gains and dividends on the way up, so it did the losses on the way down. First, the freezing up of the credit markets increased the cost of the credit lines and other debt instruments used by these funds, some quite dramatically. That put the clamps on the money used to pay dividends.

Second, the dramatic decline in the overall Canadian stock market triggered similar drops in the value of fund portfolios. That in turn pushed some funds’ debt above the limits stated in their charters, which are typically set relative to NAV. As a result, some closed-end funds found themselves in violation of debt covenants, forcing them to sell holdings at depressed prices to pay off debt. That further depressed NAVs, and shareholder value.

There are, of course, far fewer funds focused on income trusts now than there were before Halloween 2006. Just like individual trusts, even the biggest and strongest of these have been subjected to extreme stress tests, from the virtual drying up of capital to the declining fortunes of many of the businesses they hold.

As with the trusts themselves, the funds still in operation are battle-hardened. Their returns are still at the mercy of the Canadian market, a big negative since mid-2008. But those still around have survived and adapted to the emerging reality.

Some may elect to convert to different structures, merge with another fund or even liquidate their assets. Last month, for example, Strategic Energy Fund (TSX: SER-U, OTC: none) converted its structure by merging with another fund and has gone back to its roots as a developer of assets.

For the most part, however, the surviving funds are likely to stick around well past 2011. In fact, we’re seeing more and more of them amend their charters to position themselves to be dividend paying funds in what essentially will be a post-trust world.

Three to Buy

The key question is, are they worth investor dollars? Since the first issue of Canadian Edge in mid-2004, I’ve been of the strong belief that most of us investors–whether we’re purely income seekers, looking for growth or betting on a rebound in energy–are best off building our own portfolio of individual trusts rather than buying a fund.

To be honest, for most of the past five years there really wasn’t much of a difference between the performance of funds of trusts and shares of even the strongest individual trusts. For one thing, during the bull market yield-seeking investors were basically buying shares of individual trusts and funds fairly indiscriminately.

Mainly, even the shares of the most leveraged and least adept of the trusts were going up through late 2006. It really didn’t matter what you bought. That made it the perfect market for funds that simply rely on the averages to go up.

I had some individual trust holdings that did far better than the averages, and therefore the closed-end funds I was recommending. But I also had some duds that dragged down the overall value of the CE Portfolio. The result: My recommended funds did about as well as the Portfolio, and so did a large chunk of the rest of the 250-plus then in existence.

Being discriminating, however, has been far more important since energy prices peaked in mid-2008, and even since trust taxation was announced in late 2006. Including the damage from the drop in the Canadian dollar, the combined CE Conservative and Aggressive Holdings lost a little more than 30 percent last year. In contrast, my recommended funds lost 40 to 45 percent, the broad Canadian market lost more 50 percent and some of the more leveraged and energy-focused closed-ends lost even more.

My view is it’s still very important to be discriminating buying Canadian trusts and high-yielding corporations–as well as anything else you own. The stress tests behind this bear market are still very much with us, as the global economy tries to find a bottom and borrowing conditions remain tight.

As long as this thing lasts, even businesses that show strong fourth quarter earnings results in coming weeks can still stumble. That’s why it’s absolutely vital to continue checking the business numbers of every company or trust whose securities you own.

There are, however, several very good reasons to consider buying a few carefully selected funds as well. First, the many are trading at huge discounts to NAV. Open-end funds always trade at the value of their assets. In contrast, closed-ends can sometimes trade wildly above (premiums) or below (discounts) the value of what’s inside them.

In a bull market, huge premiums are common. At the depths of a bear market, however, the same funds with the same trusts inside are often available at huge discounts to NAV. Today’s discounts range to as much as 20 to 25 cents on the dollar. That’s like buying a buck’s worth of trusts for just 75 to 80 cents.

Second, funds have largely unwound the leverage troubles that plagued them in late 2008. Most have either eliminated the debt from their balance sheets entirely, or else brought it well back within conservative parameters. In a very real sense, they’ve done precisely what the managers of individual trusts have, particularly those in the energy production business.

The immediate results have been painful for investors. In fact, we’re likely to see more of the closed-end funds cut dividends in coming months, just as the individual energy producers they own have. But the crisis that triggered forced selling–and likely contributed to considerable overall market losses and volatility as well–is done.

Finally, it looks increasingly like we’re shaping up for another period of somewhat indiscriminate buying sometime later this year. The timing will depend on the global economy and how soon we hit bottom, which at this point is highly uncertain. But the Canadian market as a whole is now pricing in something along the lines of a global depression. And that’s most assuredly true of many of the trusts, including quite a few that hail from recession-resistant sectors.

As long as the recession/bear market lasts, the greatest risk to investors is a blow-up at an individual trust or high yielding corporation. Admittedly, today’s prices reflect very grim expectations. But hard experience has taught me that once an underlying business starts to really come unraveled, we’re better off selling, no matter what our gains or losses may look like to that point.

Buying and holding funds of trusts is the best way to avoid getting bushwhacked by the demise of an individual trust. You won’t benefit fully from the surges in individual trusts, as we did with Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) the past two months. But you will also avoid the damage from the Arctic Glacier Income Funds (TSX: AG-U, OTC: AGUNF) out there that hit real life-threatening landmines. And that’s likely to be all it takes to score some big gains in Canadian trusts and high-yielding corporations once their recovery takes shape.

How They Rate now tracks the fortunes of nine closed-end funds of Canadian trusts and high-yielding corporations. We currently hold two in the CE Portfolio: Select 50 S-1 Income Trust (TSX: SON-U, OTC: SFVIF) and Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF). They remain my favorites for several reasons.

First, neither has been a big employer of leverage historically, a factor which has helped them immensely in recent months. One tip-off is their relatively low payout ratios, which I calculate by dividing the dividend payment to investors by the total distributions paid by their holdings. Lower numbers mean less of the distribution is covered by the use of leverage, and/or capital gains from asset sales that are inherently unpredictable and subject to the swings in the general stock market.

Second, these funds are managed by the two houses that have generally produced the steadiest funds of trusts. In the case of Select 50, it’s Sentry Select Capital. For Series, it’s Citadel Group. Both funds have generally steady track records, and losses last year were well below those of the average fund or the market in general. Both have also posted modest rebounds this year, no small feat considering the drop in the S&P/Toronto Stock Exchange Income Trust Index and other Canadian indexes.

One reason for these funds’ outperformance long-term is their focus on trusts outside of energy production. That’s held back returns in the boom times of high energy prices, and neither fund was a standout in the first half of 2008. Since then, however, they’ve far outshined their peers by mixing it up, trying to pick the strongest businesses and maintaining a far lower weighting in energy than the broad averages, or most investors’ portfolios.

Series’ portfolio as of Jan. 15–the last date for which it has released figures as of this writing–was only 13 percent oil and gas royalty trusts. Its top four holdings were all in the energy infrastructure and eight of the top 10 were in utility-like businesses. Meanwhile, the only energy producer recently in Select’s top 10 was Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), which, as I point out in Dividend Watch List, is now a compelling value again.

Finally, both funds are arguably very cheap at these prices, trading for substantial though not extreme discounts to NAV in the upper single digit percentages. In a very real way, a more modest discount like this one is far more attractive than a very wide one, as some of the funds still present. That’s because it’s a sign that management is mindful of shareholder value and is willing to effectively act as an arbitrage agent, buying back shares when the discount grows too wide.

Even the fact that a fund’s management will routinely buy back shares acts as a backstop to market prices, as it will prevent discounts from reaching epic proportions. And as we’ve seen with some of the funds, a wide discount can become even wider if management demonstrates it won’t defend its market price by buying back shares.

Both funds’ managements have been buyers of shares in recent months, which has helped close their NAV gaps. And again, they yield comfortably in double-digits with good coverage by their holdings’ distributions.

As is the case with any fund of trusts, you’re trusting management to make good decisions with your investment. But as much as any funds, these guys have consistently performed. And if their portfolios look anything like they did when they were last made public, they should be in for some solid gains this year, even as they dish out outsized income. Buy Select 50 S-1 Income Trust and Series S-1 Income Fund up to USD10.

Those who do want a more aggressive bet on energy should focus their attention on ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVYF). The fund, as its name suggests, actively focuses on energy stocks. Backing for the fund’s current distribution from the dividends paid by holdings has eroded sharply in recent months due to the wave of dividend cuts by major energy producer trusts. (See Dividend Watch List.)

The fund’s family, however, is Middlefield, which relies on the energy price forecasts of Groppe, Long & Littell. Groppe currently forecasts a return to USD85 per barrel oil in 2009. As a result, the fund’s management states it will take these “very positive developments” into account when setting dividend policy, which means any cut may be much less than expected.

Of course, paying out more than you have is not a policy that can be continued indefinitely. And if energy prices fail to rebound in a timely manner, we may see more carnage than the 36.4 percent reduction ACTIVEnergy made last month. The fund, however, is also buying back up to 10 percent of its shares, a clear statement in a weak environment that it’s still in solid shape. And it maintains a cash position, rather than relying on leverage to boost returns.

Obviously, there can be no guarantees where energy prices and energy producers are concerned, particularly not in this environment of extreme volatility. But those looking for a more aggressive bet can buy ACTIVEnergy Income Fund up to USD9.

Others of Note

Two other small and diversified funds worth a look are Brompton VIP Income Fund (TSX: VIP-U, OTC: BVPIF) and DiversiTrust Income Fund (TSX: DTF-U, OTC: DVTRF). Brompton follows a strategy along the lines of what Series does, investing in a broad-based portfolio with only a minor focus on energy. DiversiTrust has typically followed the same course, though it has in the past been willing to overweight sectors like energy.

The pair has taken hits over the past year, as the value of their holdings has fallen. But both have outperformed the broad Canadian trust market averages. And both have generally eschewed the use of leverage, which has softened the ups and downs. Both have been prolific acquirers of their own shares, which has helped them cut their discounts to NAV considerably.

Neither is a household name, particularly in the US. But DiversiTrust manager Goodman & Co certainly does enjoy a solid reputation in Canada, as does The Brompton Group. Brompton VIP Income Fund and DiversiTrust Income Fund are buys up to USD8. Note that current yields shown in How They Rate include special end-year distributions as well as the regular monthly rates, which is true of all the funds shown.

Finally, I want to comment on EnerVest Diversified Income Trust, which I sold from the CE Portfolio in December 2008. Since that time, the fund’s share price has slipped, rebounded somewhat and now settled back just under USD3 per share. The discount to NAV has fallen a bit, though it still sits around 15.4 percent, compensating for the fund’s use of leverage as well as management’s past reluctance to buy back shares to close the gap.

The good news on EnerVest is management has apparently put the leverage question to bed. The monthly distribution remains at 7 cents Canadian a share, as it’s been for some time. That makes for a huge yield of around 25 percent, based on the shares’ current market price.

As I’ve noted in How They Rate comments in recent months, the fund’s fate from here will depend entirely on the health of Canada’s stock market. The portfolio remains broad-based and, as of the end of 2008, had only one oil and gas producer in its top 10 holdings, Canadian Oil Sands Trust. As a result, the distributions of its holdings should be fairly recession resistant, which in turn should shore up the overall payout.

Going significantly higher from here, however, will depend on a turnaround in Canada’s now slumping economy and the Canadian dollar, which will likely take a recovery in energy prices. As a result, no one who holds this fund should expect miracles. But at this point, those who did not sell when I advised should stick with EnerVest Diversified Income Trust. And the same goes for the family’s EnerVest Oil Sands Trust (TSX: EOS-U, OTC: none), which is focused on a wide range of plays from the beaten down Alberta energy sector.