Split-share corporations come with inherent drawbacks that can hand investors unexpected and unwelcomed costs sooner than they’d planned
Split-share corporations: they’re just one of the areas in which Pat McKeough’s Inner Circle can get our investment research. Members also get to ask investment questions of Pat and his research associates about investing in stocks. AND they get to see all other members’ questions, and our answers (of course, we eliminate any personal information). Members usually ask about stocks they own or are thinking of buying. Some of these stocks are so attractive that we eventually add them to our recommendations. Others are sells. In many cases, in addition to our specific advice, we provide valuable background information.
For instance, one member recently asked us about investing in stocks through split-share corporations, which are a good example of a structured financial product.
Structured products or structured notes are investments that come with special characteristics that make them superficially attractive to investors. However, they tend to be far more profitable for brokers. That’s because, once commissions and other fees come out of these investments, it’s unlikely that you’ll wind up with a profit to match your risk.
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To give you a clear sense of the drawbacks of investing in stocks through split-share corporations, I’d like to share our Inner Circle member’s question, along with our response. I hope you enjoy and profit from it.
Q: Pat: As an Inner Circle Member, I would like to ask about Dividend 15 Split Corp. Thanks.
A: Dividend 15 Split Corp., symbol DFN on Toronto (www.dividend15.com), is a split-share investment corporation that holds shares of 15 companies, including BCE Inc., Bank of Nova Scotia, Thomson Reuters, National Bank of Canada, TransAlta Corporation and Enbridge.
The company can also invest up to 15% of its portfolio in other stocks.
Dividend 15 Split Corp. has two share classes: Dividend 15 Split Corp. capital shares (Toronto symbol DFN), and Dividend 15 Split Corp. preferred shares (Toronto symbol DFN.PR.A).
Split-share corporations come with drawbacks
A split-share company issues two classes of shares. Usually, the capital shares get all or most of the capital gains and losses, and the preferred shares get most of the dividend income. In the case of Dividend 15 Split Corp., the capital shares also get any increase in the dividends issued by the 15 stocks it holds.
As a result, unitholders of capital shares get a monthly dividend for a very high yield.
Holders of preferred shares get a fixed monthly dividend.
However, Dividend 15 Split Corp. income does not cover those high distributions to its unitholders. To make up the difference, it must realize capital gains on the securities in its portfolio. But those gains are far from guaranteed, so it supports its distributions by selling call options on the stocks it holds.
Selling call options generates an income stream for the company. However, these sales tend to limit any capital gains that Dividend 15 Split Corp.’s portfolio might otherwise generate. That’s because when the stocks that the trust owns go up, holders of any call options on those stocks will buy them from the trust at the agreed-upon price. That means the company loses out on any future price gains for those stocks.
Meanwhile, Dividend 15 Split Corp. needs to hang on to its poor-performing stocks to offset its outstanding call options. Options trading also tends to generate a lot of brokerage commissions; they can eat away at the company’s capital.
The managers of Dividend 15 Split Corp.’s portfolio also aim to keep most of their individual stock holdings in the range of 4% to 8% of the fund’s overall value. That means they will need to rebalance their portfolio’s holdings from time to time. This selling and buying also generates commission expenses.
This split-share corporation faces a looming windup date
The split shares will wind up on December 1, 2024. That’s a drawback to split shares in general, and Dividend 15 Split shares in particular. Unless the windup date is extended, you will be forced to cash in your investment and deal with the tax consequences at that time. You’ll also face brokerage costs to reinvest any proceeds after you’ve redeemed your shares.
Although we like most of the stocks it holds, we advise against investing in either class of Dividend 15 Split Corp. shares.
Does a high-yield distribution increase the appeal of investing in a split-share corporation?
Note: This article was originally published in 2010 and is regularly updated.
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