The Need for Regulating Income Trusts : A Bubble Theory

Income trust units are some of the highest selling products in the Canadian securities industry, but they have been less successful beyond Canadian borders. The author discusses the remarkable profitability and proliferation of income trusts in Canada, but maintains that arguments in favour of income trusts as a sound investment are either overstated, inconsistent, or apt to mislead retail investors. Instead, the author argues that the Canadian income trust phenomenon is an irrational development in the Canadian capital market: a bubble. The income trust boom exhibits characteristics typical to a bubble: story leverage, opportunistic support by interested parties, and overoptimistic retail investors. The author identifies striking similarities between the current market for income trusts and the Tech Bubble of 1999 and 2000, examining data relating to noise trading and limits on arbitrage in income trusts. The author counters arguments that the bubble risk in income trusts is low.Nevertheless, the author accepts that some firms may be structured effectively as income trusts. To mitigate the dangers of income trust investment, the author proposes five regulatory measures, four of which address idiosyncrasies of income trusts and one which addresses a fundamental issue of securities regulation. First, promulgators need to address the misallocation of capital by tax incentives for investments in low-growth business. Second, weak trust governance should be addressed by imposing default governance structures similar to those of shareholders and corporations. Third, investors should have some control over the distribution policy of the income trust. Fourth, there is an insufficient number of institutional investors in the market for income trusts and, consequently, promulgators should avoid any limit on institutional investment in income trusts. Last, regulators increasingly need to watch the conduct of broker-dealers and mutual fund managers, as a means of protecting retail investors from the marketing of investment products that fit some, but not all, investors. Mutual fund marketing needs to be monitored in order to avoid an over-supply of investment capital in narrow markets