Labour-sponsored investment funds not for the weak
By Jim Middlemiss • Bankrate.com

The 34,000 investors in the Crocus Investment Fund learned the hard way about the risks of putting their cash into Labour-Sponsored Investment Funds, or LSIFs.

Crocus is a Manitoba-based fund that raised more than $100 million locally. Today, it sits in receivership and faces a police probe over its practices while accountants attempt to put some type of valuation on the fund's assets. Investors stand to lose millions.

Crocus stopped trading in December 2004, following concerns about the value of its units. It has since announced it will not resume trading but will sell its interest in a range of small companies. The fund once worth more than $10 a unit is now worth about $7 or less.

So, while the allure of a 30-per cent tax credit on any investment in an LSIF is hard to resist, experts say investors should be wary and examine what they're buying into before handing over their money.

Not your typical mutual fund
LSIFs are a unique breed of investment subject to a range of rules and investment restrictions that typical mutual funds do not have to follow. They are provincial in nature and designed to pump venture capital into local companies, which are usually privately held. Because their shares don't trade on a stock exchange, assessing their true value can be difficult.

To entice investors into coughing up, governments grant them a lucrative tax break -- about 30 per cent for a $5,000 investment. This is figured as the federal government offers 15 per cent and most provinces match or beat that.

If held in a nonregistered account, investors can expect to receive a $1,500 tax credit on a $5,000 investment, reducing their actual cost to $3,500. However, if the LSIF is held in an RRSP, there's an additional tax break that can reduce the overall cost to as little as $1,200 for someone in the top marginal tax bracket.

However, you have to leave your money in the fund for eight years to reap the full reward. If you withdraw before that, you must repay the tax credits.

A volatile investment
Today, there are more than 110 different LSIFs, holding more than $3.5 billion in assets, according to data from Morningstar Canada.

"We really had a promising asset class. These funds did well out of the gate," Gordon Pape, fund analyst and author of "The Mutual Fund Buyer's Guide," says he thought as the funds found mass appeal in the 1990s.

Before the technology meltdown, many LSIFs hit double-digit returns because they invested in new companies and were able to ride the technology boom. But once the bubble burst, so did their performance. Today, Pape says, "I have caution flags waving everywhere on these things."

Rudy Luukko, investment funds editor at Morningstar Canada, says his firm follows only one LSIF with a 15-year track record, the GrowthWorks Canadian Fund. Its return is negative 0.6 per cent.

He says the 10-year median return for LSIFs is negative 1.5 per cent, while their five-year compounded annual growth rate is a "horrendous" negative 10.9 per cent. He stresses that these returns do not factor in the tax credit. "They don't look quite as bad after tax," he says.

In the technology sector, he says LSIFs have performed better than similar mutual funds. The median science and technology fund lost 21.3 per cent annually over the same five-year period.

However, like any fund family, there are some stellar performers. The Front Street Energy Growth Fund, for example, has a one-year return of 47 per cent and a three-year return of 28.1 per cent. So, there are winners among the losers, but you have to tread carefully.

What to know before investing
Sandra Sigurdson, manager of strategic investment planning at Investors Group Inc., in Winnipeg, says if you want to invest in an LSIF, you need to "understand that there's a lot more risk associated. They may have a very bright future, but at present time it's really uncertain whether they are going to be successful enterprises."

Knowing that, she says, investors should limit their LSIF exposure to no more than 10 per cent of their portfolio. That means if you want to take full advantage of the tax credit by investing $5,000, you should have a total portfolio of $50,000.

Sigurdson's big concern with LSIFs is that people buy them only for the tax break without looking at their overall performance. While the provincial and federal tax credit provides 30 cents back for every dollar you invest, the real question investors need to ask is if you're comfortable with where your 70 cents is going, she says.

Investors also have to be wary of fees, since LSIFs are expensive to manage and oversee. Management expense ratios, or MERs, are typically above 4 per cent, almost double that of an equity fund, and can easily top 6 per cent or more.

As well, since they have to be held for eight years, or you pay back the tax credit, someone nearing retirement who will need access to that money should shy away from them.

For Pape, though, the biggest problem is the transparency around valuation. At the end of a trading day, funds that invest in publicly traded companies can ascertain what the investment portfolio is worth, but that's hard for LSIFs to do and get right.

"If you are going to invest in them, you should find the funds that are largely investing in publicly traded companies. If it's publicly traded, there is a credible valuation to it. Investors need to be very cautious and really understand the risk," he says.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.