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What is your opinion of split shares?

Many investors don’t realize that there are actually two kinds of split shares – preferred shares and capital (or class A) shares. Split share corporations issue both types of shares to the public and use the cash to invest in a basket of dividend-paying companies.

Even though split preferred and split capital shares are exposed to the same underlying portfolio of stocks, they behave in different ways and have dramatically different risk profiles. –

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“I only realized how they worked when it was too late … I lost a significant amount of money in the process,” said one reader who invested in split capital shares only to watch their prices tumble when the stock market hit a rough patch this fall.

The best defence is to educate yourself, so let’s look at each type of split share in turn.

Split preferred shares are actually quite conservative; they typically pay a fixed monthly distribution that is funded by the dividends from the underlying portfolio. The preferreds get first claim to these dividends and also to the capital of the underlying portfolio, up to a certain level (equivalent to the issue price of the preferred shares).

The trade-off for providing greater safety is that split preferreds offer little upside potential. This makes them appropriate for investors seeking steady income and stability.

Split capital shares, on the other hand, are much more volatile. In exchange for giving up the underlying dividends to the preferred shares, the capital shares are entitled to all of the value in the portfolio above the fixed amount allocated to the preferreds. Many capital shares also pay dividends, which are usually financed by selling options and earning premium income on the underlying stocks.

Essentially, the capital shares are a leveraged play on the underlying portfolio. If the stocks in the portfolio rise, the capital units will experience an even bigger gain. But if the portfolio stocks fall, the capital shares will suffer an even bigger loss. The dividends from capital shares can also dry up if the market turns negative.

Let’s look at an example.

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Canadian Life Companies Split Corp. invests in a portfolio of four dividend-paying Canadian life insurance companies: Manulife Financial Corp., Sun Life Financial Inc., Great-West Lifeco Inc., and Industrial Alliance Insurance and Financial Services Inc.

The preferred shares of Canadian Life Companies Split trade under the symbol LFE.PR.B and the class A or capital shares trade under LFE. (The split corporation is managed by Quadravest Capital Management Inc., which also has about a dozen other “enhanced yield” products.)

The preferreds have provided steady returns, trading between $10 and $10.50 for most of the past five years and never missing a monthly dividend payment. They currently yield about 6.25 per cent, based on trailing 12-month dividend of 62.5 cents a share.

The capital shares have been far more erratic. In January of this year, for instance, LFE traded between $6 and $7. But as life insurance stocks struggled, the class A shares have subsequently lost more than half of their value. LFE closed Friday at $2.56.

LFE’s dividend history is also spotty. Over the past five years the class A shares have declared a dividend in just 16 of 60 months – or about 27 per cent of the time. No dividends have been paid since February. When the total net asset value of the split share corporation falls below $15 – it was about $13.42 as of Nov. 30 – dividends on the class A shares are suspended.

Under the right conditions, the leveraged nature of split capital shares can work in an investor’s favour. From the start of 2016 to the end of 2017, for example, LFE posted a total return (assuming all dividends had been reinvested) of about 96 per cent – nearly triple the total return of the S&P/TSX Composite Index over the same two-year period.

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But while split capital shares can produce market-beating returns at certain times, they can also deliver gut-wrenching losses. And the dividends aren’t as reliable. For most people, preferred split shares are going to provide a much more comfortable ride.

I always remind people to do their own due diligence before investing in any security. With split shares, it’s critical that you read and understand the prospectus, ask a lot of questions and study the track records of various securities before you even consider investing a penny in these complex products. For my money, a diversified portfolio of high-quality, dividend-growing common shares is still the best way to go.

For some examples, see my model Yield Hog Dividend Growth Portfolio.

E-mail your questions to jheinzl@globeandmail.com.

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