Million Dollar Journey recently posted a primer on using flow-through funds for saving on income taxes (You may also want to check out this excellent report from BMO Nesbitt Burns on Flow-Through Limited Partnerships). Some years back, I researched these investments in depth because I received a hefty severance package and was looking for ways to save tax on the one-time boost in income. Looking back at my notes, I decided against them for the following reasons:
- Flow-through shares are issued mainly by junior mining companies in the exploration stage. Most of these companies have little in the way of revenues, let alone profits. Investments in these companies are speculative in nature and as such should be limited to a tiny portion of the portfolio.
- When you are limited to investing a small part of your portfolio, your portfolio needs to be large enough to generate enough tax savings to be worthwhile. For example, if you are in a 40% bracket, just to generate a tax savings of $1,000, you need a portfolio of $250,000 if you limit yourself to 2% exposure to junior mining stocks.
- Let’s assume you are in the 40% tax bracket. If you invest in flow-through shares, you are banking on arbitraging the 20% difference between paying income tax today and capital gains tax two years down the road. If your investment stays level, you will be gaining 20% over two years. Can speculative investments in commodity plays lose more than 20% in two years? You bet.
- Do not forget fees and there are plenty of them: there is usually a 6% upfront commission and a 2-and-20 (2% annual fee of assets under management and 20% of returns in excess of a benchmark) fee charged by the portfolio manager. Also, flow-through shares are issued at a premium to common shares by the mining company. Add it all up and your investment has to work pretty hard just to stay even.
- Keep in mind that the last few years have been unusually good for tiny exploration plays. Investor sentiments on speculative investments can sour in an instant and when it happens returns from flow-through funds will not be so rosy.
Still, flow-through funds may have a place in your portfolio because these funds tend to have a better risk/reward profile than the underlying shares due to the income-tax benefits. In hindsight, it would have been a good time to invest in these funds when I was researching them because the last few years have been unusually good for junior exploration stocks. But then, hindsight is always 20/20, right?