I wrote a piece for Canadian Business on the trust market, so I won’t go into everything here, but it’s safe to say that the trust market will remain healthy far beyond next year. Of course, trusts won’t be called trusts, most will convert into a corporation over the next couple of years, but it’s a good bet that a majority of these companies will continue to pay a high yield for the foreseeable future. It’s expected many trusts will cut distributions (called dividends in a corporate structure) by about 30%, or the amount the corporation will be taxed. You can see in my story that it won’t make much of a difference to the investor’s bottom line.

The trusts that people should have been worried about are out of the market now. Around 2006 many corporations were converting to trusts just so they could take advantage of the tax savings. But trusts aren’t for everyone. This is a generalization, but companies focused on reinvesting profits for growth shouldn’t have become operations that flow-through profits to unit holders. Those companies converted back to a corporation early on in the game, once they knew their tax advantage would be taken away. Plus, many of the weaker trusts have merged; there were 245 trusts in the Scotia Capital Income Trust Index on October 31, 2006, now there are 140.

Some of the trusts you hold may not have announced conversion plans yet. While it’s likely that the distribution will stay the same, you won’t know for sure until the company announces what it will do. So pay attention to what you own and if the trust does slash its payout significantly, it may be time to seek income elsewhere.

Bottom line: keep those trusts around and (hopefully) see those hefty dividends add up.

Read my income trusts story here.

MoneySense columnist Suzane Abboud also wrote a good story on why you should hang on to trusts. You can read her story here.

Follow me on twitter @_inthemoney.

It’s putting it mildly to say that income trusts are no longer popular. During the past three years, the total assets invested in income trust funds has shrunk by a stunning three quarters, to a meagre $5 billion. But now that some time has passed, it’s worth asking whether this massive sell-off was justified. After all, bargains often lurk among unpopular investments, and some income trust funds are now offering juicy annual cash distributions as high as 5% to 7%.

I know, I know. The income trust world is marred with uncertainty. But things may not be as bad as you fear. As a matter of fact, income trusts today look less risky to me than regular equities, with more upside potential than downside. Here are five reasons why:

The market has already discounted the extra tax. You should rest assured that nothing drastic will happen when the new income trust tax comes into effect on January 1, 2011. The market almost immediately discounted this event as soon as the government announced the change. There has now been plenty of time for the market to reprice trusts according to the new tax structure.

Even with the tax, trust funds will yield more than most dividend funds. Yes, income trusts will have less surplus cash to distribute. By my estimate, the new tax will knock out a good two percentage points from your fund’s annual income. But even after that haircut, the trust’s income spinning structure is likely to deliver a higher yield than you would get from a normal equity or dividend fund.

Trusts can now convert painlessly to corporations. Since the 2006 announcement, the federal government has passed a new law that allows income trusts to convert into corporations with minimum tax implications. Because of that, any conversions that take place in the future should not result in losses to you as an investor. What will change is the legal status of some of your fund holdings, from trusts to high-yield equities. But well-run businesses will continue to deliver value to investors, whether they are structured as trusts or corporations.

You can profit from mergers. It’s widely expected that there will be more mergers and acquisitions in the income trust field. But if one of the trusts held by your fund manager is acquired, it will most likely take place at a premium. This means that there’s often a potential for moderate capital gains.

Income investments will get more popular. The idea that companies should pay out as much as they can in dividends is gaining traction. Investors are getting weary of executives who retain cash to fund questionable expansions that satisfy their personal egos, but don’t add value for shareholders. As well, the increasing number of retired baby boomers is creating more demand for income investments. So it looks like trusts are here to stay. And as demand for them goes up, so could their value.

Yes, the income trust universe as we now know it will change. The number of available trusts will keep shrinking for a while yet. A number of income trust funds will expand their mandate to include high-yield equities (and possibly high-yield bonds) to broaden their investment scope. However, this should not have any negative effect on your wallet. And in the meantime, many trust funds have awfully attractive yields.

As with any investment, there are risks. Like stocks, income trusts were shaken by the market crash, and there may be further short-term fluctuations in their value before the markets stabilize. Further, their cash distributions are essentially dependent on the net cash flows generated by the underlying trusts. Those cash flows are dependent on the overall economic situation. During times of economic growth,surplus cash flow results in higher cash distributions to investors, and vice versa. So when the economy foundered over the past year, it forced several income trusts to cut their distributions. There is a risk of further cuts if we have a prolonged period of slow growth, or lower oil and gas prices. However, the general consensus is that the worst is behind us.

Interested in a 6% or 7% yield? The table (below left) provides a list of well-managed, relatively cheap income trust funds, with diversified portfolios. I have not included any income trust exchange-traded funds, because I find that the S&P/TSX Income Trust Index upon which they are based is overloaded with energy trusts. Further, in these uncertain times, I feel that you need a good fund manager who knows how to select sound trusts that can sustain further economic weaknesswithout cutting cash distributions.

Market prices may go up and down in the short term. However, the ultimate value of your investment will be determined by the net income that you derive from it. That’s why, when compiling my list, I focused on the funds with the highest income distributions. To calculate the estimated yield, I divided the annualized net income distributions of each trust by the net asset value, and disregarded capital gains and return of capital. If you’re interested in funds that will spin off regular income for your retirement, you may find some of these funds interesting, but be sure to do your own research too.

Trustworthy Contenders
These income trust funds are well-managed and relatively cheap — and likely to spin off a higher yield than dividend funds.

Source: Fundata Canada Limited and FundScope Limited

No doubt some of these investors really are geniuses; others, though, just happened to be in the right place at the right time. How can you tell who’s smart and who’s just lucky? Simple. Follow them over the long term and see what happens to these geniuses when their chosen sector falls out of favor.

That’s what we’ve been doing with Canada’s Best Small Investors. We began profiling these private investors a couple of years ago. There was a former pipe insulator from British Columbia who had made more than $4 million by jumping in and out of energy and natural resource stocks. There was a retired school principal living north of Toronto who had amassed more than $2.5 million by diligently scouring the market for literally hundreds of solid, quality stocks. There was a former ESL teacher who retired at 34 with a small portfolio stuffed with high-dividend stocks. And there was a Winnipeg investor who turned $35,000 into more than $2 million by betting big on a handful of firms.

Some of our Best Small Investors have continued to do well. Others had a rough year. Whether you’re a whiteknuckle gambler or a play-it-safe risk avoider, we think you’ll find that their stories offer intriguing glimpses into what makes a great investor. The lesson that emerges is that successful investors follow many different strategies, but each of them diligently sticks to whatever works for his own personality and interests. We can all learn from their perseverance—and maybe even take away a couple of interesting stock picks to boot.

Bengt Kaus was a new addition last October to our investing hall of fame, and the 61-year-old Winnipegger has demonstrated over the past year that he richly deserves his place. Kaus’s portfolio gained 26% in 2006 and a further 6% so far in 2007 to stand at $2.2 million, after a $100,000 withdrawal. Not bad for someone who largely sticks to conservative investments and keeps a quarter of his portfolio in cash.

His buttoned-down approach makes Kaus indifferent to the market’s tremors. “The violent swings we’ve been seeing are more indicative of a market top than a temporary low,” he warns. But although he expects the market may tumble, he isn’t running for the hills. Instead he’s sticking to a small group of value stocks, loading up on cash, and taking profits where he can.

For instance, he sold off about 20% of his holdings in Brookfield Asset Management, his second-largest holding, early this summer when he felt the shares had hit a short term high. The shares have since dropped further and Kaus thinks the next few months could be rocky as the property and power generation company rides out the shocks from the sub-prime mortgage implosion in the U.S. “Still, it’s always a good time to buy Brookfield, if it’s for a long-term investment,” says Kaus.

Kaus’s largest investment is ING, the international Dutch banking and insurance giant. It, too, has dipped a little in recent months, but Kaus doesn’t seem concerned. “ING is my defensive position in case we have a bear market,” he says. “The P/E ratio shows that it’s still very cheap. Unfortunately, in the U.S. the ‘E’ part of the ratio—the earnings—hasn’t held up because of the mortgage crisis.” The stock still commands a full 20% of Kaus’s portfolio and he says he isn’t planning on selling it any time soon.

When we checked in with Kaus last October, he mentioned that he was doing some research into the shipping sector. His research paid off when he decided to load up on a Greek shipping company called Euroseas. “It was trading over-the-counter at $8 a share when I bought it, and I sold it for $15 this past summer.”

Kaus has recently been dabbling in the shares of Chinese manufacturers that are trading over-the-counter in the U.S. as they wait to be listed on North American exchanges. He bought a basket of six such companies, including China-Biotics, which produces live probiotic bacteria for use in yogurt and other food products. (Its flagship bacteria goes by the moniker “Shining Essence.”) “I like these things because I can buy them for less than 10 times earnings, and they’re primed for a high rate of growth,” he says. “Plus they’ll get an immediate boost once they’re trading on the North American exchanges.”

Dale Johnson endured the scare of his life last Halloween. When we last talked to the 51-year-old former pipe insulator, he had built his portfolio’s net worth to about $4.7 million by using truckloads of borrowed cash to invest in energy income trusts and junior mining companies. Then, late last October, he was at his home in Coldstream, B.C., when disaster struck. Ottawa announced it was going to tax trusts. The announcement obliterated billions of dollars of investors’ wealth—and more than a million dollars of that wealth belonged to Johnson.

“I only slept about three hours that night,” says Johnson. “I woke up at 3:15 in the morning, but the markets don’t open here in B.C. until 6:30 a.m. So I sat in front of the computer and drank coffee. I remember thinking to myself that if I get out of this with just a 30% loss today, I’ll be lucky. But I wasn’t that lucky.”

By early afternoon, Johnson had lost $1.2 million on the accounts that he manages for himself and his brother, and the losses didn’t stop there. He spent the day madly selling off his weaker trusts to avoid a margin call, but prices continued to drop well into the following month. “By mid-November, I had bottomed out at about $2.7 million,” he says. “I think if I had hit lower than that, I would have turtled and protected my nest egg.”

Many investors would have sworn off income trusts altogether. But Johnson, who lost a total of $1.6 million, jumped right back in. Over the following 10 months he has traded aggressively to rebuild his portfolio to $4.3 million. His portfolio has almost completely recovered from the damage of last October—and Johnson has already built his leverage back up to significantly more than $1 million.

What lessons did Johnson learn from the experience? He says he went back to fundamentals and now focuses on trusts that can pay their distributions out of net income; he avoids trusts that have to borrow money or sell more units to pay existing unitholders the yield they expect. He has also put more money into Canadian miners, especially firms looking for copper and molybdenum.

His top holding is Trinidad Energy Services Income Trust, just as it was at this time last year. Trinidad, which builds and operates oil and natural gas rigs, makes up a full 65% of Johnson’s holdings, and he still considers it a buy, despite that fact that it’s been falling since mid-May. “I’m still bullish on it for the long term,” he says. “It might be weak for the next little while, but I recommend it for anyone with a window of two months or more.”

Johnson’s second-biggest holding at press time was Roca Mines, one of the companies he mentioned when we checked in with him in our October 2006 issue. Back then, Roca was trading at about $1; at press time, it was around $2.50. Roca’s main product is molybdenum, a silvery metal that’s added to the steel used in pipelines and oil drills to make it stronger and more heat resistant. The price of molybdenum has recently gone on an epic tear, soaring from $5 (U.S.) a pound in 2003 to $35 (U.S.), and Johnson says Roca should do well as long as the price stays high.

Johnson’s not alone in liking the prospects for moly. Sprott Asset Management in Toronto recently started up a molybdenum fund, which is Johnson’s third-largest holding, and Johnson feels the metal’s price will continue to soar. “Sprott’s very smart and the fund they’ve set up doesn’t have a closing date,” he says. “That indicates to me they’re bullish on moly over the longer term.”

Despite his million-dollar loss last Halloween, Johnson hasn’t slowed down one bit. In June, he switched in and out of various holdings more than 120 times—and he says that he has no plans to ease back on the throttle, thank you very much. “I still have about $1.7 million in margin right now,” he says. “I know that what I’m doing is pretty dangerous, but I’m aggressive and I like playing the game the way I play it. It’s been a bouncy year, but I can’t complain about things. I’m not too far off from where I was the last time we talked.”

Jim Chuong has achieved a 9% average return over the past year, much better than the year before—but he’s far from excited about it. One of his holdings, the California sunglasses company Oakley, is in the process of being bought out by Luxottica, the eyewear behemoth, and he’s not taking the news well. “I can’t believe it,” says the 35 year-old resident of Mississauga, Ont. “That company was a cash machine. The worst part is they’re buying it out for cash. I would have much preferred shares in Luxottica.”

Still, Chuong is taking some solace in the fact that Oakley is being bought out at $29.30 (U.S.), more than double what he bought it for. Plus, he seems thrilled that one of his other holdings, K-Swiss, has dropped by about 8% over the past year, thus presenting him with a buying opportunity. “I think that’s really awesome,” says Chuong, whose day job is working as a pharmaceutical rep. “I haven’t had an opportunity to buy K-Swiss in years.”

Otherwise, Chuong’s portfolio has been pretty much unchanged, and his other holdings are doing very nicely. Fossil, which makes watches and accessories, is up by a whopping 75%, The Buckle, a casual apparel retailer, is up 60%, and Warren Buffett’s Berkshire Hathaway (class B) is up 24%.

Meanwhile Chuong is getting more and more interested in real estate. He has devised a methodology for evaluating income properties that involves coming up with independent estimates for property expenses and ignoring most of the numbers provided by sellers. Based on this method, he believes he’s finally found a winner, a 12-plex in Kingston, Ont., that he snapped up in late August to join the two rental condos he already owns in Toronto.

Thanks to his property holdings, Chuong estimates that his net worth is now $1.1 million, up slightly from last year. He’s taking his success in stride and seems almost indifferent that, at 35, he’s already achieved what many never accomplish in a lifetime.

Carl Anderson, a 76-year-old retired high school principal in Toronto with a portfolio valued at $2.7 million, had a year that many investors will find eerily familiar. His portfolio of more than 200 blue-chip stocks and income trusts took a dive in late October when the government announced that it would tax trusts. Then his stocks enjoyed gangbuster returns until July. Finally, over the late summer, “I just got hammered,” he says.

That hammering reduced his year-over-year return to about 5%—not bad, but well below Anderson’s long-term average annual return of almost 20%. Still, Anderson, who plans on eventually donating most of his portfolio to children’s charities, is unconcerned. That’s because he’s much more interested in the dividend income his portfolio spins off than capital gains, and his dividends are steadily marching higher. Anderson calculates that they’re up by about 8%, this August over last, meaning that the roughly $65,000 in income Anderson gets from his portfolio is still growing at more than double the rate of inflation.

Since his dividend income is unthreatened by market fluctuations, Anderson has changed very little in his portfolio. His biggest move was to sell off $14,000 worth of Shiningbank Energy Income Fund, a gas trust that’s been swooning since early 2006 and recently merged with PrimeWest Energy Trust. He used the proceeds to buy into the AltaGas Income Trust, the Enbridge Income Fund and The Consumers’ Waterheater Income Fund, which he sees as much stronger trusts for the future.

Derek Foster retired three years ago at 34 with a portfolio valued at just over $400,000. That didn’t seem like a lot of money to make ends meet on for the rest of his life, but so far he’s not only supporting himself, but a growing family as well.

Foster’s fourth child, a little girl, was born in July, prompting a move to a larger 3,000 sq. ft. detached house in Ottawa. “I’ve been busy with the newborn, and we went to Disney World again, and we’ve just been taking it easy,” he says. “I haven’t really spent much time looking at my portfolio.”

That’s because things seem to be working fine. Foster’s plan was to build a portfolio that spun off enough income for him to live on, and then ignore it. So during his late 20s and early 30s he loaded up on safe, high-dividend-paying blue chips and trusts such as Canadian Oil Sands Trust, EnCana, Royal Bank, Manulife, and Johnson & Johnson. Since he never plans to sell off any of these major holdings, he doesn’t care how much they’re worth. All he cares about is making sure that the $35,000 or so in income his portfolio produces each year though dividends, distributions and tax credits goes up faster than the rate of inflation, and so far it has.

During the past year, Foster made just one big buy, The Consumers’ Waterheater Income Fund. “I picked this one because regardless of the economy, people will rent water heaters,” he says. “And the trust should be able to raise prices at least at the rate of inflation. So for me it’s like an inflation-protected bond.”

Outside his portfolio, Foster’s big project has been a sequel to Stop Working: Here’s how you can!, a book he self-published in 2005 and sells through bookstores and his website, www.stopworking.ca. He has sold over 20,000 copies and he hopes that a new book, The Lazy Investor, will do even better. His only complaint is that the money from his book sales is raising his tax bracket. “My tax credits have been reduced because of the extra income from the book,” he sighs. “I never thought it would do so well.”

One good reason to pay attention to these upstart economies is their sheer size. The four biggest of the emerging nations are Brazil, Russia, India and China, which are often referred to collectively as the BRIC countries. Just like a true brick, the BRIC countries pack a wallop. China and India are the world’s two most populous nations; Russia and Brazil also rank in the top 10, with populations many times that of Canada.

The BRIC countries are just the beginning of what’s available outside the developed world. The emerging markets category ranges from Poland to South Korea to Mexico to South Africa. Taken together, emerging markets now represent about a quarter of the global economy. Since 2001, their economic growth rate has been triple the growth rate of developed economies. Stock markets in these emerging market economies have churned out 21%-a-year gains over the past three years.

Strangely, though, Canadians don’t seem much impressed by this sizzling growth. Emerging market equities represent less than 1% of the money held in Canadian mutual funds. I fear that Canadians are simply not recognizing the new realities of the marketplace.

The most common objection I hear to investing in emerging markets is that these markets are too volatile. To some degree, I can sympathize with the complaint. Last summer, emerging market equities lost 25% of their value in less than two months. They subsequently regained all their losses, but their temporary plunge was scary.

The unfortunate reality is that you can expect more of the same. Emerging markets involve risk. Brazil and Mexico suffer from social imbalances and inefficient tax systems. Russia is moving back towards autocracy. India has to deal with inflation and a growing current account deficit. China is still a communist country where the rule of law is unpredictable.

But the problems don’t outweigh the potential. The key to investing in emerging markets is protecting yourself so you enjoy a high chance of profit and a low chance of losing your shirt. Here are four tips to help you on your way:

Think about the big picture

It’s reasonable to dedicate 15% to 20% of your portfolio to emerging markets. Don’t invest more unless you are a gambler.

No matter how much or how little you invest, make sure you diversify your holdings to ensure that a downturn in one region or country can’t sink your portfolio. In particular, you should avoid mutual funds that specialize in a single emerging market country or a small region. The risk is simply too high. A well-diversified emerging markets portfolio would have the bulk of its assets in the Asia-Pacific region (outside of Japan) with smaller portions invested in Latin America, Eastern Europe and Russia, and South Africa.

To hedge your bets, look at what else is in your portfolio. Emerging market funds usually move in ways that are out of step with Japanese equities, Canadian financial services or even Canadian balanced funds. If you mix your emerging markets investments with one or two funds from those other categories, you reduce your overall risk, since any downturn in one area is likely to be counterbalanced by gains in the other.

Go global

Choosing your own emerging market mutual fund can be tricky, since the funds available in Canada tend to be expensive and often go on hot or cold streaks that have little to do with management skill. As an alternative, consider investing in a global equity fund that has an emerging market component. The Trimark Global Endeavour Fund, the Chou Asia Fund and the Mawer World Investment Fund are all good examples.

Cut costs

If you decide to go all the way with a pure emerging equity fund, buy an exchange-traded fund (ETF) such as the MSCI Emerging Markets Index Fund, which trades on the American Stock Exchange (AMEX: EEM). This ETF gives you instant exposure to emerging markets around the world at much lower cost than an equivalent mutual fund.

It’s not just stocks

Consider emerging market bonds. A diversified portfolio of emerging market bonds is now yielding 2.5 percentage points more than a portfolio of Canadian bonds (or two percentage points more than U.S. bonds). With Canadian 10-year bonds currently offering a paltry 4% yield, this extra return is a welcome bonus for income-hungry investors.

The additional return isn’t without risk, of course. As Argentina demonstrated two years ago, governments in emerging countries sometimes default on their bonds. Still, if you keep a diversified mix of bonds, the risk premium should more than compensate you for any losses caused by default.

Before investing, you should be aware of a couple of specific pitfalls. The first is currency risk. You may take a hit if the currency the bond is issued in loses value against the Canadian dollar. This is true of any foreign investment and the best defence is a well-diversified portfolio that is split up among many different currencies.

You should also be aware that emerging market bonds fluctuate depending on how investors perceive their relative risk. The current two percentage point spread between emerging market bonds and U.S. government bonds is low by historical standards, suggesting to some observers that emerging market bonds are overvalued. Remember, though, that these are bonds, not stocks. If you (or your portfolio manager) hold on to your investment, you can enjoy the extra yield from these bonds and get back your principal upon maturity. The key is to invest only money that you will not need in the next few years.

To find a good emerging market bond fund, you will have to go outside of Canada and look at some of the ETFs available on the U.S. stock exchanges. You can examine the selection at a website called ETFconnect.com. Look for emerging market funds under the “Fixed Income” category. The site shows you the current annual interest payments and the degree of risk the fund is taking on. Risk is measured by the average credit rating of the portfolio. The holdings of emerging market bond funds typically range from relatively low risk BB+ bonds (one notch lower than investment grade) to high-risk C issues. You should look for a mix of high yield with relatively low risk. Right now, I think the Western Asset Emerging Markets Income Fund II, Inc. (NYSE: EDF) is appealing. It offers an 8% current income distribution level and has a BB+ average portfolio rating.

So where should you go looking for investment opportunities instead? In my opinion, small capitalization stocks — typically those of young companies or small firms — are the most tempting alternatives out there.

I’m not the first person to make the case for small caps, of course. Since 2001, small caps have delivered an average annual return that is north of 15% in Canada and 13.5% in the U.S. But while the prices for these stocks have soared, I believe there is still some value left, especially if you’re thinking in terms of a multi-year investment and if you know where to look.

I base my case upon history. Small caps have almost always delivered better returns over the long term than large cap stocks or bonds — and right now large cap stocks and bonds are so expensive that their returns are likely to be dismal for the foreseeable future.

James O’Shaughnessy, the well-known U.S. investment researcher and money manager, presents the evidence for smallcap stocks in his new book Predicting the Markets of Tomorrow. Using historical data, he concludes that the average real return (i.e., what you make after inflation) from an index such as the S&P 500 that focuses on large companies is just over 7%. But here’s the catch: if the actual return from these large cap stocks exceeds 7% for a sustained period, it tends to be lower in subsequent periods, thus reverting towards the historical 7% average.

O’Shaughnessy argues that since returns from the S&P 500 far exceeded the 7% historical average during the Internet bubble, we are now in a correction phase that will drag down returns to the range of 3% to 5% over the next several years. Once you factor in the 2%-plus cost of management on a typical mutual fund, you’re left with a dismal return that won’t do much to make your retirement dreams come true.

For bonds, the picture is even worse. With bond yields currently around 4% a year, you make next to nothing in real terms after you subtract inflation of 2% to 3% a year and investment costs.

The case for small cap stocks, fortunately, is much better. Smaller companies have more room to grow than big firms. They’re more nimble as well, so they can move faster than their bigger rivals to capitalize on opportunities.

History demonstrates the payoff from those advantages. Since 1925, small caps have outperformed large caps by two to three percentage points a year with only brief periods of underperformance. After crunching all the numbers, O’Shaughnessy expects small caps to return in the range of 7.6% to 9.6% a year over the next 20 years.

If he’s right, the implications are enormous. Investors who stick to traditional large caps, bonds and cash assets will need to work much harder for retirement. Those who venture more aggressively into the small cap world can reap significant long-term benefits, provided they choose their investments wisely.

The first step in choosing wisely is assessing just how much of a bargain you’re getting. Where the buys on the next page summarizes the current situation and, at first glance, it seems to contradict much of O’Shaughnessy’s advice. As you can see, large cap stocks look like a better deal at the moment than small caps. You pay a lower price-to-earnings ratio (P/E) to buy large caps. You also enjoy lower management expenses and trading costs — yet the bigger stocks are less risky than their smaller counterparts when you measure their beta, or how much they move up or down in relation to the market.

Fortunately, you see a more attractive picture if you look only at the value component of the small cap universe. These stocks are slightly cheaper and slightly less risky than the overall small cap universe. My conclusion? If you’re going to make a bet on small cap stocks, concentrate on the relatively cheap, relatively undervalued end of the category.

I am not — repeat, not — inviting you to put all your money in small cap value stocks and ignore everything else. Diversification remains the best long-term strategy. However, a moderate bias towards the small-cap value sector can let you benefit from the long-term potential of this category, while alleviating concerns about current valuations.

In Small game hunters below, I have compiled a list of funds that specialize in the small cap area and that have a decent long-term record and a value bias. My list is not based on any rigorous quantitative approach. I have simply selected a handful of small cap funds that I like, because I am familiar with their history and style. So much the better if some of those funds have sagged for the past year or so: I know they will come back, because they always have in the past.

Where the buys are

Small cap stocks are now more expensive than large cap stocks. But bargain hunters can still find a deal if they focus on small cap value stocks.

Source: data compiled from information available in the public domain on ishares.com for the benchmark index funds of each style.
Source of estimated trading costs for each style is Harry S. Marmer’s book Perspectives on Institutional Investment Management.

Small game hunters

A few of my favorite small cap funds. All my chosen funds favor value picks.

Income splitting could put thousands of extra dollars in your pocket every year, and maybe even allow you to retire earlier. “At some point just about all of us will be affected by this,” says Sandy Cardy, senior vice president of tax and estate planning at Mackenzie Financial in Toronto. “Most people are focusing on the trusts, but for many Canadians, pension splitting is going to have a much bigger impact.”

How big an impact? If you’re married and one of you gets $70,000 a year from a pension, you could get an after-tax raise of more than $5,000 a year starting in January. If you’re not retired this affects you too — at least if you want that extra cash when you do retire.

What’s changed?

The new rules allow you to reduce your taxes by spreading your family’s pension income more evenly between you and your spouse. For instance, if you get an annual $70,000 pension and your spouse has no income, you could split up to half of your pension with your husband or wife, and fill out your tax returns as if you each earned $35,000 a year. Your combined income hasn’t changed, but you’ll pay far less tax because you’re now in a lower tax bracket.

What if I’m still saving for retirement?

Then it’s time to change your retirement plan to maximize your eligible pension income, because that’s pretty much the only type of income you can split. While you’re under 65, only income from a registered pension plan, like a pension from work, qualifies. When you hit 65, then you can also split income from your RRSP by converting it to an RRIF or annuity.

To maximize your pension income, you should join your company pension plan if there is one, and keep as much of your retirement savings in an RRSP as you can, even if that means forgoing the lower tax rates on capital gains and dividends. “That’s because the tax you save by income splitting could more than offset that,” says Cardy. Of course, you’ll see the biggest impact if you have a spouse who makesconsiderably more or less money than you do. If you’re single, you’re out of luck.

Could I retire a year earlier?

In some cases, yes. Consider the $5,000 a year you would gain from pension splitting in the example above. If you’re a 65-year-old male, that $5,000-a-year gain for life is equivalent to a $67,000 annuity. With income splitting, you can save that $67,000 and use it to fund an extra year of retirement.

Could I keep my OAS from getting clawed back?

Definitely. If you expect your retirement income to be greater than about $62,000, the government will claw back some of your Old Age Security payments, which could cost you up to about $6,000 a year. Lowering your income by splitting it with your spouse means you’ll pay less tax and get more of your OAS.

Malcolm Hamilton, an actuary with Mercer Human Resource Consulting in Toronto, says planners are just starting to appreciate the wide-ranging implications. He expects some people with good pension plans will start retiring earlier so they can split their incomes, and work part time until 65. He also expects more couples will start converting their RRSPs to RRIFs right at 65 rather than waiting until they’re 69. Cardy adds that you can fine tune your net income year by year. For instance, you might want to lower your income one year to claim more medical expenses or pay less tax on dividend income, then lower your spouse’s income the next.

How much will you save?

These couples will save thousands. You could too.

Rosco and Virginia are 62 and retired. Rosco has no income;
Virginia has a $50,000-a-year pension. She can split her income 50-50
with Rosco even though she’s under 65, because it’s pension income.

Combined after-tax income before splitting: $39,800
Combined after-tax income after splitting: $43,100
Income boost: $3,300 a year

Tom and Nicole are 64. Tom has a $70,000 pension and Nicole
has no income. Otherwise, they’re in the same position as Rosco and Virginia.

Combined after-tax income before splitting: $53,400
Combined after-tax income after splitting: $58,800
Income boost: $5,400 a year

Bob and Margaret are 67 and have applied for OAS. Bob receives
$60,000 a year from his RRIF, $30,000 from consulting work, and $10,000 from
CPP. Because his income is high, all of Bob’s OAS is clawed back. By splitting
his RRIF income with Margaret, Bob pays less tax, and gets most of his OAS back.

Combined after-tax income before splitting: $76,500
Combined after-tax income after splitting: $85,900
Income boost: $9,400 a year

All figures are approximate and assume Ontario residency. CPP sharing and other credits and reductions, such as the age amount, were not taken into account.

U.S. equity
iShares Canadian S&P 500 (TSX: XSP)
TD U.S. Index Fund

International equity
iShares Canadian MSCI EAFE (TSX: XIN)
TD International Index Fund

Canadian bond
iShares Canadian Bond (TSX: XBB)
TD Canadian Bond Index

Real estate
iShares Canadian REIT Sector (TSX: XRE)

Canadian dividend
iShares Canadian Dividend (TSX: XDV)

U.S. dividend
iShares Dow Jones Select Dividend (NYSE: DVY*)

Income trusts
iShares Canadian Income Trust Sector (TSX:XTR)

*offered by iShares in the U.S.