Labour-sponsored investment funds (LSIFs) proliferated in the late 1990s, thanks to generous tax breaks from federal and provincial governments and some impressive returns.

But the bloom eventually wilted. Governments changed some of the rules and scaled back the tax breaks. Fund returns withered and new contributions began to dry up.

The LSIF sector still has billions invested in it. But poor returns have led many financial advisors to stop recommending them to their clients.

What are LSIFs and what are they designed to do?
LSIFs are designed to attract venture capital investment funds to smaller firms. A labour-sponsored investment fund is a venture capital corporation that takes in money from individual investors and then spreads it among a variety of small and micro-cap companies that appear to show some promise.

That kind of diversification does reduce overall risk. But only so far. Venture capital investments, by definition, are all risky. The companies have little track record and most are not publicly traded. Many will go belly-up; others will stagnate. It’s the few that thrive and prosper that provide the gravy that makes up for all the other losses.

Labour-sponsored investment funds, as the name suggests, must be sponsored by some kind of trade union or similar worker organization. The sponsoring union gets to appoint members to the fund’s board of directors.

The exact nature of the “labour” connection has attracted some controversy. Some LSIFs in Ontario are what some in the labour movement like to call “rent-a-union” funds – the funds pay unions to act as sponsors but the funds are typically run by Bay Street money managers – the sponsoring union may have little say in how or where the money is invested.

There is also no requirement that the companies being invested in be unionized.

What are the tax breaks?
The reality is that most people invest in LSIFs because of the tax breaks, not out of some desire to support fledgling enterprises. The funds themselves know this best; their advertising invariably keys in on the tax savings to be had by investing in them.

And those tax breaks are lucrative – just not as lucrative as they used to be. The federal government offers a 15 per cent tax credit (formerly 20 per cent) on investments of up to $5,000 in an LSIF, a break that is worth $750. Most provinces also offer an additional 15 per cent tax credit – another $750. (Ontario offers an extra five per cent tax credit on research-oriented investment funds).

There are some catches, though. To hang on to the tax credits, governments insist that investors hang on to their units for no less than eight years (before 1996, the hold period was five years). Sell before then, and you must repay all the tax credits – yet another reason why LSIF investments should be considered long-term.

To prevent a rash of redemptions following the “lock-up” period, investors can redeem their shares and immediately reinvest in shares of the same LSIF – a “rollover” that provides investors with as much as another $1,500 in tax credits. They will, of course, then have to hold the shares for another eight years.

Have they been successful in raising money?
By some estimates, labour-sponsored investment funds account for up to 40 per cent of all the venture capital raised in Canada.

According to Investor Economics, the country’s 113 LSIFs had $3.7 billion in assets as of April 30, 2005. The largest (Vengrowth II) has almost $500 million under management. But only eight LSIFs have assets of more than $100 million. By comparison, the biggest mutual funds in Canada each have several billion dollars in assets.

LSIFs want to invest in companies that they can either sell at a profit to other companies or take public and clean up on if the stock price soars. The best example of an LSIF success story is Research in Motion, the Waterloo, Ont., wireless mobile company that is now worth more than $17 billion.

How bad have the returns been?
For most LSIFs, the returns have been, shall we say, less than spectacular. Of the 10 biggest funds, nine have a five-year history. All nine lost money over the five years ending May 31, 2005. Over the last year, only one of the “big 10” has made money.

It’s not hard to see why. Most LSIFs invest in high technology and life science companies. Up to 1999, these were the sectors to be in. For instance, the average LSIF made 21.6 per cent in 1999 and 11.6 per cent in 2000.

But then came the tech meltdown. According to Morningstar Canada, the LSIF category as a whole had double-digit losses in each of 2001 and 2002 and single-digit losses in 2003 and 2004. Of the 10 biggest LSIFs, eight lost money in 2001, nine lost money in 2002, five lost money in 2003, and eight lost money in 2004.

Investors are also at the mercy of the fund’s valuation process. Equity mutual funds are easy to figure out a value for. They invest in publicly traded companies so the net asset value is much more transparent. With LSIFs, valuations of private companies must be arrived at by other methods. In the case of the Crocus Investment Fund in Manitoba, the process was flawed and valuations were not lowered despite indications the underlying investments were not worth what they were on paper.

Another factor weighing on LSIF performance? Their management fees. These are expensive funds to run, and are therefore expensive to own. The average Canadian equity mutual fund has a management-expense ratio (MER) of about 2.5 per cent per year. Management-expense ratios at labour-sponsored funds typically run at four to five per cent.