Popular
fund dips into capital
As an
analyst, I receive a ton of marketing material from mutual fund companies. In
my opinion, much of it is just plain fluff and not worth more than a skim. Just
a couple of days ago, I received a memo from Clarington Funds regarding their
Canadian Income Fund, which has been quite popular both with financial advisors
and investors alike. The reason this caught my attention was the potentially
misleading wording of its content.
Lower
interest rates mean lower income for some investors. However, investors may
neither desire, nor to be able to accept, a lower a standard of living. Hence,
it’s no secret that funds offering higher yields have been in increasing demand
throughout the last several years. In today’s ultra-low interest rate
environment, thanks in part to the events of 9-11, juicy yields are scarce.
The mutual
fund industry is well known for giving investors what they want, notwithstanding
what they really need. In 1993 and it was resource funds and aggressive small
cap funds. In 1996, it was much the same but with income trusts added in. And,
of course, 1999 saw the “birth rate” of technology funds soar – just in time
for a crash landing.
This year,
we’ve seen the introductions of many new high-income funds, which typically
invest in some combination of: high
yield common stocks, preferred shares, corporate bonds, income trusts, real
estate investment trusts (REITs), and/or energy royalty trusts. I have no beef
with these types of funds.
On the
other hand, there are plain old balanced funds that simply pay out a fixed
“distribution” on a monthly basis. While this type of “fixed distribution”
feeds the investor what s/he wants, yield-hungry investors may simply be
chewing on “empty calories”.
Suppose
someone approaches you and says, “Let me tell you about a great fund – it
boasts a fixed monthly payout of almost 10 per cent per year”. Would you think
they were lying or would you think it was too good to be true? It wouldn’t be a
lie, per se, but it would definitely be misleading.
Clarington
Canadian Income fund is a balanced fund, investing in a combination of Canadian
stocks, foreign stocks, bonds, and cash. It pays a monthly “distribution” of 8
cents per unit. Many investors needing income will simply take that monthly 8
cents per unit in cash and use it for living expenses. On the surface, it
sounds great and the fund’s value-oriented stock pickers have natural appeal in
this uncertain market. But dig a little deeper and it becomes apparent that
most of that 8 cents is not income at all.
In
aggregate, Clarington Canadian Income fund has paid out a total of $87 million
in monthly distributions, from January 1 1997 inception to June 30 2001. During
that same period, the fund generated just over $24 million in interest,
dividends, and realized capital gains, net of all management and operating
expenses. Again, that’s $87 million of payouts from $24 million of realized income.
No, this isn’t “new math”, it’s giving investors what they want.
In a recent
memo to financial advisors, Clarington describes this as a “return of growth”,
but even that doesn’t capture the true essence of this fund’s distribution
policy. In fairness, Clarington’s goal is to pay out the fund’s entire return
in the form of monthly distributions. However, it would be more accurate to
describe this practice as “borrowing potential future growth”.
An investor
who put $10,000 into Clarington Canadian Income when it was first launched,
would now have an investment worth less than $9,800 if all distributions were
taken in cash. If all distributions were reinvested, this same $10,000
investment would be worth more than $15,300. On this $10,000 investment, more
than $5,500 (i.e. $15,300 – 9,800) would have been distributed to unitholders
over nearly five years. Hence, the distributions have started nibbling at the
original capital. How have they done it? Thus far, picking stocks that have
gone up in value, but haven’t been cashed in yet, has supported the
distributions.
However,
until gains from those stocks are actually realized (i.e. stocks are sold at a
profit), the sustainability of the distribution hinges on greater future
performance – a tall task. Over the next year, the fund has to return 12 per
cent, just to get the unit price back up to $10 and maintain the distribution.
To accomplish this over the next five years, this fund must generate an
annualized return of 10.3 per cent annually. Over ten years, a return just over
10 per cent will do the trick. Is this feasible? I doubt it.
The extent
to which investors in this fund will be disappointed rests completely on the
diligence that financial advisors have shown in educating their clients before
investing their money. If they’ve told them to invest in this fund and reinvest
all distributions – they’ll probably be fine. If advisors have recommended this
fund as a way to boost after-tax cash flow for income-starved investors, disappointment
may well set in within the next few years.
Next
Week: We’ll do the math to see exactly why I think
this fund will have to reduce its distribution or face disappointing its
investors by depleting its capital in the foreseeable future.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.