Clarington
Canadian Income faces high hurdle
Last week (http://www.sterlingmutuals.com/Telus_FakeYield_07dec2001.htm),
I expressed my beef with mutual funds that offer a fixed level of
distributions. In particular, I featured the Clarington Canadian Income fund,
and its fixed payout policy. For this fund to raise its unit price back to its
original $10 and simply maintain the 8 cent per unit monthly distribution, the
fund would have to return a total of 12, 11, and 10 per cent per year, over the
next one, five, and ten years, respectively, using recent unit prices. This
week, we look at why disappointment will soon set it for investors that are
relying on this fund’s generous distribution.
That 10 per
cent return needed for Clarington Canadian Income to sustain its distribution
without dipping into capital over the next ten years is net of the fund’s 2.54
per cent management expense ratio (MER). Hence, if we look at gross returns
(i.e. before the MER), the fund will have to produce a return of 12.54 per cent
annually (0.10 + 0.0254 = 0.1254 or 12.54 per cent). Roughly half of this fund
is invested in bonds (43 per cent) and cash (7 per cent). The rest is in
foreign stocks and, to a lesser extent, Canadian stocks.
The bonds
in this fund have an estimated current yield of about 6.1 per cent. Since it
makes up 43 per cent of the fund, the bonds’ contribution to the fund’s total
return is 2.62 per cent per year (0.061 x 0.43 = 0.0262 or 2.62 per cent). The
seven per cent allocation to treasury bills currently yields an estimated 2 per
cent per year – for a contribution to total return of 0.14 per cent per year
(0.02 x 0.07 = 0.0014 or 0.14 per cent). Hence, the total of bonds and cash
will contribute an estimated 2.76 per cent annually to the fund’s gross total
return.
If interest
rates rise, that “current” yield will increase on the bonds and cash, but the
bonds will suffer price declines, which will likely offset any pick up in
yield. (And don’t forget that rising rates is also bad for stock prices.)
Hence, for simplicity, I’ve assumed flat interest rates – a very optimistic
assumption given today’s ultra-low interest rates.
Since the
fund needs a total annualized return of 12.54 per cent annually before fees,
the stock portion must kick in the remainder – 9.78 per cent (0.1254 – 0.0276 =
0.0978 or 9.78 per cent). While a return of less than ten per cent sounds
pretty feasible over ten years, don’t forget that stocks only make up half of
this fund. So that means the stocks in this fund must produce a gross return of
19.56 per cent annually (0.0978 ÷ 0.5 = a gross return of 0.1956 or 19.56 per
cent annually) for the next ten years just to maintain the current
distribution. Even with a greater emphasis on stocks, the return requirement
from that component would still approach 16 per cent annually before fees.
I’m sorry
to tell you that it just isn’t feasible, in my opinion.
If I’m
right about the return needed to sustain the current distribution not being
feasible, the fund will have two choices:
reduce the distribution or risk eroding the fund’s unit price over time.
Do you believe it’s possible to erode the capital with such a high distribution
over a long period of time? Fund supporters might argue that the managers are
very astute and, over time, will probably make up for this high distribution. I
would disagree, though it wouldn’t have anything to do with my assessment of
the manager’s skills.
Take a look
at Mackenzie Financial’s Industrial Income fund. It also fixed its distribution
at a high level ($0.25 quarterly per unit – between 10 and 12 per cent of the
unit price for many years) some time ago. It used very long-term bonds to
sustain this and it worked for a while because rates were high and falling.
However, even that environment wasn’t favourable enough to save capital from
eroding.
The
original Industrial Income fund – the A units – has seen its unit price fall
nearly 30 per cent over the past sixteen years – that’s an annual compound loss
of more than 2 per cent per year. Yes, distributions have been made
consistently, which would have produced a decent total return if reinvested. However,
this distribution has been paid out at the expense of future inflation
protection and preservation of the original investment.
The other
problem is that the distribution five and ten years from today will not be
worth nearly as much as it is today. The result: Having the distribution increase with inflation is sacrificed at
the expense of higher payouts today. The payout is so high to start with, that
the fund has no chance of growing the capital. Effectively, the investor is
left to reinvest a portion of the distribution if capital is to be fully
maintained and/or grow.
My
cautionary tone is only aimed at those depending on the overly generous
distribution to pay for living expenses. If most or all of the distribution is
reinvested, the depletion of capital is really not an issue. However, I am
making an assumption that most investors in the Clarington Canadian Income fund
are using the distribution to pay for living expenses (i.e. taking it in cash).
Otherwise, why would they pay such a generous distribution; and why would they
offer a nearly identical fund, Clarington Canadian Balanced, which is run by
the same team and distributes only “realized income and capital gains”.
(Clarington Canadian Balanced does, however, charge a substantially higher 2.9
per cent MER.)
Recall that
when you receive a distribution and have it reinvested back into more units of a
fund, it raises your cost for tax purposes (ACB – adjusted cost base). When
reinvesting distributions that are simply a “return of capital” there is no
change in the ACB. In fact, when taking a return of capital distribution “in
cash”, your ACB is reduced. The distribution isn’t taxed when received because
it’s not income – it’s capital – but you reduce your cost, which means larger
capital gains later when you sell.
I should
clarify again that Clarington’s distribution policy on their Canadian Income
fund is that they’ll continue to pay the current monthly 8 cents per unit as
long as they think it can be sustained. Otherwise, they will cut it.
To sustain
the current distribution and preserve capital, the 10 per cent annualized
return needed over the next ten years is unrealistically high. Further, if
interest rates rise over the next ten years, which is likely, it may be that
much tougher to leap that high hurdle. In my opinion, Clarington Canadian
Income fund will have no choice but to cut its distribution within the next
twelve to twenty-four months.
If you deal
with a financial advisor, s/he should clearly explain the fund, its
distribution policy, its supporting investment strategy, and the implications
thereof.
If you
depend on this fund’s distribution, start adjusting your expectations now,
before you’re forced to.
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.