Funds fail
to clear distribution hurdle
Over the
past twelve to eighteen months, financial markets have been flooded with newly
issued funds promising a fat monthly distribution. Investors couldn’t get
enough of these new funds gushing with cash flow in this very low interest rate
environment. Problem is, most of these funds made promises they couldn’t
realistically keep over time. Proof:
Many funds have recently announced deep cuts in their monthly payouts.
This mutual
fund was launched back in 1996 with the goal of paying out a monthly cash
distribution that roughly equaled the fund’s total return. Favourable market
conditions and astute management allowed the fund to pay out its fat 9.6 per
cent annual distribution ($0.08 per unit per month; fund was launched at a $10
unit price). Just six months ago, I wrote two articles - Phantom Yields (http://www.sterlingmutuals.com/Telus_FakeYield_07dec2001.htm)
and Reality Check (http://www.sterlingmutuals.com/Telus_FakeYield_II_14dec2001.htm)
- which criticized such aggressive
payout policies and the Clarington fund in particular.
I predicted
that Clarington Canadian Income’s monthly distribution of $0.08 per unit would
be cut within the next twelve to twenty-four months. Suffice it to say that
many people gave me a lot of grief over that prediction – mostly from financial
advisors who widely recommended it to clients. Some suggested that I “didn’t
know what I was talking about”. Yet, just a couple of days ago, Clarington confirmed
that the monthly distribution on its Canadian Income fund would drop to $0.06
per unit, starting August 31, 2002. The announcement was made as a result of
the fund’s 4 per cent decline in the first twenty days of June alone.
Based on
the recent unit price of $8.73, that’s still a payout rate of 8.2 per cent per
year. In my opinion, this rate remains unrealistically high to the extent that
I wouldn’t be surprised if Clarington reduced the distribution further within
the next eighteen months.
(As an aside,
Clarington recently launched two new versions of this same fund – each offering
respective distribution rates of $0.04 and $0.06 per unit per month.)
Clarington
was very clear in its memo that it would reduce the payout further if poor
market conditions persisted. However, they also stated they wouldn’t hesitate
to bump it back up in the face of a strong market recovery. Only time will
tell.
High-payout
balanced funds aren’t the only income-oriented vehicles with a case of the
blues. So-called “structured products” have also had a tough go of it lately.
Triax Capital launched its exchange-traded CaRTs (Capital Repayment Trust)
units on May 31, 2000. The idea was to:
a) pay back investor’s original capital of $25 per unit in ten years; b)
provide an income stream of at least $0.5781 per unit; and c) hopefully give
investors some growth.
As the link
above explains, this three-pronged strategy would be accomplished by taking the
money raised by selling units at $25 and setting aside some money for each
objective. For instance, if a guaranteed rate of return of 6 per cent per year was
expected, about $14 out of every $25 unit could set aside to make sure $25 was
repaid in ten years. ($14 grows to $25 if it earned about a 6 per cent compound
annual return.) In this example, that would leave $11 to apply to the fund’s
other objectives.
The income
generation was supposed to come from a strategy known as “covered call option
writing”. I won’t bore you with the complex explanation, but suffice it to say
that as stocks get more volatile (up and down price swings), the strategy
generates more income. If stock volatility decreased, the strategy would get
more aggressive to keep up the payout rate, and vice versa. Ironically, this
strategy – by definition – limits the potential upside of the underlying
portfolio so I haven’t a clue how they planned on growing the underlying
portfolio on top of the other two objectives.
As you’ve
already guessed by the title of this article, they’ve been unsuccessful. On
this and many other of Triax’s structured products, distributions have dropped
dramatically. Distributions on CaRTs started at $0.78 per unit per quarter, but
have fallen to a quarterly amount of just $0.3125 per unit.
Neither of
these recent events should really be termed a failure because their initial
promises were unrealistically optimistic – particularly in the case of
structured products. To follow up on Triax and management’s commentary, visit
the news page (http://www.triaxcapital.com/in_the_news/)
on their website.
Investors’
hunger for investments generating a decent amount of income has continued to
lend encouragement to the investment industry to keep pumping more of these
high-payout products through the pipeline. Mackenzie, Fidelity, and most
recently Franklin Templeton now offer so-called “T-SWP” (tax-efficient
systematic withdrawal plan) funds. Each uses its most popular balanced funds
and offers a monthly payout equal to about 8 per cent annually. Franklin
Templeton is also using some of its more popular pure stock funds as the
underlying strategy for some of its new T-SWP offerings.
I would
urge investors and advisors to use such high-payout funds with extreme caution.
Recent research I did on sustainable withdrawal rates suggests that any
investor that takes regular withdrawals at such a high rate runs a very serious
risk of running out of money prematurely. In fact, withdrawal rates that
started at 8 per cent of beginning portfolio value in the past ran out of money
more than half of the time in tests I did recently.
Paying
taxes, making sure your cash flow rises over time with inflation, and coping
with the swings of the stock market are the main reasons why taking a more
reasonable level of withdrawals is your best bet to make sure you don’t outlive
your money. With T-SWP and other high-payout funds, it means making sure you
don’t rely too heavily on them for cash flow.
And if your
eyes glaze over as you try to make sense of this stuff, just remember
this: there is no such thing as a free
lunch.
Dan Hallett, B.Comm., CFP, CFA is the 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, Alberta, and Manitoba.