Beware Funds That Pay More Than They Make

04/03/2013 10:30 am EST

Focus: FUNDS

John Heinzl

Reporter and Columnist,

When a mutual fund's distribution is higher than its inflows, the net asset value declines...and eventually something has to give, writes John Heinzl, reporter and columnist for Globe Investor.

Today’s lesson: When a mutual fund’s distribution seems too good to be true, it probably is.

Back in October 2011, I wrote about the BMO Monthly Income Fund. At the time, the fund was priced at $7.57, and the distribution was 6 cents a month, or 72 cents annually. The annual “yield”—and I’m putting that word in quotations for a reason—was therefore 0.72 divided by 7.57, or about 9.5%.

Wow! Sounds pretty good, right? No wonder Canadians have more than $4 billion parked in the fund.

But let’s look at what has happened since.

Distributing More Than it Makes
Turns out the fund wasn’t actually making anything close to 9.5%. Over the previous three years, it had posted a total return—from dividends, interest, and capital gains—of just 3.1% after fees.

How did it make up the difference? By giving investors their own money back.

When a fund distributes more than it makes, the unit price—or net asset value (NAV)—declines. As recently as 2007, BMO Monthly Income Fund’s NAV was more than $10. As of March 26, it had tumbled to $7.19. So, while investors were collecting those hefty distributions, their capital in the fund was gradually being eroded.

What’s more, because of the falling NAV, the distribution rate has continued to climb. It is now more than 10%. There is simply no way the fund—which has about 53% of its assets in stocks and the rest in bonds and cash—can generate that sort of return consistently. Given the meager returns of bonds, the fund’s equities would have to shoot the lights out year after year.

Chopping the Distribution
Clearly, something had to give.

In a March 11 letter to advisors, BMO Asset Management announced that it will slash the fund’s monthly distribution by 60%, to 2.5 cents from 6 cents, starting on May 16. That would reduce the distribution rate to about 4.2%—more in line with the fund’s actual expected return.

The bank also announced distributions cuts for four other products—namely, the BMO Diversified Income Portfolio, BMO Global Monthly Income Fund, BMO US Dollar Monthly Income Fund, and BMO Guardian US Dollar Monthly Income Fund Advisor Series.

“These changes are being made to ensure each fund’s distribution rate better reflects the fund’s 2013 expected earned income,” the letter said.

According to BMO spokesman Nini Krishnappa, more than 80% of BMO Monthly Income Fund unitholders reinvested their distributions back into the fund. “For those investors, the change will result in no economic impact,” he said in an e-mail.

The Right Thing to Do
Dan Hallett, director of asset management with HighView Financial Group, said he’s pleased with the bank’s decision.

He had analyzed the BMO Monthly Income Fund in 2011 and concluded that its stock component would have to return more than 19% annually, before fees, to maintain the payout level without grinding down the unit price.

Although the distribution cut will hurt investors who were relying on the cash to pay living expenses or service an investment loan, the good news is that the lower payout rate should be sustainable over the long term, he said.

“Let’s hope more companies follow this path to sustainable payouts,” he said.

BMO Not Alone
BMO Monthly Income isn’t the only fund that’s been distributing more than it can reasonably be expected to make, Hallett said. He also singled out certain funds from IA Clarington, NEI Investments, Royal Bank of Canada and Standard Life which, he said, “continue to ‘overdistribute’ in my estimation.”

The high-payout version of the BMO Monthly Income Fund isn’t going away altogether, mind you. Clients who want to maintain their high income stream have the option of switching to newly created Series R funds that will keep the previous distribution rates—with all the risk that entails for the unit price.

Bottom line: Before you consider buying a fund with a high fixed distribution, ask yourself if the fund can cover the payment with its own interest, dividends, and capital appreciation, less fees. Otherwise, you may be getting paid with your own money—and the unit price will drop as a result.

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