BMO Monthly Income sets the distribution bar unreachably high

By Dan Hallett, CFA, CFP

This week the Globe and Mail’s John Heinzl took another run at a favourite fund of mine – BMO Monthly Income.  It’s not my favourite fund for investment but rather a favourite to write about.  In his recent article, Heinzl points out that the fund’s hefty monthly cash payout – now equal to more than 9.5% annualized net of fees – has been well above the fund’s longer-term returns.

Earlier this year, I tested the BMO Monthly Income’s distribution for sustainability.  I found that since the managers would have to generate more than 17% annually from its stock picks that the distribution would either need to be cut or risk further eating into the fund’s principal.  In Heinzl’s article, BMO notes that 80% of investors reinvest this fund’s distributions.

Cash distributions

The BMO stat that only 20% of investors take this distribution in cash is important because it says that most of the fund’s investors don’t need to worry about the fund’s ability to keep up its payout.  What’s interesting, however, is if we look at the percentage of total distributions, in dollar terms, that were reinvested in the fund’s recent financials, we see that only about 67% were reinvested.  Accordingly, about 33% of this fund’s distributions were taken in cash last year.  That’s more worrying given the situation.

(Note:  I calculated these figures from the fund’s Statement of Changes in Net Assets which are available on BMO’s website for the six months ending March 31, 2011 and the years ending September 30 for 2009 and 2010.)

Sustainability update

With nearly 1/3 of distributions having been taken in cash since 2008, sustainability is a legitimate concern generally and a big concern for any investor relying on this fund’s fat payout to pay living expenses.

BMO insists the payout is sustainable, an assertion they base on the fund’s net inflows.  Indeed, while the fund has spent its last two full fiscal years in net redemptions, reinvested distributions have generally kept more money flowing into the fund than leaving.  The only exception so far was 2008, when the fund saw net redemptions of $436 million including reinvested distributions.  But this speaks only to the mechanics of where the money comes from.

When I mention “sustainability” in this context, I’m speaking to the fund’s potential to support the payout with a sufficiently high total return.  And on that basis, there are good reasons to continue questioning its sustainability.

In Heinzl’s article, a back-of-the-envelope calculation indicated that the fund’s stocks would need to generate returns north of 16% annually before fees.  That’s high enough to question long-term sustainability but my current calculation – based on October 19, 2011 data – suggests that the fund’s stocks must pump out returns north of 19% annually (before fees) to maintain the distribution without further eroding the unit price.

BMO certainly can continue to use overall net inflows as a source of cash to pay distributions.  However, the longer-term performance required to fully support the distribution with the fund’s total return is questionable at best.  I expect that BMO will have to cut its distribution at some point, which will be a shock to those using this fund’s payout to pay their bills.

Suitability

Let’s turn the focus to the way this fund is marketed to the general public.  BMO offers user-friendly profiles of its all of its funds, including the Monthly Income Fund.  The profile contains a section called “Who should buy this fund?“.  It reads:

Consider this fund if:

  • you want regular monthly cash flow with the potential for capital gains
  • you’re comfortable with low to medium investment risk
  • you plan to hold this investment for the medium to long term

That first point jumps off the page.  This fund has been around for more than a decade.  And for any investor who bought this in the prior century and took the fund’s offered “regular monthly cash flow” there has been a long-term capital loss.

Here’s another math lesson:  if the unit price falls while the distribution remains unchanged, the distribution rate rises.  As the distribution rate rises, the total return required to support the distribution rises in lock-step.

A fund’s total return is basically the combination of any cash paid out plus (minus) any rise (fall) in the price.  Over the past dozen years, BMO Monthly Income’s unit price has fallen because its total return has been less than its its cash payouts.  My sustainability test suggests the future will be no different – I expect its long-term total return to fall short of its current rate of distributions.

It is misleading, then, to tell investors to expect any potential for capital growth over and above the “regular monthly cash flow” when that hasn’t happened in the past 12 years and isn’t likely to occur in the long-term future.

Related reading

09-Feb-2010:  T-series Funds:  the tax efficiency myth & structural risks

12-Jan-2011:  Putting monthly distributions to the test

31-May-2011:  Monthly income funds’ payout sustainability – the sequel

   
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13 comments to BMO Monthly Income sets the distribution bar unreachably high

  • Excellent post, Dan. The yield illusion is so powerful. Call the distributions “giving you back your own money” and it sounds absurd. Call it “tax-efficient income via return of capital” and people eat it up.

    I thought the most amazing thing about John Heinzl’s article was the revelation that 80% of investors in the fund reinvest the income. What on earth is the point of using an income fund that mostly consists of ROC if you’re going to reinvest the distributions?

  • Thanks Dan. I think it’s a matter of balance. Return of Capital distributions are legitimately tax efficient because it’s an amount paid out in excess of the taxable income. But if the amount is realistic in terms of the portfolio’s total return potential, then it can be a fine way to draw a cash flow from a portfolio.

    As to the point about buying a monthly income fund when reinvesting the distributions, it makes sense to me for one reason; and that is that BMO Monthly Income is a reasonably priced balanced fund. But I know from experience that that many investors equate the monthly distribution with safety, stability and attractive returns. And that’s a perception that is clearly wrong because those attributes will depend on the underlying portfolio not the fund’s distribution policy.

  • As a follow up and to provide a bit of history, I’ve just uploaded a chart showing a tax breakdown of this fund’s distributions over the past dozen or so years. All data for this chart came directly from the fund’s own financial statements and annual reports.

  • JIM COUGLE

    Your comments and this newsletter are greatly appreciated.

    Jim Cougle

  • Another quick follow up…

    It seems I missed a real doozy when writing this up last week. BMO Global Monthly Income Fund is a rather egregious illustration of deliberately ‘over-distributing’.

    This fund pays out monthly cash at an annualized rate of 15.75% net of fees. It’s more than 18% annualized before fees, which translates into required stock returns north of 25% annually to fully support the distribution. About 40% of this fund’s fat distributions are paid out in cash (the rest are reinvested).

    And roughly 95% of the payout is return of capital so it’s no surprise that this fund’s original $10 unit price has plunged toward $4 per unit in seven short years.

    Needless to say that this fund’s distribution is likely to be cut much sooner than that of its Canadian sibling. I give it no more than three years before a cut is announced. But if we hit a bad market, it could happen in the next twelve months.

  • Finally, here is an updated table showing sustainability calculations for a selected group of monthly income balanced funds.

  • Rick Nyman

    Does BMO have more than one Monthly Income Fund.
    The one I have pays out .06cts per unit per month,
    which re-invests the income every month.
    I intend to take the income when I need it which won’t be
    for several yrs.Tks-handay

  • Rick, I know of two monthly income funds sold directly by Bank of Montreal. It sounds like you have the BMO Monthly Income Fund, the subject of the above article. But you can look at my last comment (just before yours) and click on the link to the table and you’ll find both BMO funds listed there with details of distributions and sustainability calculations.

  • [...] Hallet at The Wealth Steward posted BMO Monthly Income sets the distribution bar unreachably high. I don’t invest in this fund, but I did have an experience a long time ago where a fund [...]

  • The Globe & Mail’s John Heinzl is apparently still getting questions from investors confused by return of capital distributions (RoC). Accordingly, he recently wrote the following article, which does a terrific job of explaining RoC.

    What return of capital means to fund investors

  • Mike

    Hi Dan,

    What do you think the BMO global monthly income fund distribution will be cut to to make it a more sound investment?

    Mike

  • Hi Mike. If you look up just a few posts to my reply to one of my October 25, 2011 posts you’ll find a link to a table showing just this kind of calculation for a bunch of funds – including BMO Global Monthly Income. At that time – almost a year ago – I estimated that the distribution would have to be cut by almost 70% to $0.0167 per unit per month to be sustained long-term.

    Now that was a year ago. While my calculation is dated when it comes to specific figures, the overall conclusion isn’t much different.

    The fund closed last week at a unit price of $3.9078. A year ago it was $4.1917 per unit. It looks like the monthly distribution remains at its previous level of $0.055 per unit.

    A year ago, the monthly $0.055 per unit equated to 15.75% annualized. Today, with a lower unit price and the same distribution, the rate paid out equates to 16.89% annualized. So the distribution has continued cutting ever deeper into the fund’s capital by driving down the unit price despite a good double-digit total return.

    If I was to update the estimate of this fund’s sustainable distribution, I suspect that it would be only modestly lower than the $0.0167/unit monthly that I calculated a year ago.

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