This fund is unlikely to sustain its newly-lowered monthly payout

By Dan Hallett, CFA, CFP

I have been writing articles in the public domain for more than 13 years.  No series of articles has generated more interest or feedback than my many critiques and analyses of monthly income fund and assessing distribution sustainability.  Below is an edited version of the latest note from a reader named Derek with a link or two added:

In follow-up to your articles on T-series mutual funds to prove some of your points in the article, I think you could do an eye-opening analysis on the Clarington Canadian Dividend Fund (CCM511). I bought a substantial position in 2005 at $7.72/unit and I have watched the ROC distribution erode the NAV ever since then. Now, IA Clarington has decided to reduce the monthly distribution, again, to $0.038 per unit effective June 28, 2013 (down from $0.051 monthly per unit). They are blaming the “flat markets” since 2010 as the primary reason for this action. I’d love to hear your thoughts on this fund.

The negative side of compounding

I continue to be amazed by some of these products that pay out fat monthly cash amounts.  I know of this fund but have not followed it closely.  When I first looked it up in response to Derek’s note, the sub-$4 unit price prompted me to double check to make sure I had the right fund.

But such is the (negative) power of overdistributing – particularly in a volatile fund.  IA Clarington Canadian Dividend is entirely invested in stocks (unlike the many others I have reviewed and analyzed, which were balanced funds with stocks and bonds).

Distribution sustainability

Based on this fund’s May 22, 2013 unit price of $3.91, the new level of distributions that Derek notes equates to 11.66% per year (i.e. $0.038 x 12 / $3.91).  And that’s net of the fund’s 2.76% management expense ratio (i.e. MER).  Add 2.76% to annualized net payout and you have a fund that needs to kick out returns of almost 15% annually just to support the distribution and keep the unit price from falling more than it has.

Simplistically you might calculate this required return as 11.66% + 2.76% to arrive at a required return of 14.42% per year.  But a fund’s annual fees (i.e. MER) have a compounding effect.  So the calculation should be 1.1166 x 1.0276 – 1, which equals a return of 14.74% per year needed to support the distribution – before fees.

I always put the required return in a pre-MER context so that it can be cleanly assessed and compared against other funds offering a monthly cash payout.  In this case, it’s helpful to note that based on current stock valuations, a long-term future return of 7% to 8% annually isn’t out of the question (before any fees, taxes or valued added - or detracted - from active management).  But it’s far from a sure thing.

Great expectations

In order for this fund to support its new, lower distribution the fund’s lead manager will have to:

  • capture the stock market’s full return potential; and
  • add an enormous amount of value on top of the market’s return (effectively doubling the market).

The chances of that happening are unlikely in my opinion.  Accordingly, look for this fund to require another distribution cut within a year or two – a timeline that can be shortened or lengthened by the market’s direction over the next 12-24 months.  This analysis should be of particular interest to anyone using this fund’s distribution to pay for lifestyle expenses or as a key investment in a leveraging strategy.


12 comments to This fund is unlikely to sustain its newly-lowered monthly payout

  • Sadly, I fear that the next distribution cut may take longer than 2 years to arrive. This means that clueless investors will spend principal longer before they have a chance to see their mistake.

  • Unfortunately you may be right Michael. A fund sponsor may not want to cut payouts too often. But many of these funds – particularly the older ones that have eroded capital a lot already – have a policy of reviewing distributions annually to determine whether a change is needed.

    Hopefully sooner rather than later but chances are they won’t slice the distribution in half, which is what they’d need to do to make this fund’s payout more sustainable longer-term. It will be interesting to follow up on this one next spring.

  • Rob

    What investors need to do is have a very frank discussion with their advisors about why they put them in this fund and ask whether they were aware that fund managers had to get 14% just to break even.

    If the advisor didn’t know, then I think they should be fired. Not knowing basic facts like this, about a product they are selling is pathetic and very telling about ability.

    If they did know and claimed they thought that was feasible,you have to question them further as to why…. I can’t think of an answer that would satisfy me but ask them for specific rationale for their thinking. If (or more likely when) they can’t give a good answer, you should fire them.

    I am an advisor and see comment after comment about how advisors are terrible (true in a great many but not cases – there are god ones) , but people need to become better purchasers of financial advice.

    I think this analysis by Dan is great but the perfect article would have finished with the point that the advisor selling such implausible investment outcomes should be fired.

    Until people start firing bad advisors in greater numbers, nothing will change.

  • Thanks for your comments Rob. Given the falling unit price, the break-even return number would have been lower in the past but still high. If memory serves, this fund was launched in the 1990s near the time that the original Clarington Canadian Income fund was launched (it now bears the name Strategic Income) and both started at net distribution rates of around 10% per year.

    Still Rob, your point is a good one and it speaks directly to the know your product (KYP) requirements. Thanks again for adding to this discussion.

  • Steve

    So what advice would you give to someone seeking to get out now before the initial valuation declines even further?

    My initial reaction is to take all the income received over the years out of RRSP’s (thats where it went) and pay back the shortfall and don’t look back.

    Any advice would be appreciated.

  • Thanks for your question Steve. The correct course of action for each investor will be different depending on the specific circumstances. For those who simply bought this fund and had the distributions reinvest (in this same or some other fund/investment), I’m not sure there is any urgency to make any change. This isn’t a fund I’ve ever recommended but if the distributions aren’t being ‘spent’ there is no obvious emergency to such situations.

    The other extreme, however, seems more typical of the emails I’ve received – and continue to receive – privately. As I wrote in a recent Investment Executive article:

    If I were the chief compliance officer of a dealer, I would not allow any T-series fund sales that involved: borrowing to invest in funds that have a policy to pay distributions exceeding pure yield; taking the mostly “return of capital” (RoC) distribution in cash; and using that cash to pay down the loan.

    The natural inclination would be to say that if something isn’t suitable for most to start with, it should be unwound as soon as possible. But there may be exit fees on the investments or the investments may be worth less than the loan. I would generally agree with the “unwind” option but it need not be done all at once.

    Unlike with band-aids, it could make sense to unwind this more slowly. It all depends on the details.

  • Gerald Johnston

    I guess a bigger question is how many of these type of funds are out there in the same boat?
    It would be interested to do an analysis in Money Sense on where they stand.

  • It’s a good question Gerald. I know that there are many of them but I can’t quantify more precisely. As for MoneySense, it’s a good publication but I don’t write for them. While many others are certainly capable, I haven’t seen anybody else really tackle this issue the way that I have over the past dozen years.

    I figure if I keep showing examples of over-distribution that the word will get out on specific products and that individuals and advisors will start to pay more attention to sustainability and apply the analysis I’ve illustrated over the years to test any fund in which they’re interested.

  • Jim

    I too bought a fund that payed a monthly dividend (BMO monthly income fund) and was concerned over the constant lowering of the fund price for the last several years when the market was significantly increasing. When I contacted BMO Investments and expressed my concerns that the fund could not sustain itself with the payout of $.o6 they indicated that now I have more units and therefore I haven’t lost money.

    When I take the total amount of dividend reinvestment and add it to my initial investment and multiply the total number of units by the price, I am now over $10,000 lower then my total investment . Oh yes, they recently lower the dividend to $.024 which is a 60% drop!

    I believe that the managers of this fund were not doing their due diligence !

  • Thanks for your note Jim. Your experience is all too common. There are two parts to any product like this, however. One is the underlying money management, which should be managing the fund in accordance with the fund’s investment policies & goals and to the other applicable legal restrictions. I don’t have much doubt that the fund managers do this well, generally speaking.

    The second part is the marketing department. One could argue that BMO Monthly Dividend‘s original distribution was justifiable. But clearly at some point it was very clear that its $0.06 monthly per unit distribution was never going to be sustained (short of a stock picking miracle).

    I should stress that I do not know what processes or discussions occurred at BMO behind the scenes. But I am aware of other seemingly similar situations where portfolio managers push for a distribution cut while marketing executives push for the status quo (for fear that a payout cut will crimp sales).

    This kind of tug of war happens. And marketing departments win too often. The industry needs a better balance between marketing and money management to minimize the incident of products like these high payout funds.

  • Ian

    I was so surprised to learn at tax time that the “dividends” on Riocan (REI.UN) were largely return-on-capital. Indeed the ROCs were itemized for every month on the tax form. Surely it is a no-brainer for the broker to report the factual transaction in the monthly statement.
    Is this a failure of the broker in not reporting or do regulatory authorities have a role?
    IIROC claims that its members are committed to transparency. How about walking the talk?

  • Thanks Ian for your comments and questions.

    When a mutual fund like the monthly income funds I’ve written about pay a return-of-capital distribution, it means that they’ve paid out cash in excess of the fund’s taxable net income. The same applies to REITs.

    The difference is that many monthly income funds pay out cash exceeding income + capital appreciation. RioCan appears to target a payout that approximates 100% of its net free cash flow. For example, during its latest six months, RioCan paid out about 97% of its free cash flow as a distribution. (See bottom of page 22 – marked as page 20 – in RioCan’s latest quarterly financial statements”.)

    In 2012 they paid out 99% of AFFO and in 2011 the payout ratio was 107% (source: page 44 – marked 42 – in 2012 annual report). AFFO = adjusted funds from operations which is a measure of free cash flow for REITs.

    Also, many REITs depreciate some of their assets providing them with a deduction from net income. This depreciation for tax purposes is one source of return-of-capital for REITs so it doesn’t always have the same meaning as a RoC distribution from a mutual fund investing in stocks and bonds.

    RioCan and every REIT is no different from any stock or equity in terms of its overall risk level. They all have business risk and are exposed to economic risks. Still, I would be a lot more worried about the sustainability of distributions from the monthly income funds from the likes of IA Clarington, BMO and others than I am about RioCan’s ability to sustain its payout.

    The risks are different but RioCan appears to be covering its distribution out of pure cash flow so not sure it’s a big concern. So I don’t think there has ben any failure by brokers or regulators in this context.

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