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Income-paying funds can be risky ventures

Investors should keep eye on sustainability of unrealized capital gains distributions

This era of low inflation and modest bond yields is a challenge for investors seeking regular income.

Fund companies are filling the void left by low-yielding bond funds by offering income-paying mutual funds with an equity component and higher annual distribution yields. Unlike bonds funds, the distributions aren't fixed, and in some cases are unsustainable.

These income funds pay regular distributions on unrealized capital gains, which occur if an equity investment in a fund has appreciated in value but remains unsold. They do so by issuing a return of capital with no immediate tax bill.

The return of capital will lower the investor's adjusted cost base (the average purchase price) of the fund. The investor pays capital gains tax on the gain when selling the fund. But problems arise if the fund doesn't earn enough capital gains to cover the distribution.

The Fund Library stability rating was developed to point out funds not adequately covering their distributions. It tracks income-paying mutual funds in the balanced, dividend, and income trust categories. (disclosure: I'm president of the fundlibrary.com) There are three ratings: low, medium and high risk. Funds at risk of a distribution cut are deemed high risk.

The rating is a rough assessment of a fund's ability to pay distributions, often predicated on the fund manager's potential to earn capital gains on the fund's equity holdings.

The greater volatility caused by the portfolio's equity component makes the entire proposition more risky. Typically, the volatility of returns on bond funds has been lower than for balanced funds by about half on average over the past five years.

There are potential problems when return-of-capital distributions exceed the fund's capital gains over the year. In this case, investors actually get their capital handed back to them, and the value of the fund is eroded. If the distribution is not cut, the fund's value can fall to nothing.

Fund companies must be prudent about setting distributions to ensure they do not exceed the fund's returns each year. For example, the Bissett Income Fund has a one-year distribution yield of 6.64 per cent as of Aug. 31-- well covered by the fund's one-year return of 18.6 per cent. Since June of this year, the fund has paid a portion of the distribution as a return of capital, to make up for a shortfall of income and capital gains. But the strong gains over the past year more than cover this distribution.

The incentive exists for fund companies to set high monthly distributions to attract investors. The Clarington Global Income Fund has a current yield in excess of 12 per cent annually vis-à-vis a one-year return of 1.6 per cent and an annual loss over the past three years. Such numbers don't add up.

In the case of mutual funds with annual distribution yields well in excess of annual returns, investors should be prepared for a cut in the distribution some time in the future. On several occasions, companies have cut distributions that were too high to be sustained. This could prove to be a real letdown for investors expecting these funds to provide consistent income.

The stability rating fits funds into one of three risk categories -- low, medium or high -- based on stability of the distribution. A fund is deemed high risk at having its distribution cut if the ratio of the annual distribution yield to the one-year return equals 90 per cent or better. A fund is medium risk if the ratio is between 70 to 90 per cent, and low risk if the ratio is safely below 70 per cent. All data are provided by Fundata Canada Inc.

The stability rating is inappropriate for funds that typically don't pay out a set distribution.

The biggest potential weakness of the stability rating is the focus on one-year returns. A fund could have one bad year and not be forced to cut its distribution. Eric Fraipe, vice-president of product management at Clarington Funds, suggests short-term results can be misleading, especially for a fund coming off a near-term rough patch. But the rating is dynamic, changing each month; a fund that improves performance will also potentially see its rating improve.

The near-exclusive focus by investors on high-yielding mutual funds has seen an innovative response by fund companies with new income-paying funds. However, some companies have been too aggressive in setting the distribution on their funds. The new stability rating will reveal which funds are at greatest risk of a distribution cut.

Levi Folk is president and managing editor of fundlibrary.com.

Less stable

Canadian income funds whose stability risk ranks high, according to Fundlibrary. Listed by yield for yearly data ended Sept. 30, 2004.

FUND NAMETypeDistribution yield
Clarington RSP Global Income FundGlobal Balanced & Asset Alloc.16.05%
Stone & Co. Flagship Growth & Income Fund Cda Sr BCdn. Balanced12.58
Stone & Co. Flagship Growth & Income Fund Series ACdn. Balanced12.50
Clarington Global Income FundGlobal Balanced & Asset Alloc.12.28
Clarington Cdn. Dividend Fund CSCdn. Dividend11.95
Trans IMS Dividend FundCdn. Dividend11.41
Mac Cundill Cdn. Balanced Fund Class TCdn. Balanced10.19
Highstreet Years U.S. TrustSpecialty/Miscellaneous9.63
R Monthly Income Balanced FundCdn. Balanced9.62
Clarington Cdn. Income FundCdn. Balanced9.40
Fidelity Global Asset Allocation Fund Series TGlobal Balanced & Asset Alloc.9.38
Mac Cundill Global Balanced Fund Class TGlobal Balanced & Asset Alloc.8.86
Mac Ivy Growth & Income Fund Class TCdn. Balanced8.84
@rgentum Income PortfolioCdn. Dividend8.62
Mac Ivy Global Balanced Fund Class TGlobal Balanced & Asset Alloc.8.52
Fidelity Cdn. Balanced Fund Series TCdn. Balanced8.29
Northwest Growth & Income FundCdn. Balanced8.28
Fidelity Cdn. Asset Allocation Fund Series TCdn. Asset Allocation8.07
Dynamic World Convertible Debentures FundGlobal Balanced & Asset Alloc.7.94
Mac Unv Cdn. Balanced Fund Class TCdn. Balanced7.93
Clarington Cdn. Income Fund II Series ACdn. Balanced7.87
Mac Balanced Fund Class TCdn. Balanced7.53
AIC Private Portfolio Counsel Income PI-CIT UnitsSpecialty/Miscellaneous6.31
Clarington Cdn. Income Fund II Series BCdn. Balanced4.93

SOURCE: FUNDDLIBRARY.COM AND FUNDATA

© 2007 The Globe and Mail. All rights reserved.

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