Finance & Investing: Cherry Picking

Picture 3.png

By: Gordon Pape

This is a true story. It has happened to tens of thousands of Canadians. You may be one of them, although you may not realize it yet. A reader wrote to me asking about a monthly income fund she had invested in. She had chosen it because she needed cash flow, and each unit paid a distribution of $0.06 a month. She was still receiving the income but she was worried.

“The market has not been great, but the fund continues with the distribution,” she wrote. “Can it be that the monthly distribution I’m receiving is my own capital investment? If so, it can be exhausted down the road. I hate to sell the fund now as I don’t want the loss. Please explain how the company manages this kind of fund.”

Her concern was well-founded. In fact, the situation was even worse than she realized. Yes, she was receiving her own money back. On top of that, the value of her investment had fallen and, to add insult to injury, she was paying the fund company a fee for its “service.”

I took a close look at the numbers for the fund in question. Over the 12 months to April 16, investors received a total of $0.72 a unit in distributions. But during that time, the fund’s net asset value (NAV) fell from $9.26 to $7.49 per unit, a decline of $1.77. That means the value of an investment in 1,000 units of the fund dropped from $9,260 to $7,490 over the year. So the situation for our reader was worse than she realized. She actually lost 11.3 per cent over that time, once the distributions were taken into account.

I have not identified the specific fund because virtually every other mutual fund of this type produced a similar result over the same period of time. Except for funds that invest exclusively in bonds, almost every income fund showed a net loss over the year ending April 30.
The reason is simple. All balanced income funds include some stocks in their portfolios. When the market collapsed last
fall, not even the most conservatively managed funds were able to escape. Most recorded double-digit losses, even after taking the distributions into account.

Investors were shocked. Monthly income funds had come to be regarded as a safe source of steady cash flow and, in fact, many had never lost money before. The sharp drop in valuations left people wondering what to do. A chunk of their savings had melted away, and they didn’t want to lose any more.

I understand the concern, but my advice is to get over it. The market meltdown of 2008-09 is history. There may still be some bumps to come, but I believe the worst is behind us, and most monthly income funds have started to rebuild their NAVs. This is not the time to bail out — that train left the station almost a year ago.

However, this does not mean you should take needless risks. Some income funds are better positioned than others to protect your capital, and if you’re the nervous type, you should consider them first.

Here are some points to look for.

1- THE FUND’S MANDATE It’s important to understand the parameters within which a fund manager operates. Some have wide latitude in determining
a fund’s asset allocation while others are more constrained. The fund’s mandate will
be stated in its prospectus. Read it carefully, keeping in mind that the vaguer it is, the more flexibility a manager has.

2- KNOW THE CATEGORIES Sometimes, the category into which a fund is slotted can be more revealing than the official mandate contained in the prospectus. Mutual fund categories are estab-
lished by the Canadian Investment Funds Standards Committee (CIFSC) and the criteria are tightly defined. As a general rule, funds that put more emphasis on fixed-income securities will carry less
risk. For example, a fund in the Canadian Fixed Income Balanced category cannot invest more than 39 per cent of its assets in stocks. A Canadian Neutral Balanced
fund will be 40 per cent to 60 per cent in equities, while a fund in the Canadian Equity Balanced group will be 61 per cent to 89 per cent in the stock market. So if you’re looking for a low-risk balanced income fund, start with the Canadian Fixed Income Balanced category. Find a complete list of funds in that group on the CIFSC website at

Don’t be deterred from investing in a fund because it shows a negative return over the most recent 12 months. Almost all balanced funds are still displaying the effect of the market plunge. Instead, compare the performance of a fund to its peers over the long term. If it has consistently outperformed in the past, the chances are it will continue to do so in the future.

4-DON’T BE FOOLED BY THE NAME There are lots of funds that include the word “income” in their name but which, in reality, are poor choices for cash flow. For example, both the Mackenzie Ivy Growth and Income Fund and the CI Harbour Growth and Income Fund only make payments once a year, in December. Both funds are popular with investors, but if you need regular cash flow, you’ll need to look elsewhere.

5-SEE IF THE PAYOUT IS REALISTIC Never choose a fund based only on its distribution. A high payout may be unsustainable. What’s the point of getting a fat monthly cheque if most or all of it is your own money? You might as well keep the cash in a bank account and avoid paying fees to a fund manager.
Before you invest, calculate the fund’s projected 12-month yield by dividing the expected payout by the current net asset value. For example, let’s consider a fund that pays $0.06 a month ($0.72 a year) and has an NAV of $10. In this case, the projected yield of 7.2 per cent should be seen as a caution light.
Where is this money going to come from? With interest rates at record lows, clearly the fund will have to generate significant capital gains over the period. If it fails to do so, the net asset value will drop, which effectively means you are being paid with your own capital. I suggest that any payment that projects to a yield of more than four per cent annually should be viewed with skepticism.
If a four per cent yield is inadequate for your needs, you will have to accept a higher degree of risk in your fund selection. That’s fine as long as you are aware of it; unfortunately, many people were not and were blindsided as a result when the stock market fell.
Investing for income is never easy, and it’s especially difficult now with interest rates down and income trusts rapidly vanishing as the new trust tax approaches (it starts in the 2011 tax year).
But there are funds that offer respectable cash flow and relative safety. Take the time to search them out.

Gordon Papes
latest financial book,Tax-Free savings accounts: A Guide to TFSAs and how they can make you rich, is published by penguin Canada.