Increase income, save taxes — tall order

I received an e-mail recently from a gentleman who said he was looking for mutual funds that "yield good returns at reasonable risk, without the heavy tax grab by the government, both on a yearly basis and at redemption time."

That’s a tall order – good, tax-efficient returns, with moderate risk. We’d all love to find that magic formula. But there are a couple of funds that fit the bill. Here’s the run-down.

  • Guardian Monthly High Income Fund:. This one carries the higher risk of the two because it invests almost entirely in real estate investment trusts (about 40% of the portfolio), royalty trust units (29%) and income trust units (16%). This makes it much more volatile than a traditional bond or dividend fund. However, offsetting that is strong cash flow (the units pay 6cents a month) and some excellent tax advantages.

We did an analysis of this fund and found that in calendar 1999, the total distribution was 72 cents, which represented a 6.8% yield based on the price on January 1st of that year. With the oil and gas sector doing so well at this time, there is reasonable to assume that the managers will suain the 6 cents a month distribution, as they have since the fund’s inception in late 1996.

So, based on the recent price, the units should produce a cash flow of between 9% and 10% over the next 12 months. For units held outside a registered plan, much of that will be tax-sheltered – about 65% of the 1999 distribution was classified as "return of capital" and therefore not taxed in the year received.

However, all such tax-deferred income is subtracted from your adjusted cost base, which means your exposure to capital gains tax will be higher when you sell. The good news is that the inclusion rate for capital gains is now down to 66-2/3%. Who knows, maybe it will be even lower when and if you do sell the units.

  • Signature Dividend Income Fund: For less risk, but a somewhat lower return and less impressive tax breaks, choose the Signature Dividend Income Fund from the C.I. group (this was formerly the BPI Dividend Income Fund). Many so-called dividend funds are in reality simply blue-chip stock funds. This one comes closer to a true dividend fund. About half the assets are in preferred shares, thus providing good cash flow and stability. Most of the rest of the portfolio is in common stock (banks and utilities mainly).

In terms of cash-on-cash yield, this was one of the best performers in 1999 in the annual survey of dividend funds done by the Mutual Funds Update newsletter, as it had been the year previous. Cash flow yield during the year was 5%, most of which was eligible for the dividend tax credit if the units were held outside a registered plan. There was no return of capital here, so no tax deferment and no adjusted cost base.

Total return has consistently been above average for the Canadian Dividend category since Eric Bushell took over as manager. In the first five months of 2000 (to May 31st ), the fund showed a total return of 8.4%. The safety record is very good, making this fund a fine choice if you’re looking for a combination of dividends and modest capital gains. Distributions are paid monthly.

So there you have it. The Guardian entry offers superior cash flow and better short-term tax treatment, but the risk is higher and the tax bite when the units are sold will be greater. The C.I. Signature fund is safer, but your cash yield will be less and your tax rate higher. It all comes down to what your main priorities are.