Judging income funds

Investors have a tendency to judge mutual funds on a pure performance basis. That’s not only a big mistake, but can also be misleading.Income-oriented funds are an example. What really matters to most people is the cash flow they receive from their invested money and, if the funds are held outside a registered plan, the tax advantages they get. Capital gains are secondary because they can only be realized if the fund is sold.That’s why you should ignore overall performance numbers if you’re seeking income. You need to look behind them to see how the returns are being generated.

The problem is finding that kind of information. That’s why several years ago I started an annual survey of dividend and income trusts funds in my Mutual Funds Update newsletter that focuses on cash flow and tax efficiency. To my knowledge, no one else in Canada does this.

We just published the results for 2002 in our March issue. Here are some of the conclusions we reached.

Traditional dividend funds performed best. There are actually two types of dividend funds. The most common use a blue-chip stock approach in selecting securities.heir portfolios consist primarily of dividend-paying common stocks such as banks and utilities. This type fared relatively poorly in 2002 as all market indexes declined. The second type invests a high percentage of its assets in preferred shares. Normally, these funds produce a lower total return but higher cash flow than their blue-chip counterparts, but in 2002 they fared better on both counts.

Some dividend funds are unpredictable in terms of income. We found some wide variations between the 2001 and 2002 distributions in several cases. For example, in 2001 the National Bank Dividend Fund distributed a total of $1.27 per unit. Last year, it was only $0.49. For anyone depending on those payments for retirement income, that represents a severe drop. The reason for the decline was a significant decrease in the capital gains portion of the distribution, from $0.82 a unit to only $0.13 a unit. A similar situation occurred with several other funds. The message for income investors is to carefully study the distribution history of any dividend fund before making a purchase decision. If steady cash flow is important, focus on funds that pay monthly distributions and which show good consistency over time.

Some dividend funds should be renamed. For years, I pointed out how misleading the name of the AGF Dividend Fund is for investors and suggested it be changed. The fund pays out little or no money (distributions last year were zero). AGF has refused to change the name but at least the fund no longer appears in the Canadian Dividend category (it is now correctly classed as a Canadian large-cap equity fund). There are several other funds that should also be renamed or at least reclassified, based on their payment records. These include BMO Dividend Fund, which distributed only $0.08 per unit last year; Altamira Dividend Fund, which paid out just $0.09; and Standard Life Canadian Dividend Growth Fund, which paid $0.15 a unit over the year.

Some income funds are very tax-efficient. Again this year, our survey found that some income funds were very effective in terms of providing tax advantages for investors if held outside a registered plan. The following table highlights the best performers in this regard. More than half the income generated by these funds was received on a tax-deferred basis.

It’s important to remember that a tax deferral of this type means that the amount of income sheltered from immediate tax must be subtracted from the original purchase price of fund units to arrive at what is known as an adjusted cost base (ACB). The ACB is used to calculate your taxable capital gain or loss when the units are sold.

This article is excerpted from Mutual Funds Update, a monthly newsletter offering guidance on fund investing from some of Canada’s leading experts. For subscription information, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm