Fixed distributions: The good, the bad and the ugly

When a fund's payout policies are too good to be true, investors end up paying the price.

Vishal Mansukhani, CFA 18 September, 2014 | 6:00PM
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A bird in hand is worth two in the bush -- a proverb dating back to medieval falconry which implies that it is better to have a lesser but certain reward than the mere possibility of a greater one. This perhaps explains the popularity of mutual funds that pay out fixed distributions -- where many view the certainty of cash received as worth more than unspecified gains at some point in the future.

Fixed distributions are a promise that a fund will pay either a fixed percentage of its assets or a fixed dollar amount on a regular basis. In the current low-interest-rate environment, funds that pay fixed distributions are popular because they provide a regular paycheck. But the cash for these distributions has to come from somewhere, and when rates are low, it's harder for funds to earn enough to cover a big payout. When they don't earn enough, the payout comes right out of the fund's principal, creating the illusion of income -- also called return of capital. To make matters worse, this reduces the investment base to grow upon, which in turn diminishes future returns.

Mutual fund providers can take advantage of investors' hunger for income by offering products with high but unsustainable fixed distribution rates. A rate can be deemed unsustainable if it is greater than what a portfolio manager can reasonably expect to earn, thereby eroding capital. Fees set an even higher hurdle for portfolio managers to overcome. Consider a fund with a 1.3% management-expense ratio (the median in the Canadian Fixed Income fund category) and a portfolio yielding 3% (about the Canadian bond market average). Expenses would eat up nearly half of the fund's yield. If, say, the fund had an annual 4% distribution rate, it would need a total return (yield plus capital appreciation) of at least 5.3% to prevent it from eating into capital.

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Vishal Mansukhani, CFA

Vishal Mansukhani, CFA  Vishal Mansukhani, CFA, is a manager research analyst at Morningstar Canada.

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