By Mark Barnicutt on June 21, 2002
Over the past twelve to eighteen months, financial markets have been flooded with newly issued funds promising a fat monthly distribution. Investors couldn’t get enough of these new funds gushing with cash flow in this very low interest rate environment. Problem is, most of these funds made promises they couldn’t realistically keep over time. Proof: Many funds have recently announced deep cuts in their monthly payouts.
Clarington Canadian Income
This mutual fund was launched back in 1996 with the goal of paying out a monthly cash distribution that roughly equaled the fund’s total return. Favourable market conditions and astute management allowed the fund to pay out its fat 9.6 per cent annual distribution ($0.08 per unit per month; fund was launched at a $10 unit price). Just six months ago, I wrote two articles which criticized such aggressive payout policies and the Clarington fund in particular.
I predicted that Clarington Canadian Income’s monthly distribution of $0.08 per unit would be cut within the next twelve to twenty-four months. Suffice it to say that many people gave me a lot of grief over that prediction – mostly from financial advisors who widely recommended it to clients. Some suggested that I “didn’t know what I was talking about”. Yet, just a couple of days ago, Clarington confirmed that the monthly distribution on its Canadian Income fund would drop to $0.06 per unit, starting August 31, 2002. The announcement was made as a result of the fund’s 4 per cent decline in the first twenty days of June alone.
Based on the recent unit price of $8.73, that’s still a payout rate of 8.2 per cent per year. In my opinion, this rate remains unrealistically high to the extent that I wouldn’t be surprised if Clarington reduced the distribution further within the next eighteen months.
(As an aside, Clarington recently launched two new versions of this same fund – each offering respective distribution rates of $0.04 and $0.06 per unit per month.)
Clarington was very clear in its memo that it would reduce the payout further if poor market conditions persisted. However, they also stated they wouldn’t hesitate to bump it back up in the face of a strong market recovery. Only time will tell.
High-payout balanced funds aren’t the only income-oriented vehicles with a case of the blues. So-called “structured products” have also had a tough go of it lately. Triax Capital launched its exchange-traded CaRTs (Capital Repayment Trust) units on May 31, 2000. The idea was to: a) pay back investor’s original capital of $25 per unit in ten years; b) provide an income stream of at least $0.5781 per unit; and c) hopefully give investors some growth.
As the link above explains, this three-pronged strategy would be accomplished by taking the money raised by selling units at $25 and setting aside some money for each objective. For instance, if a guaranteed rate of return of 6 per cent per year was expected, about $14 out of every $25 unit could set aside to make sure $25 was repaid in ten years. ($14 grows to $25 if it earned about a 6 per cent compound annual return.) In this example, that would leave $11 to apply to the fund’s other objectives.
The income generation was supposed to come from a strategy known as “covered call option writing”. I won’t bore you with the complex explanation, but suffice it to say that as stocks get more volatile (up and down price swings), the strategy generates more income. If stock volatility decreased, the strategy would get more aggressive to keep up the payout rate, and vice versa. Ironically, this strategy – by definition – limits the potential upside of the underlying portfolio so I haven’t a clue how they planned on growing the underlying portfolio on top of the other two objectives.
As you’ve already guessed by the title of this article, they’ve been unsuccessful. On this and many other of Triax’s structured products, distributions have dropped dramatically. Distributions on CaRTs started at $0.78 per unit per quarter, but have fallen to a quarterly amount of just $0.3125 per unit.
Neither of these recent events should really be termed a failure because their initial promises were unrealistically optimistic – particularly in the case of structured products. To follow up on Triax and management’s commentary, visit the news page (http://www.triaxcapital.com/in_the_news/) on their website.
New offerings abound
Investors’ hunger for investments generating a decent amount of income has continued to lend encouragement to the investment industry to keep pumping more of these high-payout products through the pipeline. Mackenzie, Fidelity, and most recently Franklin Templeton now offer so-called “T-SWP” (tax-efficient systematic withdrawal plan) funds. Each uses its most popular balanced funds and offers a monthly payout equal to about 8 per cent annually. Franklin Templeton is also using some of its more popular pure stock funds as the underlying strategy for some of its new T-SWP offerings.
I would urge investors and advisors to use such high-payout funds with extreme caution. Recent research I did on sustainable withdrawal rates suggests that any investor that takes regular withdrawals at such a high rate runs a very serious risk of running out of money prematurely. In fact, withdrawal rates that started at 8 per cent of beginning portfolio value in the past ran out of money more than half of the time in tests I did recently.
Paying taxes, making sure your cash flow rises over time with inflation, and coping with the swings of the stock market are the main reasons why taking a more reasonable level of withdrawals is your best bet to make sure you don’t outlive your money. With T-SWP and other high-payout funds, it means making sure you don’t rely too heavily on them for cash flow.
And if your eyes glaze over as you try to make sense of this stuff, just remember this: there is no such thing as a free lunch.
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