T Series Funds: The Tax Efficiency Myth and Structural Risk

By Dan Hallett on February 9, 2010

Investors would rather invest in something that distributes a regular amount of cash than sell their shares to generate cash flow.  This psychological phenomenon seems to hold no matter what the source of cash distributions.  Add perceived tax-friendliness and it’s no wonder that T series mutual fund units are so popular.  But the mirage of T series funds’ yield and tax efficiency comes with unique challenges.

T series’ mythical tax advantage

The ‘T’ in T series is short for ‘Tax’– so called because of its perceived tax advantage. The appeal of a T series fund lies in its relatively high and level cash distribution.  The tax moniker is given because the majority of the monthly cash payout is not taxable when received.  Instead, it’s classified as “return of capital” for tax purposes.

To illustrate, compare Fidelity Canadian Balanced Series A with Fidelity Canadian Balanced Series T8.  The A and T8 labels denote separate series of units of the same fund (i.e. identical legal entity).  The A units’ quarterly, uneven distribution is made up only of a sufficient amount of net taxable income to avoid tax at the mutual fund trust level – nothing more, nothing less.

The T8 units pay out an even amount of monthly cash, currently $0.07 per unit.  (The number eight in T8 denotes an approximate distribution rate of eight percent.)  The table below summarizes the sources of total return for series A and series T8 units of Fidelity Canadian Balanced fund.

FIDELITY CANADIAN BALANCED:  A vs. T8 series(Year ended June 30, 2009)
 A seriesT8 series
Distributions (% of NAVPS)
     Dividends1.8%1.8%
     Other income0.2%0.2%
     Cap Gains0.0%0.0%
     Return of Cap0.0%7.7%
     TOTAL DISTRIBUTIONS (a)2.1%9.7%
% change in NAVPS (b)-14.3%-22.1%
Total Return (a + b)-12.2%-12.2%

Sources:  fund annual report and MRFP for year ending June 30, 2009
Totals may not add up exactly due to rounding.

Series A and series T8 are two parts of the same body, so to speak.  It should come as no surprise, then, that the taxable portion of distributions is virtually identical for each series (2.1% of NAVPS).  The total return for each series is virtually identical (-12.2% of NAVPS).  The only difference is the cash paid out in excess of the taxable income, which is classified as return of capital (RoC).

Series A units paid no RoC because its mandate is simply to pay out the fund’s taxable income.  Series T8 units paid out an equivalent of 7.7% in pure RoC distributions.  Accordingly, its unit price (or NAVPS) fell much more (by about 7.7% more) since paying out more cash reduced the fund’s net assets.  A-series investors could have replicated this cash flow stream if they’d simply sold units equal to 7.7%.  Had they done so, they’d have the same amount of jingle in their jeans – and they’d have been left with a capital loss to carry back or forward (because NAVPS fell over the period).

The issue is whether advisors and investors are more comfortable with a falling asset value or a falling unit balance – both involve taking cash out of the portfolio.  One is very explicit (selling units to generate cash) and another is a bit hidden (RoC distributions).  But they place the investor in the identical economic position at the end of the day, both pre- and post- tax.

The one tax advantage never mentioned

There is one instance where a T-series fund can provides real tax benefits.  Suppose you have a big accrued gain in a fund’s A-series units.  If the same fund also offers T-series units, investor can re-designate (i.e. switch) his units from A to T series without triggering a gain because you’ve stayed in the same legal entity.  Then you can take distributions of the T-series fund without selling units to trigger a gain on each sale.

But with a big paper gain, the adjusted cost base (ACB) per unit is low so it won’t take as long for return of capital distributions to reduce the ACB to zero, after which all subsequent distributions are taxed as capital gains.  So this is a tax deferral strategy that will only last a few years and that is only available to investors with large accrued gains.

Distribution mechanics & structural risk

Interest from bonds, dividends from stocks, trust distributions and capital gains from the profitable selling of securities combine to make up a fund’s taxable income. These are the most obvious sources of a mutual fund’s cash flow.

Where a fund pays out in cash an amount that exceeds its taxable income, there are four possible sources of this extra cash.

1. A fund that brings in more money from new and existing investors than it pays out to selling unitholders will be able to use some of the ‘net inflows’ to cover monthly distributions.

2. In the absence of ‘net inflows’, a fund may hold elevated cash reserves to fund monthly cash payouts.

3. A fully invested fund that has no significant ‘net inflows’ can instead sell some of its investments to fund monthly cash distributions (thereby triggering capital gains or losses).

4. Finally, a fund’s last resort source of cash is a line of credit that can be tapped to keep the cash flowing to investors.

In the case of the Fidelity Canadian Balanced fund, both A and T8 series units were in net redemptions for the year ending June 30, 2009 – but series O and B units pushed the overall fund into net sales for the year.  Some of the $562 million in net sales could have been used to fund cash distributions.  T series (T5 and T8 units) account for the vast majority of cash distributions.

For instance, A-series investors of this fund took just 2% of total distributions in cash (i.e. 98% was reinvested into the fund).  Investors in the T8-series units took a full 73% of their distributions in cash.

To the extent that the overall fund falls into net redemptions, the fund will have to resort to options 2 (hold more cash), 3 (sells investments) or 4 (borrow) above to continue paying out cash to investors.  But each of these options has either an associated direct or opportunity cost.  And over time, it could raise costs not just for T-series investors but those in all other series of units.

Advice

With no real tax benefits (save for one rare exception), potential additional costs and the ability to recreate the same cash flow stream using systematic withdrawals, we fail to see any real financial benefits of T-series funds.

We have a record of identifying T-series funds that are at risk of cutting distributions.  Most notable was our December 2001 prediction that IA Clarington Canadian Income-T8 would be forced to cut its distribution.  We were proven right.  When so many investors use the cash for living expenses, advisors must set the right expectations at the outset.  Doing so will make your clients much happier than if you have to explain to them why the cash they’ve been spending cannot continue.

Related:

Putting monthly distributions to the test (Jan 2011)

Monthly income funds’ payout sustainability – the sequel (May 2011)

Distribution rate does not equal yield (Jun 2011)

About Dan Hallett

Dan Hallett is Vice President and Principal at HighView. With over 20 years of industry experience, he is widely recognized as an investment expert. His professional opinion is regularly sought by print, TV, radio, and online media publications. He has also contributed to several best-selling personal finance and investment books.
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