This fund is unlikely to sustain its newly-lowered monthly payout

By Dan Hallett, CFA, CFP on May 23rd, 2013

I have been writing articles in the public domain for more than 13 years.  No series of articles has generated more interest or feedback than my many critiques and analyses of monthly income fund and assessing distribution sustainability.  Below is an edited version of the latest note from a reader named Derek with a link or two added:

In follow-up to your articles on T-series mutual funds to prove some of your points in the article, I think you could do an eye-opening analysis on the Clarington Canadian Dividend Fund (CCM511). I bought a substantial position in 2005 at $7.72/unit and I have watched the ROC distribution erode the NAV ever since then. Now, IA Clarington has decided to reduce the monthly distribution, again, to $0.038 per unit effective June 28, 2013 (down from $0.051 monthly per unit). They are blaming the “flat markets” since 2010 as the primary reason for this action. I’d love to hear your thoughts on this fund.

The negative side of compounding

I continue to be amazed by some of these products that pay out fat monthly cash amounts.  I know of this fund but have not followed it closely.  When I first looked it up in response to Derek’s note, the sub-$4 unit price prompted me to double check to make sure I had the right fund.

But such is the (negative) power of overdistributing – particularly in a volatile fund.  IA Clarington Canadian Dividend is entirely invested in stocks (unlike the many others I have reviewed and analyzed, which were balanced funds with stocks and bonds).

Distribution sustainability

Based on this fund’s May 22, 2013 unit price of $3.91, the new level of distributions that Derek notes equates to 11.66% per year (i.e. $0.038 x 12 / $3.91).  And that’s net of the fund’s 2.76% management expense ratio (i.e. MER).  Add 2.76% to annualized net payout and you have a fund that needs to kick out returns of almost 15% annually just to support the distribution and keep the unit price from falling more than it has.

Simplistically you might calculate this required return as 11.66% + 2.76% to arrive at a required return of 14.42% per year.  But a fund’s annual fees (i.e. MER) have a compounding effect.  So the calculation should be 1.1166 x 1.0276 – 1, which equals a return of 14.74% per year needed to support the distribution – before fees.

I always put the required return in a pre-MER context so that it can be cleanly assessed and compared against other funds offering a monthly cash payout.  In this case, it’s helpful to note that based on current stock valuations, a long-term future return of 7% to 8% annually isn’t out of the question (before any fees, taxes or valued added – or detracted – from active management).  But it’s far from a sure thing.

Great expectations

In order for this fund to support its new, lower distribution the fund’s lead manager will have to:

  • capture the stock market’s full return potential; and
  • add an enormous amount of value on top of the market’s return (effectively doubling the market).

The chances of that happening are unlikely in my opinion.  Accordingly, look for this fund to require another distribution cut within a year or two – a timeline that can be shortened or lengthened by the market’s direction over the next 12-24 months.  This analysis should be of particular interest to anyone using this fund’s distribution to pay for lifestyle expenses or as a key investment in a leveraging strategy.