The Dangers of Some Income Funds
The dream of many people as they approach retirement age is to derive a safe and steady monthly income from their savings. One fund that seems to fit the bill is the popular BMO Monthly Income Fund that holds nearly $5 billion. However, investors may be in for a nasty surprise.
Let’s start with the positives. This fund has a very nice looking performance chart. Apart from the blip around the end of 2008, it has been on a steady uphill climb. Another great thing is that it has paid a steady monthly distribution of 6 cents per unit per month since the beginning of 2002.
So, what’s not to like? Many people would be surprised to learn that the unit price for this fund has dropped from $9.63 in January 2002 to $7.65 on 2012 March 8. How is this possible? What happened to the nice chart that mostly went up? Well, charts like this assume that distributions are reinvested. If you spend the monthly income, your remaining money does not follow this nice chart. I wonder how many investors mentally double-count the distributions.
What’s worse is that there has been a total of 24% inflation since January of 2002. Overall, the purchasing power of an investment in 2002 has dropped 36%. With the fund yield now at 9.4%, if the distributions stay the same, it is all but certain that investors’ principal will keep dropping at an ever increasing pace. The alternative is to reduce the monthly distributions. Either outcome would be an unwelcome shock to naive investors.
Even though this fund has a respectable 10-year return of 5.58% per year, the monthly distributions have been more than the returns. It is reasonable for people to dip into their principal as they approach end of life, but this should be carefully planned. Naive investors who use this fund from too young an age without understanding the erosion of principal may be in for a shock.
Let’s start with the positives. This fund has a very nice looking performance chart. Apart from the blip around the end of 2008, it has been on a steady uphill climb. Another great thing is that it has paid a steady monthly distribution of 6 cents per unit per month since the beginning of 2002.
So, what’s not to like? Many people would be surprised to learn that the unit price for this fund has dropped from $9.63 in January 2002 to $7.65 on 2012 March 8. How is this possible? What happened to the nice chart that mostly went up? Well, charts like this assume that distributions are reinvested. If you spend the monthly income, your remaining money does not follow this nice chart. I wonder how many investors mentally double-count the distributions.
What’s worse is that there has been a total of 24% inflation since January of 2002. Overall, the purchasing power of an investment in 2002 has dropped 36%. With the fund yield now at 9.4%, if the distributions stay the same, it is all but certain that investors’ principal will keep dropping at an ever increasing pace. The alternative is to reduce the monthly distributions. Either outcome would be an unwelcome shock to naive investors.
Even though this fund has a respectable 10-year return of 5.58% per year, the monthly distributions have been more than the returns. It is reasonable for people to dip into their principal as they approach end of life, but this should be carefully planned. Naive investors who use this fund from too young an age without understanding the erosion of principal may be in for a shock.
As long as you have reinvested your dividends, or have done something constuctive with them (Like buy stocks monthly or maybe purchase another fund) You still have made a return with this fund. You have have y=used the money, it's not like it dissapeared...
ReplyDeleteIf You bought the popular ETF XIU in mid 2006 your price per share value would still be lower today in 2012 then what you bought them for in 2006. If you spent your dividends and did not reinvest them you could say the same thing about this product. Am I wrong?
@Paul: You are not wrong, but people don't buy income funds to reinvest the distributions; they are looking for income to live on. (I prefer not to call them dividends because this is misleading. They contain a significant amount of return of capital.) The danger comes when people believe that their principal is safe and they are just spending the distributions. Savvy investors will be fine, but naive investors who think they can safely spend the distributions indefinitely are in for a surprise.
ReplyDeleteYou make some good points Michael. Many investors are overly-focused on yield and ignore what really matters - "total" returns. You might be interested in this blog on the topic:
ReplyDeletehttp://www.steadyhand.com/personal_investing/2012/03/05/income_gone_wild/
@Scott R: Yes, there is a similar problem with BMO's covered call Canadain banks ETF. Setting aside the question of whether writing covered calls is a good strategy, high distributions mislead naive investors about how much they can safely spend each month.
ReplyDeleteI guess I represent one of the people who re-invest the funds. Not so much with the BMO fund, but with the TD product TDB622. The fund has returned an average of over 8% over for the last ten years.
ReplyDeleteI have had this discussion with many people already. If one can get a return of 8% over that period of time. It's a good fund. Any financial advisor who would promise to make you a better return then that would really be stretching it IMO.
Regardless of it paying a distribution or not it simply takes discipline not to use the distributions for the wrong reasons. I could just as easily sell units every month if I needed money of a fund that has no distributions. That won't help you either, and you would be in the same boat.
To Scott, if the mutual fund industry as a whole didn't have its dark side then maybe people wouldn't be shopping around for other alternatives that give them the impression of monthly gains. People like to see they made $150.00 last month. They don't want to see they made 5.546578 units.
Mutual funds deliberately hide their Fees in such a way making it nearly impossible for people to see ther gains, Fees, and what they invested, clearly separated in $ values. I think people are slowly waking up to this.
These MI funds are simple all in one funds that the average personm can understand. The risk is low being a roughly 60/40 split of equities/bonds etc. There are no ridiculous fees front or back end and and the MER's are reasonable. Their closet index funds with a bond component that pays distributions.
Some people hate em some people love em, but you can do a lot worse then picking one of them.