Can you imagine buying into an income fund that pays over 9 percent? In today's market? That's what the BMO (formerly Bank of Montreal) paid last fall. From the Globe and Mail (h/t BenS):
The BMO Monthly Income Fund pays a fixed monthly distribution of 6 cents a unit, or 72 cents annually. Based on the fund’s Oct. 17 price of $7.57, that implies a yield of about 9.5 per cent.
How on earth did they manage that? And if it's legitimate, how do I buy into that fund?
Well, they didn't do it by beating market indices, and they didn't do it with judicious management. Here is what they did do:
...[C]onsider that the fund posted an average return of just 3.1 per cent for the five years ended Sept. 30. A skeptical investor might well ask how the fund can afford to pay such a hefty distribution. Answer: By giving investors their own money back. [EE: huh??]
Accountants call it return of capital (ROC), and here’s how it works: When the fund’s fixed distribution exceeds the amount of interest, dividends and realized capital gains generated by its investments (after all fees are paid), it makes up the difference with ROC.
Where does the fund get this capital that it is returning to investors? From the money paid into the fund by investors! The numbers seem based on unrealistic expectations:
Taking into account its management expense ratio (MER) of 1.57 per cent, the fund would have to make more than 11 per cent, before the MER, to generate a net return of 9.5 per cent to cover its distribution. But given the fund’s conservative asset mix of roughly half equities and half fixed-income and cash, that seems unlikely.
... [I]f we assume (generously) that the bond component will earn 5 per cent, before fees, the equity component would need to appreciate by more than 16 per cent annually.
Funds like this seem like group annuity funds more than anything else.... You pay a bunch of money up front to receive a monthly payout that will eventually exhaust your principle. That's what happens when you buy an annuity.
But in this case, it is an entire group of investors who are buying something like a group annuity. The longer the fund can attract new suckers investors, the longer the fund will last, and the longer an initial investor can receive a monthly cheque before the fund folds.
What am I missing? This sounds more like a Ponzi scheme than an income fund.
This type of fund is ridiculous but it's not fraudulent (a la Ponzi/Madoff). Investors are stupid if they don't realize that they're paying hefty fees for the priviledge of having BMO give them their own money back (they're not being given someone else's money in a Ponzi way). Your cost basis is reduced by the return of capital, so that the endpoint is one in which the final distribution delivers whatever remaining capital you have in the fund. Sort of like an amortizing mortgage, but in reverse.
Posted by: KevinT | January 27, 2012 at 12:13 PM
Interesting pov. I think you are missing a great deal. I won't bore you with the details.
The short answer is: The investment can have periods of growth without sufficient income to cover the distributions. No Ponzi scheme. Simple math.
Posted by: Rick | January 30, 2012 at 12:13 AM