A popular investment product these days is the Income Fund. An income fund is a mutual fund that is structured to provide regular income, typically monthly. An example would be Canada’s largest mutual fund in the Canadian Dividend and Equity Income category: RBC’s Canadian Dividend Fund Series T8, which pays a target distribution of eight per cent.
When compared to other income-oriented investments, this seems quite attractive.
Consider for example the iShares Dividend Aristocrat’s Index ETF: an exchange traded fund that tracks an index entirely comprised of Canadian companies that pay dividends, and have increased their dividends five years in a row. Currently this ETF features a 12-month trailing yield of 3.27 per cent.
Or there is the Raymond James Dividend Plus Guided Portfolio, consisting of 17 Canadian stocks, all of which pay dividends. Currently the portfolio yields 3.48 per cent.
When you consider that all three investments have similar mandates, and in fact have many of the same underlying investments, how is it then that the income fund pays so much more.
There is a simple answer. In the case of the mutual fund, the eight per cent is a distribution yield (not a dividend yield). The fund does earn dividends, but not at eight per cent. To be precise, in 2013 the fund’s dividend yield was 1.5 per cent.
So with a distribution that came in at 8.2 per cent, where did the remaining 6.7 per cent come from? Return of capital, as it happens. In other words, investors were paid back their own money.
This can be a good thing, and here is why: Return of Capital is not taxed. So by keeping the dividend yield low, the amount of tax that will need to be paid is also low. This does create a deferred tax liability, but in some cases it is worth it.
However, it is a double-edged sword: the more you withdraw over and above the dividend yield, the more you rely on a rising market to make up for what you withdraw. When you consider that fees also need to be covered, an eight per cent distribution is not easy to maintain. If you are intent on keeping your principal in-tact, consider the following options:
• Opt for a lower distribution. The above-mentioned fund, for example, also has a five per cent option. There will still be down years. But in the long run, a five per cent distribution will be more sustainable.
• Invest in a portfolio of dividend-paying stocks, and only take the dividend income. The underlying stocks are likely to rise in value over time, as are the dividends. Your income will start lower, but will increase from year to year.
— For more on this topic and which approach is best for you, free to call Jim at 250-594-1100, or e-mail email@example.com. The views of the author do not necessarily reflect those of RJL. This article is for information only. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds and other securities are not insured nor guaranteed, their values change frequently and past performance may not be repeated. Raymond James Ltd., member-Canadian Investor Protection Fund.