This week the Globe and Mail's John Heinzl took another run at a favourite fund of mine - BMO Monthly Income. It's not my favourite fund for investment but rather a favourite to write about. In his recent article, Mr. Heinzl points out that the fund's hefty monthly cash payout - now equal to more than 9.5 per cent annualized net of fees - has been well above the fund's longer-term returns.
Earlier this year, I tested the BMO Monthly Income's distribution for sustainability. I found that since the managers would have to generate more than 17 per cent annually from its stock picks that the distribution would either need to be cut or risk further eating into the fund's principal. In Mr. Heinzl's article, BMO notes that 80 per cent of investors reinvest this fund's distributions.
Cash distributions
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The BMO stat that only 20 per cent of investors take this distribution in cash is important because it says that most of the fund's investors don't need to worry about the fund's ability to keep up its payout. What's interesting, however, is if we look at the percentage of total distributions, in dollar terms, that were reinvested in the fund's recent financials, we see that only about 67 per cent were reinvested. Accordingly, about 33 per cent of this fund's distributions were taken in cash last year. That's more worrying given the situation.
(Note: I calculated these figures from the fund's Statement of Changes in Net Assets which are available on BMO's website for the six months ending March 31 and the years ending Sept. 30 for 2009 and 2010.)
Sustainability update
With nearly one-third of distributions having been taken in cash since 2008, sustainability is a legitimate concern generally and a big concern for any investor relying on this fund's fat payout to pay living expenses.
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BMO insists the payout is sustainable, an assertion they base on the fund's net inflows. Indeed, while the fund has spent its last two full fiscal years in net redemptions, reinvested distributions have generally kept more money flowing into the fund than leaving. The only exception so far was 2008, when the fund saw net redemptions of $436-million including reinvested distributions. But this speaks only to the mechanics of where the money comes from.
When I mention "sustainability" in this context, I'm speaking to the fund's potential to support the payout with a sufficiently high total return. And on that basis, there are good reasons to continue questioning its sustainability.
In Mr. Heinzl's article, a back-of-the-envelope calculation indicated that the fund's stocks would need to generate returns north of 16 per cent annually before fees. That's high enough to question long-term sustainability, but my current calculation - based on Oct. 19 data - suggests that the fund's stocks must pump out returns north of 19 per cent annually (before fees) to maintain the distribution without further eroding the unit price.
BMO certainly can continue to use overall net inflows as a source of cash to pay distributions. However, the longer-term performance required to fully support the distribution with the fund's total return is questionable at best. I expect that BMO will have to cut its distribution at some point, which will be a shock to those using this fund's payout to pay their bills.
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Suitability
Let's turn the focus to the way this fund is marketed to the general public. BMO offers user-friendly profiles of its all of its funds, including the Monthly Income Fund. The profile contains a section called Who should buy this fund? It reads:
Consider this fund if:
- you want regular monthly cash flow with the potential for capital gains
- you're comfortable with low to medium investment risk
- you plan to hold this investment for the medium to long term
That first point jumps off the page. This fund has been around for more than a decade. And for any investor who bought this in the prior century and took the fund's offered "regular monthly cash flow" there has been a long-term capital loss.
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Here's another math lesson: If the unit price falls while the distribution remains unchanged, the distribution rate rises. As the distribution rate rises, the total return required to support the distribution rises in lock-step.
A fund's total return is basically the combination of any cash paid out plus (minus) any rise (fall) in the price. Over the past dozen years, BMO Monthly Income's unit price has fallen because its total return has been less than its its cash payouts. My sustainability test suggests the future will be no different - I expect its long-term total return to fall short of its current rate of distributions.
It is misleading, then, to tell investors to expect any potential for capital growth over and above the "regular monthly cash flow" when that hasn't happened in the past 12 years and isn't likely to occur in the long-term future.
Editor's Note: BMO Monthly Income fund's monthly cash payout has been well above the fund's longer-term returns. An earlier version of this article stated the opposite. This version has been corrected.
Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com. He has spent more than a dozen years doing research on investment funds, portfolio managers and financial markets. Formerly the president of Dan Hallett and Associates Inc. in Windsor, he is now responsible for manager research, portfolio construction and investment program design at HighView. Mr. Hallett has a Bachelor of Commerce degree from the Odette School of Business at the University of Windsor.