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Unhappy business woman at a computer. (brian goodman/Getty Images/iStockphoto)
Unhappy business woman at a computer. (brian goodman/Getty Images/iStockphoto)

Wealth Steward

Leveraging + high payout funds = unhappy ending Add to ...

The final chapter to the series of articles I've written this year on high-payout investments funds features leveraging. Over the past few years, I have been contacted by several individual investors and financial advisors about strategies they've been proposed or have seen in use involving borrowing to invest in funds that pay out fat monthly distributions. Every inquiry I received described a troubling and strikingly similar plan.

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The strategy Each case involved an investor setting up a line of credit secured by available home equity. The proceeds from the line of credit would be used to invest in one or more T-series or other funds paying out large monthly distributions. Then, the investor would take the distributions in cash - mostly made up of return of capital - either for personal spending or to put toward the investment loan.

After some undefined period of time, the expectation is that the remaining investments (i.e. net of cash distributions) would be sufficient to wipe out the loan balance, with hopefully something extra to add some jingle to the investor's jeans.

Investment risk In my recent article about the BMO Monthly Income Fund, I took exception with its two-fold objective of providing investors with monthly cash flow and the potential of capital appreciation. I argued that the fund handed investors so much of that monthly cash flow that it left no room for its secondary objective of capital appreciation. Accordingly, its unit price had fallen over the past dozen years. Here's a hypothetical example to explain how this works.

Consider a stock mutual fund with a target return of 12 per cent per year. Net of the fund's 2.5 per cent management expense ratio, the target return is 9.2 per cent annually. Let's give the fund the benefit of the doubt and assume that it hits its target.

There are two ways in which this net return can be 'delivered' to fund investors - i.e. in the form of cash distributions or as a rising unit price. In any case, the total of distributions paid and price changes have to add up to 9.2 per cent annually.

So if this hypothetical fund pays out all of its total return - 9.2 per cent - in the form of monthly cash payouts, the unit price will be flat over time and cannot grow. In other words, if this fund's distribution is taken in cash, the money that remains invested won't grow. And if the fund earns 'only' 7 per cent or 8 per cent net of fees, then the unit price will take a one-way trip south. You either get a high 9.2 per cent annualized monthly cash payout or you get a 9.2 per cent rise in price but you can't get both.

If investing in such funds with borrowed money, what you do once that distribution lands in your bank account is very important. If the distribution goes to personal spending, the remaining investment is unlikely to be able to keep pace with the loan plus interest.

If, however, the distributions are used to pay down the loan then your chances of success improve. Still, if you happen to be in a fund with a falling unit price, you could end up with a remaining investment value that is falling along with the loan balance. Even this scenario doesn't result in the happiest ending.

Unfortunately, the tax side of this strategy can get ugly.

Tax risk Canada Revenue Agency generally allows individuals to deduct interest paid on money borrowed to invest in stocks, bonds and/or mutual funds holding the same. The test for deductibility requires that borrowed funds be used for income-producing purposes. If an investor borrows money to invest in a T-series or high payout fund, interest costs should generally be deductible.

While distributions made up of taxable income can be taken in cash without any tax consequence, the same is not true of return-of-capital (RoC) distributions. CRA views RoC cash distributions (i.e. not reinvested) no differently than a withdrawal of principal or the sale of fund units. And given CRA's fondness of paper trails, they will only allow you to continue deducting interest tied to that 'withdrawn' portion if it continues to be used for income-producing purposes.

CRA does not consider paying down a loan - even an investment loan - to be an income-producing use. And personal spending certainly doesn't qualify.

So spending every monthly RoC cash payout or applying it to the loan makes a proportionate amount of the interest cost non-deductible. The larger the proportion of non-deductible interest, the higher the after-tax cost of the loan. And I already showed how the investment remaining net of the cash distribution is unlikely to grow, resulting in a squeeze at both ends.

Failing to deduct the proper interest expense and/or failing to keep proper records could add up to a giant tax headache.

Summary I'm no fan of leveraging but it can work well if it's done judiciously (e.g., in the midst of a bear market). And it's best suited to otherwise debt-free investors with plenty of excess cash flow - enough to comfortably continue paying principal and interest even with sharp spikes in interest rates.

But the above-noted strategy that I've heard so much about strips the investment of its most powerful force - i.e. compounding reinvested distributions - while jacking up the cost of the loan. And that's a leveraging strategy that seems destined to end badly.

Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.

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