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In exchange for getting a higher yield now, investors sacrifice some – or all – unit price appreciation over the long run.
In exchange for getting a higher yield now, investors sacrifice some – or all – unit price appreciation over the long run.

investor clinic

Is my ETF’s yield too good to be true? Add to ...

I bought the iShares Canadian Financial Monthly Income ETF (FIE-T) largely for the yield of more than 7 per cent. I keep thinking of the warning “if it seems too good to be true, it probably is,” but I guess my greed overcame my fear. The fund’s MER is high – 0.85 per cent – but I’ll forgive them for that if they keep the yield flowing. What do you think?

I chose this reader’s e-mail because it illustrates a problem I see frequently: Some investors are so blinded by yield that they ignore everything else – even their own better judgment. In this case, the reader knows the yield may be “too good to be true,” yet he can’t help himself and is even willing to overlook the ETF’s unusually high management expense ratio (MER).

The investment industry understands the intoxicating effect that a high yield can have, which is why these sorts of products exist. So let’s dig a little deeper into FIE to understand why, when a yield seems unrealistically high, it pays to be skeptical.

According to FIE’s website, the ETF’s investment objective is to “maximize total return and to provide a stable stream of monthly cash distributions.” The ETF’s list of holdings includes Canadian banks, insurers, asset managers and real estate investment trusts, plus exposure to preferred shares and corporate bonds through two other iShares ETFs. The fund’s “distribution yield,” as of Oct. 11, was 7.26 per cent.

Right away, a yellow flag should go up. Canadian banks and insurance companies generally yield between 3 per cent and 5 per cent, and the REITs and preferred shares in the fund yield, on average, about 5 per cent to 6 per cent. How is the fund able to distribute more than 7 per cent?

You won’t find the answer on the ETF’s main web page. You have to click through to a PDF of the prospectus where, on page 46, you’ll find the following:

“If FIE’s net income and net realized capital gains in a year are insufficient to fund the regular distributions [of 4 cents a month or 48 cents annually], the balance of the regular distributions will constitute a return of capital to unitholders.”

Aha! Return of capital, or ROC, is the portion of a distribution that doesn’t consist of dividends, interest or capital gains triggered by the sale of securities. In FIE’s case, ROC represents a huge part of the fund’s distribution – about 35 per cent in 2015, 52 per cent in 2014 and 66 per cent in 2013. Again, you have to dig for this information, which can be found under the “distributions” tab using the “calendar year” and “table” views.

Now we know how FIE is generating that juicy yield of more than 7 per cent: it’s giving back a portion of unitholders’ capital in the fund. This is cash that would otherwise remain invested in the fund’s securities to grow and generate more income.

Skill-testing question: How do you suppose all of those hefty ROC distributions have affected FIE’s unit price over the years? Well, on the fund’s inception date of April 16, 2010, FIE closed at $7.10. On Friday – 6 1/2 years later – the units closed at $6.65. So, an investor who held the units since the beginning would have collected the monthly distribution but taken a loss on the unit price.

If the investor were to sell the units today, however, he or she would still likely have to report a capital gain. That’s because ROC distributions – while not taxed immediately – are subtracted from the adjusted cost base of an investment for the purposes of calculating capital gains or losses.

The lesson here is that ROC is not a free lunch. In exchange for getting a higher yield now, investors sacrifice some – or all – unit price appreciation over the long run. This isn’t necessarily a bad thing; some retirees, for example, might need the cash flow now and don’t mind dipping into their investment capital to get it. For these people, mutual funds or ETFs that pay a fixed monthly distribution that includes ROC can be an acceptable solution.

The problem is that many investors don’t take the time to understand where their distributions are coming from. If you own a fund whose yield seems too good to be true, chances are you are paying for that yield out of your own capital without even realizing it.

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Follow on Twitter: @johnheinzl

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