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This 7-per-cent yield comes with questions Add to ...

Rule One of conservative investing: In a 2- to 4-per-cent world, you can't get 7 per cent without taking on some extra risk.

Rule Two is that some investors will forget Rule One and end up hurting themselves.

So let's have a lesson on the risks of trying to do better than bonds, guaranteed investment certificates and blue-chip dividend stocks using a real-life product called Dividend Select 15. It's a closed-end fund - think of a mutual fund that you buy and sell like a stock - that began trading a week ago on the Toronto Stock Exchange under the stock symbol DS.

Dividend Select 15 holds 15 stocks drawn from a master list of 20 high-yielding, true blue-chip names like Bank of Montreal, Enbridge, Great-West Lifeco, Shoppers Drug Mart Corp. and TransCanada Corp. Dividends paid by these companies will help the fund accomplish its No. 1 objective, which is to make monthly cash payments to shareholders.

The fund will start off by targeting a payout of 5.83 cents a share on a monthly basis, which would produce a yield of 7 per cent based on the issue price of $10.

"It sounds so good on the surface - 7 per cent," said Warren MacKenzie, president and CEO of Weigh House Investor Services. "But then you get into the prospectus and they admit that if you buy the underlying stocks in the fund, the yield is about 4 per cent."

The company behind Dividend Select 15 is Quadravest Capital Management, which was founded in 1997 and describes itself as an independent investment company specializing in "enhanced yield products" for retail investors. Enhanced yield means using financial engineering to, for example, take a portfolio of stocks with a 4-per-cent dividend yield and generate a 7-per-cent return for investors after fees.

Dividend Select 15 uses an established options strategy called covered call writing to generate the additional five percentage points of return necessary to make those payments of 5.83 cents a month and cover fees.. Covered call writing limits your upside gains on a stock, but it also offers the potential to outperform in a slightly rising, flat or falling market. It works best in volatile markets.

Is it feasible to expect Dividend Select 15 to consistently generate the extra returns needed to make its targeted level of cash payouts? For an answer, Mr. MacKenzie consulted an outside money management firm with some expertise in dividend investing.

"They said you can't do that," Mr. MacKenzie said. "There's no way to consistently generate [the extra]5 per cent."

Quadravest thinks its managers can deliver. "I know they'll assess [the payout]each month, but it would be highly unlikely they wouldn't be able to generate enough income," said Shari Payne of Quadravest's investor relations department.

Ms. Payne noted that the fund will use only a limited amount of covered call writing. But at today's volatility levels, she said, the fund could probably generate more income through this strategy than it actually needs to maintain the 7-per-cent yield.

And yet, the prospectus for Dividend Select 15 contains a bold-print warning about the monthly payout: "The amount of the monthly distributions may fluctuate from month to month and there can be no assurance that the Company will make any distributions in any particular month or months."

Take this warning seriously, conservative investors. If the monthly payouts get chopped, the share price will decline, too. An income-producing investment that pays less income is less valuable to investors.

You could argue that the same risks apply to someone who buys one of the quality dividend stocks in the Dividend Select portfolio, or even with a bond. It's rare, but troubled companies can cut or suspend dividends, and they can default on bond payments. Bonds and dividend stocks can fall in price, too, although bonds eventually get redeemed.

Dividend Select 15 is more risky, though. Stocks and bonds are influenced by things we can all watch and more or less understand - the economy, interest rates, conditions in particular industries, the comings and goings of top management, and so forth. With Dividend Select 15, the 7-per-cent income flow is riding on a strategy that is beyond the comprehension of a large number of investors.

This brings us to Rule Three of investing at a time of low interest rates: If you don't understand how a product works, it's not for you.



Chasing Yield

Warren MacKenzie, president and CEO of Weigh House Investor Services, uses a new income producing product called Dividend Select 15 to show the kind of information you should be seeking if you're considering something similar:

What are the fees?

The prospectus lists a management fee of 0.75 per cent, a service fee of 0.4 per cent (goes to advisers who sell the product), plus operating and trading expenses. Figure on an estimated management expense ratio of about 1.5 per cent.

Is the return guaranteed?

Dividend Select 15 is not a principal-protected product.

What can go wrong?

Monthly income can fluctuate or not be paid at all.

What is the compensation to the adviser selling the fund?

Sellers of Dividend Select 15 took 5.25 cents of every $10 invested in the fund when it was issued; there's also the 0.4 per cent service fee.

Can you create something similar on your own?

You can easily buy the stocks in Dividend Select 15 individually; a common dividend fund would likely own many of them, too.

Rob Carrick





Follow on Twitter: @rcarrick

 

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