My column last week about mutual funds that distribute more than they make prompted several questions. Today I'll answer a few of them.
When an investment consistently pays out more than its profits, particularly when it's substantially more, isn't that referred to as a Ponzi scheme?
No. They're fundamentally different. In a Ponzi scheme such as the one perpetrated by Bernard Madoff, investors are promised unrealistically high returns. The fraudsters claim to be generating these returns legitimately, when in fact the money is coming from new investors who are recruited into the scheme. The Ponzi organizers also siphon off cash to support extravagant lifestyles.
Eventually the scheme collapses when the perpetrators disappear, the number of new recruits isn't sufficient to sustain the payments or a lot of people try to get their money out at the same time.
With a mutual fund that distributes more than it makes in dividends, interest and capital growth, no money is siphoned off surreptitiously to buy yachts or Ferraris for the fund managers. (The fund charges fees, of course, but those are legal.) Another crucial distinction is that the fund doesn't use other people's money to pay the investor – it uses the investor's own money.
There's nothing illegal about this, but it often comes as a surprise to the investor, which is why it's crucial for people to understand what they're getting into with funds that offer unrealistically high payouts.
Let's look at a hypothetical example. Say you buy one unit of XYZ Fund on Jan. 1, when the price is $10. The fund has a policy of distributing $1 to unitholders every Dec. 31, regardless of how the fund performed in the preceding year. To make things simple, we'll assume XYZ charges no fees and that its investments do not change in value during the year.
On Dec. 31, you would get a $1 distribution. This is $1 more than the fund's total return, which was zero. As a result, the price (or net asset value) of XYZ Fund would fall to $9 to reflect the fact that $1 just went out the door.
You would now have $1 in cash, and one unit worth $9, for a total of $10. Even though you received a distribution, you are no further ahead – or behind – than you were at the start of the year. That's because a portion of your initial investment was simply returned to you.
If a fund distributes more than it makes, where does the cash come from to pay unitholders?
Mutual funds generate cash from dividends and interest, and they keep some money on hand for redemptions and other purposes. Also, because many fund investors reinvest their distributions in additional units, this frees up more cash to pay those who choose to take the money.
How are the distributions treated for tax purposes?
When a fund distributes more than it makes in dividends, interest and realized capital gains, the difference is classified as return of capital (ROC), which is not taxable. Instead, ROC is subtracted from the adjusted cost base of the investment, which affects the capital gain (or loss) when the investment is ultimately sold.
In the example above, if you sold your unit after one year the adjusted cost base would be $9 ($10 purchase price minus $1 in ROC) and the proceeds of the sale would also be $9, for a capital gain of zero.
Where can I look up a fund's ROC?
This information can be found in the annual management report of fund performance, available on sedar.com, or on your T3 slip. Keep in mind, however, that the presence of ROC doesn't necessarily mean that a fund distributed more than its total return for the year. ROC is defined as the portion of the distribution that does not consist of interest, dividends or realized capital gains. But the fund could also have unrealized capital gains. Only when a fund's distributions exceed its total return from all sources will the unit price decline.
The easiest way to see whether this is the case is to compare a fund's total return for a given year to its distributions for the same year. Funds that chronically distribute more than they make will see their unit prices steadily fall.