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Monthly income funds are a hit with investors, and it's easy to see why: They provide a one-stop solution for folks seeking diversification, low fees and – most important – a juicy income stream.

No wonder Canadians have parked more than $25-billion in the Big Five banks' monthly income funds, some of which sport yields that are higher – in some cases a lot higher – than they can get from individual stocks or bonds.

But here's something they may not realize: In some cases, the reason yields are so high is that the funds are paying investors with their own money.

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Let's look at an example. The BMO Monthly Income Fund pays a fixed monthly distribution of 6 cents a unit, or 72 cents annually. Based on the fund's Oct. 17 price of $7.57, that implies a yield of about 9.5 per cent.

Sounds pretty good – until you consider that the fund posted an average return of just 3.1 per cent for the five years ended Sept. 30. A skeptical investor might well ask how the fund can afford to pay such a hefty distribution. Answer: By giving investors their own money back.

Accountants call it return of capital (ROC), and here's how it works: When the fund's fixed distribution exceeds the amount of interest, dividends and realized capital gains generated by its investments (after all fees are paid), it makes up the difference with ROC.

ROC isn't necessarily bad. In some cases it may be supported by capital gains the fund hasn't yet realized. It also has certain tax advantages. However, if a fund consistently distributes more than its total return from interest, dividends and capital gains (realized or not), the fund's net asset value – and the investor's capital – will gradually be eroded by ROC.

"Do I think it's a problem? Yeah, I do," said David O'Leary, director of fund analysis at Morningstar Canada. "I don't think the average investor understands" that when a yield is exceptionally high, the fund may be recycling their own money back to them.

ROC could become an even bigger factor in the future. With bond yields at rock-bottom levels, some funds may find it increasingly challenging – if not impossible – to cover their lofty distributions from portfolio returns alone.

Let's go back to the BMO Monthly Income Fund for a moment. Taking into account its management expense ratio (MER) of 1.57 per cent, the fund would have to make more than 11 per cent, before the MER, to generate a net return of 9.5 per cent to cover its distribution. But given the fund's conservative asset mix of roughly half equities and half fixed-income and cash, that seems unlikely.

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According to Mr. O'Leary, if we assume (generously) that the bond component will earn 5 per cent, before fees, the equity component would need to appreciate by more than 16 per cent annually.

"That's a very aggressive expectation," he said. "Stocks may very well generate that type of return in any given year but I haven't seen any experts who would predict that type of return consistently over the long term."

To take a less extreme case, the CIBC Monthly Income Fund yields 5.7 per cent. To generate the required gross return of about 7.15 per cent, before the fund's MER of 1.45 per cent is deducted, the equity portion would have to appreciate by nearly 10 per cent annually – far from a slam dunk in these uncertain times.

Not all funds push the envelope with distributions. The TD Monthly Income Fund, for example, yields a modest 3 per cent and aims to cover its payout – which it adjusts periodically based on market conditions – with interest and dividends. Funds from Royal Bank and Bank of Nova Scotia have slightly higher yields.

For its part, BMO says it has no plans to cut the fund's distribution.

"Our objective with that fund is to provide a stable, predictable cash flow to our investors so they know how much they're going to be getting each month so they can meet their monthly living expenses," said Mark Stewart, director of product development and management with BMO Investments. "My gut feel is we will stay the course."

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BMO can maintain the 6-cent monthly payout, he said, because more than 80 per cent of unitholders reinvest their distributions in more units, leaving plenty of money for those who want their payments in cash.

None of this is to suggest that if you own the BMO fund, you should rush out and sell it. I own the BMO, TD and RBC funds, and I'm not bailing. These are perfectly good funds, and if you reinvest your distributions, your capital won't be eroded by ROC.

But if you take your distributions in cash and the yield seems exceptionally high, just remember that you may be paying for that extra juice out of your own pocket.

"Whether it's a mutual fund, stock, bond or an investment scheme your friend tells you about, if the yield is so much better than anything else you've heard of, you have to wonder why," Mr. O'Leary said.



Read more of Globe Investor's 29 Ways in 29 Days to be a better investor

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