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Investor Education John Heinzl: Why this Income Fund’s high payout isn’t a free lunch for investors

What do you think of the Canoe EIT Income Fund (EIT.UN)? It pays a very good yield of 10.4 per cent.

When an investment pays a double-digit distribution, it’s imperative to dig deeper. If you go to Canoe EIT Income Fund’s website and look under “asset mix," you’ll see that nearly 70 per cent of the fund’s assets consist of Canadian and U.S. equities. The rest is largely cash and international stocks.

You might well ask: How can a fund can pay a distribution of more than 10 per cent when the assets it owns don’t yield anything close to that? To find out, let’s look under “tax information” on the fund’s website.

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In 2018, the closed-end fund distributed 10 cents a month, or $1.20 in total. Of that, just 4.7 per cent consisted of eligible dividends, 48.7 per cent was realized capital gains and the remaining 46.6 per cent was return of capital, or ROC.

ROC is defined as the portion of a distribution that does not consist of dividends, interest or realized capital gains. A small amount of ROC is usually no cause for concern. But when ROC gets very large, it can exert a drag on a fund’s unit price. If you look at a long-term chart of EIT.UN you’ll notice that the units, which closed Friday at $11.52, are trading below their market price of more than $12 five years ago. So, yes, investors have collected a juicy distribution, but they have effectively subsidized that high yield with a falling unit price.

It’s worth noting that this erosion happened during a strong period for markets – especially U.S. markets. In other words, even with the wind at its back, the fund’s total return – from dividends, interest, realized and unrealized capital gains – wasn’t enough to cover the $1.20 distribution. What will happen if markets produce only modest returns – or, worse, fall?

“In theory, it’s possible that the fund performs well enough to keep this payout going. But it’s highly unlikely in my opinion,” said Dan Hallett, vice-president and principal of HighView Financial Group.

Because the fund has a management expense ratio of about 1.6 per cent, to fully cover its 10.4-per-cent distribution, it has to generate a total return, before fees, of about 12 per cent, Mr. Hallett said. “The question is really whether the fund can generate that level of total returns to sustain the distribution, and I don’t believe that it can,” he said.

Rob Taylor, manager of the Canoe EIT Income Fund, disagrees. The fund has paid a 10-cent monthly distribution since 2009 and he says he is confident that it can continue to do so. He pointed to the fund’s annualized total return of 11.5-per-cent, after fees, for the 10 years ended March 29. “There’s no reason for us to believe that, based on our process, that we shouldn’t be able to achieve the same returns that we have historically on a go-forward basis,” he said.

Still, Mr. Hallett noted that, if the fund’s unit price continues to decline, it will get even harder to cover the distribution. That’s because, as the unit price falls, the distribution yield goes up. Mr. Hallett has seen this pattern before: Several years ago, for example, he correctly predicted that the BMO Monthly Income Fund would have to cut its distribution.

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With $1.46-billion in assets under management, Canoe EIT Income Fund is certainly popular with investors. But if you are tempted by the fund’s 10.4-per-cent payout, just remember that a big chunk of it is coming from investors’ capital and there are no guarantees the lofty distribution will be sustained over the long run, especially if markets become less hospitable.

E-mail your questions to jheinzl@globeandmail.com.

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