A while ago, i was asked by a regulator to speak to its enforcement staff about T-series mutual funds, which pay investors generous monthly cash distributions. The regulator wanted an independent view on product mechanics, common uses and risks, and was particularly interested in my thoughts on leveraging.
I happily obliged, ending my talk with a firm recommendation:
If I were the chief compliance officer of a dealer, I would not allow any T-series fund sales that involved: borrowing to invest in funds that have a policy to pay distributions exceeding pure yield; taking the mostly "return of capital" (RoC) distribution in cash; and using that cash to pay down the loan. Here's my reasoning:
- suitability. Borrowing is suitable for those who have taken full advantage of RRSPs and tax-free savings accounts and who have ample cash flow to fund multi-year loan payments even if interest rates rise significantly. Relying on fund distributions to service the loan signals a lack of suitability.
- investment risk. Some T-series funds simply pay out portfolio income. In theory, borrowing to buy such funds is fine, but this breed of T-series funds is in the minority. Most either set distributions at roughly the portfolio's expected total return (income plus expected capital appreciation) or at unsustainably high levels regardless of return potential.
These latter two contingents pose the highest risk. If a fund pays out 100% or more of its total return, the remaining capital will stay level or drop over time. This robs investors of the opportunity to benefit from compounded growth, which is key to successful leveraging.
- tax risk. The Canada Revenue Agency does not consider paying down interest and/or principal to be an "income-producing use" of capital - even on an investment loan. So, every time an RoC distribution is taken in cash to service an investment loan, a proportional amount of the loan interest ceases to be deductible. This raises the loan's true after-tax cost. But a real tax risk exists, to the extent that this is not accurately tracked and reported on client tax returns.
- the numbers. Suppose a client borrows $100,000 on an interest-only line of credit charging 3.5% annually to invest in a fund that pays out 10% annually (90% of which is RoC) while generating a constant total return of 8% per annum. I'm being very generous: healthy returns, no bear market or volatility, no rate hikes. And yet, after seven years, the client's net after-tax benefit is a mere $10,542.
After seven years, the fund is worth $81,023, net of cash distributions, which has reduced the loan to $48,835. But profits are squeezed considerably by taxes on a bit of income, declining interest deductibility and taxes on redemption. It would take more than a dozen years for the distributions to pay off this hypothetical $100,000 loan - for a net, after-tax benefit of $21,778.
Although benefits of $10,000-$20,000 are not insignificant, they seem insufficient after so many years and the potential downside. A rate hike, bear market or distribution cut could easily put this investment into the red. The chances of success are lean, the potential gain is small and the downside is huge.
And given that so many of the Mutual Funds Dealers Association Canada's settlements involve this kind of leveraging strategy gone terribly wrong, it's time to put a stop to it.
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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