pen, magnifying glass and financial graphs

This story has been updated.

For diversified monthly-pay ETFs, the balancing act isn’t only about managing the mix of stocks, bonds and other assets. It’s also about deciding how much to distribute to investors, and whether to dip into the original investment.

There are two main approaches to payouts. One is to rely solely on what the portfolio holdings can generate, including capital appreciation. The other approach is to bump up the distributions by, in essence, giving investors their own money back.

The latter is known as return of capital. And while these payments are desirable for investors who want regular and fairly stable monthly payouts, they tend to muddy the waters when it comes to yield comparisons between competing products. Advisors and investors should be aware of the sources of distributions, and whether seemingly generous yields are coming at the expense of shrinking net asset values.

Consider the Purpose Monthly Income Fund, which boasts a lofty 5.7% distribution yield and invests mostly in an actively managed mix of North American and overseas equities and fixed income, complemented by options strategies. Since its inception seven years ago, it has consistently distributed 8.3 cents a month, totalling $1 a year per unit.

However, that’s considerably more than the fund’s total return has been able to support. Looking back on the ETF’s past six full calendar years, according to regulatory filings, return of capital has accounted for anywhere from 56 cents to 85 cents of the fund’s $1-a-year total distributions.

As a result, despite positive investment returns since inception of more than 3% on an annual basis, the fund’s net asset value has shrunk. At a recent $17.45, it’s 13% lower than when first launched at $20 in September 2013. A spokesperson for Purpose Investments said the firm continuously reviews distributions on all relevant funds, but has to date elected not to change it.*

While return of capital isn’t taxed right away, it lowers the adjusted cost base of the investment. This, in turn, represents a potential future tax liability if the ETF is held in a non-registered account.

On a more sustainable path to maintain net asset value is the Vanguard Retirement Income ETF Portfolio, which was launched in mid-September. Toronto-based Vanguard Investments Canada Inc. has targeted a 4% distribution yield for the portfolio, which holds eight broadly based index ETFs and has a 50-50 split between equities and fixed income.

“This ETF was conceived to provide a consistent level of income with a fixed dollar amount not only to retirees, but also any investor looking for income during a low interest rate environment,” says Tim Huver, Vanguard Canada’s head of intermediary sales. Vanguard projects the ETF will generate about 2.4% a year in income distributions, with the remainder of the 4% payout coming from capital appreciation.

“We predict an annual return of 5%, which provides an additional buffer to account for unexpected market events,” Huver says. “The goal of this ETF is to ensure investors have a steady, dependable and long-term income stream without the risk of potentially outliving their savings or significantly reducing their capital.” Return of capital may be paid out “in rare instances” in the event that the ETF is unable to meet the 4% payout, which is subject to review.

A portion of a balanced ETF’s monthly distributions may be in the form of return of capital even if the fund manager isn’t specifically intending to make such payouts. This is the case with the BMO Monthly Income ETF, whose eight underlying ETFs are weighted about 60% in equities and 40% in fixed income.

“We want to pay simply what the underlying investments are yielding,” says Chris McHaney, director and portfolio manager, BMO ETFs, with Toronto-based BMO Asset Management Inc. However, he adds, as a result of covered-call strategies employed by some of the underlying ETFs, portions of the distributions have been deemed to be return of capital.

The reason is that the BMO ETF flows through to investors the premium income generated by the writing of covered-call options. Though these premiums are taxed as capital gains, they can also be used to offset capital losses that may be incurred elsewhere in the ETF’s portfolio. “So that distribution that was already paid becomes a return of capital,” McHaney says.

Since the BMO ETF’s inception in January 2011, return of capital has ranged between one-third of the distributions in one year and less than one-tenth of the total in others.

McHaney estimates that BMO Monthly Income can generate an income yield of a little more than 4%. This is based on its asset mix consisting primarily of dividend-focused common stocks and investment-grade corporate bonds, along with lesser amounts in real estate investment trusts and preferred shares.

“On the equity side, with a dividend-focused mandate, you can achieve about a 5% dividend yield,” McHaney says. “On the fixed-income side, in the corporate bond space, without going into high yield or anything like that, the yields are [about] 3%.” He characterized these yields as sustainable, and suitable for conservative investors who are willing to tolerate some degree of fluctuations in the ETF’s net asset value.

To avoid significant erosion of net asset value, ETF providers may decide to lower the amounts of their fixed distributions. In response to a falling yield environment, Toronto-based BlackRock Asset Management Canada Ltd. did so in 2016, cutting the regular distribution of iShares Diversified Monthly Income ETF to five cents a month, or 60 cents annually, down from 72 cents.

While a predictable income stream is a feature of the iShares ETF, “at the same time it’s important to in the long run preserve the net asset value,” says Steven Leong, BlackRock Canada’s head of ETF product.

Although management seeks to generate a yield that’s about 100 basis points higher than prevailing bond and equity yields in broad markets, Leong adds, this target won’t necessarily drive the monthly payout. “We’re evaluating whether the monthly payout continues to be reasonable in a given year.”

Return of capital constituted 28 cents out of 60 cents of the 2019 distributions, and 25 cents in 2018, but zero in 2017. As is the case with other monthly-pay ETFs, a portion of the return of capital was attributable to offsetting capital losses.

BlackRock will make return of capital distributions in some years to maintain the stability of monthly distributions. But generally, the distribution policy is based on the “economic total return” of the portfolio, which includes capital appreciation as well as dividends and other income.

Based on the recent net asset value of $10.38, the ETF currently has a distribution yield of 5.8%, roughly a couple of percentage points higher than the combined dividend and interest income yield.

Since about half the iShares ETF is held in equities, it’s unsuitable for very risk-averse investors, Leong says. “The sweet spot is for an investor with the monthly income need and the risk tolerance and appetite for a reasonable amount of equity volatility.”

*The original version of the story included a statement from Purpose noting that it was considering lowering the fund’s distribution rate. Purpose has since revised its statement. Return to the revised sentence.